Overview

We build satellite ground systems and equipment for command and control, integration and test, data processing, and simulation. Since our inception, we have provided ground systems for over 200 different satellite missions for communications, science, meteorology, and earth resource applications. We have an established domestic and international customer base that includes government and commercial satellite operators, spacecraft and payload manufacturers, and aerospace systems integrators.

Effective with the first quarter of our fiscal year 2009, it is now our practice to close our books and records on the Friday prior to the calendar quarter end to align our financial closing with our business processes. This practice only affects interim periods, as our fiscal year end remains September 30. We do not believe this change materially affects the comparability of the quarters and six month periods presented within this Management's Discussion and Analysis of Financial Condition and Results of Operations.

We measure financial performance for each operating segment based on income from operations, which consists of revenue less cost of revenue, selling, general & administrative, research & development, and intangible asset amortization expenses.

During the first quarter of fiscal year 2009, we realigned our Space Communications Systems segment to include the operations of our SAT subsidiary. The signal monitoring products sold by SAT are better aligned with the product offerings of the Space Communications Systems segment. SAT was previously included in the Commercial Systems segment.

This section contains forward-looking statements, all of which are based on current expectations. Our projections may not in fact be achieved and these projections do not reflect any acquisitions or divestitures that may occur in the future. Reference should be made to the various important factors listed under the heading "Forward-Looking Statements" that could cause actual future results to differ materially.

Outlook

This outlook section contains forward-looking statements, all of which are based on current expectations. There is no assurance that our projections will in fact be achieved and these projections do not reflect the impact of any acquisitions or divestitures that may occur in the future. Reference should be made to the various important risk factors listed under the heading "Risk Factors" in Item 1A of our annual report on Form 10-K for the fiscal year ended September 30, 2008, any of which could cause our results of operations to differ from our outlook. Please also refer to the section under the heading "Forward-looking Statements" in this document.

Integral Systems primarily derives its revenues from customers in the aerospace and defense industry and, to a lesser extent, customers in other industries such as telecommunications and media. The aerospace and defense community is comprised of major government operations (including defense, civil, and homeland security), and large-scale commercial operators including satellite operators, communications companies and other media companies.

Due to recent schedule delays on several large government contracts, the loss or cancellation of three government programs within the past two weeks, and continued weakness in the aerospace market, the Company now expects fiscal year 2009 revenue to be approximately $170 million and net earnings to be approximately $0.45 per share. The Company previously had expected fiscal year 2009 revenue of approximately $176 million and net earnings of approximately $1.01 per share. The Company expects gross profit as a percentage of revenue for fiscal year 2009 to decline compared to fiscal year 2008 due to projected changes in the mix of lower margin services revenue versus higher margin product sales.

Critical Accounting Policies

Management's discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from those estimates.

Critical accounting policies are those that are both important to the presentation of our financial condition and results of operations and require management's most difficult, complex, or subjective judgments. A discussion of our critical accounting policies, which relate to revenue recognition, allowance for doubtful accounts, the recoverability of goodwill and other long-lived assets, stock-based compensation, the recoverability of deferred tax assets, and obsolescence of inventory, are discussed in the "Notes to Consolidated Financial Statements" of our Annual Report on Form 10-K for the year ended September 30, 2008.

Impact of Last Year's Accounting Restatement on Revenue in the First Six Months of Fiscal Year 2009

In its Annual Report on Form 10-K for the fiscal year ended September 30, 2008, the Company disclosed that it had restated its previously filed unaudited financial statements for the interim periods ended December 31, 2007, March 31, 2008, and June 30, 2008, to correct errors in accounting treatment largely relating to the timing of recognition of revenue between periods (the "2008 Restatement"). As a result of the 2008 Restatement, $10.5 million in revenue and $3.9 million in gross profit were deferred from the first three quarters of fiscal year 2008 to future periods. Of the deferred revenue amounts, approximately $1.0 million was recognized in the fourth quarter of fiscal year 2008 and approximately $3.3 million was recognized in the first six months of fiscal year 2009.

The four matters described below accounted for 99% of the total deferred revenue and 98% of the total deferred gross profit resulting from the 2008 Restatement:

Timing of Revenue Recognition for Advance Purchases of Equipment. During the second and third quarters of fiscal year 2008, the Company made advance purchases of equipment under a major cost plus incentive award fee U.S. government contract, and also under a second commercial contract. The Company received timely reimbursement from the government for the cost incurred on the government project. For the commercial project, reimbursement for the purchases occurs upon the achievement of performance milestones. As disclosed at the time in the Company's periodic filings under the Securities Exchange Act of 1934 (the "34 Act"), the Company recognized revenue under cost-plus contracts during these periods based upon actual costs incurred and a pro rata amount of the negotiated fee. During the fiscal year 2008 audit, the Company determined that the advance equipment purchases should not be included in the measurement of costs incurred until such time as the equipment is utilized in the projects.

Timing of Revenue Recognition on Multiple Element Contracts Involving Post-Contract Customer Support ("PCS"). During the first three quarters of fiscal year 2008, the Company recognized revenue under its fixed-price contracts using the contract value as one single element. As disclosed at the time in the Company's periodic filings under the 34 Act, the Company recognized PCS revenue during these periods on a percentage-of-completion basis. During the fiscal year 2008 audit, the Company determined that it should have allocated a portion of the total contract value based on vendor specific objective evidence of the fair value to the PCS services and recognize revenue for the PCS element separately from the remainder of the contract.

Timing of Revenue Recognition on Multiple Element Contracts Involving Software Licenses. During the first quarter of fiscal year 2008, the Company made up-front delivery of software licenses under the GPS OCX cost-plus contract with Northrop Grumman Corporation and received payment of $2.4 million for those licenses. As disclosed at the time in the Company's periodic filings under the 34 Act, the Company recognized revenue of $2.4 million relating to the sale of these licenses. During the fiscal year 2008 audit, the Company determined that it should have applied percentage-of-completion accounting for the entire contract, including the software licenses, as significant modification of the software was being performed.

Timing of Revenue Recognition on Certain Contracts That Do Not Involve Significant Customization, Modification, or Production. During the first three quarters of fiscal year 2008, the Company's subsidiaries, Real Time Logic, Inc. and SAT Corporation, made certain software sales under contracts that did not require significant customization to configure the products for the customers. These contracts were accounted for under the percentage-of-completion method. During the fiscal year 2008 audit, the Company determined that it should have recognized revenue on these sales upon either shipment or customer acceptance, depending upon the terms of the specific contract.

Results of Operations - Three Months Ended March 27 2009 Compared to Three
Months Ended March 31, 2008



                                                                 Three Months Ended
                                                                                            Favorable
                                             March 27, 2009        March 31, 2008         (unfavorable)
                                                              (in thousands of dollars)
Revenue
Government Systems
Contract revenue                             $        23,544       $        19,590       $         3,954
Software maintenance revenue                             495                   518                   (23 )

Total Government Systems                              24,039                20,108                 3,931
Commercial Systems
Contract revenue                                       4,846                 3,854                   992
Software maintenance revenue                             717                   537                   180

Total Commercial Systems                               5,563                 4,391                 1,172
Space Communications Systems
Contract revenue                                       9,824                10,921                (1,097 )
Software maintenance revenue                           1,067                   901                   166
Product revenue                                        4,573                 3,230                 1,343

Total Space Communications Systems                    15,464                15,052                   412

Elimination of intersegment sales                     (2,298 )              (1,847 )                (451 )

Total revenue                                         42,768                37,704                 5,064

Cost of revenue:
Government Systems
Contract and software maintenance cost
of revenue                                            14,975                16,236                 1,261
Commercial Systems
Contract and software maintenance cost
of revenue                                             4,224                 3,366                  (858 )
Space Communications Systems
Contract and software maintenance cost
of revenue                                             7,347                 7,050                  (297 )
Product cost of revenue                                2,196                 2,023                  (173 )

Total Space Communications Systems                     9,543                 9,073                  (470 )
Elimination of intersegment sales                     (2,298 )              (1,847 )                 451

Total cost of revenue                                 26,444                26,828                   384


Gross profit:
Government Systems                                     9,064                 3,872                 5,192
Commercial Systems                                     1,339                 1,025                   314
Space Communications Systems                           5,921                 5,979                   (58 )

Total gross profit                                    16,324                10,876                 5,448


Operating expense:
Government Systems                                     5,108                 2,487                (2,621 )
Commercial Systems                                     1,256                 1,127                  (129 )
Space Communications Systems                           5,716                 2,886                (2,830 )

Total operating expense                               12,080                 6,500                (5,580 )

Income from operations:
Government Systems                                     3,956                 1,385                 2,571
Commercial Systems                                        83                  (102 )                 185
Space Communications Systems                             205                 3,093                (2,888 )

Total income from operations                           4,244                 4,376                  (132 )

Other income (expense), net                              (72 )                 265                  (337 )
Income before income taxes                             4,172                 4,641                  (469 )
Provision for income taxes                             1,527                 1,601                    74

Net income                                   $         2,645       $         3,040       $          (395 )

Revenue

Consolidated revenue in the second quarter 2009 was $42.8 million, an increase of $5.1 million, or 13.4%, compared to $37.7 million in the second quarter 2008. The increase in revenue was related to the following:

Government Systems revenue was $24.0 million in the second quarter 2009, an increase of $3.9 million or 19.6%, compared to $20.1 million in the second quarter 2008. During the second quarter 2009, we received a written acknowledgement from our customer on a large United States Air Force contract that it will seek additional funding for allowable and allocable costs (determined under the Federal Acquisition Regulation, which provides guidance on the types of costs that are allowable) incurred in previous periods that have exceeded the contract funding on this contract. During the second quarter 2009, we recognized revenue above funding as we believe that we will be awarded funding in the third quarter of fiscal year 2009. Further, we had increases in work scope during the second quarter 2009 compared to the second quarter 2008. These two items resulted in an increase in revenue of $3.1 million on this contract. In addition, revenue increased $2.2 million in the second quarter 2009 compared to the second quarter 2008 relating to an increase in work scope and level of effort on other existing contract work with the United States Air Force. On our GPS OCX contract, we received a funding increase in the second quarter 2009 relating to higher costs incurred than initially anticipated on this contract, which resulted in $0.6 million in additional revenue. This increase was offset by a decrease in revenue of $0.5 million due to a decrease in level of effort in the second quarter 2009 compared to the second quarter 2008 due to this work nearing completion. Offsetting these revenue increases were decreases in revenue of $1.3 million relating to two civilian programs that are almost complete as of the end of the second quarter 2009.

Commercial Systems revenue was $5.6 million in the second quarter 2009, an increase of $1.2 million, or 26.7%, compared to $4.4 million in the second quarter 2008. The increase in revenue for this segment in the second quarter 2009 was attributable to revenue increases of $2.0 million from new and existing command and control contract services work, $0.2 million from Newpoint due to an increase in contract services revenue, and $0.1 million from Integral Systems Europe S.A.S. due to an increase in software maintenance revenue, offset by decreases in revenue of $1.3 million relating to command and control contract services work that was completed in the second quarter 2008.

Space Communications Systems revenue was $15.5 million in the second quarter 2009, an increase of $0.4 million or 2.7%, compared to $15.1 million in the second quarter 2008. The increase in revenue for this segment in the second quarter 2009 was attributable to a $2.4 million increase in product revenue due to an increase in volume of shipments and higher software maintenance revenue at RT Logic, and a $1.0 million increase in contract services revenue from SAT relating to a new contract that was awarded in the first quarter 2009. Offsetting these increases was a decrease in revenue of $2.2 million relating to RT Logic due to the completion of a large contract services contract that had work during the second quarter 2008 and a decrease in revenue on another large contract during the second quarter 2009 compared to the second quarter 2008. In addition, product revenue decreased $0.5 million relating to Lumistar, which is attributable to a decline in the commercial aircraft industry market as a result of the economy, and $0.3 million relating to SAT.

Gross Profit

Our gross profit can vary significantly depending on the type of product or service provided. Generally, license and maintenance revenue related to the sale of our commercial off-the-shelf software products have the highest gross profit margins due to minimal incremental costs to produce them. By contrast, gross margin for equipment and subcontractor costs are typically lower. Engineering service gross margin is typically in the 20% range or higher.

Gross profit was $16.3 million in the second quarter 2009, an increase of $5.4 million, or 50.1%, compared to $10.9 million in the second quarter 2008. The increase in gross profit in the second quarter 2009 was attributable to our Government Systems and Commercial Systems segments.

Government Systems gross profit was $9.1 million in the second quarter 2009, an increase of $5.2 million, or 134%, compared to $3.9 million in the second quarter 2008. Gross profit increased $3.4 million due to the large United States Air Force contract noted above, for which an increase in revenue was realized relating to an increase in the funding amount on this contract for certain work and due to an increase in work scope on this contract. Gross profit increased $0.6 million from an increase in funding on the GPS OCX contract. In addition, gross profit increased $1.4 million relating to increases in work scope and level of effort on other existing contract work with the United States Air Force. Offsetting these gross profit increases were decreases in gross profit of $0.7 million relating to two civilian programs that are almost complete as of the end of the second quarter 2009.

Commercial Systems gross profit was $1.3 million in the second quarter 2009, an increase of $0.3 million, or 30.7%, compared to $1.0 million in the second quarter 2008. An increase in gross profit of $0.5 million attributable to increases in revenue from command and control work was offset by a decrease of $0.3 million in gross profit relating to higher overhead support relating to product development and new business development.

Space Communications Systems gross profit was $5.9 million in the second quarter 2009, a decrease of $0.1 million, or 9.7%, compared to $6.0 million in the second quarter 2008. Gross profit decreased $0.7 million from SAT due to cost relating to the replacement of equipment on a contract for which work had previously been completed and higher overhead support costs, offset by an increase in gross profit of $0.6 million attributable to a decrease in equipment expense in the second quarter 2009 compared to the second quarter 2008, due to the delivery of equipment on a significant contract in the second quarter 2009 and lower salary and personnel-related expense due to a decrease in headcount.

Operating Expenses

Operating expenses were $12.1 million in the second quarter 2009, an increase of $5.6 million, or 85.8%, compared to $6.5 million in the second quarter 2008. The increase was attributable to $1.8 million of higher professional services fees, including accounting fees, legal fees, and professional services fees associated with infrastructure development projects and compliance related activities, and $2.2 million in higher salary and personnel-related expenses due to an increase in support and infrastructure headcount. During the second quarter 2009, we incurred $0.7 million in severance expense relating to personnel actions taken in March 2009. As a result of these personnel actions, stock-based compensation expense decreased by $0.4 million relating to forfeitures of unvested stock options. Stock-based compensation, net of the forfeitures, increased $0.2 million.

Operating expenses in our Government Systems segment were $5.1 million in the second quarter 2009, an increase of $2.6 million, or 104%, compared to $2.5 million in the second quarter 2008, due to an increase in the allocation of corporate expenses and severance expense.

Operating expenses in our Commercial Systems segment in the second quarter 2009 were comparable to the second quarter 2008. Allocation of corporate expenses was higher in the second quarter 2009 compared to the second quarter 2008, and $0.2 million was incurred relating to the establishment of Integral Systems Europe Limited in the United Kingdom. These increases were offset by a decrease in our Newpoint operating expenses in the second quarter 2009 compared to the second quarter 2008.

Operating expenses in our Space Communications Systems segment were $5.7 million in the second quarter 2009, an increase of $2.8 million compared to $2.9 million in the second quarter 2008. The increase was attributable to an increase in the allocation of corporate expenses of $2.7 million, an increase in labor and related expense of $0.3 million relating to the integration of the satID product line that was acquired from QinetiQ Limited, and $0.3 million relating to higher research and development expenses incurred in the second quarter 2009 compared to the second quarter 2008.

Income Tax Expense

We recorded income tax expense of $1.5 million in the second quarter 2009 and $1.6 million in the second quarter 2008. The effective tax rates for the second quarter 2009 and the second quarter 2008 were 36.6% and 34.5%, respectively.

Results of Operations - Six Months Ended March 27, 2009 Compared to Six Months
Ended March 31, 2008



                                                                  Six Months Ended
                                                                                            Favorable
                                             March 27, 2009        March 31, 2008         (unfavorable)
                                                              (in thousands of dollars)
Revenue
Government Systems
Contract revenue                             $        41,109       $        34,724       $         6,385
Software maintenance revenue                             952                   826                   126

Total Government Systems                              42,061                35,550                 6,511
Commercial Systems
Contract revenue                                      10,046                 8,546                 1,500
Software maintenance revenue                           1,626                 1,171                   455

Total Commercial Systems                              11,672                 9,717                 1,955
Space Communications Systems
Contract revenue                                      20,093                21,426                (1,333 )
Software maintenance revenue                           2,857                 2,110                   747
Product revenue                                        8,566                 5,852                 2,714

Total Space Communications Systems                    31,516                29,388                 2,128

Elimination of intersegment sales                     (4,011 )              (2,991 )              (1,020 )

Total revenue                                         81,238                71,664                 9,574

Cost of revenue:
Government Systems
Contract and software maintenance cost
of revenue                                            28,725                27,655                (1,070 )
Commercial Systems
Contract and software maintenance cost
of revenue                                             8,947                 6,697                (2,250 )
Space Communications Systems
Contract and software maintenance cost
of revenue                                            13,661                13,610                   (51 )
Product cost of revenue                                4,171                 3,269                  (902 )

Total Space Communications Systems                    17,832                16,879                  (953 )

Elimination of intersegment sales                     (4,011 )              (2,991 )               1,020

Total cost of revenue                                 51,493                48,240                (3,253 )


Gross profit:
Government Systems                                    13,336                 7,895                 5,441
Commercial Systems                                     2,725                 3,020                  (295 )
Space Communications Systems                          13,684                12,509                 1,175

Total gross profit                                    29,745                23,424                 6,321


Operating expense:
Government Systems                                    10,538                 5,917                (4,621 )
Commercial Systems                                     2,378                 2,266                  (112 )
Space Communications Systems                          11,285                 5,547                (5,738 )

Total operating expense                               24,201                13,730               (10,471 )


Income from operations:
Government Systems                                     2,798                 1,978                   820
Commercial Systems                                       347                   754                  (407 )
Space Communications Systems                           2,399                 6,962                (4,563 )

Total income from operations                           5,544                 9,694                (4,150 )
Other income (expense), net                              (65 )                 200                  (265 )

Income before income taxes                             5,479                 9,894                (4,415 )
Provision for income taxes                             1,809                 1,802                    (7 )

Net income                                   $         3,670       $         8,092       $        (4,422 )

Revenue

Consolidated revenue was $81.2 million in the six months ended March 27, 2009, . . .