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 2008 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.

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.

In the first quarter 2009, the Company was awarded a contract valued at over $18 million to build a new nuclear power plant simulator for a two unit reactor plant in Slovakia. The contract includes approximately $12 million of hardware that the customer has requested be a part of the contract in addition to approximately $6 million related specifically to the simulator. Margins on the hardware portion of the contract are minimal, while margins on the more traditional simulation portions will be consistent with those in the past. The utility customer in Slovakia is constructing two new Russian designed VVER-440 nuclear reactors at the site that will incorporate Siemens / Areva control systems. Work on this contract commenced in the first quarter 2009 and is scheduled for completion in approximately 30 months. GSE, in partnership with Siemens, built the first full scope simulator at the same site in 1997. Including this contract, the Company logged approximately $39.2 million in nuclear simulation orders in the six months ended June 30, 2009.

The Company's fossil fueled power simulation business has grown 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 global recession and financial credit crisis has not currently had a significant effect on the Company's business. Specifically, the Company has seen no delays or cancellations to the projects it is currently working on, and is unaware of any delays or cancellations to projects that the Company expects to secure in 2009.

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 revenue:

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(in thousands)          Three months ended June 30,                           Six months ended June 30,
                       2009            %          2008          %           2009          %           2008          %
Contract revenue    $   10,650        100.0 %    $ 6,555       100.0 %    $ 18,778       100.0 %    $ 13,638       100.0 %
Cost of revenue          8,037         75.5 %      4,648        70.9 %      13,736        73.1 %       9,866        72.3 %

Gross profit             2,613         24.5 %      1,907        29.1 %       5,042        26.9 %       3,772        27.7 %
Operating
expenses:
Selling, general
and
administrative           1,833         17.2 %      1,952        29.8 %       3,611        19.3 %       3,891        28.6 %
Depreciation               122          1.1 %        103         1.6 %         242         1.3 %         203         1.5 %
Total operating
expenses                 1,955         18.3 %      2,055        31.4 %       3,853        20.6 %       4,094        30.1 %

Operating income
(loss)                     658          6.2 %       (148 )      (2.3 )%      1,189         6.3 %        (322 )      (2.4 )%

Interest income,
net                         22          0.2 %         40         0.6 %          34         0.2 %          34         0.3 %
Gain (loss) on
derivative
instruments                194          1.8 %         (5 )      (0.1 )%        207         1.1 %           5         0.0 %
Other expense,
net                       (111 )       (1.0 )%       (65 )      (0.9 )%       (221 )      (1.2 )%       (129 )      (0.9 )%

Income (loss)
before income
taxes                      763          7.2 %       (178 )      (2.7 )%      1,209         6.4 %        (412 )      (3.0 )%

Provision for
income taxes               192          1.8 %         92         1.4 %         305         1.6 %         151         1.1 %

Net income (loss)   $      571          5.4 %    $  (270 )      (4.1 )%   $    904         4.8 %    $   (563 )      (4.1 )%

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, 2008 is included in Note 2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2008. 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 2008 Annual Report on Form 10-K for the fiscal year ended December 31, 2008.

Results of Operations - Three and Six Months ended June 30, 2009 versus Three and Six Months ended June 30, 2008

Contract Revenue. Total contract revenue for the quarter ended June 30, 2009 totaled $10.6 million, which was 62.5% higher than the $6.6 million total revenue for the quarter ended June 30, 2008. For the six months ended June 30, 2009, contract revenue totaled $18.8 million, a 37.7% increase from the $13.6 million for the six months ended June 30, 2008. The Company recorded total orders of $42.4 million in the six months ended June 30, 2009 versus $18.0 million in the six months ended June 30, 2008. Included in the 2009 orders was an $18.4 million contract to build a new nuclear power plant simulator for a two unit reactor plant in Slovakia. The contract includes approximately $12 million for hardware, the largest portion being a digital control system from Siemens, that the customer has requested be a part of the contract in addition to approximately $6 million related specifically to the simulator. Due to the significant hardware portion of the project, the overall margin on the project is lower than the Company's normal gross margin. In the three and six months ended June 30, 2009, the Company recognized $1.5 million and $1.8 million, respectively, of contract revenue on this project using the percentage-of-completion method, which accounted for 14.4% and 9.6%, respectively, of the Company's consolidated revenue. At June 30, 2009, the Company's backlog was $62.2 million, of which $16.6 million related to this contract.

Selling, General and Administrative Expenses. Selling, general and administrative ("SG&A") expenses totaled $1.8 million in the quarter ended June 30, 2009, a 6.1% decrease from the $2.0 million for the same period in 2008. For the six months ended June 30, 2009 and 2008, SG&A expenses totaled $3.6 million and $3.9 million, respectively. The decrease reflects the following spending variances:

¨ Business development and marketing costs decreased from $809,000 in the second quarter 2008 to $783,000 in the second quarter of 2009 and decreased from $1.6 million for the six months ended June 30, 2008 to $1.4 million in the same period 2009. The decrease mainly reflects a reduction in bidding and proposal costs, which are the costs of operations personnel in assisting with the preparation of contract proposals.

¨ The Company's general and administrative expenses were virtually unchanged, totaling $1.0 million in both the second quarter 2009 and 2008 and totaling $2.1 million in both the six months ending June 30, 2009 and 2008.

¨ Gross spending on software product development ("development") totaled $139,000 in the quarter ended June 30, 2009 as compared to $299,000 in the same period of 2008. For the three months ended June 30, 2009, the Company expensed $72,000 and capitalized $67,000 of its development spending while in the three months ended June 30, 2008, the Company expensed $99,000 and capitalized $200,000 of its development spending. For the six months ended June 30, 2009, gross development spending totaled $240,000 versus $537,000 in the same period of 2008. The Company expensed $97,000 and capitalized $143,000 of its development spending in the six months ended June 30, 2009 and expensed $144,000 and capitalized $393,000 of its development spending in the same period of 2008. The Company's capitalized development expenditures in 2009 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 replacement of the current Graphic User Interface of SimSuite Pro with JADE Designer. The Company anticipates that its total gross development spending in 2009 will approximate $500,000.

Depreciation. Depreciation expense totaled $122,000 and $103,000 during the quarters ended June 30, 2009 and 2008, respectively. For the six months ended June 30, 2009 and 2008, depreciation expense totaled $242,000 and $203,000, respectively. The higher 2009 depreciation expense is a result of the Company's 2008 capital purchases related to the Company's move to its Sykesville, Maryland headquarters in 2008 and the purchase of new computers for new hires.

Interest Income, Net. Net interest income totaled $22,000 in the quarter ended June 30, 2009 versus net interest income of $40,000 in the quarter ended June 30, 2008. For both the six months ended June 30, 2009 and 2008, net interest income totaled $34,000.

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"), replacing the Company's credit facility with Laurus Master Fund. 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 second line of credit was originally in the principal amount of up to $1.5 million, however, on May 5, 2009, the credit agreement was amended to increase the principal amount to $2.5 million. The other line of credit is in the principal amount of up to $2.5 million. The Company has not borrowed any funds against either BOA line of credit.

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. Amortization expense totaled $89,000 in the six months ended June 30, 2008. The deferred financing costs incurred in conjunction with the BOA lines of credit are being amortized over the two-year period of the lines of credit. Amortization began in April 2008 and totaled $9,000 and $27,000 for the three and six months ended June 30, 2009, respectively, and $18,000 in both the three and six months ended June 30, 2008.

At June 30, 2009 and 2008, the Company had approximately $4.9 million and $2.9 million, respectively, of cash in Certificates of Deposit with BOA that were being used as collateral for various performance and advance payment bonds. The Company recorded interest income of $17,000 and $29,000 from the Certificates of Deposit in the three and six months ended June 30, 2009, respectively, versus $40,000 and $64,000 of interest income in the three and six months ended June 30, 2008, respectively. The reduction in interest income reflects lower interest rates on the Certificates of Deposit in 2009.

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. The Company recorded interest income of $10,000 and $19,000 in the three and six months ended June 30, 2009 respectively. For the three and six months ended June 30, 2008, the Company recorded interest income of $14,000 and $29,000, respectively.

Interest income earned on short-term investments of the Company's operating cash totaled $1,000 for the three months ended June 30, 2009 versus $7,000 for the three months ended June 30, 2008 and totaled $4,000 for the six months ended June 30, 2009 versus $40,000 for the six months ended June 30, 2008. The lower interest income in 2009 mainly reflects lower interest rates on the short-term investments.

Gain (Loss) on Derivative Instruments. The Company periodically enters into forward foreign exchange contracts to manage market risks associated with the fluctuations in foreign currency exchange rates on foreign-denominated trade receivables. As of June 30, 2009, the Company had foreign exchange contracts for sale of approximately 2.0 million Pounds Sterling, 3.1 million Euro and 970 million Japanese Yen at fixed rates. The contracts expire on various dates through February 2014. The Company has not designated the contracts as hedges and has recognized a loss on the change in the estimated fair value of the contracts of $25,000 for the three months ended June 30, 2009 and a gain of $101,000 for the six months ended June 30, 2009.

At June 30, 2008, the Company had contracts for the sale of approximately 225,000 Euro at fixed rates. The contracts expired on various dates through February 2009. The Company had not designated the contracts as hedges and recognized a loss of $5,000 in the change in the estimated fair value of the contracts during the three months ended June 30, 2008 and a gain of $5,000 during the six months ended June 30, 2008.

Other Expense, Net. For the three and six months ended June 30, 2009, other expense, net was $111,000 and $221,000, respectively. For the three and six months ended June 20, 2008, other expense, net was $65,000 and $129,000, respectively. The major components of other expense, net included the following items:

¨ The Company accounts for its investment in the Emirates Simulation Academy using the equity method. In accordance with the equity method, the Company eliminated 10% of the profit from this contract as the training simulators are assets that have been recorded on the books of ESA, and the Company was thus required to eliminate its proportionate share of the profit included in the asset value. The profit elimination totaled $(1,000) and $38,000 for the three and six months ended June 30, 2008. ESA began to amortize the training simulators effective January 1, 2009 over a four year life; accordingly, GSE began to amortize the deferred profit in January 2009 and recognized a gain of $45,000 and $90,000 for the three and six months ended June 30, 2009, respectively.

¨ For the three and six months ended June 30, 2009, the Company recognized a $156,000 and $313,000 equity loss, respectively, on its investment in ESA. For the three and six months ended June 30, 2008, the Company's recognized a $63,000 and $88,000 equity loss, respectively.

Provision for Income Taxes.

The Company files in the United States federal jurisdiction and in several state and foreign jurisdictions. Because of the net operating loss carryforwards, the Company is subject to U.S. federal and state income tax examinations from years 1997 and forward and is subject to foreign tax examinations by tax authorities for years 2001 and forward. Open tax years related to state and foreign jurisdictions remain subject to examination but are not considered material to our financial position, results of operations or cash flows.

As of June 30, 2009, there have been no material changes to the liability for uncertain tax positions. 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.

The Company expects to pay U.S. federal alternative minimum income taxes in 2009 and to pay income taxes in Sweden and China. 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 June 30, 2009 with the exception of the deferred tax assets of its Swedish subsidiary which are expected to be realized in 2009, which total $126,000.

Liquidity and Capital Resources

As of June 30, 2009, the Company's cash and cash equivalents totaled $5.3 million compared to $8.3 million at December 31, 2008.

Cash provided by (used in) operating activities. For the six months ended June 30, 2009, net cash provided by operations totaled $58,000. Significant changes in the Company's assets and liabilities in the six months ended June 30, 2009 included:
¨ A $4.3 million increase in the Company's contract receivables. The Company's trade receivables decreased from $7.3 million at December 31, 2008 to $6.5 million at June 30, 2009 while the Company's unbilled receivables increased by $5.1 million to $8.8 million at June 30, 2009. At June 30, 2009, trade receivables outstanding for more than 90 days totaled $1.9 million versus $2.2 million at December 31, 2008. Included in the over 90 day balance at both June 30, 2009 and December 31, 2008 was $1.6 million due from ESA. The Company believes the entire overdue balance will be received and has not increased its bad debt reserve. The increase in the unbilled receivables is due to the timing of contracted billing milestones of the Company's current projects. In July 2009, the Company invoiced $2.8 million of the unbilled amounts; the balance of the unbilled amounts is expected to be invoiced and collected within one year.

¨ A $2.5 million increase in accounts payable, accrued compensation and accrued expenses. The Company's accounts payable and accrued liabilities have increased due to material purchases and the utilization of subcontractors on several of the Company's current projects.

Net cash used in operating activities for the six months ended June 30, 2008 totaled $1.1 million. Significant changes in the Company's assets and liabilities in the six months ended June 30, 2008 included:
¨ A $1.9 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 $8.5 million at June 30, 2008 (including $3.9 million due from ESA) while the Company's unbilled receivables decreased by $2.4 million to $4.2 million at June 30, 2008. At June 30, 2008, trade receivables outstanding for more than 90 days totaled $3.0 million (including $2.6 million from ESA) versus $2,000 at December 31, 2007.

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