| DYNAMICS RESEARCH CORP Item 1A RISK FACTORS In addition to the other information in this Annual Report on Form 10-K, you should carefully consider the risks described below before deciding to invest in shares of our common stock |
| These are risks and uncertainties we believe are most important for you to consider |
| Additional risks and uncertainties not presently known to us, or which we currently deem immaterial, or which are similar to those faced by other companies in our industry or business in general, may also impair our business operations |
| If any of the following risks or uncertainties actually occurs, our business, financial condition, results of operations or cash flows would likely suffer |
| In that event, the market price of our common stock could decline |
| Our Revenue is Highly Concentrated on the Department of Defense and Other Federal Agencies, and A Significant Portion of Our Revenue is Derived From a Few Customers |
| Decreases in Their Budgets, Changes in Program Priorities or Military Base Closures Could Affect Our Results |
| In the two years ended December 31, 2005, approximately 89prca of our revenue was derived from United States Government agencies |
| Within the Department of Defense, certain individual programs account for a significant portion of our United States Government business |
| Our revenue from contracts with the Department of Defense, either as a prime contractor or subcontractor, accounted for approximately 78prca of our total revenue in the two years ended December 31, 2005 |
| We cannot provide any assurance that any of these programs will continue as such or will continue at current levels |
| Our revenue could be adversely affected by significant changes in defense spending during periods of declining United States defense budgets |
| Among the effects of this general decline has been increased competition within a consolidating defense industry |
| Current budget pressures on the United States Government caused by the war in Iraq and natural disasters may have adverse effects on the company’s business |
| It is not possible for us to predict whether defense budgets will increase or decline in the future |
| Further, changing missions and priorities in the defense budget may have adverse effects on our business |
| Funding limitations could result in a reduction, delay or cancellation of existing or emerging programs |
| We anticipate there will continue to be significant competition when our defense contracts are re-bid, as well as significant competitive pressure to lower prices, which may reduce profitability in this area of our business, which could adversely affect our business, financial condition, results of operations and cash flows |
| We historically have derived a substantial portion of our revenue from contracts and subcontracts with the United States Government |
| A significant portion of our federal and state government contracts are undertaken on a time and materials nature, with fixed hourly rates that are intended to cover salaries, benefits, other indirect costs of operating the business and profit |
| The pricing of such contracts is based upon estimates of future costs and assumptions as to the aggregate volume of business that we will perform in a given business division or other relevant unit |
| 14 _________________________________________________________________ [45]Table of Contents Alternatively, we undertake various government projects on a fixed-price basis, as distinguished from billing on a time and materials basis |
| Under a fixed-price contract, the government pays an agreed upon price for our services or products, and we bear the risk that increased or unexpected costs may reduce our profits or cause us to incur a loss |
| Significant cost overruns can occur if we fail to: • adequately estimate the resources required to complete a project; • properly determine the scope of an engagement; or • complete our contractual obligation in a manner consistent with the project plan |
| For fixed price contracts, we must estimate the costs necessary to complete the defined statement of work and recognize revenue or losses in accordance with such estimates |
| Actual costs may vary materially from the estimates made from time to time, necessitating adjustments to reported revenue and net income |
| Underestimates of the costs associated with a project could adversely affect our overall profitability and could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| While we endeavor to maintain and improve contract profitability, we cannot be certain that any of our existing or future time and materials or fixed-price projects will be profitable |
| The company’s revenues earned under fixed price contracts have increased as a percentage of total revenues to approximately 23prca in 2005 from approximately 19prca in 2004 |
| This increase is primarily due to the company’s contract with the State of Ohio to design, develop and install a statewide automated child welfare case management system |
| A substantial portion of our United States Government business is as a subcontractor |
| In such circumstances, we generally bear the risk that the prime contractor will meet its performance obligations to the United States Government under the prime contract and that the prime contractor will have the financial capability to pay us amounts due under the subcontract |
| The inability of a prime contractor to perform or make required payments to us could have a material adverse effect on the company’s business, financial condition, results of operations and cash flows |
| Our Contracts and Subcontracts with Government Agencies are Subject to a Competitive Bidding Process and to Termination Without Cause by the Government |
| A significant portion of our federal and state government contracts are renewable on an annual basis, or are subject to the exercise of contractual options |
| Multi-year contracts often require funding actions by the United States Government, state legislature or others on an annual or more frequent basis |
| As a result, our business could experience material adverse consequences should such funding actions or other approvals not be taken |
| Recent federal regulations and renewed congressional interest in small business set aside contracts is likely to influence decisions pertaining to contracting methods for many of the company’s customers |
| These regulations require more frequent review and certification of small business contractor status, so as to ensure that companies competing for contracts intended for small business are qualified as such at the time of the competition |
| The company’s contracts with the Aeronautical Systems Center (“ASC”), the Air Force Electronic Systems Center (“ESC”) and the Internal Revenue Service (“IRS”), which provided approximately dlra49 million, dlra30 million and dlra10 million, respectively, of revenues in the year 2005, and approximately dlra47 million, dlra31 million and dlra12 million, respectively, of revenues in the year 2004, were subject to re-competition in 2005 |
| The services provided under the ASC/Blanket Purchase Agreement were subject to re-competition in 2005 as the Consolidated Acquisition of Professional Services (“CAPS”) contract |
| The competition for prime contract awards was restricted to small businesses |
| The company participated in the competition through HJ Ford, its wholly owned subsidiary |
| HJ Ford along with HMR Tech has formed a small business joint venture for this competition |
| HJ Ford and HMR Tech are participants in the US Small Business Administration Mentor Protege program |
| The company currently anticipates awards on the CAPS contract will occur late in the first quarter or second quarter of 2006 with the transition of task orders to the new contract occurring throughout the balance of 2006 and into early 2007 |
| There can be no assurance that the company’s joint venture will succeed in obtaining the contract award |
| The company anticipates if the joint venture is awarded the CAPS contract, that a successful transition to CAPS via the joint venture would enable DRC to retain and preserve profits on substantially its entire labor base currently supporting these customers |
| The company currently derives approximately dlra24 million of annual revenues from work performed by subcontractors under the company’s prime contract with the ASC Upon completion of the transition of task orders from the 15 _________________________________________________________________ [46]Table of Contents current contract to the new CAPS contract, if it is awarded to the joint venture, it is anticipated that the company’s current subcontractors would contract directly with the joint venture prime contractor entity |
| As a result it is estimated that, if the CAPS contract is awarded to the joint venture, upon the completion of the task order transitions, the company’s annual revenue would be reduced by approximately dlra24 million while positively affecting the profit margin percent of the remaining revenue |
| The services provided under the ESC contract were originally scheduled for re-competition in 2005 |
| The re-competition was delayed |
| It is currently anticipated that the competition for a portion of the work to be performed for ESC will be full-and-open to all qualified contractors and the competition for the remainder of the work will be restricted to small businesses |
| It is now anticipated that the government contract award and initial task order transitions will occur in late 2006 |
| The company expects to participate in the competition primarily as a sub-contractor to a qualified small business and that a successful re-competition would enable DRC to retain and preserve profits on substantially its entire labor base currently supporting these customers, which is expected to increase profit margins |
| The full year revenue impact of moving from prime contractor to a sub-contractor role is anticipated to be an approximate dlra11 million revenue reduction |
| There can be no assurance that the company will be successful in receiving the ESC contract award |
| The base contract agreement covering the company’s work with the IRS was the subject of re-competition in 2005 |
| The company’s current task orders have been extended through May 2006 |
| Contract awards were announced in the fourth quarter of 2005 |
| The company did not receive a new base contract award |
| After May 2006, the company anticipates continuing work with the IRS either through a United States General Services Administration (“GSA”) schedule contract or as a sub-contractor |
| As a result of this transition, the company anticipates that about dlra5 million of sub-contractor revenues reflected in 2005 revenues will no longer be included in company revenues |
| Governmental awards of contracts are subject to regulations and procedures that permit formal bidding procedures and protests by losing bidders |
| Such protests may result in significant delays in the commencement of expected contracts, the reversal of a previous award decision or the reopening of the competitive bidding process, which could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| Because of the complexity and scheduling of contracting with government agencies, from time to time we may incur costs before receiving contractual funding by the United States Government |
| In some circumstances, we may not be able to recover such costs in whole or in part under subsequent contractual actions |
| Failure to collect such amounts may have material adverse consequences on our business, financial condition, results of operations and cash flows |
| In addition, the United States Government has the right to terminate contracts for convenience |
| If the government terminated contracts with us, we would generally recover costs incurred up to termination, costs required to be incurred in connection with the termination and a portion of the fee earned commensurate with the work we have performed to termination |
| However, significant adverse effects on our indirect cost pools may not be recoverable in connection with a termination for convenience |
| Contracts with state and other governmental entities are subject to the same or similar risks |
| As a defense contractor, we are subject to many levels of audit and review, including by the Defense Contract Audit Agency, various inspectors general, the Defense Criminal Investigative Service, the General Accountability Office, the Department of Justice and Congressional Committees |
| These audits, reviews and the pending grand jury investigation and civil suit in the United States District Court for the District of Massachusetts could result in the termination of contracts, the imposition of fines or penalties, the withholding of payments due to us or the prohibition from participating in certain United States Government contracts for a specified period of time |
| Any such action could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| Loss of Key Personnel Could Limit Our Growth |
| We are dependent on our ability to attract and retain highly skilled technical personnel |
| Many of our technical personnel may have specific knowledge and experience related to various government customer operations and these individuals would be difficult to replace in a timely fashion |
| In addition, qualified technical personnel are in high demand worldwide and are likely to remain a limited resource |
| The loss of services of key personnel could impair our ability to perform required services 16 _________________________________________________________________ [47]Table of Contents under some of our contracts, to retain such business after the expiration of the existing contract, or to win new business in the event that we lost the services of individuals who have been identified in a given proposal as key personnel in the proposal |
| Any of these situations could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| Some government contracts require us to maintain facility security clearances, and require some of our employees to maintain individual security clearances |
| If our employees lose or are unable to obtain security clearances on a timely basis, or we lose a facility clearance, the government client can terminate the contract or decide not to renew the contract upon its expiration |
| As a result, to the extent that we cannot obtain the required security clearances for our employees working on a particular contract, or we fail to obtain them on a timely basis, we may not derive the revenue anticipated from the contract, which could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| Many of the systems we develop, install and maintain involve managing and protecting information involved in intelligence, national security, and other sensitive or classified government functions |
| A security breach in one of these systems could cause serious harm to our business, damage our reputation, and prevent us from being eligible for further work on sensitive or classified systems for federal government clients |
| We could incur losses from such a security breach that could exceed the policy limits under our errors and omissions and product liability insurance |
| Damage to our reputation or limitations on our eligibility for additional work resulting from a security breach in one of our systems could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| We are exposed to the risk that employee fraud or other misconduct could occur |
| Misconduct by employees could include intentional failures to comply with federal government procurement regulations, engaging in unauthorized activities, or falsifying time records |
| Employee misconduct could also involve the improper use of our clients’ sensitive or classified information, which could result in regulatory sanctions against us and serious harm to our reputation |
| It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in controlling unknown or unmanaged risks or losses, which could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| As a defense contractor, the company is subject to many levels of audit and review from various government agencies, including the Defense Contract Audit Agency, various inspectors general, the Defense Criminal Investigation Service, the Government Accountability Office, the Department of Justice and Congressional Committees |
| Both related to and unrelated to its defense industry involvement, the company is, from time to time, involved in audits, lawsuits, claims, administrative proceedings and investigations |
| The company accrues for liabilities associated with these activities when it becomes probable that future expenditures will be made and such expenditures can be reasonably estimated |
| Except as noted below, the company does not presently believe it is reasonably likely that any of these matters would have a material adverse effect on the company’s business, financial position, results of operations or cash flows |
| The company’s evaluation of the likelihood of expenditures related to these matters is subject to change in future periods, depending on then current events and circumstances, which could have material adverse effects on the company’s business, financial position, results of operations and cash flows |
| On October 26, 2000, two former company employees were indicted and charged with conspiracy to defraud the United States Air Force, and wire fraud, among other charges, arising out of a scheme to defraud the United States out of approximately dlra10 million |
| Both men subsequently pled guilty to the principal charges against them |
| On October 9, 2003, the United States Attorney filed a civil complaint in the United States District Court for the District of Massachusetts against the company based in substantial part upon the actions and omissions of the former employees that gave rise to the criminal cases against them |
| In the civil action, the United States is asserting claims against the company based on the False Claims 17 _________________________________________________________________ [48]Table of Contents Act and the Anti-Kickback Act, in addition to certain common law and equitable claims |
| The United States Attorney seeks to recover up to three times its actual damages and penalties under the False Claims Act, and double damages and penalties under the Anti-Kickback Act |
| The United States Attorney also seeks to recover its costs and interest in this action |
| The company believes it has substantive defenses to these claims and intends to vigorously defend itself |
| However, the outcome of this litigation and other proceedings to which the company is a party, if unfavorable, could have a material adverse effect on the company’s business, financial position, results of operations and cash flows |
| The company has provided documents in response to a previously disclosed grand jury subpoena issued on October 15, 2002 by the United States District Court for the District of Massachusetts, directing the company to produce specified documents dating back to 1996 |
| The subpoena relates to an investigation, currently focused on the period from 1996 to 1999, by the Antitrust Division of the Department of Justice into the bidding and procurement activities involving the company and several other defense contractors who have received similar subpoenas and may also be subjects of the investigation |
| Although the company is cooperating in the investigation, it does not have a sufficient basis to predict the outcome of the investigation |
| Should the company be found to have violated the antitrust laws, the matter could have a material adverse effect on the company’s business, financial position, results of operations and cash flows |
| On June 28, 2005 a suit, characterized as a class action employee suit, was filed in the US Federal Court for the District of Massachusetts alleging violations of the Fair Labor Standards Act and certain provisions of Massachusetts General Laws |
| The company believes that its practices comply with the Fair Labor Standards Act and Massachusetts General Laws |
| The company will vigorously defend itself and has sought to have the complaint dismissed from Federal Court and addressed in accordance with the company’s mandatory Dispute Resolution Program for the arbitration of workplace complaints |
| Nevertheless, the outcome of this litigation, if unfavorable, could have a material adverse effect on the company’s business, financial position, results of operations and cash flows |
| If Our Internal Controls over Financial Reporting Do Not Comply with Financial Reporting and Control Management Requirements, There Could Be a Material Adverse Effect on Our Operations or Financial Results |
| Effective internal controls are necessary for us to provide reliable financial reports |
| If we cannot provide reliable financial reports, our business and operating results could be harmed |
| We have in the past discovered, and may in the future discover, areas of our internal control over financial reporting that need improvement |
| Although our management has determined, and our independent registered public accounting firm has attested, that our internal controls over financial reporting were effective as of December 31, 2005, we cannot assure you that we or our independent registered public accounting firm will not identify a material weakness in our internal controls in the future |
| A material weakness in our internal controls over financial reporting would require management and our independent registered public accounting firm to evaluate our internal controls as ineffective |
| If our internal controls over financial reporting are not considered adequate, we may experience a loss of public confidence in our reported financial information, which could have an adverse effect on our business and the trading price of our stock |
| The markets for our services are highly competitive |
| The government contracting business is subject to intense competition from numerous companies, many of which have significantly greater financial, technical and marketing resources than we do |
| The principal competitive factors are prior performance, previous experience, technical competence and price |
| Competition in the market for our commercial products is also intense |
| There is a significant lead-time for developing such business, and it involves substantial capital investment including development of prototypes and investment in manufacturing equipment |
| Principal competitive factors are product quality, the ability to specialize our engineering in order to meet our customers’ specific system requirements and price |
| Our precision products business has a number of competitors, many of which have significantly greater financial, technical and marketing resources than we do |
| Competitive pressures in our government and commercial businesses could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| In our efforts to enter new markets, including commercial markets and United States Government agencies other than the Department of Defense, we generally face significant competition from other companies that have prior experience with such potential customers, as well as significantly greater financial, technical and marketing 18 _________________________________________________________________ [49]Table of Contents resources than we have |
| We May Be Subject to Product Liability Claims |
| Our precision manufactured products are generally designed to operate as important components of complex systems or products |
| Defects in our products could cause our customer’s product or systems to fail or perform below expectations |
| Although we attempt to contractually limit our liability for such defects or failures, we cannot assure you that our attempts to limit our liability will be successful |
| Like other manufacturing companies, we may be subject to claims for alleged performance issues related to our products |
| Such claims, if made, could damage our reputation and could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| Economic Events May Affect Our Business Segments |
| Many of our precision products are components of commercial products |
| Factors that affect the production and demand for such products, including economic events both domestically and in other regions of the world, competition, technological change and production disruption, could adversely affect demand for our products |
| Many of our products are incorporated into capital equipment, such as machine tools and other automated production equipment, used in the manufacture of other products |
| As a result, this portion of our business may be subject to fluctuations in the manufacturing sector of the overall economy |
| An economic recession, either in the United States or elsewhere in the world, could have a material adverse effect on the rate of orders received by the commercial division |
| Significantly lower production volumes resulting in under-utilization of our manufacturing facilities would adversely affect our business, financial condition, results of operations and cash flows |
| We offer sophisticated products and services in areas in which there have been and are expected to continue to be significant technological changes |
| Many of our products are incorporated into sophisticated machinery, equipment or electronic systems |
| Technological changes may be incorporated into competitors’ products that may adversely affect the market for our products |
| If our competitors introduce superior technologies or products, we cannot assure you that we will be able to respond quickly enough to such changes or to offer services that satisfy our customers’ requirements at a competitive price |
| Further, we cannot provide any assurance that our research and product development efforts will be successful or result in new or improved products that may be required to sustain our market position |
| Our Financing Requirements May Increase and We Could Have Limited Access to Capital Markets |
| While we believe that our current resources and access to capital markets are adequate to support operations over the near term and foreseeable future, we cannot assure you that these circumstances will remain unchanged |
| Our need for capital is dependent on operating results and may be greater than expected |
| Our ability to maintain our current sources of debt financing depends on our ability to remain in compliance with certain covenants contained in our financing agreements, including, among other requirements, maintaining a minimum total net worth and minimum cash flow and debt coverage ratios |
| If changes in capital markets restrict the availability of funds or increase the cost of funds, we may be required to modify, delay or abandon some of our planned expenditures, which could have a material adverse effect on our business, financial condition, results of operations and cash flows |
| Accounting System Upgrades and Conversions May Delay Billing and Collections of our Accounts Receivable |
| In 2004, we installed a new enterprise business system, and from time to time, we may be required to make changes to that system as we integrate businesses or upgrade to new technologies |
| Future accounting system conversions and upgrades could cause delays in billing and collection of accounts receivable under our contracts, which could adversely affect our business, financial condition, results of operations and cash flows |
| Our revenue and earnings may fluctuate from quarter to quarter depending on a number of factors, including: • the number, size and timing of client projects commenced and completed during a quarter; 19 _________________________________________________________________ [50]Table of Contents • bid and proposal efforts undertaken; • progress on fixed-price projects during a given quarter; • employee productivity and hiring, attrition and utilization rates; • accuracy of estimates of resources required to complete ongoing projects; • the trend in interest rates, and • general economic conditions |
| Demand for our products and services in each of the markets we serve can vary significantly from quarter to quarter due to revisions in customer budgets or schedules and other factors beyond our control |
| In addition, because a high percentage of our expenses is fixed and does not vary relative to revenue, a decrease in revenue may cause a significant variation in our operating results |
| In 2004, we acquired Impact Innovations Group LLC, and in 2002, we acquired HJ Ford Associates, Inc |
| and Andrulis Corporation |
| We may seek to continue to expand our operations through mergers, acquisitions or strategic alliances with businesses that will complement our existing business |
| However, we may not be able to find attractive candidates, or enter into acquisitions on terms that are favorable to us, or successfully integrate the operations of companies that we acquire |
| In addition, we may compete with other companies for these acquisition candidates, which could make an acquisition more expensive for us |
| If we are able to successfully identify and complete an acquisition or similar transaction, it could involve a number of risks, including, among others: • the difficulty of assimilating the acquired operations and personnel; • the potential disruption of our ongoing business and diversion of resources and management time; • the potential failure to retain key personnel of the acquired business; • the difficulty of integrating systems, operations and cultures; and • the potential impairment of relationships with customers as a result of changes in management or otherwise arising out of such transactions |
| We cannot assure you that any acquisition will be made, that we will be able to obtain financing needed to fund such acquisitions and, if any acquisitions are so made, that the acquired business will be successfully integrated into our operations or that the acquired business will perform as expected |
| In addition, if we were to proceed with one or more significant strategic alliances, acquisitions or investments in which the consideration consists of cash, a substantial portion of our available cash could be used to consummate the strategic alliances, acquisitions or investments |
| The financial impact of acquisitions, investments and strategic alliances could have a material adverse effect on our business, financial condition, results of operations and cash flows and could cause substantial fluctuations in our quarterly and annual operating results |
| The Market Price of Our Common Stock May Be Volatile |
| The market price of securities of technology companies historically has faced significant volatility |
| The stock market in recent years has also experienced significant price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of particular companies |
| Many factors that have influenced trading prices will vary from period to period, including: • decreases in our earnings and revenue or quarterly operating results; • changes in estimates by analysts; • market conditions in the industry; • announcements and new developments by competitors; and • regulatory reviews |