GSE Systems, Inc. ("GSE Systems", "GSE" or the "Company") is a world leader in real-time high fidelity simulation. The Company provides simulation and educational solutions and services to the nuclear and fossil electric utility industry, and the chemical and petrochemical industries. In addition, the Company provides plant monitoring and signal analysis monitoring and optimization software primarily to the power industry. GSE is the parent company of GSE Power Systems, Inc., a Delaware corporation; GSE Power Systems, AB, a Swedish corporation; GSE Engineering Systems (Beijing) Co. Ltd, a Chinese limited liability company; GSE Systems Ltd, a UK limited liability company; and has a 10% minority interest in Emirates Simulation Academy, LLC, a United Arab Emirates limited liability company. The Company has only one reportable segment.

Cautionary Statement Regarding Forward-Looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward looking statements. Forward-looking statements are not statements of historical facts, but rather reflect our current expectations concerning future events and results. We use words such as "expects", "intends", "believes", "may", "will" and "anticipates" to indicate forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements, including, but not limited to, those factors set forth under Item 1A - Risk Factors of the Company's 2007 Annual Report on Form 10-K and those other risks and uncertainties detailed in the Company's periodic reports and registration statements filed with the Securities and Exchange Commission. We caution that these risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict these new risk factors, nor can we assess the effect, if any, of the new risk factors on our business or the extent to which any factor or combination of factors may cause actual results to differ from those expressed or implied by these forward-looking statements.

If any one or more of these expectations and assumptions proves incorrect, actual results will likely differ materially from those contemplated by the forward-looking statements. Even if all of the foregoing assumptions and expectations prove correct, actual results may still differ materially from those expressed in the forward-looking statements as a result of factors we may not anticipate or that may be beyond our control. While we cannot assess the future impact that any of these differences could have on our business, financial condition, results of operations and cash flows or the market price of shares of our common stock, the differences could be significant. We do not undertake to update any forward-looking statements made by us, whether as a result of new information, future events or otherwise. You are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in this report.

General Business Environment

The nuclear power industry has been largely dormant for the last thirty years with few opportunities to provide new full scope simulators. The Company's nuclear simulation business has concentrated mainly on providing services to the installed base of nuclear simulators worldwide. These services are primarily related to upgrading antiquated simulation software and hardware systems, providing new and improved plant and system simulation models, and modifying the simulator to reflect changes in the physical plant. However, over the last several years, the nuclear power industry has experienced a dramatic change, and most energy experts believe the industry is on the verge of a "renaissance", driven by the gap between the energy that the world is projected to need versus the current capacity, the rising cost of oil, and growing environmental concerns caused by fossil fuels. Government and industry sources and trade journals report that up to 200 new nuclear plants will be built over the next 20 years. In the U.S. alone, applications for accelerated construction and operating licenses have been or are expected to be submitted for 35 new nuclear plants. Each new plant will be required to have a full scope simulator ready for operator training and certification about two years prior to plant operation. In some cases where identical plants share a common site, one simulator will serve both plants. Similar nuclear plant construction programs are underway or planned in China, Russia, Ukraine, Japan and Central Europe to meet growing energy demands. In addition, most U.S. nuclear electric utilities have applied for license extensions and/or power upgrades. These license extensions will lead to significant upgrades to the physical equipment and control room technology which will result in the need to modify or replace the existing plant control room simulators. The Company, having what it believes is the largest installed base of existing simulators, over 60% on a global basis, is well positioned to capture a large portion of this business, although no assurance can be given that it will be successful in doing so. The Company logged approximately $21.1 million in nuclear simulation orders in the nine months ended September 30, 2008.

The Company's fossil fueled power simulation business has been growing rapidly over the past three years. The transition from obsolete analog control systems to modern digital control systems and the new requirements for complex emission control systems are contributing to the growth the Company is experiencing in this business, coupled with the fact that GSE's high-fidelity simulation models can be used to validate control schemes and logics for new designs before the control systems are deployed to the field. GSE builds the plant models based upon design specifications supplied by its customers, and the models then drive the actual digital control systems in the factory. This testing can uncover numerous control system discrepancies. By correcting these problems at the factory versus in the field, GSE's customers can save millions in reduced down time and reduced commissioning time. The Company logged approximately $8.6 million in fossil simulation orders in the nine months ended September 30, 2008.

GSE's process industries simulation business customers include primarily oil and gas production facilities, oil refining plants, chemical plants and petro-chemical facilities. The increased need for oil and oil based refined products coupled with the rising price of oil is creating a global expansion in oil production facilities. In addition, there is more focus on regular, periodic and systematic training of plant operator personnel which may reduce the risk of operator errors and potentially catastrophic environment disasters and/or loss of life.

Results of Operations

The following table sets forth the results of operations for the periods
presented expressed in thousands of dollars and as a percentage of revenues:



(in thousands)           Three months ended September 30,                     Nine months ended September 30,
                     2008           %         2007          %           2008           %           2007          %
Contract revenue   $   7,001       100.0 %   $ 7,526       100.0 %    $ 20,639        100.0 %    $ 23,769       100.0 %
Cost of revenue        5,023        71.7 %     5,150        68.4 %      14,889         72.1 %      16,345        68.8 %

Gross profit           1,978        28.3 %     2,376        31.6 %       5,750         27.9 %       7,424        31.2 %
Operating
expenses:
Selling, general
and
administrative         1,694        24.3 %     1,813        24.1 %       5,585         27.1 %       5,567        23.4 %
Depreciation             114         1.6 %        59         0.8 %         317          1.5 %         168         0.7 %
Total operating
expenses               1,808        25.9 %     1,872        24.9 %       5,902         28.6 %       5,735        24.1 %

Operating income
(loss)                   170         2.4 %       504         6.7 %        (152 )       (0.7 )%      1,689         7.1 %

Interest income
(expense), net            42         0.6 %       (62 )      (0.8 )%         76          0.4 %        (425 )      (1.8 )%
Other income
(expense), net           317         4.5 %       (88 )      (1.2 )%        193          0.9 %        (353 )      (1.5 )%

Income (loss)
before income
taxes                    529         7.5 %       354         4.7 %         117          0.6 %         911         3.8 %

Provision for
income taxes              99         1.4 %        51         0.7 %         250          1.2 %         229          .9 %

Net income
(loss)             $     430         6.1 %   $   303         4.0 %    $   (133 )       (0.6 )%   $    682         2.9 %

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our estimates, judgments and assumptions are continually evaluated based on available information and experience. Because of the use of estimates inherent in the financial reporting process, actual results could differ from those estimates.

A summary of the Company's significant accounting policies as of December 31, 2007 is included in Note 2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2007. Certain of our accounting policies require higher degrees of judgment than others in their application. These include revenue recognition on long-term contracts, capitalization of computer software development costs, and deferred income tax valuation allowances. These critical accounting policies and estimates are discussed in the Management's Discussion and Analysis of Financial Condition and Results of Operations section in the 2007 Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

Results of Operations - Three and Nine Months ended September 30, 2008 versus Three and Nine Months ended September 30, 2007

Contract Revenue. Contract revenue for the quarter ended September 30, 2008 totaled $7.0 million, which was 7.0% lower than the $7.5 million total revenue for the quarter ended September 30, 2007. For the nine months ended September 30, 2008, contract revenue totaled $20.6 million, a 13.2% decrease from the $23.8 million for the nine months ended September 30, 2007. The decrease mainly reflects the substantial completion of the $16.9 million ESA contract in 2008. For the three months ended September 30, 2008 and 2007, the Company recognized $40,000 and $2.1 million, respectively, of contract revenue on this project using the percentage-of-completion method, which accounted for 0.6% and 27.4% of the Company's consolidated revenue, respectively. For the nine months ended September 30, 2008 and 2007, the Company recognized $1.2 million and $8.1 million, respectively of contract revenue on the ESA project, which accounted for 6.0% and 34.2%, respectively, of the Company's consolidated revenue. The decrease in revenue from the ESA project was partially offset by an increase in the Company's fossil fueled power simulation revenue, which totaled $2.1 million in the third quarter 2008 versus $1.7 million in the third quarter 2007 and totaled $6.8 million in the nine months ended September 30, 2008 versus $4.6 million in the same period of 2007. In the nine months ended September 30, 2008, the Company recorded total orders of $31.2 million versus $29.3 million in the nine months ended September 30, 2007. At September 30, 2008, the Company's backlog was $34.7 million.

Selling, General and Administrative Expenses. Selling, general and administrative ("SG&A") expenses totaled $1.7 million in the quarter ended September 30, 2008 as compared to $1.8 million in the quarter ended September 30, 2007. For both the nine months ended September 30, 2008 and 2007, SG&A expenses totaled $5.6 million. The variance in SG&A spending reflects the following:

¨ Business development and marketing costs increased from $663,000 in the third quarter 2007 to $675,000 in the third quarter of 2008 and increased from $1.9 million for the nine months ended September 30, 2007 to $2.3 million in the same period 2008. The increase in the 2008 year-to-date costs mainly reflects a $30,000 increase in bidding and proposal costs, which are the costs of operations personnel in assisting with the preparation of contract proposals, a $128,000 increase in business development travel expenses, the cost of attending the first quarter 2008 Society in Computer Simulation trade show ($27,000) and the cost of the Company's September 2008 Simworld user's conference in Beijing, China ($68,000).

¨ The Company's general and administrative expenses totaled $920,000 in the third quarter 2008, which was 13.5% lower than the $1.1 million incurred in the third quarter 2007. For the nine months ended September 30, 2008 and 2007, general and administrative expenses totaled $3.1 and $3.2 million, respectively. The decrease in general and administrative expense in 2008 as compared to 2007 reflects the following spending variances:

o The Company incurred lower legal fees in the third quarter 2008 as compared to the third quarter 2007.

o In 2007, the Company hired an independent accounting firm to evaluate the changes in the Company's ownership and to determine the amount of any limitation on the usage of the Company's tax loss carryforwards.

¨ Gross spending on software product development ("development") totaled $236,000 in the quarter ended September 30, 2008 as compared to $251,000 in the same period of 2007. For the nine months ended September 30, 2008, gross development spending totaled $773,000 versus $953,000 in the same period of 2007. For the three months ended September 30, 2008, the Company expensed $99,000 and capitalized $137,000 of its development spending while in the three months ended September 30, 2007, the Company expensed $86,000 and capitalized $165,000 of its development spending. For the nine months ended September 30, 2008, the Company expensed $243,000 and capitalized $530,000 of its development spending and expensed $440,000 and capitalized $513,000 of its development spending in the nine months ended September 30, 2007. The Company's capitalized development expenditures in 2008 were mainly related to the customization of RELAP5-RT software (which simulates transient fluid dynamics, neutronics and heat transfer in nuclear power plants) to run on the Company's real-time executive software and the enhancement to JCAD to add the capability to convert AutoCAD Control Logic Diagrams to the Company's JControl modeling tool. The Company anticipates that its total gross development spending in 2008 will approximate $1.0 million.

Operating Income. The Company had operating income of $170,000 (2.4% of revenue) in the third quarter 2008, as compared with operating income of $504,000 (6.7% of revenue) for the same period in 2007. For the nine months ended September 30, 2008 and 2007, the Company had an operating loss of $152,000 (0.7% of revenue) and operating income of $1.7 million (7.1% of revenue), respectively. The variances were due to the factors outlined above.

Interest Income (Expense), Net. For the three and nine months ended September 30, 2008, net interest income totaled $42,000 and $76,000, respectively. For the three and nine months ended September 30, 2007, net interest expense totaled $62,000 and $425,000, respectively.

In June 2007, using a portion of the proceeds from the Company's June 2007 common stock and warrant transaction, the Company paid off the outstanding balance of its Laurus Master Fund Ltd. line of credit and did not borrow against the line of credit in 2008. On March 6, 2008, the Laurus line of credit expired. The Company incurred interest expense of $0 and $107,000 on borrowings from the Laurus line of credit in the three and nine months ended September 30, 2007, respectively.

On March 28, 2008, the Company entered into two separate revolving line of credit agreements for two-year revolving lines of credit with Bank of America ("BOA") in an aggregate amount of up to $5.0 million. One line of credit is in the principal amount of up to $3.5 million and is guaranteed by the U.S. Export-Import Bank. The other line of credit is in the principal amount of up to $1.5 million. The Company has not borrowed any funds against either BOA line of credit since the closing.

The deferred financing costs incurred in conjunction with the Laurus Master Fund line of credit were amortized over the two-year period of the line of credit, with the final amortization expense recorded in February 2008. Thus, there was no amortization expense in the three months ended September 30, 2008, but amortization expense totaled $89,000 in the nine months ended September 30, 2008. This compares to amortization expense of $133,000 and $399,000 in the three and nine months ended September 30, 2007, respectively. Amortization of the deferred financing costs incurred in conjunction with the BOA lines of credit began in April 2008; amortization expense totaled $18,000 and $35,000 in the three and nine months ended September 30, 2008, respectively.

At September 30, 2008, the Company has approximately $3.0 million of cash in Certificates of Deposit with BOA that are being used as collateral for four performance bonds. At September 30, 2007, the Company had approximately $2.3 million of cash in Certificates of Deposit being used as collateral for four performance bonds. The Company earned approximately $33,000 and $97,000 in interest income on the Certificates of Deposit in the three and nine months ended September 30, 2008, respectively, versus $25,000 and $74,000 in interest income in the three and nine months ended September 30, 2007, respectively.

In May 2007, the Company deposited $1.2 million into a restricted, interest-bearing account at the Union National Bank in the United Arab Emirates as a partial guarantee for the $11.8 million credit facility that UNB has extended to ESA. GSE recorded approximately $10,000 and $39,000 interest income in the three and nine months ended September 30, 2008, respectively.

Other miscellaneous interest income, net totaled $5,000 and $12,000 in the three and nine months ended September 30, 2008, respectively. Other miscellaneous interest income (expense), net totaled $6,000 of interest income and $33,000 of interest expense in the three and nine months ended September 30, 2007, respectively.

Other Income (Expense), Net. For the three and nine months ended September 30, 2008, other income (expense), net was $317,000 and $193,000, respectively. For the three and nine months ended September 30, 2007, other income (expense), net was ($88,000) and ($353,000), respectively. The major components of other income (expense), net include the following items:

¨ The Company accounts for its investment in ESA using the equity method. In accordance with the equity method, the Company has eliminated 10% of the profit from this contract as the training simulators are assets that will be recorded on the books of ESA, and the Company is thus required to eliminate its proportionate share of the profit included in the asset value. The profit elimination totaled $0 and $38,000 for the three and nine months ended September 30, 2008 and $105,000 and $371,000 for the three and nine months ended September 30, 2007, respectively.

¨ For the three and nine months ended September 30, 2008, the Company recognized a $50,000 and $138,000 equity loss, respectively, on its investment in ESA.

¨ At September 30, 2008, the Company had contracts for the sale of approximately 2.4 million Euro, 2.5 million British Pounds Sterling, and 135 million Japanese Yen at fixed rates. The contracts expire on various dates through September 2013. The Company had not designated the contracts as hedges and has recorded the change in the estimated fair value of the contracts during the three and nine months ended September 30, 2008 (a gain of $360,000 and $365,000, respectively) in other income (expense).

¨ At September 30, 2007, the Company had contracts for the sale of approximately 36 million Japanese Yen and 125,000 British Pounds Sterling at fixed rates. The contracts expired on various dates through January 2008. The Company had not designated the contracts as hedges and recorded the change in the estimated fair value of the contracts during the three and nine months ended September 30, 2007 (a loss of $6,000 and $8,000, respectively) in other income (expense).

Provision for Income Taxes. In July 2006, the Financial Accounting Standards Board, or FASB, issued Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109, "Accounting for Income Taxes". FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in the Company's financial statements. It also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and expanded disclosure with respect to uncertainty in income taxes. The Company adopted the guidance of FIN No. 48 effective January 1, 2007. The adoption of this accounting pronouncement did not have a material effect on the Company's financial position, results of operations or cash flows. Furthermore, the Company is not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits would significantly decrease or increase within the next twelve months.

As of September 30, 2008, there have been no material changes to the liability for uncertain tax positions.

The Company does not expect to pay U.S. federal income taxes in 2008, but does expect to pay income taxes in Sweden. In addition, the Company will pay foreign income tax withholding on several non-U.S. contracts. The Company has a full valuation allowance on its deferred tax assets at September 30, 2008.

Liquidity and Capital Resources

As of September 30, 2008, the Company's cash and cash equivalents totaled $7.5 million compared to $8.2 million at December 31, 2007.

Cash provided by (used in) operating activities. Net cash provided by operating activities for the nine months ended September 30, 2008 totaled $773,000. Significant changes in the Company's assets and liabilities in the nine months ended September 30, 2008 included:
¨ A $1.2 million increase in the Company's contract receivables. The Company's trade receivables increased from $4.2 million at December 31, 2007 (including $1.0 million due from ESA) to $8.7 million at September 30, 2008 (including $2.7 million due from ESA) while the Company's unbilled receivables decreased by $3.3 million to $3.2 million at September 30, 2008. At September 30, 2008, trade receivables outstanding for more than 90 days totaled $3.3 million (including $2.7 million from ESA) versus $2,000 at December 31, 2007. Despite the increase in overdue receivables, the Company believes the entire balance will be received and has not increased its bad debt reserve.

¨ A $1.4 million increase in billings in excess of revenues earned. The increase . . .