Item 2.                          Management’s Discussion and Analysis of Financial Condition and Results of Operations

SM&A is the world’s leading provider of competition management (business capture and proposal development) services, and a leading provider of program services (post-award risk mitigation and profit maximizing) services.  Under these two service lines, our approximately 300350 employees and consultants provide strategy, proposal management, program management, systems engineering, program planning, and other high-value technical support to major industrial customers in the defense, homeland security, aerospace, information technology, and engineering sectors.  Since 1982, we have managed more than 1,000 proposals worth more than $340 billion for our clients and have achieved an 85% win rate on awarded contracts.

Results of Operations

The following table sets forth certain historical operating results (in millions):

Three Months Ended September 30, 2006March 31, 2007 Compared to Three Months Ended September 30, 2005March 31, 2006

Revenue.  Revenue decreased $2.7increased $5.9 million, or 14%33.3%, to $17.0a record $23.6 million for the three months ended September 30, 2006March 31, 2007 compared to $19.7$17.7 million for the same period of the prior year.  The decreaseacquisition of PPI on February 9, 2007 contributed $1.1 million or 4.6% of total revenue for the three months ended March 31, 2007.   The increase in our revenue was realized inacross all of our non-service lines and our traditional aerospace and defense businessvertical.  Our non aerospace and defense vertical, titled system integration and information technology (“SIIT”) declined year over year.  This decline is due primarily to oneour largest client who reducedin this vertical reducing our service levelsservices starting in the second quarter of 2006 due to their internal budget pressures.  We haveExcluding this one client, our SIIT revenue increased our service levels with this client at the end of this quarter as the customer entered their new fiscal year.  This reduction accounted for a decrease of $1.8 millionby $580,000, or 47% compared to the same period of the prior year.  Total non-aerospace and defenseThe following table is provided to display our revenue declined $2.1 million, or 33% to $4.3 million asresults compared to $6.5 million for the same period of the prior year.  Total aerospace

We attribute this record revenue performance from executing on our strategy to continue to build client relationships with our strategic clients and defenseoffering our services and solutions across our clients’ program life cycle.  Another significant contributor is our Account Executive team which has not experienced turnover in over 15 months.  No turnover has allowed the Company to better understand our clients’ needs and build valued relationships.   Since last year, our focus on expanding our Program Services business line has also produced consistent sequential quarterly revenue declined 4%growth.   The acquisition of PPI also contributed to $12.7 million compared to $13.2 million duringour revenue performance.  The results in the three months ended September 30, 2006 and 2005, respectively.

The percentage of revenues from competition management and program services was 58% and 42% fortable above reflect the three months ended September 30, 2006, respectively, compared to 60% and 40% for the same period of the prior year.  The percentage of revenue coming from our aerospace and defense clients was 74% and 67% for the three months ended September 30, 2006 and 2005, respectively.  During the three months ended September 30, 2006, we were engaged by five new customers who accounted for 4%success of our total revenue.  This compares to five new customers which accounted for 1% of our total revenue during the same period of the prior year.efforts.

Gross Margin. Gross margin decreased $1.8increased $2.1 million, or 22%29.6%, to $6.4$9.2 million for the three months ended September 30, 2006March 31, 2007 compared to $8.2$7.1 million for the same period of the prior year.  The decreaseincrease in gross margin dollars is due to the decreaseincrease in sales as discussed above andoffset by a decrease in gross margin as a percentage of revenue.  As a percentage of revenue, gross margin decreased to 38%39.0% for the three months ended September 30, 2006March 31, 2007 compared to 42%40.1% for the same period of the prior year.  The deceasedecline was due to three factors.  First, wea reduction in the level of success fees earned, revenue mix, and pricing structures offered to some of our largest customers.  We recorded success fees of $103,000$0 and $169,000$102,000 for the three months ended September 30,March 31, 2007 and 2006, and 2005, respectively.  Second, we realized a planned increase in our sales compensation expense as a percentage of revenue triggered by Account Executives that had exceeded their annual sales goals; and third, we are evaluating a pricing structure in which we reduce our competition management service rates in lieu of extended Program Service revenue onWe expect the program if awarded.  Excluding these three items, our gross margins would have been consistent with our historical levels of more than 40%.to be approximately 40.0% for fiscal year 2007.

Selling, General and Administrative Expenses.  Selling, general and administrative expenses consist principally of salary and benefit costs for executive, sales and administrative personnel, stock-based employee compensation, expense,depreciation and amortization, professional services and other general corporate activities.  As a result of adopting Statement 123(R) we recorded stock-based compensation expense of $313,000 during the three months ended September 30, 2006.  No stock compensation expense was

recordedSelling, general and administrative expenses increased $1.6 million, or 30.2%, to $6.9 million for the three months ended September 30, 2005.  Excluding stock-based compensation expense, selling, general and administrative expenses increased $1.2 million or 27% during the three months ended September 30, 2006March 31, 2007, as compared to the same period of the prior year.  With the creation of Practice Leader functions in late calendar year 2005, which have the responsibility to create new service solutions and enhance our overall service offerings, we incurred planned expenses of approximately $600,000 during the three months ended September 30, 2006.  No similar function existed during the three months ended September 30, 2005.  Our sales and marketing expenses increased by $260,000 due to increased travel and sales support expenses.  Our general operating expenses increased by approximately $360,000 including $92,000 in depreciation expense and approximately $160,000 in non-routine expenses related to the post implementation costs of our new ERP system which went live in June 2006.  The post implementation professional services expenses ceased as of September 30, 2006.

Operating Income.  Operating income decreased $3.3 million, or 87%, to $521,000 for the three months ended September 30, 2006 compared to $3.8$5.3 million for the same period of the prior year.

During the three months ended March 31, 2007, the Company completed the acquisition of PPI and the Company’s Founder, Chairman and Chief Executive Officer, Steven S. Myers, retired and was succeeded by Cynthia A. Davis as Chief Executive Officer.  Ms. Davis was elected to the Board of Directors.  A current board member, Dwight Hanger, replaced Mr. Myers as Chairman of the Board.  The decreaseexpenses related to the changes in operating income was duemanagement which included a retirement payment and executive search firm fees totaled approximately $700,000.  The approximately $100,000 in expenses related to decrease in sales, gross margin,the acquisition of PPI includes travel, advisory, meeting and increased selling, generalmiscellaneous other expenses incurred outside the normal course of business.  The following table is provided to display our SG&A results segregating these areas of cost for comparison purposes

Excluding the acquisition and administrativemanagement transition related expenses, discussed above.  AsSG&A as a percentage of revenue operating income decreased to 3%24.2% for the three months ended September 30, 2006,March 31, 2007, as compared to 19%27.7% for the same period of the prior year.

Operating Income Tax Expense.  Our effectiveOperating income tax ratesincreased $445,000, or 27.8% to $2.3 million for the three months ended September 30, 2006 and 2005 were 39% and 35%, respectively.

Results of Operations

The following table sets forth certain historical operating results (in millions):

Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005

Revenue.  Revenue decreased $7.2 million, or 12%, to $53.0 million for the nine months ended September 30, 2006March 31, 2007, compared to $60.2 million for the same period of the prior year.  Total aerospace and defense revenue declined by $4.8 million or 11% to $39.0 million compared to $43.8 million during the nine months ended September 30, 2006 and 2005, respectively.  This decline was due primarily to a client who is experiencing budget pressure on one of their programs.  This program contributed $2.2 million and $9.3 million or 4% and 15% of total revenue for the nine months ended September 30, 2006 and 2005, respectively.  Our non-aerospace and defense revenue declined by $2.4 million, or 15%, to $14.0 million for the nine months ended September 30, 2006 compared to $16.4 million during the same period of the prior year.  The decrease was due primarily to one client who temporarily reduced our service levels due to their internal budget pressures.  This reduction accounted for a decrease of $2.8 million compared to the same period of the prior year.  We have increased our service levels with this client at the end of this quarter as the customer entered their new fiscal year.

The percentage of revenues from competition management and program services was 62% and 38% for the nine months ended September 30, 2006, respectively, compared to 56% and 44% for the same period of the prior year.  The percentage of revenue coming from our aerospace and defense clients was 74% and 73% for the nine months ended September 30, 2006 and 2005, respectively.  During the nine months ended September 30, 2006, we were engaged by 18 new customers who accounted for 5% of our total revenue.  This compares to 20 new customers which accounted for 7% of our total revenue during the same period of the prior year.

Gross Margin. Gross margin decreased $4.1 million, or 16%, to $21.5 million for the nine months ended September 30, 2006 compared to $25.6 million for the same period of the prior year.  The decrease in gross margin dollars is due to the decrease in sales as discussed above and the decrease in gross margin as a percentage of revenue.  As a percentage of revenue, gross margin decreased to 41% for the nine months ended September 30, 2006 compared to 43% for the same period of the prior year.  The decline was due to increased wages, benefit, commission and travel expenses offset by an increase in the level of success fees earned. We recorded success fees of $910,000 and $734,000 for the nine months ended September 30, 2006 and 2005, respectively.  We expect the gross margins to be approximately 40% for fiscal year 2006.

Selling, General and Administrative Expenses.  Selling,general and administrative expenses consist principally of salary and benefit costs for executive, sales and administrative personnel, stock-based compensation expense, professional services and other general corporate activities. As a result of adopting Statement 123(R) and the recording of stock-based compensation expense related to the restatement discussed in footnote 2, we recorded stock-based compensation expense of $942,000 and $2.2 million during the nine months ended September 30, 2006 and 2005, respectively.  Excluding stock-based compensation expense, selling, general and administrative expenses increased $2.4 million or 17% during the nine months ended September 30, 2006 compared to the same period of the prior year.  With the creation of Practice Leader functions in late calendar year 2005, which have the responsibility to create new service solutions that enhance our overall service offerings, we incurred planned expenses of approximately $1.3 million during the nine months ended September 30, 2006.  No similar function existed during the nine months ended September 30, 2005.

Our general operating expenses increased by approximately $1.1 million including $190,000 in depreciation expense and $585,000 in non-routine expenses including $225,000 related to the restatement discussed in footnote 2, and approximately $360,000 related to the post implementation costs of our new ERP system which went live in June 2006.  The post implementation professional services expenses ceased as of September 30, 2006.   The remaining increase in general operating expenses of approximately $330,000 was due to increased travel, employee benefits, director compensation offset by a decrease in royalties that expired in calendar year 2005

Operating Income.  Operating income decreased $5.2 million, or 55% to $4.2 million for the nine months ended September 30, 2006, compared to $9.4$1.8 million for the same period of the prior year.  As a percentage of revenue, operating income decreased to 8%9.7% for the ninethree months ended September 30, 2006,March 31, 2007, as compared to 16%10.2% for the same period of the prior year.  Operating income primarily decreasedincreased due to the increase in sales and gross profit offset by the plannedan increase in selling, general and administrative expenses, as discussed above.

Income Tax Expense.  Our effective income tax rates for the ninethree months ended September 30,March 31, 2007 and 2006 and 2005 were 41% and 35%41%, respectively.  During 2005, the Company recorded a reduction of income tax expense of approximately $160,000, which related to the reduction of a federal income tax liability that was reversed due to the expiration of a statute of limitations.

Capital Resources and Liquidity

Our working capital decreased to $28.9$26.9 million at September 30, 2006March 31, 2007 from $32.8$28.4 million at December 31, 2005.2006.  In addition, our cash and cash equivalents plus investments decreased to $15.2$8.6 million at September 30, 2006,March 31, 2007, from $24.1$15.1 million at December 31, 2005.2006.  The decrease in cash and cash equivalents plus investments was due to the funds used to acquire PPI and professional service fees associated with the acquisition, the share buyback activity in which the Company repurchased $7.3 million$842,000 of common shares during the ninethree months ended September 30, 2006.  The reduction was also due toMarch 31, 2007, and the increase in the number of days sales outstanding discussed below.  (“DSO”).  The change in accounts receivable was due primarily to the significant increase in sales and the timing of cash receipts related to two of our largest clients.  Periodically, when our larger client’s contracts are under renewal we are authorized to continue providing our services while the contract is being processed.  This process can take two to three months to finalize at which time we invoice all unbilled amounts.  Our client will typically pay the balances within 60 days upon receipt of our invoices.  A significant portion of the past due balances at March 31, 2007 have been collected subsequent to March 31, 2007.  At April 24, our cash and cash equivalents balance has increased to $13.6 million and our DSO’s have improved from 92 days to 69 days.  Our historical average DSO is 70 days.

Cash flows from operating activities of continuing operations used $498,000$2.7 million during the ninethree months ended September 30, 2006,March 31, 2007, compared to the $9.4$1.9 million provided for the same period during the prior year.  The decrease in our cash flows from operating activities is due primarily to the increase in our day’s sales outstanding discussed above offset by the timing of our payroll cycles, and the difference in tax benefits from stock-based compensation.cycles.

The change in accounts receivable was due primarily to the timing of cash receipts related to one of our largest customers.  As significant portion of the past due balance as of September 30, 2006 was collected in October 2006.  At September 30, 2006, our day’s sales outstanding (DSO) is consistent with our historical average of 68 days.

For the remaining fiscal year 2006, we plan to use approximately $500,000 of cash on hand to implement two additional modules to our existing Enterprise Resource Planning Software.  We expect the implementation of the Enterprise Resource Planning Software to conclude at the end of this fiscal year.

In May 2004, the Company’s Board of Directors (“Board”) authorized a plan to repurchase up to $7.0 million of the Company’s common stock.  In April and October 2005, the Company’s Board of Directors authorized an increase of an additional $5.0 million and $8.0 million, respectively, increasing the total authorization to repurchase the Company’s common stock to $20.0 million.  In January 2006, the Company’s Board of Directors authorized an increase of an additional $10.0 million increasing the total authorization to repurchase the Company’s common stock to $30.0 million.  The Company intends to repurchase shares from time to time, at prevailing prices, in the open market.  The timing and amount of the share repurchases will be at the discretion of management and will be based on such factors as the stock price, general economic and market conditions, and other factors.  The share repurchase plan may be suspended or discontinued at any time.  Shares repurchased under the plan prior to our reincorporation in the state of Delaware were cancelled.  After the date of reincorporation (November 30, 2006), the shares are cancelled.included in treasury shares.  For the ninethree months ended September 30,March 31, 2007 and 2006, and 2005, the Company repurchased 1,153,900139,417 shares at a total cost of $7.3 million$842,000 and 446,995205,800 shares at a total cost of $3.7$1.4 million, respectively.  Since the inception of the share repurchase plan, the Company has repurchased 2,967,0663,354,860 shares at a total cost of $21.9$24.2 million.  Share repurchases are being completed with cash on hand.  TheAs of March 31, 2007, the Company currently has approximately $8.1$5.8 million remaining in share repurchase authorization.

The Company has a revolving credit agreement which allows for borrowings up to $10.0 million at the prime rate minus one half of one percent (-0.50%) per annum or LIBOR plus two and one quarter percent (2.25%) per annum.  The revolving credit agreement is renewable annually on April 30th of each year.  Borrowings under the revolving credit agreement are unsecured.  The agreement requires the Company to comply with certain financial covenants pertaining to its tangible net worth, ratio of total liabilities to tangible net worth, and ratio of current assets to current liabilities (as defined in the agreement).  The agreement also contains certain negative covenants which, among other things, restrict the Company’s ability to incur additional indebtedness of more than $1.0 million in excess of the $10.0 million limit set forth in the credit agreement and make capital expenditures in excess of $3.0 million without the prior written approval of the lender.  At September 30, 2006,March 31, 2007, the Company was in compliance with its covenants and had no outstanding borrowings under the line of credit, the bank had issued a letter of credit for $64,000 and $9.9 million was available.

We believe we have sufficient working capital available under the line of credit and cash generated by continuing operations will be sufficient to fund operations for at least the next twelve months.

Item 3.                          Quantitative and Qualitative Disclosures About Market Risk

The Company currently has no instruments that are sensitive to market risk.

Item 4.                          Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this quarterly report on Form 10-Q.  Based on this evaluation, our principal executive officer and principal financial officer concluded that these disclosure controls and procedures are effective and designed to ensure that the information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the requisite time periods.

While the Company’s disclosure controls and procedures provide reasonable assurance that the appropriate information will be available on a timely basis, this assurance is subject to limitations inherent in any control system, no matter how well designed and administered.

Changes in Internal Controls

There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) identified in connection with the evaluation of our internal control performed during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

Item 1.         Legal Proceedings

We are involved in routine litigation incidental to the conduct of our business.  There are currently no material pending litigation proceedings to which we are a party or to which any of our property is subject.

Item 1A.      Risk Factors

ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS

In addition to the other information in this Quarterly Report on Form 10-Q, the following factors should be considered carefully in evaluating our business and prospects.

Our business depends substantially on the defense industry.

Our competition management and program services business depends substantially on U.S. Government expenditures for defense products.  Any decline in the future defense, information technology or homeland security procurement expenditures could affect the opportunities available to our clients and, indirectly, our business. A number of factors could contribute to such a decline in opportunities, including:

·                  Loss of political support for current or increased levels of spending;

·                  Changes of presidential administration, particularly changes from one political party to another, that typically result in a mass reordering of priorities that reduce new proposal activity for up to a year;

·      Threat scenarios evolving away from global conflicts to regional conflicts;

·                  Spending for ongoing operations, such as the war on terrorism or the occupation of Iraq, creating downward pressure on spending for procurement of new systems and research and development spending; and

·                  Cancellation of programs or emphasis on government shifting programs.

In the event expenditures for products of the type manufactured by our clients are reduced and not offset by other new programs or products, there will be a reduction in the volume of contracts or subcontracts to be bid upon by our clients and, as a result, a reduction in the volume of proposals we manage.  Unless offset, such reductions could materially and adversely affect our business, operating results and financial condition.

We rely on a relatively limited number of clients.

We derive a significant portion of revenue from continuing operations from a relatively limited number of clients.  Our seven largest customers accounted for 80%77% and 84%80% of our revenue for 20052006 and 2004,2005, respectively.  Clients typically retain our services as needed on an engagement basis rather than pursuant to long-term contracts, and a client can usually terminate the engagement at any time without a significant penalty.  Moreover, there can be no assurance that existing clients will continue to engage us for additional assignments or do so at the same revenue levels.  The loss of any significant client could materially and adversely affect our business, financial condition and results of operations.  In addition, the level of services required by an individual client may diminish over the life of the relationship, and there can be no assurance we will be successful in establishing relationships with new clients as this occurs.

The markets in which we operate are highly competitive.

The market for competition management services in the procurement of government and commercial contracts for aerospace and defense work is a niche market with a number of competitors.  We are the largest provider of such services and principally compete with the in-house capability of our clients.  In addition, numerous smaller proposal management companies compete in this highly specialized industry.  With sufficient resources in the form of money and excellent talent with current security clearances, our competitors could erode our current market share and such a reduction could materially and adversely affect our business, operating results and financial condition.

We rely heavily upon our key senior management personnel and our ability to recruit and maintain skilled professionals.

Our success is highly dependent upon the efforts, abilities, and business generation capabilities and project execution of our strategic account managers and account executives.  The loss of the services onof these individuals, for any

reason, could materially and adversely affect our business, operating results and financial condition.

Our business involves the delivery of professional services and is highly labor-intensive.  Our success depends largely on our general ability to attract, develop, motivate and retain highly skilled professionals.  The loss of some or a significant number of our professionals or the inability to attract, hire, develop, train and retain additional skilled personnel could have a serious negative effect on us, including our ability to obtain and successfully complete important engagements and thus maintain or increase our revenue.

Quarterly results may fluctuate.

We may experience fluctuations in future quarterly operating results due to a number of factors, including the size, timing and duration of client engagements.

Our stock price is subject to significant volatility.

Our common stock was first publicly traded on January 29, 1998 after our initial public offering at $12.00 per share. Between January 29, 1998 and September 30, 2006,March 31, 2007, the closing sale price has ranged from a high of $31.13 per share to a low of $0.75 per share. The market price of our common stock could continue to fluctuate substantially due to a variety of factors, including:

·                  Quarterly fluctuations in results of operations;

·                  Adverse circumstances affecting the introduction, or market acceptance of new services we offer;

·                  Announcements of new services by competitors;

·                  Announcements of poor operating results by us or our competitors;

·                  Loss of key employees;

·                  Changes in the regulatory environment or market conditions affecting the defense and aerospace industry;

·                  Changes in earnings estimates and ratings by analysts;

·                  Lack of market liquidity resulting from a relatively small amount of public stock float;

·                  Changes in generally accepted accounting principles;

·                  Sales of common stock by existing holders;

·                  The announcement of proposed acquisitions and dispositions; and

·                  The repurchase of common shares under the share repurchase plan.

We cannot guarantee that future acquisitions, mergers or investments in other companies will be successful.

If appropriate opportunities present themselves, we may consider acquiring, merging with or making investments in companies or assets that we believe will complement, enhance or expand our current business or otherwise offer us growth opportunities.  We will likely compete for such opportunities with companies with greater financial and management resources than us.  There can be no assurance that suitable acquisition or other investment opportunities will be identified, that any of these transactions can be consummated, or that, if acquired, the new businesses can be integrated successfully and profitably into our operations.  These acquisitions and investments may also entail the following risks:

·                  the diversion of our management’s attention from our existing business while evaluating acquisitions, investments and other prospective business combinations and thereafter while assimilating the operations and personnel of the new business;

·                  adverse short-term effects on our operating results;

·                  the inability to successfully and rapidly integrate the new businesses, personnel and products with our existing business, including financial reporting, management and information technology systems;

·                  higher than anticipated costs of integration;

·                  customer concentration risk in the acquired business;

·unforeseen operating difficulties and expenditures;

·                  the need to manage a significantly larger business;

·                  potential dilution to our shareholdersstockholders to the extent we use our common stock as currency for an acquisition;

·                  the assumption of liabilities;

·                  the use of a substantial amount of our available cash to consummate an acquisition;acquisitions;

·                  difficulties inherent in the implementation and application of the provisions of the Sarbanes-Oxley Act of 2002 to the operations of a privately-held entity acquired by the Company; and

·                  loss of employees of an acquired business, including employees who may have been instrumental to the success or growth of that business.

·We may not be able to successfully integrate or operate profitably any new business we acquire and we cannot assure you that any other investments we make, or strategic alliances we enter into, will be successful.

Principal shareholder has significant control.

At September 30, 2006, Steven S. Myers, Chief Executive Officer and Chairman of the Board, beneficially owned or controlled approximately 17% of our outstanding common stock and will have the ability to control or significantly influence the election of directors and the results of other matters submitted to a vote of shareholders.  This concentration of ownership may have the effect of delaying or preventing a change in control and may adversely affect the ability of other holders of our common stock to pass shareholder resolutions and control our actions.  Our board of directors is currently comprised entirely of individuals nominated with the approval of Mr. Myers.

Item 2.         Changes in Securities, Use of Proceeds and Issuer Purchase of Equity Securities

Issuer Purchases of Equity Securities

Information about securities purchased under the Company’s share repurchase program is incorporated by reference to Note 89 to the condensed consolidated financial statements.