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DRCO > SEC Filings for DRCO > Form 10-Q on 9-Nov-2012All Recent SEC Filings

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Form 10-Q for DYNAMICS RESEARCH CORP


9-Nov-2012

Quarterly Report


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

The following discussion and analysis of our financial condition and results of operations should be read together with the consolidated financial statements and the notes to those statements that appear elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K filed with the Securities Exchange Commission on March 13, 2012.

Some of the statements in the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations", and elsewhere in this Quarterly Report on Form 10-Q, contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, regarding future events and the future results of DRC that are based on our current expectations, estimates, forecasts, and projections about the industries in which DRC operates and the beliefs and assumptions of the management of DRC.
Words such as "anticipates", "believes", "estimates", "expects", "intends", "plans", "projects", "may", "will", "should", and other similar expressions are intended to identify these forward-looking statements. Such statements are subject to factors that could cause actual results to differ materially from anticipated results. Such factors include, but are not limited to, the following:

Our dependency on the Federal government and changes in federal spending priorities;

A shift in pricing structure for government contracts;

Risks associated with actual and potential goodwill impairment;

An increased focus on the elimination of administrative costs within the Department of Defense;

Failure to obtain new government contracts or retain existing contracts;

The effect of Federal government in-sourcing on our business;

The loss of skilled personnel;

The risk of security breaches in systems we develop, install, or maintain;

Failure by Congress to timely approve budgets governing spending by Federal agencies;

Risks due to government contract provisions providing for rights unfavorable to us, including the ability to terminate contracts at any time for convenience;

Potential systems or service failures that could result in liability to our company;

Competition with competitors who may have advantages due to having greater resources or qualifying for special statuses;

Failure to obtain or maintain necessary security clearances;

Risks associated with various, complex Federal government procurement laws and regulations;

Adverse effects in the event of an unfavorable Federal audit of our contracts;

Failure to adequately safeguard confidential information;

An adverse outcome related to ongoing legal proceedings;

Incurrence of expenditures prior to final receipt of contracts;

Competitive conditions in current markets and difficulties in entering new markets; and

Our ability to maintain sufficient sources of financing and the risk that our financing requirements should increase.

These and other risk factors are more fully described in our Annual Report on Form 10-K for the year ended December 31, 2011 under the section entitled "Risk Factors", and from time to time, in other filings with the SEC. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this document. Actual results may differ materially and adversely from those expressed in any forward-looking statements.
Except to the extent required by applicable law or regulation, DRC undertakes no obligation to revise or update publicly any forward-looking statements for any reason.

Unless the context otherwise requires, references in this Form 10-Q to "DRC", "we", "us", or "our" refer to Dynamics Research Corporation and its subsidiaries.


OVERVIEW

Business

Dynamics Research Corporation, headquartered in Andover, Massachusetts, is a leading provider of innovative management consulting, engineering, and information technology services and solutions to federal and state governments.

Our go-to-market strategy is sharply focused within each of four dimensions:

Solutions. We deliver five high-value, differentiated solutions to our clients: business transformation, information technology, training and performance support, management services, and science and engineering services. We believe our solutions align well with the needs of our government customers today who require improved efficiencies and effectiveness, and face procurement reform, transformational and technology based changes, and ongoing, changing security threats.

Markets and Customers. We target markets which are based on long-term market force drivers that have sustained demand for our services. We select specific customers from government agencies in our target growth markets with needs that well match the solutions we provide. Currently our target growth markets include homeland security, healthcare, cyber security, intelligence, and financial/regulatory reform.

Prime Government and Agency-Wide Contracts. We hold a portfolio of government and agency-wide multiple award schedule ID/IQ task order contracts. Today, these types of contracts are the federal government's preferred means of procurement for services.

Acquisitions. We use acquisitions, funded through both operationally generated cash and leverage, to strengthen our position in our target growth markets.

On September 30, 2011, we completed the merger of High Performance Technologies, Inc. ("HPTi") for $143 million in cash plus net working capital of $3.4 million. HPTi is a leading provider of high-end technology services to the federal healthcare and military technology markets. The merger strengthens and expands the Company's market presence as a provider of high-end services and solutions in the federal market.

Market

In the first nine months of 2012 as well as in 2011, we generated 95% of our revenue from contracts with the United States government, either as a prime contractor or as a subcontractor. As a result, we are significantly impacted by trends and changes in federal expenditures and procurement policies. The U.S. government deficit, budgetary challenges, and efforts to curtail expenditures are ongoing and reflected in (i) the Budget Control Act of 2011, which increased the debt ceiling and enacted 10-year discretionary spending caps and automatic spending cuts, referred to as sequestration, which will require $1.2 trillion of spending cuts over 10 years, if not amended by Congress and the President, (ii) the Defense Strategic Guidance, issued on January 5, 2012, which outlines fundamental changes in the strategy of United States armed forces, which is smaller and leaner but agile, flexible, and technologically advanced, and (iii) the President's budget submission for the fiscal year beginning October 1, 2012.
Additionally, sizeable mandatory outlays for social security and medical programs in the face of large budget deficits indicate that federal discretionary spending will remain under pressure.

Overall, the President's information technology budget request of $78.9 billion for fiscal year 2013 is down slightly from the fiscal year 2012 enacted budget, reflecting reductions in defense and intelligence budgets and increases in civilian agencies such as the Departments of Treasury, Veterans Affairs, and Education.


We have seen and anticipate continued impacts from government budget management initiatives, the specific timing and effects of which may not be predictable, such as:

Program delays, cuts, and terminations,

fewer new program starts,

intensified price competition for new business and re-competes of current business, and

pressure to reduce dependency on service contractors and set more work aside for small and socially disadvantaged businesses.

These events may result in (i) new business contract wins being lower than expected or needed to sustain growth, (ii) ending of or reductions to current programs and contracts, and (iii) lower profit margins as a result of pricing pressure and the need to invest in winning new and retaining existing business - all of which may adversely affect our results of operations and financial condition.

NON-GAAP FINANCIAL MEASURES

In evaluating our operating performance, management uses certain non-GAAP financial measures to supplement the consolidated financial statements prepared under generally accepted accounting principles in the United States ("GAAP").

Management believes these non-GAAP measures help indicate our operating performance before charges that are considered by management to be outside our ongoing operating results. Accordingly, management uses these non-GAAP measures to gain a better understanding of our comparative operating performance from period-to-period and as a basis for planning and forecasting future periods. Management believes these non-GAAP measures, when read in conjunction with our GAAP financials, provide useful information to investors by offering:

the ability to make more meaningful period-to-period comparisons of our ongoing operating results, net of the effect of goodwill impairment;

the ability to better identify trends in our underlying business and perform related trend analysis;

a higher degree of transparency for certain expenses (particularly when a specific charge impacts multiple line items);

a better understanding of how management plans and measures our underlying business; and

an easier way to compare our most recent results of operations against investor and analyst financial models.

The non-GAAP measures we use exclude the goodwill impairment charges incurred in the second and third quarters of 2012, the transaction-related costs related to the HPTi merger and its related tax effect that management believes is outside of our ongoing operations for the periods presented.

These non-GAAP measures have limitations; however, because they do not include all items of expense that impact our operations. Management compensates for these limitations by also considering our GAAP results. The non-GAAP financial measures we use are not prepared in accordance with, and should not be considered an alternative to, measurements required by GAAP, such as operating loss, net loss and loss per share, and should not be considered measures of our liquidity. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the most directly comparable GAAP measures. In addition, these non-GAAP financial measures may not be comparable to similar measures reported by other companies.


Non-GAAP financial measures, together with a reconciliation with the most direct comparable financial measures under GAAP for the three and nine months ended September 30, 2012 and 2011 were as follows:

                                                                 Three Months Ended                 Nine Months Ended
                                                                    September 30,                     September 30,
(in thousands)                                                  2012             2011             2012             2011
Selling, general and administrative expenses                $      5,684     $      7,041     $     18,985     $     19,519
Operating transaction costs                                            -                -                -           (1,703 )
Non-GAAP selling, general and administrative                $      5,684     $      7,041     $     18,985     $     17,816

Operating income (loss)                                     $    (32,092 )   $      8,844     $    (33,332 )   $     16,809
Impairment of goodwill                                            36,600                -           48,600                -
Operating transaction costs                                            -                -                -            1,703
Non-GAAP operating income                                   $      4,508     $      8,844     $     15,268     $     18,512

Interest expense, net                                       $     (2,579 )   $     (3,027 )   $     (7,979 )   $     (4,047 )
Non operating transaction costs                                        -                -                -              533
Non-GAAP interest expense, net                              $     (2,579 )   $     (3,027 )   $     (7,979 )   $     (3,514 )

Income (loss) before provision (benefit) for income taxes   $    (32,257 )   $      5,660     $    (38,833 )   $     12,768
Impairment of goodwill                                            36,600                -           48,600                -
Total transaction costs                                                -                -                -            2,236
Non-GAAP income before provision for income taxes           $      4,343     $      5,660     $      9,767     $     15,004

Provision (benefit) for income taxes                        $    (11,663 )   $      2,382     $    (13,951 )   $      5,345
Tax benefit for impairment of goodwill                            13,200                -           17,700                -
Tax benefit for transaction costs                                      -                -                -              940
Non-GAAP provision for income taxes                         $      1,537     $      2,382     $      3,749     $      6,285

Net income (loss)                                           $    (20,594 )   $      3,278     $    (24,882 )   $      7,423
Impairment of goodwill, net of taxes                              23,400                -           30,900                -
Total transaction costs, net of taxes                                  -                -                -            1,296
Non-GAAP net income                                         $      2,806     $      3,278     $      6,018     $      8,719

Earnings (loss) per share:
GAAP Basic                                                  $      (1.99 )   $       0.32     $      (2.40 )   $       0.74
Per share effect of goodwill impairment                             2.26                -             2.98                -
Per share effect of transaction costs                                  -                -                -             0.13
Non-GAAP Basic                                              $       0.27     $       0.32     $       0.58     $       0.87

GAAP Diluted                                                $      (1.99 )   $       0.32     $      (2.40 )   $       0.73
Per share effect of goodwill impairment                             2.25                -             2.97                -
Per share effect of transaction costs                                  -                -                -             0.13
Non-GAAP Diluted(1)                                         $       0.27     $       0.32     $       0.58     $       0.85

Weighted average shares outstanding:
Basic                                                         10,360,203       10,244,868       10,356,334       10,060,585
Diluted                                                       10,384,518       10,314,413       10,394,775       10,205,603

(1) May not add due to rounding.


RESULTS OF OPERATIONS

Operating results expressed as a percentage of total revenue are as follows:

                                                 Three Months Ended September 30,
(in millions)                                       2012                     2011
 Revenue                                   $    76.8                   $ 96.4

 Gross profit                              $    11.2         14.6 %    $ 17.4       18.1 %
 Selling, general and administrative             5.7          7.4 %       7.0        7.3 %
 Amortization of intangible assets               1.0          1.3 %       1.6        1.6 %
 Impairment of goodwill                         36.6         47.7 %         -        0.0 %
 Operating income (loss)                       (32.1 )      (41.8 )%      8.8        9.2 %
 Interest expense, net                          (2.6 )       (3.4 )%     (3.0 )     (3.1 )%
 Other income (expense), net                     2.4          3.1 %      (0.2 )     (0.2 )%
 Provision (benefit) for income taxes(1)       (11.7 )       36.2 %       2.4       42.1 %
 Net income (loss)(2)                      $   (20.6 )      (26.8 )%   $  3.3        3.4 %



                                                 Nine Months Ended September 30,
(in millions)                                      2012                     2011
 Revenue                                   $  243.5                  $ 234.4

 Gross profit                              $   37.3        15.3 %    $  38.6       16.5 %
 Selling, general and administrative           19.0         7.8 %       19.5        8.3 %
 Amortization of intangible assets              3.1         1.3 %        2.3        1.0 %
 Impairment of goodwill                        48.6        20.0 %          -        0.0 %
 Operating income (loss)                      (33.3 )     (13.7 )%      16.8        7.2 %
 Interest expense, net                         (8.0 )      (3.3 )%      (4.0 )     (1.7 )%
 Other income, net                              2.5         1.0 %        0.0        0.0 %
 Provision (benefit) for income taxes(1)      (14.0 )      35.9 %        5.3       41.9 %
 Net income (loss)(2)                      $  (24.9 )     (10.2 )%   $   7.4        3.2 %

(1) The percentage of provision for income taxes relates to a percentage of income (loss) before income taxes.

(2) Net income (loss) may not add due to rounding.


Revenues

Revenues for the three and nine months ended September 30, 2012 were earned from
the following sectors:

                                                      Three Months Ended September 30,
(in millions)                                            2012                     2011
National defense and intelligence agencies      $   44.6          58.0 %   $ 59.5        61.7 %
Homeland security                                   11.8          15.4       13.0        13.5
Federal civilian agencies                           16.3          21.3       20.1        20.9
Total revenue from federal agencies                 72.7          94.7       92.6        96.1
State and local government agencies and other        4.1           5.3        3.8         3.9
Total revenue                                   $   76.8         100.0 %   $ 96.4       100.0 %



                                                      Nine Months Ended September 30,
(in millions)                                         2012(2)                   2011
National defense and intelligence agencies      $  142.0        58.3 %   $ 154.8        66.0 %
Homeland security                                   36.2        14.9        36.6        15.6
Federal civilian agencies                           53.3        21.9        31.7        13.5
Total revenue from federal agencies(1)             231.4        95.1       223.1        95.2
State and local government agencies and other       12.0         4.9        11.3         4.8
Total revenue(1)                                $  243.5       100.0 %   $ 234.4       100.0 %

(1) Totals may not add due to rounding.

(2) Revenues for the first and second quarter of 2012 have been reclassified to conform to current period and 2011 presentation as follows:

                                                            Three Months Ended
(in millions)                                     March 31, 2012          June 30, 2012
National defense and intelligence agencies      $  50.4        58.7 %   $ 47.0        58.2 %
Homeland security                                  12.3        14.3       12.1        14.9
Federal civilian agencies                          19.2        22.4       17.7        21.9
Total revenue from federal agencies                81.9        95.4       76.8        95.0
State and local government agencies and other       3.9         4.6        4.0         5.0
Total revenue                                   $  85.9       100.0 %   $ 80.8       100.0 %

We reported total revenue of $76.8 million and $96.4 million in the third quarter of 2012 and 2011, respectively, and $243.5 million and $234.4 million in the first nine months of 2012 and 2011, respectively. Total revenues represent a decrease of 20.3% in the third quarter of 2012 and an increase of 3.9% in the first nine months of 2012, from the comparable periods in 2011. Several contracts ended in the fourth quarter of 2011, which represented more than half of the decline in revenue in the third quarter of 2012 compared with the same period in 2011. The increase for the first nine months of 2012 was due to HPTi results being included in all reporting periods during 2012.

During the fourth quarter of 2011, we saw evidence of aggressive government cost-cutting initiatives that impacted several successful programs, which were completed in the fourth quarter of 2011, where clients deferred or cancelled follow-on awards due to cost-cutting efforts. The reduction in annual revenue from these completed programs totaled approximately $30 million, which has impacted the first nine months of 2012 and our outlook for the remainder of 2012.

In the first six months of 2012, we continued to see a shortage of new business awards, but saw strong activity in third quarter contract actions. The total contract value of our new business wins in the first nine months of 2012 totaled $150.1 million. Regarding competitions to re-win existing business we won $158 million, or 85%, of the award decisions made in the first nine months of 2012, down from a re-win rate of 98% for the 2011 fiscal year.


In the second quarter of 2012, we were adversely impacted by two contracts which were subject to re-compete or extension. One of the contracts was not extended or re-competed due to a lack of funds, and the other, which was scheduled for a competitive procurement, was awarded on a sole source basis to a small, socially disadvantaged business. The contracts, which impacted the third quarter of 2012, generated approximately $11 million in annual revenue with 75 employees.

Revenues by contract type as a percentage of revenues were as follows:

                                                           Three Months Ended            Nine Months Ended
                                                              September 30,                September 30,
                                                          2012            2011          2012           2011
 Fixed price, including service type contracts                 45 %            46 %          46 %          48 %
 Time and materials                                            37              33            34            31
 Cost reimbursable                                             18              21            20            21
                                                              100 %           100 %         100 %         100 %

 Prime contract                                                83 %            82 %          84 %          78 %
 Sub-contract                                                  17              18            16            22
                                                              100 %           100 %         100 %         100 %

Backlog and Bookings

Our backlog position was as follows:

(in millions)   September 30, 2012       December 31, 2011
Backlog:
Funded          $             182.4     $             183.3
Unfunded                      574.9                   618.6
Total backlog   $             757.3     $             801.9

We expect that substantially all of our funded backlog at September 30, 2012 will generate revenue during the subsequent twelve month period. The funded backlog generally is subject to possible termination at the convenience of the contracting party. Contracts are typically funded on an annual basis or incrementally for shorter time periods. The funded backlog as of September 30, 2012 and December 31, 2011 covered approximately 7.1 months and 6.2 months of revenue, respectively. Funded bookings were $108.0 million and $61.5 million in the three months ended September 30, 2012 and December 31, 2011, respectively, and generated a book-to-bill ratio of approximately 1.4 to 1.0 and 1.0 to 1.0 for each respective period.

Gross Profit

Gross profit was $11.2 million and $17.4 million for the third quarter of 2012 and 2011, respectively, resulting in a gross margin of 14.6% and 18.1%, respectively. For the first nine months of 2012 and 2011, gross profit was $37.3 million and $38.6 million, respectively, resulting in a gross margin of 15.3% and 16.5%, respectively.

In the third quarter of 2012, lower revenue represented about $6 million of the gross profit decline. Price erosion represented about $0.7 million, or 0.1 point of gross profit reduction. Indirect overhead costs were 2 points higher as a percent of revenue due in part to higher than normal severance costs.

Overhead costs included in gross profit totaled $17.8 million, or 23.2 percent of revenue, in the third quarter of 2012, compared with $20.3 million, 21.0 percent of revenue, for the third quarter of 2011.


Selling, general and administrative expenses

Selling, general and administrative expenses were $5.7 million and $7.0 million for the third quarter of 2012 and 2011, respectively, and $19.0 million and $19.5 million, respectively, in the first nine months of 2012 and 2011, respectively. Selling, general and administrative expenses as a percent of total revenue in the third quarter of 2012 and 2011 were 7.4% and 7.3%, respectively, and 7.8% and 8.3% in the first nine months of 2012 and 2011, respectively. The decrease in selling, general and administrative expenses in third quarter of 2012 was due to our indirect cost reduction initiatives. The decrease in selling, general and administrative expenses in the nine months of 2012 was due to transaction-related costs of $1.7 million recorded in the second quarter of 2011 and our indirect cost reduction initiatives partially offset by added costs for the merger of HPTi.

Intangible assets

Amortization expense was $1.0 million and $1.6 million in the third quarter of 2012 and 2011, respectively, and $3.1 million and $2.3 million in the first nine months of 2012 and 2011, respectively. The increase in amortization expense for the first nine months of 2012 was due to a full year of amortization related to the $20 million of acquired intangible assets from the HPTi merger. The remaining amortization expense for the current fiscal year is expected to be approximately $1.0 million.

Impairment of goodwill

During the second quarter of 2012, we recorded an estimated goodwill impairment charge of $12.0 million based on a step 1 analysis performed. We completed the step 2 analysis on October 31, 2012, and determined the total amount of the goodwill impairment to be $48.6 million, which resulted in an additional charge of $36.6 million in the quarter ending September 30, 2012. . . .

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