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First Consulting Group 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549


FORM 10-Q

(Mark One)

 

 

 

 

 

x

 

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

 

 

 

For the quarterly period ended September 29, 2006

 

 

 

OR

 

 

 

o

 

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

 

 

 

For the transition period from               to                   

 

Commission File Number 0-23651


First Consulting Group, Inc.

(Exact name of registrant as specified in its charter)

Delaware

 

95-3539020

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

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

(Address of principal executive offices, including zip code)

(562) 624-5200

(Registrant’s telephone number, including area code)

 

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

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 x No o

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

Large accelerated filer o                                           Accelerated filer x                                            Non-accelerated filer x

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

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

Common Stock, $.001 par value

 

25,752,590

(Class)

 

(Outstanding at October 27, 2006)

 

 




First Consulting Group, Inc.
Table of Contents

COVER PAGE

 

 

 

 

 

TABLE OF CONTENTS

 

 

 

 

 

PART I.  FINANCIAL INFORMATION

 

 

 

 

 

ITEM 1. FINANCIAL STATEMENTS

 

 

 

 

 

Consolidated Balance Sheets

 

 

 

 

 

Consolidated Statements of Operations

 

 

 

 

 

Consolidated Statements of Cash Flows

 

 

 

 

 

First Consulting Group, Inc. and Subsidiaries

 

 

 

 

 

Notes to Consolidated Financial Statements

 

 

 

 

 

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

 

 

 

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

 

 

 

 

 

ITEM 4.  CONTROLS AND PROCEDURES

 

 

 

 

 

PART II.  OTHER INFORMATION

 

 

 

 

 

ITEM 1.  LEGAL PROCEEDINGS

 

 

 

 

 

ITEM 1A.  RISK FACTORS

 

 

 

 

 

ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

 

 

 

 

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

 

 

 

 

 

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

 

 

 

 

ITEM 5.  OTHER INFORMATION

 

 

 

 

 

ITEM 6.  EXHIBITS

 

 

 

 

 

SIGNATURES

 

 

 

 

 

EXHIBIT INDEX

 

 

 

2




Part I.  Financial Information

Item 1. Financial Statements

First Consulting Group, Inc. and Subsidiaries

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

(unaudited)

 

 

September 29,
2006

 

December 30,
2005

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

51,196

 

$

35,106

 

Short-term investments

 

3,009

 

 

Accounts receivable, less allowance of $1,650 and $1,633 as of September 29, 2006 and December 30, 2005, respectively

 

17,828

 

20,993

 

Unbilled receivables

 

15,272

 

12,352

 

Prepaid expenses and other current assets

 

3,444

 

3,532

 

Total current assets

 

90,749

 

71,983

 

 

 

 

 

 

 

Property and equipment:

 

 

 

 

 

Furniture, equipment, and leasehold improvements

 

4,691

 

3,475

 

Information systems equipment and software

 

31,247

 

30,220

 

 

 

35,938

 

33,695

 

Less accumulated depreciation and amortization

 

25,186

 

21,365

 

 

 

10,752

 

12,330

 

 

 

 

 

 

 

Other assets:

 

 

 

 

 

Executive benefit trust

 

10,498

 

10,141

 

Long-term accounts receivable, net

 

2,371

 

1,661

 

Deferred contract costs

 

4,492

 

3,476

 

Goodwill, net

 

18,159

 

18,159

 

Intangibles, net

 

649

 

1,228

 

Other

 

2,908

 

2,654

 

 

 

39,077

 

37,319

 

Total assets

 

$

140,578

 

$

121,632

 

 

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

3




First Consulting Group, Inc. and Subsidiaries

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

(unaudited)

 

 

September 29,
          2006          

 

December 30,
          2005          

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

2,002

 

$

1,685

 

Accrued liabilities

 

3,985

 

5,280

 

Accrued payroll and payroll taxes

 

3,828

 

1,595

 

Accrued vacation

 

6,135

 

7,082

 

Accrued employee benefits

 

2,899

 

2,741

 

Accrued severance

 

16

 

2,813

 

Accrued incentive compensation

 

1,874

 

1,113

 

Customer advances

 

8,818

 

7,201

 

Accrued restructuring costs

 

659

 

3,204

 

Total current liabilities

 

30,216

 

32,714

 

Non-current liabilities:

 

 

 

 

 

Supplemental executive retirement plan

 

9,789

 

10,172

 

Total non-current liabilities

 

9,789

 

10,172

 

Commitments and contingencies

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred Stock, $.001 par value; 9,500,000 shares authorized, no shares issued and outstanding

 

 

 

Series A Junior Participating Preferred Stock, $.001 par value; 500,000 shares authorized, no shares issued and outstanding

 

 

 

Common Stock, $.001 par value; 50,000,000 shares authorized, 25,665,807 shares issued and outstanding at September 29, 2006 and 24,567,759 shares issued and outstanding at December 30, 2005

 

26

 

25

 

Additional paid-in capital

 

97,213

 

91,202

 

Retained earnings (deficit)

 

3,214

 

(12,558

)

Accumulated other comprehensive income

 

120

 

77

 

Total stockholders’ equity

 

100,573

 

78,746

 

Total liabilities and stockholders’ equity

 

$

140,578

 

$

121,632

 

 

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

4




 

First Consulting Group, Inc. and Subsidiaries

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

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September
29, 2006

 

September
30, 2005

 

September
29, 2006

 

September
30, 2005

 

Revenues before reimbursements

 

$

65,238

 

$

72,717

 

$

197,450

 

$

208,780

 

Reimbursements

 

3,326

 

3,887

 

10,596

 

11,321

 

Total revenues

 

68,564

 

76,604

 

208,046

 

220,101

 

 

 

 

 

 

 

 

 

 

 

Cost of services before reimbursable expenses

 

47,044

 

56,073

 

142,723

 

160,398

 

Reimbursable expenses

 

3,326

 

3,887

 

10,596

 

11,321

 

Total cost of services

 

50,370

 

59,960

 

153,319

 

171,719

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

18,194

 

16,644

 

54,727

 

48,382

 

 

 

 

 

 

 

 

 

 

 

Selling expenses

 

4,016

 

7,621

 

12,438

 

21,473

 

General and administrative expenses

 

8,930

 

9,459

 

27,379

 

30,069

 

Income (loss) from operations

 

5,248

 

(436

)

14,910

 

(3,160

)

Other income (expense):

 

 

 

 

 

 

 

 

 

Interest income, net

 

646

 

234

 

1,409

 

674

 

Other income (expense), net

 

653

 

(18

)

640

 

(51

)

Income (loss) from continuing operations before income tax provision

 

6,547

 

(220

)

16,959

 

(2,537

)

Income tax provision

 

458

 

20

 

1,187

 

5,381

 

Income (loss) from continuing operations

 

6,089

 

(240

)

15,772

 

(7,918

)

Loss on discontinued operations, net of tax benefit

 

 

 

 

(537

)

Net income (loss)

 

$

6,089

 

$

(240

)

$

15,772

 

$

(8,455

)

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share:

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations, net of tax

 

$

0.24

 

$

(0.01

)

$

0.63

 

$

(0.33

)

Loss on discontinued operations, net of tax

 

 

 

 

(0.02

)

Net income (loss)

 

$

0.24

 

$

(0.01

)

$

0.63

 

$

(0.35

)

 

 

 

 

 

 

 

 

 

 

Diluted net income (loss) per share:

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations, net of tax

 

$

0.23

 

$

(0.01

)

$

0.62

 

$

(0.33

)

Loss on discontinued operations, net of tax

 

 

 

 

(0.02

)

Net income (loss)

 

$

0.23

 

$

(0.01

)

$

0.62

 

$

(0.35

)

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in computing:

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

 

25,472

 

24,468

 

25,074

 

24,429

 

Diluted net income (loss) per share

 

26,229

 

24,468

 

25,643

 

24,429

 

 

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

5




 

First Consulting Group, Inc. and Subsidiaries

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

 

 

Nine Months Ended

 

 

 

September 29,
2006

 

September 30,
2005

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss):

 

$

15,772

 

$

(8,455

)

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

5,388

 

4,765

 

Intangible amortization

 

579

 

971

 

Provision for bad debts

 

(99

)

336

 

Loss on sale/disposal of assets

 

473

 

44

 

Stock-based compensation

 

629

 

43

 

Interest income on notes receivable – stockholders

 

 

(44

)

Loss on operations of discontinued operations, net of tax benefit

 

 

537

 

Change in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

3,264

 

6,725

 

Unbilled receivables

 

(2,920

)

(4,791

)

Prepaid expenses and other current assets

 

88

 

(3,762

)

Long term account receivable

 

(710

)

2,620

 

Deferred contract costs

 

(1,016

)

(1,310

)

Other assets

 

(397

)

(31

)

Accounts payable

 

317

 

(710

)

Accrued liabilities

 

(1,295

)

243

 

Accrued payroll and payroll taxes

 

2,233

 

72

 

Accrued vacation

 

(947

)

568

 

Accrued employee benefits

 

158

 

1,081

 

Accrued severance

 

(2,797

)

446

 

Accrued incentive compensation

 

761

 

(355

)

Customer advances

 

1,617

 

(1,521

)

Accrued restructuring costs

 

(2,545

)

(1,470

)

Deferred income taxes

 

 

5,361

 

Supplemental executive retirement plan

 

(740

)

419

 

Other

 

(97

)

(154

)

Net cash provided by operating activities of continuing operations

 

17,716

 

1,628

 

Net cash used in operating activities of discontinued operations

 

 

(469

)

Net cash provided by operating activities

 

17,716

 

1,159

 

Cash flows from investing activities:

 

 

 

 

 

Proceeds from sale/maturity (purchase) of investments, net

 

(3,009

)

17,439

 

Purchase of property and equipment

 

(4,358

)

(6,502

)

Net cash provided by (used in) investing activities of continuing operations

 

(7,367

)

10,937

 

Net cash provided by investing activities of discontinued operations

 

 

113

 

Net cash provided by (used in) investing activities

 

(7,367

)

11,050

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of capital stock, net

 

5,465

 

862

 

Collections of loan receivable

 

61

 

39

 

Capital stock repurchase

 

 

(2,530

)

Net cash provided by (used in) financing activities

 

5,526

 

(1,629

)

Effect of exchange rate changes on cash and cash equivalents

 

215

 

(209

)

Net change in cash and cash equivalents

 

16,090

 

10,371

 

Cash and cash equivalents at beginning of period

 

35,106

 

15,012

 

Cash and cash equivalents at end of period

 

$

51,196

 

$

25,383

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information

 

 

 

 

 

Cash paid during the period for interest

 

$

5

 

$

57

 

Cash paid during the period for income taxes, net of refunds

 

$

530

 

$

470

 

Supplemental disclosure of non-cash investing and financing activities

 

 

 

 

 

Release from escrow of common stock to complete acquisition of business

 

$

 

$

900

 

Settlement of officer loan receivable by repurchase of common stock

 

$

82

 

$

67

 

 

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

6




 

First Consulting Group, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

September 29, 2006

Note 1                    Accounting Policies

Basis of Presentation

The accompanying consolidated balance sheet of First Consulting Group, Inc. and subsidiaries (the “Company” or “FCG”) at September 29, 2006 and consolidated statements of operations and consolidated statements of cash flows for the three-month and nine-month periods ended September 29, 2006 and September 30, 2005 are unaudited.  These financial statements reflect all adjustments, consisting of only normal recurring adjustments, which, in the opinion of management, are necessary to fairly present the financial position of the Company at September 29, 2006 and the results of operations for the three-month and nine-month periods ended September 29, 2006 and September 30, 2005.  The results of operations and cash flows for the three-month and nine-month period ended September 29, 2006 are not necessarily indicative of the results to be expected for the year ending December 29, 2006.  For more complete financial information, these financial statements should be read in conjunction with the audited financial statements for the year ended December 30, 2005 included in the Company’s Annual Report on Form 10-K.  Certain reclassifications have been made to the 2005 financial statements to conform to the 2006 presentation.

Principles of Consolidation

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

Revised Presentation of Consolidated Statements of Cash Flow

The Company has stated the operating, investing, and financing portions of the cash flows of discontinued operations as separate lines within each such category for all periods presented, while in prior reports, they were reported on a combined basis.

Revised Presentation of Cost Classification

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

7




Stock-Based Compensation

Restricted Stock

A summary of restricted stock activity for the nine months ended September 29, 2006 is as follows:

 

Shares

 

Weighted Average
Grant Date
Fair Value

 

Balance at December 30, 2005

 

 

 

Grants

 

180,000

 

$

8.49

 

Balance at September 29, 2006

 

180,000

 

$

8.49

 

 

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

Adoption of SFAS 123R

On December 31, 2005, the Company adopted SFAS No. 123 (revised 2004),Share-Based Payment” (“SFAS 123R”) and related interpretations, which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors, including employee stock options, based on estimated grant date fair values.  Previously, the Company elected to account for these share-based payment awards using the intrinsic-value method under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and elected to only disclose the impact of expensing the fair value of stock options in the notes to the financial statements.  Under the intrinsic-value method in APB 25, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date over the amount an employee must pay to acquire the stock.  The Company grants options with an exercise price equal to the market value of the common stock on the date of grant, therefore no compensation expense was recognized related to those options for the nine months ended September 30, 2005.  Further, none of the grants contains any market or company-performance conditions.

The Company adopted SFAS 123R using the modified prospective transition method which requires applying the standard as of December 31, 2005 (“the adoption date”). The modified prospective transition method does not allow for the restatement of prior periods and accordingly, the results of operations for the quarter ended September 29, 2006 and future periods will not be comparable to historical results of operations.  Under this transition method, SFAS 123R applies to new equity awards and to equity awards modified, repurchased, or canceled after the adoption date. Additionally, compensation cost for the portion of awards granted prior to the adoption date for which the requisite service has not been rendered as of the adoption date shall be recognized as the requisite service is rendered. The compensation cost for that portion of awards shall be based on the grant date fair value of those awards as calculated in the prior period pro forma disclosures under SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). Changes to the grant date fair value of equity awards granted before the effective date are precluded.

Upon adoption of SFAS 123R, the Company changed its method of attributing the value of stock-based compensation expense from the multiple-option (i.e., accelerated) approach to the single-option (i.e., straight-line) method. Compensation expense for share-based awards granted through December 30,

8




2005 will continue to be subject to the accelerated multiple-option method, while compensation expense for share-based awards granted on or after December 31, 2005 will be recognized using a straight-line, or single-option method.  The Company recognizes these compensation costs over the service period of the award, which is generally the option vesting term of three to four years.

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

Valuation and Expense Information under SFAS 123R

As a result of adopting SFAS 123R, expense associated with stock-based compensation for the three months and nine months ended September 29, 2006 is $230,000 and $578,000, respectively, which had the effect of reducing basic and diluted earnings per share by $0.01 for the three-month period and $0.02 for the nine-month period.  Stock-based compensation included $187,000 as a component of cost of services, $97,000 as a component of selling expense, and $294,000 as a component of general and administrative expense for the nine months ended September 29, 2006.  In addition, prior to the adoption of SFAS 123R, the Company presented the tax benefit of stock option exercises as operating cash flows.  Upon the adoption of SFAS 123R, tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options are classified as financing cash flows.  For the first nine months of 2006, there were no tax benefits resulting from tax deductions in excess of the compensation cost recognized.  Because the Company maintained a full valuation allowance on its deferred tax assets, the Company did not recognize any tax benefit related to stock-based compensation expense for the nine months ended September 29, 2006.

The Company has historically used the Black-Scholes option pricing model to value its options under SFAS 123, and has elected to continue to do so under SFAS 123R.  The fair value of each option granted during the three months and nine months ended September 29, 2006 was estimated on the date of grant using such model with the following assumptions:

 

Three Months Ended
September 29, 2006

 

Nine Months Ended
September 29, 2006

 

Expected volatility

 

N/A

 

55.0

%

Risk-free interest rate

 

N/A

 

4.9

%

Expected dividends

 

 

 

 

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

9




 

Stock option activity for the nine months ended September 29, 2006 is as follows:

 

Shares

 

Weighted Average
Exercise Price

 

Weighted Average
Remaining
Contractual Life (Years)

 

 

 

 

 

 

 

 

 

Outstanding at December 30, 2005

 

4,665,491

 

$

7.43

 

 

 

Grants

 

560,000

 

$

8.89

 

 

 

Exercised

 

(928,475

)

$

5.95

 

 

 

Cancelled

 

(623,177

)

$

8.82

 

 

 

Outstanding at September 29, 2006

 

3,673,839

 

$

7.78

 

5.73

 

 

 

 

 

 

 

 

 

Exercisable at September 29, 2006

 

2,738,082

 

$

7.88

 

4.72

 

 

As of September 29, 2006, there was $2.3 million of total unrecognized compensation cost related to unvested stock options.  This cost is expected to be recognized over a weighted-average period of approximately 1.5 years.

Pro Forma Information Under SFAS 123 For Periods Prior to 2006

For the periods prior to 2006, the Company elected to apply APB 25 and related interpretations in accounting for its stock-based compensation plans. The following is a reconciliation of net loss per weighted average share had the Company adopted the fair value recognition provisions of SFAS 123 for the three and nine months ended September 30, 2005 (in thousands, except per share amounts):

 

Three Months Ended
September 30, 2005

 

Nine Months Ended
September 30, 2005

 

 

 

 

 

 

 

Net loss

 

$

(240

)

$

(8,455

)

Deduct:Total stock-based employee compensation expense determined under fair value method for all awards, net of tax

 

(147

)

(827

)

Add:Amount of such stock-based compensation expense included in net loss under APB 25, net of tax

 

 

 

Pro forma net loss

 

$

(387

)

$

(9,282

)

 

 

 

 

 

 

Basic and diluted loss per share      As reported

 

$

(0.01

)

$

(0.35

)

                                                        Pro forma

 

$

(0.02

)

$

(0.38

)

 

Basic and Diluted Net Income (Loss) Per Share

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

The following represents a reconciliation of basic and diluted net income (loss) per share for the three months and nine months ended September 29, 2006 and September 30, 2005 (in thousands, except per share data):

10




 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September
29, 2006

 

September
30, 2005

 

September
29, 2006

 

September
30, 2005

 

Income (loss) from continuing operations

 

$

6,089

 

$

(240

)

$

15,772

 

$

(7,918

)

Loss on discontinued operations, net of tax benefit

 

 

 

 

(537

)

Net income (loss)

 

$

6,089

 

$

(240

)

$

15,772

 

$

(8,455

)

 

 

 

 

 

 

 

 

 

 

Basic weighted average number of shares outstanding

 

25,472

 

24,468

 

25,074

 

24,429

 

Effect of dilutive options and contingent shares

 

757

 

 

569

 

 

Diluted weighted average number of shares outstanding

 

26,229

 

24,468

 

25,643

 

24,429

 

 

 

 

 

 

 

 

 

 

 

Basic per share:

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

$

0.24

 

$

(0.01

)

$

0.63

 

$

(0.33

)

Loss on discontinued operations, net of tax benefit

 

 

 

 

(0.02

)

Net income (loss) per share

 

$

0.24

 

$

(0.01

)

$

0.63

 

$

(0.35

)

 

 

 

 

 

 

 

 

 

 

Diluted per share:

 

 

 

 

 

 

 

 

 

Income (loss) from continuing operations

 

$

0.23

 

$

(0.01

)

$

0.62

 

$

(0.33

)

Loss on discontinued operations, net of tax benefit

 

 

 

 

(0.02

)

Net income (loss) per share

 

$

0.23

 

$

(0.01

)

$

0.62

 

$

(0.35

)

 

For the three months ended September 29, 2006 and September 30, 2005, there were 1,288,392 and 5,075,785 anti-dilutive outstanding stock options, respectively, excluded from the calculation of diluted income (loss) per share.  For the nine months ended September 29, 2006 and September 30, 2005, there were 2,003,147 and 5,179,378 anti-dilutive outstanding stock options, respectively, excluded from the calculation of diluted income (loss) per share.

Use of Estimates

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

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

Cash and Cash Equivalents

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

11




 

New Accounting Standards

Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements

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

Fair Value Measurements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which provides guidance for using fair value to measure assets and liabilities.  SFAS 157 will apply whenever another standard requires or permits assets or liabilities to be measured at fair value. The standard does not expand the use of fair value to any new circumstances.  SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.  The Company’s adoption of SFAS 157 is not expected to have a material impact on the consolidated financial statements.

Accounting for Uncertainty in Income Taxes

  In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”).  FIN 48 clarifies the application of SFAS No. 109, “Accounting for Income Taxes”, by establishing a threshold condition that a tax position must meet for any part of the benefit of that position to be recognized in the financial statements.  In addition to recognition, FIN 48 provides guidance concerning measurement, de-recognition, classification, and disclosure of tax positions.  FIN 48 is effective for fiscal years beginning after December 15, 2006 and the Company will adopt FIN 48 in the first quarter of 2007.  Management has not yet determined the impact that FIN 48 will have on its consolidated financial statements or on the effective tax rate in future periods.

Note 2                    Investments

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

Note 3                    Long-Term Receivable

At September 29, 2006, the Company carried $2.4 million in long-term accounts receivable.  Of this amount, $2.2 million represents the discounted value of the deferral of one and one-half month’s revenue on an outsourcing contract which began in August 2005.  This payment has been deferred until the current expiration date of the contract in December 2009.  The receivable was discounted using an interest rate of 7% and the unamortized discount at September 29, 2006 was $555,000.

12




 

Note 4                    Stock Repurchase

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

Note 5                    Goodwill and Intangible Assets

Under SFAS 142, the Company no longer amortizes its goodwill and is required to complete an annual impairment testing which is performed during the fourth quarter of each year.  The Company believes that the accounting assumptions and estimates related to the annual goodwill impairment testing are critical because these can change from period to period.  Various assumptions, such as discount rates, and comparable company analysis are used in performing these valuations.  The impairment test requires the Company to forecast future cash flows, which involves significant judgment.   Accordingly, if expectations of future operating results change, or if there are changes to other assumptions, estimates of the fair value of reporting units could change significantly resulting in a goodwill impairment charge, which could have a significant impact on the consolidated financial statements.  The Company performed an impairment test on each of its components of goodwill as of the fourth quarter of fiscal year 2005 and determined that none of its goodwill was impaired.  As of September 29, 2006, the Company had $18.2 million of goodwill and $649,000 of amortizable intangible assets recorded on its balance sheet.

There were no changes in the net carrying amounts of goodwill for the nine months ended September 29, 2006.  The amounts of goodwill are as follows (in thousands):

 

Health
Delivery
Services

 

Health
Delivery
Outsourcing

 

Life
Sciences

 

Software
Services

 

Total

 

Balance as of December 30, 2005

 

$

3,225

 

$

5,193

 

$

1,481

 

$

8,260

 

$

18,159

 

Acquired

 

 

 

 

 

 

Balance as of September 29, 2006

 

$

3,225

 

$

5,193

 

$

1,481

 

$

8,260

 

$

18,159

 

 

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

 

Customer
Related

 

Balance as of December 30, 2005

 

$

1,228

 

Amortization

 

(579

)

Balance as of September 29, 2006

 

$

649

 

Amortization Period in Years

 

4

 

 

13




 

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

Fiscal Year

 

 

 

2006 (remainder of year)

 

$

193

 

2007

 

456

 

Total

 

$

649

 

 

Note 6                    Restructuring Costs

At September 29, 2006, the Company had approximately $659,000 of restructuring accrual which related to facility closure costs incurred in prior years, primarily in the Life Sciences segment.  In February 2006, the Company signed an agreement with a landlord to return excess space.  As part of the agreement, the Company is making $2.9 million of payments to the landlord in equal installments over the last ten months of fiscal year 2006 in order to extinguish the Company’s obligations under the lease.

The restructuring cost liability activity through September 29, 2006 is summarized as follows (in thousands):

Accrual balance at December 30, 2005

 

$

3,204

 

Cash payments

 

(2,545

)

Accrual balance at September 29, 2006

 

$

659

 

 

Note 7                    Comprehensive Income (Loss)

Comprehensive income (loss), net of taxes, for the three months and nine months ended September 29, 2006 and September 30, 2005, is as follows (in thousands):

 

Three Months Ended

 

Nine Months Ended

 

 

 

September
29, 2006

 

September
30, 2005

 

September
29, 2006

 

September
30, 2005

 

Net income (loss)

 

$

6,089

 

$

(240

)

$

15,772

 

$

(8,455

)

 

 

 

 

 

 

 

 

 

 

Foreign currency translation adjustment

 

40

 

(34

)

50

 

(424

)

Unrealized gain (loss) on investments

 

5

 

14

 

(7

)

13

 

Other comprehensive income (loss), net of tax

 

45

 

(20

)

43

 

(411

)

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

6,134

 

$

(260

)

$

15,815

 

$

(8,866

)

Note 8                    Discontinued Operations

On December 7, 2004, the Company’s Board of Directors approved a plan to sell and exit its clinical and non-clinical Call Center Services (“CCS”) operation due to recurring losses.  On February 2, 2005, the Company executed a definitive agreement with the MPB Group, LLC, d/b/a The Beryl Companies.  FCG received 12 monthly payments of $12,500, totaling $150,000, for selected customer contracts. The disposal plan consisted primarily of the termination of normal CCS activity, calculation of termination benefits for the existing CCS employees, termination of a lease agreement, abandonment of property and equipment, collection of accounts receivable, and settlement of liabilities. In accordance

14




with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” this disposal represents a discontinued operation.

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

Note 9                    Disclosure of Segment Information

For fiscal year 2006, the Company has the following six reportable segments:

·                  Health Delivery Services - the delivery of consulting and systems integration services to health delivery and government clients;

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

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

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

·                  Software Services - the delivery of blended shore software development; and

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

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

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

Due to another organizational change that the Company made which took effect at the beginning of the third quarter of 2006, the Government and Technology Services segment was split.  The Government group has been combined into the Health Delivery Services segment and the remaining segment has been named Software Services.  The history shown in the financial tables included in this note is consistent with this change.

The Company evaluates its segments’ performance based on revenues and operating income.  Certain selling and general and administrative expenses (including corporate functions, occupancy related costs, depreciation, professional development, recruiting, and marketing) are managed at the corporate level and allocated to each operating segment based on either net revenues and/or actual usage.  The

15




Company does not manage or track most assets by segment.  As a result, interest and other charges are not included in the tables below.

The following segment information is for the three months and nine months ended September 29, 2006 and September 30, 2005 (in thousands):

16




For the three months ended September 29, 2006:
(in thousands)

 

 

Health
Delivery
Services

 

Health
Delivery
Outsourcing

 

Health
Delivery
Total

 

Life
Sciences

 

Health
Plan

 

Software
Services

 

Software
Products

 

Other

 

Totals

 

Revenues before reimbursements

 

$

14,171

 

$

26,900

 

$

41,071

 

$

8,152

 

$

8,074

 

$

7,170

 

$

472

 

$

299

 

$

65,238

 

Reimbursements

 

2,078

 

32

 

2,110

 

129

 

916

 

162

 

8

 

1

 

3,326

 

Total revenues

 

16,249

 

26,932

 

43,181

 

8,281

 

8,990

 

7,332

 

480

 

300

 

68,564

 

Cost of services before reimbursable expenses

 

8,299

 

23,307

 

31,606

 

4,121

 

6,087

 

4,579

 

638

 

13

 

47,044

 

Reimbursable expenses

 

2,078

 

32

 

2,110

 

129

 

916

 

162

 

8

 

1

 

3,326

 

Total cost of services

 

10,377

 

23,339

 

33,716

 

4,250

 

7,003

 

4,741

 

646

 

14

 

50,370

 

Gross profit

 

5,872

 

3,593

 

9,465

 

4,031

 

1,987

 

2,591

 

(166

)

286

 

18,194

 

Selling expenses

 

1,642

 

283

 

1,925

 

990

 

562

 

501

 

78

 

(40

)

4,016

 

General & administrative expenses

 

2,602

 

1,878

 

4,480

 

1,815

 

994

 

886

 

207

 

548

 

8,930

 

Income (loss) from operations

 

$

1,628

 

$

1,432

 

$

3,060

 

$

1,226

 

$

431

 

$

1,204

 

$

(451

)

$

(222

)

$

5,248

 

 

For the three months ended September 30, 2005:
(in thousands)

 

 

Health
Delivery
Services

 

Health
Delivery
Outsourcing

 

Health
Delivery
Total

 

Life
Sciences

 

Health 
Plan

 

Software
Services

 

Software
Products

 

Other

 

Totals

 

Revenues before reimbursements

 

$

16,947

 

$

35,265

 

$

52,212

 

$

7,272

 

$

4,938

 

$

6,199

 

$

823

 

$

1,273

 

$

72,717

 

Reimbursements

 

2,497

 

198

 

2,695

 

318

 

701

 

113

 

9

 

51

 

3,887

 

Total revenues

 

19,444

 

35,463

 

54,907

 

7,590

 

5,639

 

6,312

 

832

 

1,324

 

76,604

 

Cost of services before reimbursable expenses

 

11,071

 

31,488

 

42,559

 

4,249

 

3,398

 

3,669

 

898

 

1,300

 

56,073

 

Reimbursable expenses

 

2,497

 

198

 

2,695

 

318

 

701

 

113

 

9

 

51

 

3,887

 

Total cost of services

 

13,568

 

31,686

 

45,254

 

4,567

 

4,099

 

3,782

 

907

 

1,351

 

59,960

 

Gross profit

 

5,876

 

3,777

 

9,653

 

3,023

 

1,540

 

2,530

 

(75

)

(27

)

16,644

 

Selling expenses

 

2,772

 

1,718

 

4,490

 

1,543

 

606

 

533

 

126

 

323

 

7,621

 

General & administrative expenses

 

3,015

 

1,873

 

4,888

 

2,239

 

638

 

937

 

308

 

449

 

9,459

 

Income (loss) from operations

 

$

89

 

$

186

 

$

275

 

$

(759

)

$

296

 

$

1,060

 

$

(509

)

$

(799

)

$

(436

)

 

17




 

For the nine months ended September 29, 2006:
(in thousands)

 

 

Health
Delivery
Services

 

Health
Delivery
Outsourcing

 

Health
Delivery
Total

 

Life
Sciences

 

Health
Plan

 

Software
Services

 

Software
Products

 

Other

 

Totals

 

Revenues before reimbursements

 

$

45,725

 

$

81,113

 

$

126,838

 

$

24,238

 

$

22,307

 

$

20,511

 

$

2,217

 

$

1,339

 

$

197,450

 

Reimbursements

 

6,720

 

101

 

6,821

 

528

 

2,770

 

427

 

39

 

11

 

10,596

 

Total revenues

 

52,445

 

81,214

 

133,659

 

24,766

 

25,077

 

20,938

 

2,256

 

1,350

 

208,046

 

Cost of services before reimbursable expenses

 

27,722

 

70,397

 

98,119

 

13,411

 

15,940

 

12,624

 

2,120

 

509

 

142,723

 

Reimbursable expenses

 

6,720

 

101

 

6,821

 

528

 

2,770

 

427

 

39

 

11

 

10,596

 

Total cost of services

 

34,442

 

70,498

 

104,940

 

13,939

 

18,710

 

13,051

 

2,159

 

520

 

153,319

 

Gross profit

 

18,003

 

10,716

 

28,719

 

10,827

 

6,367

 

7,887

 

97

 

830

 

54,727

 

Selling expenses

 

5,571

 

715

 

6,286

 

2,719

 

1,599

 

1,476

 

319

 

39

 

12,438

 

General & administrative expenses

 

7,613

 

5,711

 

13,324

 

6,052

 

3,111

 

2,444

 

712

 

1,736

 

27,379

 

Income (loss) from operations

 

$

4,819

 

$

4,290

 

$

9,109

 

$

2,056

 

$

1,657

 

$

3,967

 

$

(934

)

$

(945

)

$

14,910

 

For the nine months ended September 30, 2005:
(in thousands)

 

 

Health
Delivery
Services

 

Health
Delivery
Outsourcing

 

Health
Delivery
Total

 

Life
Sciences

 

Health
Plan

 

Software
Services

 

Software
Products

 

Other

 

Totals

 

Revenues before reimbursements

 

$

53,436

 

$

94,660

 

$

148,096

 

$

24,831

 

$

13,069

 

$

16,021

 

$

1,953

 

$

4,810

 

$

208,780

 

Reimbursements

 

7,578

 

568

 

8,146

 

739

 

1,828

 

316

 

62

 

230

 

11,321

 

Total revenues

 

61,014

 

95,228

 

156,242

 

25,570

 

14,897

 

16,337

 

2,015

 

5,040

 

220,101

 

Cost of services before reimbursable expenses

 

34,080

 

84,713

 

118,793

 

13,680

 

9,857

 

9,666

 

2,758

 

5,644

 

160,398

 

Reimbursable expenses

 

7,578

 

568

 

8,146

 

739

 

1,828

 

316

 

62

 

230

 

11,321

 

Total cost of services

 

41,658

 

85,281

 

126,939

 

14,419

 

11,685

 

9,982

 

2,820

 

5,874

 

171,719

 

Gross profit

 

19,356

 

9,947

 

29,303

 

11,151

 

3,212

 

6,355

 

(805

)

(834

)

48,382

 

Selling expenses

 

7,446

 

3,428

 

10,874

 

5,327

 

1,748

 

1,361

 

400

 

1,763

 

21,473

 

General & administrative expenses

 

10,181

 

5,328

 

15,509

 

6,884

 

2,162

 

2,228

 

1,084

 

2,202

 

30,069

 

Income (loss) from operations

 

$

1,729

 

$

1,191

 

$

2,920

 

$

(1,060

)

$

(698

)

$

2,766

 

$

(2,289

)

$

(4,799

)

$

(3,160

)

 

18




 

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

Detail of Health Delivery Outsourcing Revenues

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

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 29,
2006

 

September 30,
2005

 

September 29,
2006

 

September 30,
2005

 

Internally generated revenues

 

$

25,511

 

$

30,165

 

$

76,948

 

$

78,727

 

Subcontractor revenues

 

1,389

 

5,100

 

4,165

 

15,933

 

Revenues before reimbursements

 

$

26,900

 

$

35,265

 

$

81,113

 

$

94,660

 

 

Note 10                  Income Taxes

The Company recorded a $1.2 million tax provision for the nine months ended September 29, 2006 versus a $5.4 million tax provision for the nine months ended September 30, 2005.  The 7% tax provision for the nine months ended September 29, 2006 is for annual estimated current taxes payable for U.S. federal alternative minimum tax and certain state and foreign income taxes, as the Company’s net operating loss carryforwards offset most of the federal and certain state tax liabilities.  The tax provision for the nine months ended September 30, 2005 primarily consisted of a $6.0 million tax asset valuation allowance.  The valuation allowance was recorded as a result of the historical losses the Company had incurred, creating additional negative evidence as to the uncertainty of the Company’s ability to realize its deferred tax assets, as assessed per the guidance of the applicable tax accounting standard, SFAS 109.

Note 11                  Sale of Cyberview

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

Note 12                  Health Plan Outsourcing Contract

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

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

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

Overview

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

We typically bill for our services on an hourly or fixed-fee basis as specified by the agreement with a particular client.  For services billed on an hourly basis, in our consulting and systems integration businesses (“CSI”), fees are determined by multiplying the amount of time expended on each assignment by the project hourly rate for the staff members assigned to the engagement.  Fixed fees, including outsourcing fees, are established on a per-assignment or monthly basis and are based on several factors such as the size, scope, complexity and duration of an assignment, the number of our employees required to complete the assignment, and the volume of transactions or interactions.  Revenues are generally recognized related to the level of services performed, the amount of cost incurred on the assignment versus the estimated total cost to complete the assignment, or on a straight-line basis over the period of performance of service.  Additionally, we have been licensing an increased amount of our software products, generally in conjunction with the customization and implementation of such software products.  Revenues from our software licensing and maintenance were approximately 3.1% of our net revenues in fiscal year 2005 and 4.2% of our net revenues for the nine months ended September 29, 2006.  We expect our software licensing and related implementation revenues to continue to grow incrementally in the near future.

Provisions are made for estimated uncollectible amounts based on our historical experience.  We may obtain payment in advance of providing services.  These advances are recorded as customer advances and reflected as a liability on our balance sheet until services are provided.  Provisions for estimated losses on individual contracts are made in the period in which the loss first becomes known.

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

Cost of services primarily consists of the salaries, bonuses, and related benefits of client-serving staff, subcontractor expenses, and infrastructure costs related to services provided to clients and in our offshore shared service center.  Selling expenses primarily consist of the salaries, benefits, travel, and other costs of our sales force, as well as marketing and market research expenses.  General and administrative expenses primarily consist of costs to support our business such as non-billable travel, internal information systems and infrastructure, salaries and expenses for executive management, financial accounting and administrative personnel, and legal and other professional services.  As staff related costs are relatively fixed in the short term, variations in our revenues and operating results in our

20




CSI business can occur as a result of variations in billing margins and utilization rates of our billable associates.

Our most significant expenses are our human resource and related salary and benefit expenses.  As of September 29, 2006, approximately 1,514 of our 2,612 employees are billable consultants and software developers.  Another 733 employees are part of our outsourcing business.  The salaries and benefits of such billable personnel staff and outsourcing related employees are recognized in our cost of services.  Most non-billable employee salaries and benefits are recognized as a component of either selling or general and administrative expenses.  Approximately 14.0% of our workforce, or 365 employees, are classified as non-billable.  Our cost of services as a percentage of net revenues is directly related to several factors, including, but not limited to:

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

·                  The amount and timing of cost incurred;

·                  Our ability to control costs on our outsourcing projects;

·                  The billed rate on time and material contracts; and

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

In our outsourcing contracts, a significant portion of our revenues are fixed and allocated over the contract on a straight-line basis, as we are required to provide a specified level of ongoing services.  Also, certain revenues may fluctuate under the contracts based on the volume of transactions we process or other measurements of service provided.  If we incur higher costs to provide the required services or receive less revenue due to reduced transaction volumes or penalties associated with service level failures, our gross profit can be negatively impacted.

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

In response to competition and continued pricing and rate pressures, we have implemented a global sourcing strategy into our business operations, which includes the deployment of offshore resources as well as resources that perform services remote from the client site.  We also incorporate larger numbers of variable cost or per diem staff in some of our projects.  We expect these strategies to continue to reduce cost of services through a combination of lower cost attributable to offshore resources and higher leverage of resources that perform services offsite or on a variable cost basis.  To the extent we pass through reduced costs to our clients related to offshore resources, the global sourcing strategy may result in lower revenues on a per engagement basis. However, we expect to offset this potential revenue impact with improved competitive positioning in our markets, which could result in an increased number

21




of engagements to offset the potential revenue impact.  Several of our competitors employ both global sourcing and variable staffing strategies to provide software development and other information technology services to their clients, while at the same time reducing their cost structure and improving the quality of services they provide.  If we are unable to realize the perceived cost benefits of our strategies or if we are unable to deliver quality services, our business may be adversely impacted and we may not be able to compete effectively.

Results of Operations for the Three Months Ended September 29, 2006 and September 30, 2005

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

In Health Delivery Services, net revenues decreased by $2.8 million, or 16.4%, due to lower revenues from our consulting and implementation services.  The lower revenues were attributable to the discontinuation of certain underperforming service lines in late 2005 and a need to restructure our sales model in this area to improve our sales effectiveness.

The most significant offsetting increase in our net revenues was in Health Plan, which increased by $3.1 million, or 63.5%, due to market acceptance of our blended shore delivery model by mid-size and large health plans.  Software Services (formerly named Paragon Solutions, Inc.) revenues increased by $971,000, or 15.7%, due to general growth in providing offshore software development services to independent software vendors.  Life Sciences revenue grew by $880,000, or 12.1%, due to unusual weakness in revenues in that segment during the latter half of 2005.

In March 2006, we received a one year extension of one of our existing major outsourcing contracts, University of Pennsylvania Health System (UPHS), and that contract is now set to expire in March 2007.  We currently receive annual revenues of approximately $24 million from this contract.  We have no assurances that the contract will be extended past the one year renewal period, and UPHS still has the right to terminate the contract for convenience on 180 days notice.  The renewal process is currently being competitively bid and it is anticipated that a vendor of choice decision will be made in the fourth quarter of 2006.  If we are unable to execute a longer term renewal with UPHS or if we are unable to enter into new outsourcing engagements, our Health Delivery Outsourcing revenues would be adversely impacted.  Revenues in our business units other than outsourcing are not expected to change significantly from their levels at the end of the third quarter of 2006, with some modest growth expected to continue in the Health Plan and Software Services segments.  Growth in Health Delivery Services and Outsourcing is highly dependent upon capturing market share through successfully restructuring our selling model and acceptance by the health delivery market of our blended shore delivery model.

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Cost of Services.  Cost of services before reimbursable expenses was $47.0 million for the quarter ended September 29, 2006, a decrease of 16.1% from $56.1 million for the quarter ended September 30, 2005.  The decrease was primarily due to an $8.2 million decline in costs in the Health Delivery Outsourcing segment directly related to the reduction in revenues described above.  Health Delivery Services costs decreased by $2.8 million as we reduced costs in that area, primarily through staff attrition and staff reductions in the fourth quarter of 2005, to improve profitability.  Costs in Health Plan increased by $2.7 million and costs in Software Services increased by $910,000 in order to serve the revenue growth in those segments.

Gross Profit.  Gross profit was $18.2 million, or 27.9% of net revenues, for the quarter ended September 29, 2006, an increase of 9.3% from $16.6 million, or 22.9% of net revenues, for the quarter ended September 30, 2005.  This increase was due to $1.0 million of additional gross profit in the Life Sciences segment due to the revenue increase in that segment, and the margin associated with the revenue increases in the Health Plan segment described above.

Selling Expenses.  Selling expenses were $4.0 million for the quarter ended September 29, 2006, a decrease of 47.3% from $7.6 million for the quarter ended September 30, 2005.  This decrease was primarily due to reductions in the sales force and marketing costs.  Selling expenses as a percentage of net revenues decreased to 6.2% for the quarter ended September 29, 2006 from 10.5% for the quarter ended September 30, 2005 for the same reasons.  We expect to invest increased amounts in sales and marketing costs over the next several quarters, which may affect profitability.

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

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

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

Income Taxes.  We recorded a $458,000 tax provision for the quarter ended September 29, 2006, compared to a $20,000 tax provision for the quarter ended September 30, 2005.  The 7% tax provision for the quarter ended September 29, 2006 was for annual estimated current taxes payable for U.S. federal alternative minimum tax and certain state and foreign income taxes, as our net operating loss carryforwards offset most of the federal and certain state tax liabilities.  The tax provision for the quarter ended September 30, 2005 of $20,000 reflects a minor adjustment to achieve an estimated effective annual tax benefit rate of 24.4% for 2005 (exclusive of a valuation allowance). We continue to expect that our tax provision in fiscal 2006 will remain low, but that our long-term tax provision will return to levels consistent with full federal and state tax rates.

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Results of Operations for the Nine Months Ended September 29, 2006 and September 30, 2005

Revenues.  Our net revenues were $197.5 million for the nine months ended September 29, 2006, a decrease of 5.4% from $208.8 million for the nine months ended September 30, 2005.  Our total revenues were $208.0 million for the nine months ended September 29, 2006, a decrease of 5.5% from $220.1 million for the nine months ended September 30, 2005.  The decreases in net revenues were in Health Delivery Outsourcing and Health Delivery Services, partially offset by increases in Health Plan and Software Services.  The Health Delivery Outsourcing segment had the most significant decrease compared to the nine months ended September 30, 2005, $13.5 million, or 14.3%, primarily due to the termination of two outsourcing contracts at the end of the fourth quarter of 2005.  Outsourcing revenues for the nine months ended September 30, 2005 from the two terminated contracts totaled $34.5 million.  Revenues from two new contracts which began in August 2005 were $22.5 million for the nine months ended September 29, 2006 compared to only two months of revenue recognized of $4.0 million for the nine months ended September 30, 2005.

The net revenues in the Health Delivery Services segment decreased $7.7 million, or 14.4% due to lower revenues from our consulting and implementation services offerings.  The most significant offsetting increase was in Health Plan, which increased by $9.2 million, or 70.7%, due to market acceptance of our blended shore delivery model.  Software Services revenues increased by $4.5 million, or 28.0%, primarily due to general growth in providing offshore software development services to independent software vendors.

Cost of Services.  Cost of services before reimbursable expenses was $142.7 million for the nine months ended September 29, 2006, a decrease of 11.0% from $160.4 million for the nine months ended September 30, 2005.  The decrease was primarily due to a $14.3 million decline in costs in the Health Delivery Outsourcing segment directly related to the reduction in revenues described above.  Health Delivery Services costs decreased by $6.4 million as we reduced costs in that area, primarily through staff attrition and staff reductions in the fourth quarter of 2005, to improve profitability.  Costs in Health Plan increased by $6.1 million and costs in Software Services increased by $3.0 million in order to serve the revenue growth in those segments.

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

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

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

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Interest Income, Net.  Interest income, net of interest expense, was $1.4 million for the nine months ended September 29, 2006, an increase of 109.1% from $674,000 for the nine months ended September 30, 2005, due to higher interest rates earned on higher cash and investments balances.  Interest income, net of interest expense, as a percentage of net revenues increased to 0.7% for the nine months ended September 29, 2006 from 0.3% for the nine months ended September 30, 2005.

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

Income Taxes.  We recorded a $1.2 million tax provision for the nine months ended September 29, 2006, compared to a $5.4 million tax provision for the nine months ended September 30, 2005.  The 7% tax provision for the nine months ended September 29, 2006 was for annual estimated current taxes payable for U.S. federal alternative minimum tax and certain state and foreign income taxes, as the net operating loss carryforwards offset most of the federal and certain state tax liabilities.  The tax provision for the nine months ended September 30, 2005 of $5.4 million primarily consisted of a $6.0 million deferred tax asset valuation allowance.  The valuation allowance was recorded as a result of the historical losses we had incurred, creating additional negative evidence as to the uncertainty of our ability to realize our deferred tax assets, as assessed per the guidance of the applicable tax accounting standard, SFAS 109.

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

Liquidity and Capital Resources

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

Our days sales outstanding (DSO) of accounts receivable was 34 days for the third quarter of 2006, the same as the fourth quarter of 2005.  We expect our DSO to remain at approximately its current level for the near future, subject to routine fluctuations.

 In February 2006, we signed an agreement with a landlord to return excess office space to them.  As part of the agreement, we are required to make $2.9 million of payments to the landlord in equal installments over the last ten months of fiscal year 2006 in order to extinguish our obligation.  These payments are being charged against amounts that have been accrued in prior years for facility closure costs, and thus affect cash flow in fiscal year 2006 without affecting pretax income.  The balance of this liability at September 29, 2006 is $659,000.

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

During the nine months ended September 29, 2006, our cash flow benefited from $5.5 million of stock option exercises, primarily by former employees.

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Further, we used approximately $4.4 million of cash to purchase property and equipment, primarily information technology and related equipment, while incurring $5.4 million of depreciation and amortization.  During the third quarter of 2006, we made commitments of approximately $2 million for leasehold improvements and furniture to move and expand our office in Bangalore, India.  Approximately $800,000 of this capital was spent in the third quarter of 2006, with approximately $1.2 million expected to be spent in the fourth quarter of the year.  Additionally, we expect to incur several months of duplicate rent and a termination fee of approximately $300,000 during the fourth quarter of 2006.

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

Our cash flow in fiscal year 2006 is highly dependent on our ability to continue to be profitable.  Generally, we expect any pretax profitability in fiscal year 2006 to contribute positively to cash flow.  A significant amount of income in 2006 or thereafter (approximately $25 million) is not expected to be subject to federal taxation or require any significant book tax provision in our income statement due to the existence of net operating loss carryforwards.  We continue to expect that our tax provision in fiscal 2006 will remain low, but that our long-term tax provision will return to levels consistent with full federal and state tax rates.

As of September 29, 2006, the following table summarizes our contractual commitments (in thousands):

 

Payments Due by Period

 

Contractual Obligation

 

Less than 1
Year

 

1 -3
Years

 

3-5
Years

 

Total

 

Operating leases, net of subleases

 

$

5,004

 

$

4,992

 

$

1,829

 

$

11,825

 

Purchase obligations

 

1,529

 

412

 

 

1,941

 

Total

 

$

6,533

 

$

5,404

 

$

1,829

 

$

13,766

 

 

Management believes that our existing cash and cash equivalents, together with funds generated from operations, will be sufficient to meet operating requirements for at least the next twelve months.  Our cash and cash equivalents are available for capital expenditures (which are projected at approximately $6 million for 2006), upfront setup costs and deferred fees on new contracts, strategic investments, mergers and acquisitions, and other potential large-scale cash needs that may arise.

We had a revolving line of credit, under which we were allowed to borrow up to $7.0 million at an interest rate of the prevailing prime rate with an expiration of May 1, 2006.  There was no outstanding balance under the line of credit at December 30, 2005.  Due to repeated loan covenant violations related to our quarterly losses in 2005, we elected to discontinue the line of credit during the first quarter of 2006 rather than accept new restrictive conditions to the credit line which were proposed by the bank.

Critical Accounting Policies and Estimates

The foregoing discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, cost to complete client engagements, valuation of goodwill and long-lived and intangible assets, accrued liabilities, income taxes, restructuring costs, idle

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facilities, litigation and disputes, and the allowance for doubtful accounts.  We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources.  Our actual results may differ from our estimates and we do not assume any obligation to update any forward-looking information.

We believe the following critical accounting policies reflect our more significant assumptions and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition and Unbilled Receivables

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

Revenues from time-and-materials arrangements are generally recognized based upon contracted hourly billing rates as the work progresses.  Revenues from level-of-effort arrangements are recognized based upon a fixed price for the level of resources provided.  Revenues from fixed fee arrangements for consulting and systems integration work are generally recognized on a rate per hour or percentage-of-completion basis.  We maintain, for each of our fixed fee contracts, estimates of total revenue and cost over the contract term. For purposes of periodic financial reporting on the fixed price consulting and system integration contracts, we accumulate total actual costs incurred to date under the contract. The ratio of those actual costs to our then-current estimate of total costs for the life of the contract is then applied to our then-current estimate of total revenues for the life of the contract to determine the portion of total estimated revenues that should be recognized.  We follow this method because reasonably dependable estimates of the revenues and costs applicable to various stages of a contract can be made.

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

We account for certain of our outsourcing contracts using EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” which addresses how to account for arrangements that involve the delivery or performance of multiple products, services, and/or rights to use assets.  Revenue arrangements with multiple deliverables are divided into separate units of accounting if the deliverables in the arrangement meet the following criteria: (1) the delivered item has value to the customer on a standalone basis; (2) there is objective and reliable evidence of the fair value of undelivered items; and (3) delivery of any undelivered item is probable.  Arrangement consideration is allocated among the separate units of accounting based on their relative fair values, with the amount allocated to the delivered

27




item being limited to the amount that is not contingent on the delivery of additional items or meeting other specified performance conditions.

In our outsourcing contracts, a significant portion of our revenues are fixed and allocated over the contract on a straight-line basis, as we are required to provide a specified level of services subject to certain performance measurements.  Also, certain revenues may fluctuate under the contracts based on the volume of transactions we process or other measurements of service provided.  If we incur higher costs to provide the required services or receive lower revenues due to reduced transaction volumes or penalties associated with service level failures, our gross profit can be negatively impacted.

On certain contracts, or elements of contracts, costs are incurred subsequent to the signing of the contract, but prior to the rendering of service and associated recognition of revenue.  Where such costs are incurred and realization of those costs is either paid for upfront or guaranteed by the contract, those costs are deferred and later expensed over the period of recognition of the related revenue.  At September 29, 2006, we had deferred $4.5 million of unamortized costs which are included in non-current assets.

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

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

Software license and maintenance revenues comprised approximately 4.2% of our net revenues for the nine months ended September 29, 2006.  Additionally, we realized additional revenues from the implementation of our software.  We recognize software revenues in accordance with the provisions of the American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions”, and in accordance with the Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 104, “Revenue Recognition”. We license software under non-cancelable license agreements and provide related professional services, including consulting, training, and implementation services, as well as ongoing customer support and maintenance.  Most of our software license fee revenues are from arrangements which include implementation services that are essential to the functionality of our software products, and are recognized using contract accounting, including the percentage-of-completion methodology, over the period of the implementation.

In those more limited cases where our software arrangements do not include services essential to the functionality of the product, license fee revenues are recognized when the software product has been shipped, provided a non-cancelable license agreement has been signed, there are no uncertainties surrounding product acceptance, the fees are fixed or determinable and collection of the related receivable is considered probable. We do not generally offer rights of return or acceptance clauses to our customers. In situations where we do provide rights of return or acceptance clauses, revenue is deferred until the clause expires. Typically, our software license fees are due within a twelve-month period from the date of shipment. If the fee due from the customer is not fixed or determinable, including payment terms greater

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than twelve months from shipment, revenue is recognized as payments become due and all other conditions for revenue recognition have been satisfied. In software arrangements that include rights to multiple software products, specified upgrades, maintenance or services, we allocate the total arrangement fee among the deliverables using the fair value of each of the deliverables determined using vendor-specific objective evidence. Vendor-specific objective evidence of fair value is determined using the price charged when that element is sold separately. In software arrangements in which we have fair value of all undelivered elements but not of a delivered element, we use the residual method to record revenue. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered element(s) and is recognized as revenue. In software arrangements in which we do not have vendor-specific objective evidence of fair value of all undelivered elements, revenue is deferred until fair value is determined or all elements have been delivered, or is spread over the term of an arrangement as a subscription.

Revenues from training and consulting services are recognized as services are provided to customers. Revenues from maintenance contracts are deferred and recognized ratably over the term of the maintenance agreements. Revenues for customer support and maintenance that are bundled with the initial license fee are deferred based on the fair value of the bundled support services and recognized ratably over the term of the agreement; fair value is based on the renewal rate for continued support arrangements.

Unbilled receivables of $15.3 million represent revenues recognized for services performed that were not billed as of September 29, 2006.  The majority of these amounts are billed in the subsequent month; however, certain unbillable amounts arising from contracts occur when revenues recognized exceed allowable billings in accordance with the contractual agreements.  Such unbillable amounts most often become billable upon reaching certain project milestones stipulated per the contract, or in accordance with the percentage of completion methodology.  As of September 29, 2006, we had unbillable amounts of approximately $2.9 million, which were generally expected to be billed within one year.

We had a long-term receivable at September 29, 2006 and December 30, 2005 of $2.4 million and $1.7 million.  Of the long-term receivables of $1.7 million at December 30, 2005, $1.3 million was created in August 2005 through the deferral until 2009 of the first month of fees of a new outsourcing contract.  In January 2006, an additional amount of approximately $800,000 related to this contract was deferred until 2009.  Both deferrals were in accordance with the terms of the contract executed with this client in July 2005.

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

Allowance for Doubtful Accounts

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our clients to make required payments. This allowance is based on the amount and aging of our accounts receivable, creditworthiness of our clients, historical collection experience, current economic trends, and changes in client payment patterns.  If the financial condition of our clients was to deteriorate, resulting in an impairment of their ability to make payments, additional allowances would be required.  Our bad debt losses have generally been moderate due to the size and quality of our customers; however, we have recently incurred some bad debt losses in our growing Software Services segment due to the lower credit quality of our clients in that segment.  Should one of our larger clients unexpectedly become unable to pay us, our allowance would have to increase significantly.

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Deferred Income Taxes

We account for income taxes in accordance with SFAS 109, “Accounting for Income Taxes,” which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements which differ from our tax returns.  We use significant estimates in determining what portion of our deferred tax asset is more likely than not to be realized.  Prior to fiscal year 2003, our net deferred tax assets had historically consisted primarily of the tax benefit related to restructuring costs for facility closures, supplemental executive retirement plan contributions, and other accrued liabilities such as accrued vacation pay, which are not deductible for tax purposes until paid.

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

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

This valuation allowance does not, in any way, limit our ability to use our deferred tax assets, primarily loss carryforwards, to offset taxable income in the future.  As well as not being subject to federal taxation other than the Alternative Minimum Tax, a significant amount (approximately $25 million) of any future pretax income from the beginning of fiscal year 2006 and thereafter will not require a significant tax provision in the income statement.  Additionally, if at some point in the future, the realization of any of our deferred tax assets is considered more likely than not based on successive years of generating taxable income, we will reverse all or a portion of any existing valuation allowance at that time.  Our valuation allowance for deferred income taxes has been a particularly volatile estimate over the past several years, as our level of income and loss has fluctuated, requiring us to reassess the likelihood of realization of our tax assets.

Goodwill and Intangible Assets

Under SFAS 142, we no longer amortize our goodwill and are required to complete an annual impairment testing which we perform during the fourth quarter of each year.  We believe that the accounting assumptions and estimates related to the annual goodwill impairment testing are critical because these can change from period to period.  We use various assumptions, such as discount rates, and comparable company analysis in performing these valuations.  The impairment test requires us to forecast our future cash flows, which involves significant judgment.   Accordingly, if our expectations of future operating results change, or if there are changes to other assumptions, our estimate of the fair value of our reporting units could change significantly resulting in a goodwill impairment charge, which could have a significant impact on our consolidated financial statements.  We performed an impairment test on each of our components of goodwill as of the fourth quarter of fiscal year 2005 and determined that none of our goodwill was impaired.  As of September 29, 2006, we have $18.2 million of goodwill and $649,000 of intangible assets recorded on our balance sheet (see Note 5 of the Notes to Consolidated Financial Statements included in this report).

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Recent Accounting Pronouncements

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

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (see New Accounting Standards in Note 1 in Item 1 of this report).

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (see New Accounting Standards in Note 1 in Item 1 of this report).

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

Item 3.  Quantitative and Qualitative Disclosures about Market Risks

Our financial instruments include cash and cash equivalents (i.e., short-term and long-term cash investments), accounts receivable, unbilled receivables, and accounts payable.  Only the cash and cash equivalents which totaled $51.2 million at September 29, 2006 present us with market risk exposure resulting primarily from changes in interest rates.  Based on this balance, a change of one percent in the interest rate would cause a change in interest income for the annual period of approximately $512,000.  Our objective in maintaining these investments is the flexibility obtained in having cash available for payment of accrued liabilities and acquisitions.

Item 4.  Controls and Procedures

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

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

As previously disclosed in Item 9A to our Annual Report on Form 10-K for the fiscal year ended December 30, 2005 (“2005 10-K”), our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were not effective as of the end of the 2005 year because we did not maintain effective controls over the determination and reporting of our provision for income taxes, and we had a “material weakness” in internal controls as defined in Audit Standard No. 2 adopted by the Public Company Accounting Oversight Board.  The material weakness was related to the inaccurate identification and recording of state tax net operating losses (NOLs) during fiscal years 2000 through 2004, resulting in excess state tax contingency reserves accumulating on our balance sheet and $1.3

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million of higher cumulative tax expense over those periods.  The proper procedure for estimating the state deferred tax assets and the related contingency reserves is to use the income of each of our subsidiaries and the tax rates for each state jurisdiction in which such subsidiary operates in performing the calculations.  In preparing the 2005 10-K, we applied the proper procedure, which resulted in management identifying the excess tax contingency reserve for the first time.  The 2005 10-K correctly states our 2005 income tax expense and we restated our previously issued consolidated financial statements for the 2001 through 2004 fiscal years to account for the inaccuracies that we identified in preparing the 2005 10-K. As a result of the inaccuracies in tax accounting described above, management concluded that our controls were not effective because there were not sufficient personnel in our corporate tax department who were qualified and trained to properly calculate state deferred tax assets and contingency reserves.  Since the calculation of state NOLs and the related accounting is performed on a once per year basis after all tax returns are filed for the previous year, the initial testing to confirm that the material weakness described above and in Item 9A of our 2005 10-K has been remediated will occur in late 2006.  We have recently hired a new tax director with experience in calculating deferred tax assets, and in applying SFAS 109, “Accounting for Income Taxes,” who began employment in late August, and will perform the appropriate detailed analysis on an ongoing basis starting in fiscal year 2006.

Except as described above, there has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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Part II.  Other Information

Item 1.  Legal Proceedings.

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

Item 1A.  Risk Factors.

Except as set forth below, there have been no material changes from risk factors as previously disclosed in response to Item 1A in Part I of our 2005 10-K and to Item 1A in Part II of our Form 10-Q for the fiscal quarter ended June 30, 2006.

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