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DRCO > SEC Filings for DRCO > Form 10-Q on 8-May-2013All Recent SEC Filings

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Form 10-Q for DYNAMICS RESEARCH CORP


8-May-2013

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 18, 2013.

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;

Failure by Congress to timely approve budgets governing spending by Federal agencies or to raise the Federal debt ceiling;

Risks associated with actual and potential goodwill impairment;

A shift in pricing structure for government contracts;

The effect of cost-cutting measures within the Department of Defense and elsewhere in the Federal government, including in-sourcing;

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

Failure to obtain new government contracts or retain existing contracts;

Risks relating to competitive bidding, recompetes, contract protests, and multiple source contracts;

The loss of skilled personnel;

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

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;

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

Failure to adequately safeguard confidential information;

Incurrence of expenditures prior to final receipt of contracts;

Restrictions contained in our credit facilities;

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, 2012 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.


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OVERVIEW

Business

Dynamics Research Corporation is a leading technology and management consulting company focused on driving performance, process, and results for government clients. We have large company capabilities, small company agility, and a track record providing innovative solutions and rock solid results. Our go-to-market strategy has several dimensions:

Well Positioned in the Best Funded Federal Markets. We believe these markets - healthcare, research and development, homeland security, intelligence, surveillance and reconnaissance, and financial/regulatory reform - will receive sustained priority funding for years to come, based on long-term market force drivers such as (i) the need to curb the growth of healthcare costs and improve quality of care, (ii) the continued emergence of cyber threats, (iii) the on-going war on terrorism, (iv) immigration reform, (v) increased financial regulation, (vi) tax reform, (vii) the need for greater efficiency, (viii) technologically driven change, and (ix) changing federal workforce demographics.

Relevant, Differentiated Capabilities. We solve our clients' most complex problems, applying cost effective and emerging technologies. Our solutions - in the science and technology, information technology and management services areas - are differentiated capabilities such as high performance computing, cloud computing, big data, health informatics, mobile, cyber-security, technology strategy and governance, and systems and software engineering. We believe our capabilities align well with the needs of today's government clients that require improved efficiencies and effectiveness, and face procurement reform, transformational and technology based changes, and ongoing, changing security threats.

Highly Talented Workforce. We have a highly credentialed and degreed staff - smart, talented experts in their field. Our staff has a record of success solving difficult technical problems, providing the most cost effective solutions, and using a process driven approach. We have hard-working, vibrant breakthrough thinkers, who are focused on client needs and results driven.

Extensive Prime Contract Portfolio. Our contracts enable direct client access. We hold a broad, outstanding portfolio of government and agency-wide multiple award schedule indefinite delivery/indefinite quantity ("ID/IQ") task order contracts and single award base purchase agreements. Today, these types of contracts are the federal government's preferred means of procurement for services.

Strong Growth Platform. Rapidly adaptable to change, our integrated financial, contracts, human resources, and technology infrastructure provides consistent, reliable results to our clients. As a highly scalable capability, we can commit to support our clients' most stringent and complex needs.

Market

In 2012, 95% of our total revenues were derived 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 on-going 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 enact $1.2 trillion of spending cuts over 10 years,
(ii) the Defense Strategic Guidance, issued on January 5, 2012 which outlines fundamental changes in Federal defense strategy, providing for a force which is smaller, leaner but agile, flexible, and technologically advanced, and (iii) the ongoing inability of the federal government to legislate spending priorities through the timely approval of an annual budget.


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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:

Reduced professional services spending;
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.

RESULTS OF OPERATIONS

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

                                             Three Months Ended March 31,
                                              2013                   2012
(in millions)
 Revenue                               $  73.6                 $ 85.9

 Gross profit                          $  10.9       14.8 %    $ 13.6       15.8 %
 Selling, general and administrative       5.7        7.8 %       6.9        8.0 %
 Amortization of intangible assets         0.9        1.3 %       1.0        1.2 %
 Operating income                          4.2        5.7 %       5.7        6.6 %
 Interest expense, net                    (2.2 )     (3.0 )%     (2.8 )     (3.2 )%
 Other income, net                         0.1        0.1 %       0.1        0.2 %
 Provision for income taxes(1)             0.9       41.1 %       1.2       40.9 %
 Net income(2)                         $   1.2        1.7 %    $  1.8        2.1 %

(1) The percentage of provision for income taxes relates to a percentage of income from continuing operations before income taxes.

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


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Revenues

Revenues were earned from the following sectors:

                                                                          Three Months Ended
                                                                               March 31,
(in millions)                                                         2013                   2012
Healthcare                                                     $ 15.3        20.8 %   $ 15.1        17.6 %
Homeland Security                                                10.0        13.6       12.3        14.3
Research and Development                                         11.4        15.5       11.9        13.9
Intelligence, Surveillance, and Reconnaissance                   10.4        14.1        9.5        11.1
Federal Regulation and Reform                                     6.1         8.3        6.2         7.3
Priority Markets (1)                                             53.2        72.3       55.1        64.2
Defense Readiness, Logistics, and Command, Control, and
Communication                                                    15.3        20.8       26.6        31.0
State Government and Other                                        5.0         6.9        4.1         4.8
Total Markets (1)                                              $ 73.6       100.0 %   $ 85.9       100.0 %

(1) Totals may not add due to rounding.

Revenue decreased by $12.3 million, or 14.3%, in the first quarter of 2013 compared to the same period in 2012. First quarter 2013 revenue in our priority markets were $53.2 million, 3.4% below the same period a year ago, reflecting lower homeland security revenue as a result of scope reductions on certain Department of Homeland Security ("DHS") headquarters information technology programs. In the Defense Readiness, Logistics, and Command, Control, and Communications market sectors, various cost reduction initiatives and an increase in set-asides under Small Business Administration ("SBA") programs, resulted in revenue reductions of 42.5% relative to 2012.

Due to on-going federal budget challenges, we anticipate continued turbulence in 2013 in the federal market, including unanticipated scope reductions on existing contracts, delays in award decisions and new program initiatives, and an increase in set-asides under SBA programs, for which we will be ineligible to compete as a prime contractor. Along these lines, two events have occurred in 2013. First, a Department of Defense research program, which generated $7.2 million of mostly pass-through revenue in 2012, ended in April 2013, and second, we are anticipating scope reductions on DHS headquarters information technology programs as a result of budget cuts in the range of $4 to $6 million in 2013 as compared with 2012.

The DHS Enterprise Acquisition Gateway to Leading Edge ("EAGLE") contract is currently under re-competition. We have been one of the leading providers of services under the management services function category of EAGLE. We believe we are well positioned to win the successor contract. However, the outcome from the competition remains uncertain and there can be no assurance that a successor contract will be awarded to DRC.

Regarding competitions to re-win existing business we won 100% of the award decisions made in the first quarter of 2013, compared to 79% of the award decisions made in the first quarter of 2012.


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During 2012, revenues were earned from the following sectors:

                                                                    Three Months Ended 2012                         Year Ended
                                                                                                                   December 31,
                                                  March 31       June 30       September 30       December 31        2012 (1)
Healthcare                                       $     15.1     $    14.3     $         13.2     $        14.0     $        56.6
Homeland Security                                      12.3          12.1               11.8              11.3              47.5
Research and Development                               11.9          10.7               11.8              11.2              45.6
Intelligence, Surveillance and Reconnaissance           9.5           9.6               10.3              10.2              39.6
Federal Regulation and Reform                           6.2           5.9                6.0               5.9              24.1
Priority Markets (1)                                   55.1          52.6               53.1              52.6             213.5
Defense Readiness, Logistics, and Command,
Control and Communication                              26.6          24.4               19.7              16.5              87.2
State Government and Other                              4.1           3.8                4.0               4.3              16.3
Total Markets (1)                                $     85.9     $    80.8     $         76.8     $        73.5     $       317.0

(1) Totals may not add due to rounding.

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

                                                    Three Months Ended
                                                         March 31,
                                                   2013            2012
 Fixed price, including service type contracts          43 %            46 %
 Time and materials                                     39              34
 Cost reimbursable                                      18              20
                                                       100 %           100 %

 Prime contract                                         80 %            85 %
 Sub-contract                                           20              15
                                                       100 %           100 %

Backlog and Bookings

Our backlog position was as follows:

                 March 31,
(in millions)      2013          December 31, 2012
Backlog:
Funded          $     130.5     $             163.6
Unfunded              430.1                   568.1
Total backlog   $     560.6     $             731.7

We expect that substantially all of our funded backlog at March 31, 2013 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 March 31, 2013 and December 31, 2012 covered approximately 5.3 months and 6.7 months of revenue, respectively. Funded bookings were $44.7 million and $54.4 million in the three months ended March 31, 2013 and December 31, 2012, respectively, and generated a book-to-bill ratio of approximately 1.0 to one for both periods.


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Total contract backlog of $560.6 million as of March 31, 2013 was down from $731.7 million at December 31, 2012 primarily as a result of our termination of participation in a ten-year Department of Defense research program, which generated monthly pass through revenue, removing $109 million from contract backlog. In addition, a contract awarded to DRC in 2012 and protested was recently terminated and as a result reduced contract backlog by $19 million.

Gross Profit

Total gross profit was $10.9 million and $13.6 million for the first quarter of 2013 and 2012, respectively, resulting in a gross margin of 14.8% and 15.8% for each respective period. Lower revenue in the first quarter of 2013 represented approximately $1.9 million of the gross profit decline. Overhead costs included in gross profit totaled $16.4 million, or 22.3% of revenue for the first quarter of 2013, compared with $19.0 million, or 22.2% of revenue for the same period in 2012.

Selling, General and Administrative Expenses

Selling, general and administrative expenses were $5.7 million and $6.9 million in the first quarter of 2013 and 2012, respectively. Selling, general and administrative expenses as a percent of total revenue decreased to 7.8% in the first quarter of 2013 from 8.0% in the same period in 2012. The decrease in selling, general and administrative expenses in the first quarter of 2013 was primarily due to staffing reductions and other indirect cost reduction initiatives.

Amortization of Intangible Assets

Amortization expense was $0.9 million and $1.0 million the first quarter of 2013 and 2012, respectively. The remaining amortization expense for the current fiscal year is expected to be approximately $2.8 million.

Interest Expense, net

We incurred net interest expense of $2.2 million and $2.8 million in the first quarter of 2013 and 2012, respectively. The decrease in interest expense in the first quarter of 2013 compared to the same period in 2012 was due to the lower outstanding debt balances and lower interest rates.

Other Income (Expense), net

Other income (expense) consists of our portion of earnings and losses in HMRTech, gains and losses realized from our deferred compensation plan and results from other non-operating transactions, all of which were immaterial to our results.

Income Tax Provision

We recorded income tax provisions of $0.9 million and $1.2 million in the first quarter of 2013 and 2012, respectively. The effective income tax rate was 41.1% and 40.9% in the first quarter of 2013 and 2012, respectively.


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LIQUIDITY AND CAPITAL RESOURCES

The following discussion analyzes liquidity and capital resources by operating, investing, and financing activities. Our principal sources of liquidity are cash flows from operations and borrowings from our revolving credit agreement.

Our results of operations, cash flows, and financial condition are subject to trends, events, and uncertainties, including demands for capital to support growth, economic conditions, government payment practices, and contractual matters. Our need for access to funds is dependent on future operating results, our growth and acquisition activity, and external conditions.

We have evaluated our future liquidity needs, both from a short-term and long-term basis. We believe we have sufficient funds to meet our working capital and capital expenditure needs for the short-term. Cash on hand plus cash generated from operations along with cash available under our credit lines are expected to be sufficient in 2013 to service debt, finance capital expenditures, pay federal and state income taxes, and fund expected pension plan contributions, if necessary. To provide for long-term liquidity, we believe we can generate substantial positive cash flow, as well as obtain additional capital, if necessary, from the use of debt or equity. In the event that our current capital resources are not sufficient to fund requirements, we believe our access to additional capital resources would be sufficient to meet our needs.

With the HPTi merger, we have utilized our access to capital resources to acquire a business that aligns with our growth strategy. In the long-term, we believe that selective acquisitions are an important component of our growth strategy and we may acquire, from time to time, businesses or contracts that are aligned with our core capabilities and which complement our customer base.

Operating Activities

Net cash used in operating activities was $6.8 million during the first quarter of 2013 compared with $1.6 million for the first quarter of 2012. The first quarter of each fiscal year is seasonally the weakest quarter of each year from a cash flow viewpoint as a result of payments made in the first quarter of each year for annual incentive compensation, taxes, and increases in prepayments of rents and other expenses.

Cash outflows from net contract receivables were $8.1 million in the first quarter of 2013 compared to $4.4 million in the same period of 2012. In the first quarter of 2013, billed receivables represented $6.3 million and unbilled receivables represented $1.8 million of total change in net contract receivables compared to billed receivables representing essentially the entire change in the same period of 2012. Contract receivables days sales outstanding ("DSO"), was 69 days at March 31, 2013 compared to 59 days at December 31, 2012 and 74 days at March 31, 2012. Federal business DSO, which excludes the effect of state contracts, was 59 days at March 31, 2013 compared to 50 days at December 31, 2012 and 67 days at March 31, 2012. A slowdown in federal government payments, including the Department of Defense suspension in late February 2013 of the Quick Pay initiative, was the primary cause of an increase of more than $6 million in billed receivables as of March 31, 2013 as compared in December 31, 2012.

On March 1, 2013, we received an indication of intent from a customer to reduce the scope of our work on a contract, on which we had $4.2 million and $4.0 million in unbilled receivables at March 31, 2013 and December 31, 2012, respectively, for costs incurred in advance of billings. Recovery of these costs is expected through (i) future milestone payments of $2.2 million for work completed or expected to be completed and delivered, and (ii) the remaining balance under the termination for convenience provision of the contract for work we had performed prior to the reduction in scope.

Our net deferred tax asset was $10.9 million and $11.7 million at March 31, 2013 and December 31, 2012, respectively. The decrease in the net deferred tax asset was primarily due to amortization of intangible assets. During the first quarter of 2013, we received a net refund of approximately $0.1 million in income taxes and currently anticipate net income tax refunds of $0.5 million in the remaining three quarters of 2013, for a total refund anticipated of $0.6 million for the full year 2013.


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Share-based compensation was $0.1 million and $0.2 million in the first quarter of 2013 and 2012, respectively. As of March 31, 2013 the total unrecognized compensation cost related to restricted stock awards was $1.0 million which is expected to be amortized over a weighted-average period of 2.0 years, and the unrecognized compensation cost related to stock option awards was under $0.1 million and is expected to be amortized over a weighted-average period of 0.6 years.

Non-cash amortization expense of our acquired intangible assets was $0.9 million and $1.0 million in the first quarters of 2013 and 2012, respectively. We anticipate that non-cash expense for the amortization of intangible assets will remain at a comparable quarterly level for the remainder of 2013.

Our defined benefit pension plan was underfunded by $28.1 million and $28.9 million at March 31, 2013 and December 31, 2012, respectively. We contributed $0.7 million to fund the pension plan in the first quarter of 2013 compared to $0.4 million in the same period of 2012. We recorded pension expense of under $0.1 million and $0.2 million in the first quarter of 2013 and 2012, respectively. We expect to contribute a total of $2.8 million to fund the pension plan and anticipate pension expense to be approximately $0.2 million in 2013.

Investing Activities

Net cash used in investing activities was $0.3 million and $2.4 million in the first quarter of 2013 and 2012, respectively. Net cash used in investing activities in the first quarter of 2013 primarily consisted of payments for capital expenditures. Net cash used in investing activities in the first quarter of 2012 primarily consisted of the settlement of a working capital payment related to the High Performance Technologies, Inc. acquisition of $2.4 million and payments for capital expenditures of $0.1 million. We expect discretionary capital expenditures in 2013 to be in the range of $1 million to $2 million.

Financing Activities

Net cash provided by financing activities was $7.0 million and $0.2 million in the first quarter of 2013 and 2012, respectively. Net cash provided by financing activities in the first quarter of 2013 was primarily due to $10.6 million in net borrowing under the revolver and proceeds from the issuance of common stock through stock plan transactions, partially offset by repayments under the senior term loan of $3.4 million and $0.2 million in payments of repurchased shares, which represented the fair value of shares re-issued in connection with the rescission offer. Net cash provided by financing activities in the first quarter of 2012 was primarily due to $2.8 million in net borrowings under the revolver and proceeds from the issuance of common stock through stock plan transactions, partially offset by repayments under the senior term loan of $2.8 million.

During the first quarter of 2013, the average outstanding balance of our senior term loan was $66.5 million at a weighted average interest rate of 4.34% . . .

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