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 for interim periods, to align our financial closing with our business processes. We also intend to change our fiscal year end date to the last Friday of September of each year. This change is effective beginning with the current fiscal year, resulting in our fiscal year 2009 ending on September 25, 2009. We do not believe this change materially affects the comparability of the quarters and nine 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.

In accordance with SFAS No. 142, "Good-will and Other Intangible Assets", we previously completed our annual goodwill impairment testing as of the last day of the fiscal year (including fiscal year 2008). Effective August 5, 2009, we changed the date of our annual goodwill impairment testing to the first day of the fourth quarter in order to provide additional time to quantify the fair value of our reporting units and if necessary to determine the implied fair value of goodwill. This change in timing also reduces the likelihood that the annual impairment analysis would not be completed by the filing date of our annual financial statements. In accordance with SFAS No. 142, we will also perform interim impairment testing should circumstances requiring it arise. We believe the resulting change in accounting policy related to the annual testing date will not delay, accelerate, or avoid an impairment charge. We determined that the change in accounting policy related to the annual testing date is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively.

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 identified under the heading "Risk Factors" in Item 1A of our Annual Report on Form 10-K for the fiscal year ended September 30, 2008, and under the heading "Risk Factors" in Item 1A of Part II of this quarterly report on Form 10-Q, any of which could cause our results of operations to differ materially. Please also refer to the section under the heading "Forward-Looking Statements" in this document.

Outlook

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.

A significant portion of our revenue is derived from contracts and subcontracts funded by the U.S. government, which are subject to the budget and funding process of the U.S. government. During the first nine months of fiscal year 2009, the timing of receipt of funding increases on our existing contracts and subcontracts with the U.S. government was delayed in comparison to historical timeframes. Furthermore, the award of new contracts and subcontracts with the U.S. government has not occurred within the timeframes initially anticipated. As a result of these delays, and the substantial completion of work on several existing contracts, our backlog has declined since the end of fiscal year 2008.

Due to recent schedule delays on several large government contracts, the loss or cancellation of three government programs during the second quarter, and continued weakness in the aerospace market, the Company now expects fiscal year 2009 revenue to be approximately $160 million and net earnings to be approximately $0.15 per share. The Company previously had expected fiscal year 2009 revenue of approximately $170 million and net earnings of approximately $0.45 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 Nine Months of Fiscal Year 2009

In our Annual Report on Form 10-K for the fiscal year ended September 30, 2008, we disclosed that we had restated our 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"). Additional information about the 2008 Restatement is provided in our Quarterly Report on Form 10-Q for the quarter ended March 27, 2009. 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 $9.0 million was recognized in the first nine months of fiscal year 2009.

Results of Operations - Three Months Ended June 26, 2009 Compared to Three
Months Ended June 30, 2008



                                                                 Three Months Ended
                                                                                             Favorable
                                             June 26, 2009          June 30, 2008          (unfavorable)
                                                              (in thousands of dollars)
                                                                     (Unaudited)
Revenue
Government Systems
Contract revenue                            $        22,227        $        23,302        $        (1,075 )
Software maintenance revenue                            505                    570                    (65 )

Total Government Systems                             22,732                 23,872                 (1,140 )
Commercial Systems
Contract revenue                                      5,983                  3,775                  2,208
Software maintenance revenue                          1,018                    644                    374

Total Commercial Systems                              7,001                  4,419                  2,582
Space Communications Systems
Contract revenue                                      7,533                 12,226                 (4,693 )
Software maintenance revenue                          1,576                  1,150                    426
Product revenue                                       4,215                  3,893                    322

Total Space Communications Systems                   13,324                 17,269                 (3,945 )
Elimination of intersegment sales                    (3,274 )               (3,398 )                  124

Total revenue                                        39,783                 42,162                 (2,379 )

Cost of revenue:
Government Systems
Contract and software maintenance cost
of revenue                                           19,784                 15,608                 (4,176 )
Commercial Systems
Contract and software maintenance cost
of revenue                                            6,099                  3,376                 (2,723 )
Space Communications Systems
Contract and software maintenance cost
of revenue                                            6,148                  7,673                  1,525
Product cost of revenue                               2,169                  2,297                    128

Total Space Communications Systems                    8,317                  9,970                  1,653
Elimination of intersegment sales                    (3,274 )               (3,398 )                 (124 )

Total cost of revenue                                30,926                 25,556                 (5,370 )

Gross profit:
Government Systems                                    2,948                  8,264                 (5,316 )
Commercial Systems                                      902                  1,043                   (141 )
Space Communications Systems                          5,007                  7,299                 (2,292 )

Total gross profit                                    8,857                 16,606                 (7,749 )

Operating expense:
Government Systems                                    5,122                  5,010                   (112 )
Commercial Systems                                    1,464                    660                   (804 )
Space Communications Systems                          6,093                  3,138                 (2,955 )

Total operating expense                              12,679                  8,808                 (3,871 )

(Loss) income from operations:
Government Systems                                   (2,174 )                3,254                 (5,428 )
Commercial Systems                                     (562 )                  383                   (945 )
Space Communications Systems                         (1,086 )                4,161                 (5,247 )

Total (loss) income from operations                  (3,822 )                7,798                (11,620 )

Other income (expense), net                             (60 )                   63                   (123 )
(Loss) income before income taxes                    (3,882 )                7,861                (11,743 )
Income tax (benefit) provision                       (2,394 )                2,694                  5,088

Net (loss) income                           $        (1,488 )      $         5,167        $        (6,655 )

Revenue

Consolidated revenue in the third quarter 2009 was $39.8 million, a decrease of $2.4 million, or 5.6%, compared to $42.2 million in the third quarter 2008. The decrease in revenue was related to the following:

Government Systems revenue was $22.7 million in the third quarter 2009, a decrease of $1.1 million, or 4.8%, compared to $23.9 million in the third quarter 2008. Contract services revenues decreased $4.8 million as a result of the near completion of work scope on a sub-contract with the United States Air Force and a civilian contract. These contracts had contributed $5.5 million of revenue in the third quarter 2008. Offsetting these decreases was an increase in contract services revenue of $3.6 million relating to an increase in work scope, the utilization of significant equipment in the performance of the work scope, and the level of effort on an existing contract with the United States Air Force.

Commercial Systems revenue was $7.0 million in the third quarter 2009, an increase of $2.6 million, or 58.4%, compared to $4.4 million in the third quarter 2008. Contract services revenue increased $3.7 million as a result of six new contracts, (two from our Command and Control division, which resulted in a $3.4 million increase, and four from Integral Systems Europe S.A.S, which resulted in an increase of $0.6 million) and an increase in contract services revenue from Newpoint of $0.5 million due to a higher volume of product shipments. Offsetting this increase was a decrease in contract services revenue of $0.8 million from our Command and Control division relating to two contracts with a customer experiencing financial difficulty. Because of our concern over collection from this customer, we did not realize any revenue with respect to these two contracts during the third quarter 2009.

Space Communications Systems revenue was $13.3 million in the third quarter 2009, a decrease of $4.0 million, or 22.8%, compared to $17.3 million in the third quarter 2008. Contract services revenue decreased by $3.0 from our RT Logic operation due to the near completion of two large contracts that had contributed $2.9 million of revenue in the third quarter 2008. In addition, contract services revenue decreased $1.7 million from SAT due to four contracts that had projects scheduled in the third quarter 2008, but were completed prior to the third quarter 2009. Product revenue increased $0.3 million from SAT and $0.3 million from RT Logic, offset by a $0.3 million decrease due to a decrease in volume of product shipments from Lumistar. Revenue from software maintenance agreements increased $0.3 million, from RT Logic and $0.1 million from 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 $8.9 million in the third quarter 2009, a decrease of $7.7 million, or 46.7%, compared to $16.6 million in the third quarter 2008. The decrease in gross profit in the third quarter 2009 was attributable to the following:

Government Systems gross profit was $2.9 million in the third quarter 2009, a decrease of $5.3 million, or 64.3%, compared to $8.3 million in the third quarter 2008. Gross profit decreased $3.3 million as a result of the near completion of a sub contract with the United States Air Force and two civilian contracts as of the end of the third quarter 2009. These contracts had contributed $8.6 million of gross profit in the third quarter 2008. In addition, gross profit decreased $2.1 million relating to a decrease in the level of effort on existing projects and a shift to lower margin projects relating to two contracts with the United States Air Force.

Commercial Systems gross profit was $0.9 million in the third quarter 2009, a decrease of $0.1 million, or 13.5%, compared to $1.0 million in the third quarter 2008. A decrease in gross profit from contract services of $1.6 million relates to two contracts with a customer in our Command and Control operation that is experiencing financial difficulty. Because of our concern over collection from this customer, no revenue was realized with respect to those contracts and an allowance for bad debt of $0.8 million was established during the third quarter 2009. Offsetting this decrease was an increase in contract services gross profit of $0.9 million attributable to six new contracts, as mentioned above, and $0.2 million from our Newpoint operation.

Space Communications Systems gross profit was $5.0 million in the third quarter 2009, a decrease of $2.3 million, or 31.4%, compared to $7.3 million in the third quarter 2008. Contract services gross profit decreased $1.9 million from RT Logic due to the near completion of two large contracts that had contributed $1.0 million of gross profit in the third quarter 2008 and due to a new contract with a civilian government agency that is generating a $0.2 million negative gross profit. In addition, contract services gross profit decreased $1.1 million from SAT due to four contracts that had work scope in the third quarter 2008, but were completed prior to the third quarter 2009. Gross profit from product shipments increased by $0.6 million from RT Logic due to high profit follow-on product shipments, offset by a decrease of $0.2 million from Lumistar relating to a decline in revenue. Gross profit from software maintenance agreements increased $0.3 million, from RT Logic and $0.1 million from SAT.

Operating Expenses

Operating expenses were $12.7 million in the third quarter 2009, an increase of $3.9 million, or 44.0%, compared to $8.8 million in the third quarter 2008. The increase was attributable to $1.0 million from stock based compensation as a result of stock option grants in July 2008 and May 2009, $0.9 million in higher salary and personnel-related expenses due to an increase in support and infrastructure headcount, an increase in research and development expense of $0.9 million and $0.6 million of higher professional services fees, including accounting and tax fees and professional services fees associated with infrastructure development projects and compliance related activities, offset by lower legal fees. During the third quarter 2009, our corporate headquarters moved to Columbia, MD. The facilities in Lanham, MD, the previous location of our corporate headquarters, have not been sublet, and we do not anticipate this space to be sublet before June 2010, therefore an anticipated loss of $0.5 million was recognized in the current quarter. As a result of these two locations, the facility expense increased by $0.5 million.

Operating expenses in our Government Systems segment were $5.1 million in the third quarter 2009, an increase of $0.1 million, or 2.2%, compared to $5.0 million in the third quarter 2008, due to an increase in corporate expenses, offset by lower travel expense.

Operating expenses in our Commercial Systems segment in the third quarter 2009 were $1.5 million in the third quarter 2009, an increase of $0.8 million, or 121.8%, compared to $0.7 million in the third quarter 2008. Corporate expenses were higher in the third quarter 2009 compared to the third quarter 2008 and $0.3 million was incurred relating to the establishment of Integral Systems Europe Limited in the United Kingdom.

Operating expenses in our Space Communications Systems segment were $6.1 million in the third quarter 2009, an increase of $3.0 million or 94.2%, compared to $3.1 million in the third quarter 2008. The increase was attributable to an increase in corporate expenses of $2.5 million, an increase in labor and related expense of $0.2 million relating to the integration of the satID product line that was acquired from QinetiQ Limited, in the second quarter of 2009 and $0.3 million relating to higher research and development expenses incurred in the third quarter 2009 compared to the third quarter 2008.

Income Tax Expense

We recorded an income tax benefit of $2.4 million in the third quarter 2009 and income tax expense of $2.7 million in the third quarter 2008. The tax benefit for the third quarter 2009 included discrete benefits of approximately $0.7 million related to the settlement of our U.S. income tax audit for the years ended September 30, 2004 through 2006 and $0.2 million related to tax return filings in the period that reflected lower tax expense than previously recorded. Excluding these discrete benefits, the effective tax rates for the third quarter 2009 and the third quarter 2008 were 39.0% and 37.8%, respectively. The increase in the effective tax rate excluding discrete items was due to (i) a change in the estimated forecast of pretax income for the year that impacted the overall expected effective tax rate, (ii) an increase in the tax credits for research and experimental expenditures over the prior year as the Congress had not yet extended the credit and (iii) partially offset by losses incurred in certain foreign jurisdictions in 2009 for which no tax benefit was provided. We established a valuation allowance in certain foreign jurisdictions where management believes it is not more likely than not that the deferred tax assets will be realized.

Results of Operations - Nine Months Ended June 26, 2009 Compared to Nine Months
Ended June 30, 2008



                                                                 Nine Months Ended
                                                                                           Favorable
                                             June 26, 2009         June 30, 2008         (unfavorable)
                                                             (in thousands of dollars)
                                                                    (Unaudited)
Revenue
Government Systems
Contract revenue                            $        63,336       $        58,026       $         5,310
Software maintenance revenue                          1,457                 1,396                    61

Total Government Systems                             64,793                59,422                 5,371
Commercial Systems
Contract revenue                                     16,029                12,374                 3,655
Software maintenance revenue                          2,644                 1,762                   882

Total Commercial Systems                             18,673                14,136                 4,537
Space Communications Systems
Contract revenue                                     27,626                33,652                (6,026 )
Software maintenance revenue                          4,433                 3,260                 1,173
Product revenue                                      12,781                 9,745                 3,036

Total Space Communications Systems                   44,840                46,657                (1,817 )
Elimination of intersegment sales                    (7,285 )              (6,389 )                (896 )

Total revenue                                       121,021               113,826                 7,195

Cost of revenue:
Government Systems
Contract and software maintenance cost
of revenue                                           48,509                43,263                (5,246 )
Commercial Systems
Contract and software maintenance cost
of revenue                                           15,046                10,073                (4,973 )
Space Communications Systems
Contract and software maintenance cost
of revenue                                           19,809                21,283                 1,474
Product cost of revenue                               6,340                 5,566                  (774 )

Total Space Communications Systems                   26,149                26,849                   700
Elimination of intersegment sales                    (7,285 )              (6,389 )                 896

Total cost of revenue                                82,419                73,796                (8,623 )

Gross profit:
Government Systems                                   16,284                16,159                   125
Commercial Systems                                    3,627                 4,063                  (436 )
Space Communications Systems                         18,691                19,808                (1,117 )

Total gross profit                                   38,602                40,030                (1,428 )

Operating expense:
Government Systems                                   15,660                10,927                (4,733 )
Commercial Systems                                    3,842                 2,926                  (916 )
Space Communications Systems                         17,378                 8,685                (8,693 )

Total operating expense                              36,880                22,538               (14,342 )

Income from operations:
Government Systems                                      624                 5,232                (4,608 )
Commercial Systems                                     (215 )               1,137                (1,352 )
Space Communications Systems                          1,313                11,123                (9,810 )

Total income from operations                          1,722                17,492               (15,770 )

Other income (expense), net                            (125 )                 263                  (388 )

Income before income taxes                            1,597                17,755               (16,158 )
Income tax (benefit) provision                         (585 )               4,496                 5,081

Net income                                  $         2,182       $        13,259       $       (11,077 )

Revenue

Consolidated revenue was $121.0 million in the nine months ended June 26, 2009, an increase of $7.2 million, or 6.3%, compared to $113.8 million in the nine months ended June 30, 2008. During the nine months ended June 26, 2009, the Company identified and recorded adjustments related to prior periods that increased revenues, pre-tax income and net income by approximately $900,000, $660,000 and $425,000, respectively. The Company has concluded that these corrections are immaterial to the 2008 and 2009 annual financial statements and accordingly, retroactive adjustments to previously issued financial statements are unnecessary. The increase in revenue for the nine months ended June 26, 2009, compared to the nine months ended June 30, 2008, was related to the following:

Government Systems revenue was $64.8 million in the nine months ended June 26, 2009, an increase of $5.4 million, or 9.0%, compared to $59.4 million in the . . .