The Company budgeted EBITDA of Telos Corporation (California)$(3.0) million for the three months ended March 31, 2006, and excluding non-budgeted legal costs of $2.7 million, achieved $(2.8) million of EBITDA for the period. Subsequent to March 31, 2006, approximately $1.2 million of such legal costs have been reimbursed by the Company’s insurers. Total expenses related to litigation were (exclusive of any such reimbursement) $3.5 million for the first quarter of 2006, and $4.1 million for the 12 months ending December 31, 2005. Such extraordinary legal expenses have adversely affected cash flow.

The Company derives substantially all of its revenue from U.S. Government contracting, and as such it is annually subject to the seasonality of the U.S. Government purchasing. As the U.S. Government fiscal year ends on September 30, it is not uncommon for U.S. Government agencies to award extra tasks in the weeks immediately prior to the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. As a result of this cyclicality, the Company has historically experienced higher revenues in its third and fourth fiscal quarters, ending September 30, and December 31, respectively, with the pace of orders substantially reduced during the January to June time period. During the three month period ending March 31, 2006, this seasonal reduction in orders and extraordinary litigation expense, have combined to adversely affect the Company’s EBITDA and cash flows. As the anticipated U.S. Government orders are realized during the third and fourth quarters of 2006, the Company, based upon current projected EBITDA, believes its liquidity will improve during these periods. The Company further believes such projected improvements in its liquidity later in 2006 will be sufficient to generate adequate amounts of cash to meet the Company’s needs for operating expenses, debt service requirements, and planned capital expenditures for 2006.

On July 19, 2002,The Company is actively working with its vendors, partners and subcontractors to mitigate the effect of these cash flow constraints during this period. Additionally, as discussed in Note 3 – Debt Obligations, the Company and L-3 Communications Corporation (“L-3”) entered into a Stock Purchase Agreement wherebyWells Fargo Foothill have amended the Senior Revolving Credit Facility to provide the Company sold allwith a four-month over-advance in the amount of $3 million. There can be no assurances as to the continuing ability of the issuedCompany to successfully work with vendors, partners and outstanding sharessubcontractors or Wells Fargo Foothill to mitigate these current cash flow constraints.

These consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As described in Note 3 – Debt Obligations, the Company has obtained waivers and less restrictive cash flow covenants with respect to its Senior Revolving Credit Facility. Although no assurances can be given, the Company expects that it will be in compliance throughout the term of the amended credit facility with respect to the financial and other covenants. Also, as more fully described in Note 4 – Redeemable Preferred Stock, the Company has engaged Jefferies Quarterdeck, a nationally known investment bank, to explore strategic alternatives for the sale of its wholly ownedXacta subsidiary Telos Corporation (California) (“TCC”)or one or more lines of business of its Xacta subsidiary. The Company intends to L-3 forvigorously pursue such a purchase priceprocess, with the objective, if such a process could yield sufficient cash proceeds, of approximately $20 million which included: 1) approximately $15.3 millionusing the proceeds to partially or completely recapitalize its balance sheet, although, as stated above, there can be no assurance whether, or as to the Company at closing; 2) $2.0 million held in an escrow account, $1.0 million of which was released and paid in October 2003 and the remaining $1.0 million was released and paid in February 2005; and 3) approximately $2.7 million held back as deposits for liabilities relating to leased propertiestime frame in which, at the time of closing TCC wasstrategic process with respect to the Company’s Xacta subsidiary might enable the Company to retire its debt obligations and/or pay dividends and/or partially or completely retire its redeemable preferred stock. While the Company intends to make every effort to successfully consummate such a lessee or guarantor. Approximately $1 milliontransaction, including by assisting a proposed purchaser in obtaining necessary regulatory approvals, there can be no certainty as to the timeframe of such hold-back was released and paid in August 2002, $0.8 million paid in August 2004 with the remaining $0.8 million scheduled to be released in 2007.

According to the Stock Purchase Agreement, the purchase price was to be increasedprocess completion or decreased on a dollar-for-dollar basis by the amount of proceeds that the closing date net assets deviated from $2.3 million. The closing date net assets were $4.6 million, an increase of an additional $2.3 million. Such amount was invoiced by the Company and collected in October 2002 from L-3. Accordingly,would be realized as a result of such transaction.

As noted in Note 4 – Redeemable Preferred Stock, on May 12, 2006, the increase in purchase price duringBoard of Directors voted to confirm that the fourth quarter 2002,Company’s intent with respect to the payment of dividends on the Public Preferred Stock for the period 1992 through June 1995 changed from its previously stated intent to pay PIK dividends to that of an intent to pay cash dividends. The Company adjustedis therefore changing the gain by $2.3accrual from $4.0 million to $13.2 million. The Company recognized a bonus accrual for certain key employees considered critical$13.4 million, the result of which will be to the sale in the amount of $560,000 and, accordingly, the gain was adjusted to $12.6 million. In accordance withincrease the Company’s Senior Credit Facility, proceeds fromnegative shareholder equity by the sale were useddifference between those two amounts, $9.4 million, by recording an additional $9.4 million charge to pay downinterest expense for the Company’s Facility.second quarter of 2006, resulting in a balance of $82.2 million (pro forma as of April 30, 2006) for the principal amount and all accrued dividends on the Public Preferred Stock. This action is a change in accounting estimate as defined in SFAS 154, “Accounting Changes and Error Corrections,” which replaces APB No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” The pro forma consolidated balance sheet as of April 30, 2006, and consolidated statement of operations for the period then ended are as follows:

As additional consideration for the sale of the shares of TCC, the Company and its affiliates committed to certain “Non-Compete” and “Non-Solicitation” provisions relating primarily to the business and employees associated with its TCC/Ft. Monmouth operations.

The sale of TCC has been treated as a discontinued operation in accordance with SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Pursuant to SFAS 144, the revenue, costs and expenses of TCC have been excluded from their respective captions in the Company’s consolidated statements of operations and the net results of these operations have been reported separately as “Income (loss) from discontinued operations,” accordingly, for the quarter ended March 31, 2005, a gain on sale of TCC (under the discontinued operations caption) was recorded on the receipt of the $1.0 million received in February 2005.

Note 7. Contingencies

Discretionary Incentive Bonus Plan

Based upon current and projected performance, the Company had recorded no bonuses accrual for the three and nine months ended September 30, 2005 under the Discretionary Incentive Bonus Plan.

Legal Proceedings

On May 6, 2005, SecureInfo Corporation (SecureInfo) filed suit in the U.S. District Court for the Eastern District of Virginia against Telos Corporation, its subsidiary Xacta Corporation, andThe Company is a Vice President of Xacta, alleging, among other things, copyright infringement and theft of trade secrets. On May 12, 2005, SecureInfo and Telos voluntarily agreed to enter into a temporary restraining order, including a specific denial by Telos of any liability and by which Telos agreed that it would not access SecureInfo’s software. On May 26, 2005, Telos, Xacta, and the Vice President filed a motion to dismiss SecureInfo’s complaint. On June 16, 2005, SecureInfo amended its complaint, adding additional claims and, as additional defendants, Telos’ Chief Executive Officer and Chief Technology Officer, as well as an independent consultant. SecureInfo’s amended complaint asserted a variety of statutory and other claims against the Telos for relief, including copyright infringement; violations of the federal Computer Fraud and Abuse Act and federal Racketeer Influenced Corrupt Organization Act; violations of the Virginia Computer Crimes Act and the Virginia Uniform Trade Secrets Act; conspiracy to obtain trade secrets; tortious interference with contract; combining to injure SecureInfo; trespass to chattels; and detinue. SecureInfo also renewed its Motion for Preliminary Injunction. On July 14, 2005,Telos filed a motion to dismiss all counts in the amended complaint. Although there can be no assurance asparty to the ultimate outcome of this litigation Telos continues to strenuously deny SecureInfo’s claims and will vigorously defend this lawsuit, and at the appropriate time to file a patent infringement counterclaim against SecureInfo.set forth below.

On September 9, 2005 the U.S. District Court for the Eastern District of Virginia granted Telos’ Motion to Dismiss by dismissing 10 of the 13 counts in the amended complaint: Counts I, II and III (Computer Fraud and Abuse Act), V (fraud and deceit), VI (conspiracy to fraudulently obtain trade secrets by deceit and tortuous interference with contract), VII (common law tortuous interference with contract), VIII (Racketeer Influenced Corrupt Organization Act – RICO), IX (combination to injure Plaintiff’s reputation, trade, or business), X (Virginia Computer Crimes Act), and XII (common law trespass to chattels). Accordingly all counts against John B. Wood, Chairman and CEO of Telos Corporation, were dismissed and substantially all of the counts were dismissed against the other individual officers.

On September 21, 2005, SecureInfo withdrew its Motion for a Preliminary Injunction.

As previously reported in the Form 8-K filed on SeptemberMarch 27, 2005 on2006 regarding the current status of litigation with SecureInfo Corporation (see Item 8.01 Other Events), the Company has entered into a pretrial conferencesettlement agreement with SecureInfo in which all parties dismissed, with prejudice, all pending claims, including the patent infringement counterclaim. As part of the settlement agreement, Telos agreed to not pursue legal action for patent infringement against SecureInfo for a period of three years from the date of the agreement. In addition, the parties have entered into various business arrangements including software licensing agreements, an Original Equipment Manufacturer (OEM) agreement and a reseller agreement. A joint stipulation of dismissal was heldfiled on October 19, 2005. The magistrate judge scheduled October 28, 2005 asMarch 22, 2006 with the deadline for SecureInfo to file its Motion for Leave to Amend the ComplaintUnited States District Court for the second time and scheduled oral arguments for November 4, 2005. The deadline for the discovery period on the merits was set for January 20, 2006.Eastern District of Virginia.

Costa Brava

On November 4, the magistrate judge denied SecureInfo’s request to amend its complaint for a second time. On November 7, 2005, Telos Corporation, its subsidiary Xacta Corporation, and certain named individual officers, filed an Answer to the Amended Complaint including a patent infringement counterclaim against SecureInfo.

On October 17, 2005,As previously reported, Costa Brava Partnership III, L.P. (“Costa Brava”), a holder of the Company’s Public Preferred Stock, filed a lawsuit in the Circuit Court of Baltimore City in the State of Maryland (“Complaint”) against the Company, its directors, and certain of its officers. According to Amendment No. 6 to Schedule 13D filed by Costa Brava on October 18, 2005, Costa Brava owns 15.9% of the outstanding Public Preferred Stock.

The Complaint alleges thatOn January 9, 2006, the Company filed a motion to dismiss the Complaint or, in the alternative, to stay the action until the Special Litigation Committee had sufficient time to properly investigate and itsrespond to Costa Brava’s demands. On the same day, the Company officers and directors have engagedeach filed a motion to dismiss for lack of personal jurisdiction and failure to state a claim. The oral arguments were heard on February 28, 2006 before Judge Albert J. Matricciani, Jr.

On February 8, 2006, Wynnefield Small Cap Value, L.P. (“Wynnefield”) filed a motion to intervene as a matter of right, and in tacticsthe alternative at the discretion of the court. On February 23, 2006, Telos filed a motion to avoid paying mandatory dividendsstay the intervention proceedings pending resolution of its motion to dismiss. The judge issued the order to stay on February 27th.

On March 30, 2006, the Public Preferred Stock,court granted the Company’s motions in part and asserts thatdenied them in part. The motion to dismiss filed by the Public Preferred Stock has characteristics of debt instruments even though issueddirectors was granted with respect to Director Stewart, but denied in all other parts. The motion to dismiss filed by the officers was denied. In the motion filed by the Company, in the form of stock.motion to dismiss was granted with respect to Costa Brava alleges, among other things, that the Company andBrava’s demand for an Independent Committee of the Board of Directors have done nothing to improve what they claim to be the Company’s insolvency, or its ability to redeem the Public Preferred Stock and pay accrued dividends. They also challenge the bonus payments to the Company’s officers and directors, and consulting fees paid to the holder of a majority of the Company’s common stock.

Costa Brava is seeking the following relief: (I) the officers and directors who are named in the Complaint be deemed to be involuntary trustees of certain bonus amounts received by them from the Company, and that any proceeds from those bonuses be held in constructive trust for the Company with the duty to return them to the Company; (II) an injunction enjoining the Company from making future bonus payments and further grants of stock options in the Company and its wholly owned subsidiaries to any officers and directors unless and until dividend arrearages on the Public Preferred Stock are satisfied in full, and an injunction enjoining any officers and directors who have already received grants of stock options in the Company’s wholly owned subsidiaries from exercising those options unless and until dividend arrearages on the Public Preferred Stock are satisfied in full; and (III) appointment of a receiver for the Company to take charge of the Company’s assets and operate the business, as necessary and proper to preserve them, and to take such actions as are necessary to remedy and/or prevent the fraudulent conveyances complained of in the Complaint. In the alternative, Costa Brava is seeking (IV) appointment of a receiver for the Company to take charge of the Company’s assets and operate the business; and (V) judicial dissolution of the Company and appointment of a temporary receiver to take charge of the Company’s assets and operate the business. In addition, the court granted the motion to dismiss the specific counts of the Complaint with respect to any derivative claims based on transactions or events that occurred prior to January 25, 2005, but denied the motion with respect to the derivative claims based on transactions or events that occurred on or after January 25, 2005. The judge also denied the alternative request for a stay.

The Company’s answer to the complaint was filed on April 28, 2006.

On May 12, 2006, Telos opposed Wynnefield’s motion to intervene at a hearing. On May 16, 2006, the court issued an order denying Wynnefield’s motion to intervene as a matter of right, but granted the motion on permissive grounds since Wynnefield is similarly situated with Costa Brava also seeks damagesalthough their interests are not identical.

On May 22, 2006, a status conference took place with all the parties before Judge Matricciani. The trial date is currently set to begin on April 9, 2007.

On May 25, 2006, an Amended Order was entered by Judge Matricciani, designating Wynnefield Partners as the Plaintiff with Costa Brava in the Lawsuit.

On May 26, 2006, Costa Brava and Wynnefield Partners filed a Motion for Preliminary Injunction asking the Court to enjoin the Company from the officers and directorsselling Xacta Corporation (“Xacta”) or any of the Company.assets of Xacta, until the litigation is resolved on the merits. The opposition to the motion is due on June 26, 2006.

At this early stage of the litigation in which the jurisdiction and the parties have just been established, it is impossible to reasonably determine the degree of probability related to Costa Brava’s success in any of its assertions. Although there can be no assurance as to the ultimate outcome of this litigation, the Company and its officers and directors including the members of the Independent Committee of the Board of Directors, strenuously deny Costa Brava’sBrava claims, and will vigorously defend this lawsuitthe matter, and oppose the relief sought by Costa Brava.sought.

Other Litigation

In addition, the Company is a party to litigation arising in the ordinary course of business. In the opinion of management, while the results of such litigation cannot be predicted with any reasonable degree of certainty, the final outcome of such known matters will not, based upon all available information, have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

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

Government oversight

As a U.S. Government contractor, the Company is subject to oversight by many agencies and entities of the U.S. Government that may investigate and make inquiries of the Company’s business practices and conduct audits of contract performance and cost accounting. Depending on the results of any such audits and investigations, the U. S. Government may make claims against the Company. Under U.S. Government procurement regulations and practices, an indictment of a U.S. Government contractor could result in that contractor being fined and/or suspended for a period of time from eligibility for bidding on, or for the award of, new U.S. Government contracts. A conviction could result in debarment for a specified period of time. To the best of management’s knowledge, there are no pending investigations, inquiries, claims or audits against the Company likely to have a material adverse effect on the Company’s business or its consolidated results of operations, cash flows or financial position.

General

As

The Company’s secure messaging solution is called the

New Contract Vehicles: In the first quarter of 2006, the Company invested in getting Xacta IA Manager, Xacta IA Consulting Services, and Xacta Secure Messaging solutions added to the GSA “SmartBuy” Enterprise Software Initiative (ESI) Blanket Purchase Agreement (BPA). SmartBuy is the latest enterprise software agreement that the Federal Government has signed with its major suppliers. SmartBuy is a preferred vehicle for purchasing enterprise software solutions and supporting services because it provides for pre-negotiated discounts on its NETCENTS team, to include Verizon and EDS, which will sell theirsuch products and services through the NETCENTS contract. NETCENTS will also be an important sales mechanism for Xacta and the Managed Solutions offerings. The award of the NETCENTS contract entitled the Company to bid on the Air Force’s Second Generation wireless contract. The Company’s proposal for the Second Generation contract was unsuccessful. While Telos was not awarded the Second Generation contract, an event which the Company previously disclosed as possibly adverse to its continued growth in the U.S. Air Force wireless business, any adverse impact of such loss to date has been negligible and remains unquantifiable.

services.

Backlog

The Company’s total backlog was $99.2$113.1 million and $103.1$89.2 million at September 30,March 31, 2006 and 2005, and 2004, respectively. Backlog was $106.4$118.3 million at December 31, 2004.2005. The total backlog of each of the segments at September 30,March 31, 2006 and 2005 and 2004 was as follows: Managed Solutions Group - $32.3$20.5 million and $7.3$8.7 million, respectively; and Xacta - $66.9$92.6 million and $95.8$80.5 million, respectively.

Such backlog amounts include both funded backlog (unfilled firm orders for the Company’s products for which funding has been both authorized and appropriated,appropriated) and unfunded backlog (firm orders for which funding has not been appropriated). Funded backlog as of September 30,March 31, 2006 and 2005 and 2004 was $90.0$67.0 million and $100.7$80.0 million, respectively.

Consolidated Results of Operations

The Company’s operating cycle involves many types of solution, product and service contracts with varying delivery schedules. Accordingly, results of a particular quarter, or quarter-to-quarter comparisons of recorded sales and operating profits, may not be indicative of future operating results and the following comparative analysis should therefore be viewed in such context.

The condensed consolidated statements of operations include the results of Telos Corporation and its wholly owned subsidiaries. The Company substantiallybudgeted EBITDA of $(3.0) million for the three months ended March 31, 2006, and excluding non-budgeted legal costs of $2.7 million, achieved its operating goals.

$(2.8) million of EBITDA for the period. Subsequent to March 31, 2006, approximately $1.2 million of such legal costs have been reimbursed.

The principal elementselement of the Company’s operating expenses as a percentage of sales for the three and nine months ended September 30,March 31, 2006 and 2005 and 2004 are as follows:

Financial Data by Market Segment

Sales, gross profit, and gross margin by market segment for the periods designated below are as follows:

The Company’s sales for the thirdfirst quarter of 20052006 were $40.6$25.2 million, an increasea decrease of $8.9$9.8 million or 27.9% over28.1% compared to the thirdfirst quarter 20042005 sales of $31.7$35.0 million. Such increasedecrease consists of a $10.7$5.9 million increasedecrease in sales from Xacta, primarily attributable to a decrease in “Secure Wireless” revenue from customer delays in contracted site installations. The $3.9 million decrease in sales from Managed Solutions offset byis primarily due to a declinelarge purchase under the ARISS (Army Recruiting Information Security System) laptop resale program in salesthe first quarter of $1.8 million for Xacta.

2005 that the Company does not expect to recur in the near term.

The Company’s cost of sales for the thirdfirst quarter of 20052006 was $33.4$20.7 million, an increasea decrease of $13.0$6.8 million compared to the same period in 2004.

2005, due primarily to the decrease in sales.

The Company’s gross profit for the thirdfirst quarter in 2005of 2006 decreased by $4.1$3.0 million to $7.2$4.5 million compared to the same period in 2004.2005. Gross margin decreased to 17.7%17.9% from 35.7%21.4% in the comparable period in 2004.2005, primarily attributable to higher margin on the ARISS laptop resale program in the first quarter of 2005. The Company’stiming of the ARISS laptop resale program was also the primary cause for the decline in gross margin (from 20% to 10%) for products revenue, displayed on a nonsegmented basis on the face of the statements of operations, between the three month periods ended March 31, 2005 and 2006. The gross margin for services revenue, displayed on a nonsegmented basis on the Managed Solutions Group increasedface of the statements of operations, remained relatively constant between the periods, slightly declining from 5.3%24.0% to 7.2%23.3%. Xacta gross margin decreased from 42.4% to 24.8%, due primarily to the decline in sales of its higher margin messaging solutions and an increase in lower margin product revenue.

The Company’s selling, general, and administrative expense (“SG&A”) for the thirdfirst quarter of 20052006 was $6.8$10.4 million, a decreasean increase of approximately $.7$3.4 million or 9.6%48.1% compared to the same period in 2004,2005, primarily due to $3.5 million of litigation expenses, as fully discussed in Note 6 – Contingencies and Subsequent Events.

The Company’s operating loss for the $2 million in bonus accrual recorded in the thirdfirst quarter of 2004. SG&A for the nine months ended September 30, 20052006 was $21.7$5.9 million, an increase of $5.2$6.4 million compared to the same period in 2004, primarily due to independent committee expenses of $.8 million, SecureInfo litigation expenses of $.8 million, and increases in sales and marketing expenses.

The Company’s operating income for the third quarter of 2005 was $.4 million, a decrease of $3.4 million compared to $3.7$.5 million of operating income in the same period in 2004.

2005, primarily attributable to high margin on the ARISS laptop resale program in the first quarter of 2005, and litigation expenses in the first quarter of 2006, as explained above.

The Company recorded a full valuation allowance against its deferred tax assets as of March 31, 2005 and December 31, 2004.2005. The Company maintained its full valuation position during the quarter ended September 30, 2005.

March 31, 2006.

The Company’s net loss for the thirdfirst quarter of 20052006 was $1.9$8.2 million, a decreasean increase of $3.4$7.5 million compared to $1.5$.6 million net incomeloss in the same period in 2004.2005.

Liquidity and Capital Resources

In addition to the Company’s common stock, the Company’s capital structure consists of a revolving credit facility, subordinated notes, capital lease obligations, and redeemable preferred stock.

Senior Revolving Credit Facility

On October 21, 2002,In April 2005, the Company entered into arenewed, on amended terms, the $22.5 million Senior Revolving Credit Facility Agreement(as amended, the “Facility”) with Wells Fargo Foothill, Inc. (“Wells Fargo Foothill”) (formerly known as Foothill Capital Corporation) that was originally scheduled to mature on October 21, 2005. On April 15, 2005, the Company and Wells Fargo Foothill entered intoThe amended terms included, primarily a Waiver and Eighth Amendment to Loan and Security Agreement. Pursuant to the Waiver and Eighth Amendment, the revolving line limit was established atof $15 million and thewith an interest rate atof Wells Fargo “prime rate” plus 1%. The, and an extension of its maturity date of the Facility was set to October 21, 2008. Pursuant to the terms of the Facility, in lieu of having interest charged at the rate based on the Wells Fargo prime rate, the Company has the option to have interest on all or a portion of the advances on such Facility be charged at a rate of interest based on the LIBOR Rate, plus 4%. Borrowings under the Facility remainare collateralized by substantially all of the Company’s assets including inventory, equipment, and accounts receivable. The amount of available borrowings fluctuates based on the eligible underlying asset-borrowing base, as defined in the Facility agreement. At September 30, 2005, the Company had outstanding borrowings of $8.6 million and unused borrowing availability of $6.4 million on the Facility. As of September 30, 2005, the interest rate on the Facility was 7.75%.

The Facility has various covenants which,that may, among other things, affect the ability of the Company to merge with another entity, sell or transfer certain assets, pay dividends and make other distributions beyond certain limitations. The Facility also requiresrequired the Company to meet certain financial covenants, including cash flow targets based on EBITDAtangible net worth and earnings before interest, taxes, depreciation and amortization (EBITDA), as defined in the Facility. Since the Facility’s inception, certain financial covenants have been amended and restated to more accurately reflect the Company’s performance. The financial covenants were amended and restated in August 2004, to eliminate the tangible net worth requirement.

At March 31, 2006, the Company was not in compliance with certain of its covenants pursuant to the Facility. Certain EBITDA covenants were not achieved. Accordingly, as of June 20, 2006, the Company has obtained waivers for any such covenant violations, and the Company and Wells Fargo Foothill have agreed upon modified cash flowEBITDA covenants through October 21, 2008. Forto more accurately reflect the nine months ended September 30, 2005,Company’s future performance based upon revised projections. In addition, the Company was in compliance withand Wells Fargo Foothill have amended the covenants containedFacility, to temporarily provide for a four-month over-advance in the Facility.amount of $3.0 million, the available balance of which declines over the term, which ends July 31, 2006. Such over-advance is subject to certain additional covenants and reporting requirements, including a minimum sales requirement.

At March 31, 2006, the Company had outstanding borrowings of $7.4 million and unused borrowing availability of $3.0 million on the Facility. As of March 31, 2006, the interest rate on the Facility was 8.75%.

For the ninethree months ended September 30, 2005,March 31, 2006, cash used inprovided by continuing operating activities was $.2$3.0 million. Cash provided byused in investing activities was approximately $.1$.4 million. Cash provided byused in financing activities was approximately $.2$2.7 million.

Senior Subordinated Notes

The Company’s Senior Subordinated Notes (“Notes”) totaled $5.2 million at September 30, 2005.March 31, 2006. The maturity date of such Notes has been extended to October 31, 2008, with interest rates ranging from 14% to 17%, and paid quarterly on January 1, April 1, July 1, and October 1 of each year. In consideration for such extension, the Company agreed to pay a one-time fee of 1%. During the first ninethree months of 2006 and 2005, the Company paid $566,000$187,000 in interest to subordinated note holders. In addition, these notes have a cumulative prepayment premium of 13.5% per annum payable only upon certain circumstances, which if in effect, would be approximately $14$15.2 million at September 30, 2005.March 31, 2006. See Note 3 – Debt Obligations.

Redeemable Preferred Stock

The Company currently has two primary classes of redeemable preferred stock - Senior Redeemable Preferred Stock and Public Preferred Stock. Each class carries cumulative dividend rates of 12% to 14.125%. At September 30, 2005,March 31, 2006, the total carrying amount of redeemable preferred stock, including accumulated and unpaid dividends was $78.1$81.0 million. The Company accrues dividends and provides for accretion related to the redeemable preferred stock. During the first ninethree months of 2006 and 2005, the Company recorded $3.2$1.1 million of dividends on the two classes of redeemable preferred stock.

Senior Redeemable Preferred Stock

OnRedemption for all shares of the Senior Redeemable Preferred Stock plus all accrued dividends on those shares was scheduled, subject to limitations detailed below, on October 31, 2005. However, on April 14, 2005, Toxford Corporation, the holder of 72.6% of the Senior Redeemable Preferred Stock, extended the maturity of its instruments to October 31, 2008. Mandatory redemption for 27.4% of the outstanding shares of the Senior Redeemable Preferred Stock plus all accrued dividends on those shares was scheduled, subject to limitations detailed below, on October 31, 2005. Among the limitations with regard to the mandatoryscheduled redemptions of the Senior Redeemable Public Preferred Stock areis the legal availability of funds, pursuant to Maryland law, and the requirement of such paymentlaw. Accordingly, due to be from excess cash flows, as set forth in the Company’s Articles of Amendment and Restatement. Accordingly the Companycurrent financial position, it is precluded by Maryland law from making the scheduled payment and as the excess cash flow requirement has not been met, current assets will not be used to satisfy the scheduled redemption.payment. As the Senior Redeemable Preferred Stock is not due on demand, or callable, within twelve months from DecemberMarch 31, 2005,2007, the remaining 27.4% is accordinglyalso classified as noncurrent.

Public Preferred Stock

Mandatory redemptionRedemption Provisions

Redemption for the Public Preferred Stock is contractually scheduled from 2005 through 2009. Since 1991, the Company has not declared or paid any dividends on its Public Preferred Stock, based upon its interpretation of restrictions in its Articles of Amendment and Restatement, limitations in the terms of the Public Preferred Stock instrument, specific dividend payment restrictions in the Facility entered into with Wells Fargo Foothill, and other senior obligations and limitations pursuant to Maryland law. Pursuant to their terms, the Company is scheduled, but not required, to redeem the Public Preferred Stock in five annual tranches during the period 2005 through 2009. However, due to its substantial senior obligations, limitations set forth in the covenants in the Facility, foreseeable capital and operational requirements, restrictions and prohibitions of its Articles of Amendment and Restatement, and provisions of Maryland law, and assuming sufficient liquidity to undertake any stock redemption (which is presently unquantifiable), the Company believes the likelihood is that it will not be able to meet the redemption schedule set forth in the terms of the Public Preferred Stock instrument. Moreover, the Public Preferred Stock is not payable on demand, nor callable, for failure to redeem the Public Preferred Stock in accordance with the redemption schedule set forth in the instrument. Therefore, the Company has classified these securities as noncurrent liabilities in the balance sheet as of December 31, 2004 and September 30, 2005.

The Company had previously classified the entirety of its obligation to redeem the Public Preferred Stock as a noncurrent obligation. As stated above, the terms of the Public Preferred Stock provide for a scheduled redemption of the Public Preferred Stock in five annual tranches beginning on December 1, 2005 and concluding on December 1, 2009, however this scheduled redemption is, by the terms of the Public Preferred Stock, subject to the legal availability of funds, any contractual restrictions then binding on the Company (including restrictions under any agreements regarding the borrowing of funds or the extension of credit which is binding upon the Company or any subsidiary of the Company) and applicable state law. For the reasons set out below, the Company concludes that it correctly classified the entirety of its obligation to redeem the Public Preferred Stock as a long-term obligation, but that the specific basis previously stated for such conclusion was not correct. The Company will therefore continue to classify the entirety of its obligation to redeem the Public Preferred Stock as a long-term obligation.

The basis of the Company’s classification of the entirety of its obligation to redeem the Public Preferred Stock as a long-term obligation was previously incorrect, in that the Company believed that it had the ability to exchange the Public Preferred Stock for indebtedness that would not become due for payment until 2009. Such basis failed to take account of the mandatory redemption requirements of the indebtedness for which the Company could exchange the Public Preferred Stock. The Company believed that it had the ability to exchange the Public Preferred Stock on a long-term basis under Article Five, Section C5 of the Company’s Articles of Amendment and Restatement, which permits the Company to exchange the Public Preferred Stock for a 12% Junior Subordinated Debentures Due 2009, and believed that the indebtedness from this refinancing would not become payable until 2009 and would not be subject to any earlier amortization. In fact, the 12% Junior Subordinated Debentures Due 2009 has a mandatory amortization schedule requiring that five payments be made, starting in December 2005 and annually thereafter. The first redemption payment due in December 2005 would thus, if the Company made the exchange, be a short-term liability which would, for the reasons set out below, not be permitted by the Senior Credit Facility Agreement (“Facility”) with Wells Fargo Foothill , Inc. (“Wells Fargo Foothill”).

March 31, 2006.

The Company and certain of its subsidiaries are parties to the Facility agreement with Wells Fargo Foothill, whose term expires on October 21, 2008. Under the Facility, agreement, the Company agreed that, so long as any credit under the Facility agreement is available and until full and final payment of the obligations under the Facility, agreement, it would not make any distribution or declare or pay any dividends (other than common stock) on its stock, or purchase, acquire, or redeem any stock, or exchange any stock for indebtedness, or retire any stock. The Company continues to actively rely upon the credit facility available to it under the Facility agreement and expects to continue to do so until the Facility agreement expires on October 21, 2008.

Accordingly, as stated above, the Company will continue to classify the entirety of its obligation to redeem the Public Preferred Stock as a long-term obligation. The Wells Fargo Foothill Facility agreement prohibits, among other things, the redemption of the Public Preferred Stockany stock, common or preferred, until October 21, 2008. The Public Preferred Stock by its terms cannot be redeemed if doing so would violate the terms of an agreement regarding the borrowing of funds or the extension of credit which is binding upon the Company or any subsidiary of the Company, and it does not include any other provisions that would otherwise require any acceleration of the redemption of or amortization payments with respect to the Public Preferred Stock. Thus, the Public Preferred Stock is not and will not be due on demand, nor callable, within twelve months from DecemberMarch 31, 2005.2006. This classification is consistent with ARB No. 43 and FASB Statement No. 78 (“FASB 78”), “Classification of Obligations that are Callable by the Creditor”.

Paragraph 7 of Chapter 3A of ARB No. 43 defines a current liability, as follows:

“The term current liabilities is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. As a balance sheet category, the classification is intended to include obligations for items that have entered into the operating cycle, such as payables incurred in the acquisition of materials and supplies to be used in the production of goods or in providing services to be offered for sale; collections received in advance of the delivery of goods or performance of services; and debts that arise from operations directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties, and income and other taxes. Other liabilities whose regular and ordinary liquidation is expected to occur within a relatively short period of time, usually 12 months, are also intended for inclusion, such as short-term debts arising from the acquisition of capital assets, serial maturities of long-term obligations, amounts required to be expended within 1 year under sinking fund provisions, and agency obligations arising from the collection or acceptance of cash or other assets for the account of third persons.”

Paragraph 5 of FASB 78, provides the following:

“The current liability classification is also intended to include obligations that, by their terms, are due on demand or will be due on demand within one year (or operating cycle, if longer) from the balance sheet date, even though liquidation may not be expected within that period. It is also intended to include long-term obligations that are or will be callable by the creditor either because the debtor’s violation of a provision of the debt agreement at the balance sheet date makes the obligation callable or because the violation, if not cured within a specified grace period, will make the obligation callable…”

If, pursuant to the terms of the Public Preferred Stock, the Company does not redeem the Public Preferred Stock in accordance with the scheduled redemptions described above, the terms of the Public Preferred Stock require the Company to discharge its obligation to redeem the Public Preferred Stock as soon as the Company is ablecapable and permitted to do so.

The Company has noted in previous filings (see Form 10-Q for Therefore, by its very terms, the period ending September 30, 2003 – Reclassifications) that its ability to successfully restructure its debt obligations could affect the Company’s future operating results and that for a variety of reasons, the Company believes it will more likely than not be unable to meet the redemption schedule set forth in the terms of the Company’s Public Preferred Stock instrument.

In its continuing effortHowever, on any dividend payment date after November 21, 1991, the Company may exchange the Public Preferred Stock, in whole or in part, for 12% Junior Subordinated Debentures that are redeemable upon terms substantially similar to address the Company’s capital structure,Public Preferred Stock and the adverse impact of SFAS 150 (Accountingsubordinated to all indebtedness for Certain Financial Instruments with Characteristics of both Liabilitiesborrowed money and Equity), which resulted in the reclassificationlike obligations of the redeemable preferred stock from equity to liability (see Note 4 – RedeemableCompany.

Dividend Provisions

The Public Preferred Stock)Stock accrues a semi-annual dividend at the annual rate of 12% ($1.20) per share, based on November 23, 2004, the Company’s Boardliquidation preference of Directors established a committee comprised of independent directors to consider any$10 per share and all proposals and alternatives with respect to the possible restructuringis fully cumulative. Dividends in additional shares of the Company. The independent committee’s charter includes addressingPublic Preferred Stock for 1990 and 1991 were paid at the unsuccessful restructuring effortsrate of 6% of a share for each $.60 of such dividends not paid in cash. Dividends on the Public Preferred Stock are paid by the Company, when and if declared by the Board of Directors, and management, undertaken pursuantare required to be paid out of legally available funds in accordance with Maryland law. For the cash dividends payable since December 1, 1995, the Company has accrued $41.1 million as of March 31, 2006 and $37.3 million as of March 31, 2005.

In accordance with SFAS 150, both the Senior Redeemable Preferred Stock and the Public Preferred Stock have been reclassified from equity to liability. Consequently, for the three months ended March 31, 2006 and 2005, dividends totaling $1.0 million were accrued and reported as interest expense in the respective periods. Prior to the resolutioneffective date of SFAS 150 on July 1, 2003, such dividends were charged to stockholders’ accumulated deficit. The aggregate fair value of the Boardpublic preferred stock at March 31, 2006 was $47.8 million.

The carrying value of Directors detailed in Form 8-K dated March 26, 2004. In January 2005, the independent committee informedaccrued Paid-in-Kind (“PIK”) dividends on the Board of Directors that it had retained legal counsel and engaged a financial advisor and had initiated its deliberations. On May 3, 2005, in a letter from certain holdersPublic Preferred Stock for the period 1992 through June 1995 was $4.0 million. Had the Company accrued cash dividends on the outstanding shares of the Public Preferred Stock for this time period, the total amount accrued would have been $13.4 million. The Company’s Charter, Section 2(a) states, “Any dividends payable with respect to the independent committee, such stockholders set forth their views on matters pending before the independent committee. Such letter was incorporated in a Schedule 13D/A filed by Ewing & Partners on May 5, 2005, and by Wynnefield Capital Management, LLC and Costa Brava Partnership III, L.P. on May 9, 2005. On August 4, 2005, the independent committee provided an interim report to the Board of Directors with regard to its process and deliberations.

Pursuant to the disclosures made on Form 8-K filed on November 3, 2005, at a special meeting of the Company’s Board of Directors held on October 31, 2005, the independent committee on capital restructuring (the “Committee”) presented its final report addressing the potential capital restructuring of the Company. The Committee and its advisors reported to the Board the various alternatives which it had considered and evaluated.

The Committee made the following recommendations:

1. While focusing on increasing the equity value of the Company, management should initiate discussions with the various stakeholders to determine if a consensual restructure or purchase of the Company’s 12% Cumulative Exchangeable Redeemable Preferred Stock (“Public Preferred Stock”) canduring the first six years after the Effective Date (November 20, 1989) may be negotiated at a significant discountpaid (subject to the liquidation preference and accrued dividends, and at a price level which the Company can financerestrictions under applicable state law), in the near term. A compromise price for the near term repurchase of the Public Preferred Stock would appear to be in the best interest of the Company. After repurchase of the Public Preferred Stock, a consensual restructuring of the securities which remain outstanding might be easier to accomplish.

2. Whether or not a near term transaction is available, management must continue to operate the Company’s business with a focus on maximizing enterprise value. If successful in increasing the value of the enterprise, the Company could be in a position to undertake a transaction that would generate sufficient funds to satisfy all stakeholders. In making this recommendation, the Committee recognized that the effect of SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, on the Company’s financial statements makes it more difficult for the Company to win new business and the adversarial actions of certain Public Preferred Stockholders make it more difficult to build the Company’s enterprise value to the levels needed to satisfy all stakeholders.

3. If a compromise price for a near term repurchase of the Public Preferred Stock is not available and future circumstance shows that the Company will not be able to achieve its forecasted results, the Company will have to consider other approaches to restructuring its capital.

The Board accepted the Committee’s report and accordingly dissolved the Committee. The Board thereafter retained the investment banking firm, Jefferies & Company, Inc., to work with the stakeholders and to undertake such steps as may be reasonable and necessary in an effort to effectuate the recommendations from the Committee.

To the best of the Company’s knowledge, after diligent inquiry, none of the Company’s present directors has disclosed any material financial interest with any holder of the Notes, Senior Redeemable Preferred Stock or Public Preferred Stock. Also, other than directors fees and stock options received for their service as memberssole discretion of the Board of Directors, in cash or by issuing additional full paid and nonassessable shares of Exchangeable Preferred Stock …”. Accordingly, the Board had the discretion to pay the dividends for the referenced period in cash or by the issuance of additional shares of Public Preferred Stock. During the period in which the Company stated its intent to pay PIK dividends, the Company stated its intention to amend its charter to permit the payment of these by the issuance of additional shares of Public Preferred Stock. In consequence, as required by applicable accounting requirements, the accrual for these dividends was recorded at the estimated fair value (as the average of the ask and bid prices) on the dividend date of the shares of Public Preferred Stock that would have been (but were not) issued. This accrual was $9.4 million lower than the accrual would be, if the intent was only to pay the dividend in cash, at that date or any later date.

In March 2006, the Company engaged Jefferies Quarterdeck, a nationally known investment bank, to explore strategic alternatives with respect to it Xacta subsidiary or one or more lines of business of its Xacta subsidiary. The objective of the Company is, if such a process could yield sufficient cash proceeds, to use the proceeds to partially or fees for servicecompletely recapitalize its balance sheet. There can be no assurance as membersto the outcome of this process, or as to the time frame in which this process might be completed.

The Board concluded, in consequence of the Company’s Proxy Board, nonecommencement of this process by Jefferies Quarterdeck and the ability to pay cash dividends derived from a transaction or transactions sufficient to meet such obligation, that the accrual of PIK dividends for the period 1992 through June 1995 was no longer appropriate. Since 1995, the Company has disclosed in the footnotes to its audited financial statements the carrying value of the non-executive directors receive any consulting or advisory fees or other compensation fromaccrued PIK dividends on the Public Preferred Stock for the period 1992 through June 1995 was $4.0 million, and that had the Company accrued cash dividends during this time period, the total amount accrued would have been $13.4 million. The objective of the Company to utilize the proceeds of this strategic process with respect to its Xacta subsidiary to partially or completely recapitalize its balance sheet, therefore, is inconsistent with any continued intent to pay a PIK dividend by the issuance of any additional shares of Public Preferred Stock. Accordingly on May 12, 2006, the Board of Directors voted to confirm that the Company’s intent with respect to the payment of dividends on the Public Preferred Stock for this period changed from its subsidiaries.previously stated intent to pay PIK dividends to that of an intent to pay cash dividends, although, as stated above, there can be no assurance whether or as to the time frame in which the strategic process with respect to the Company’s Xacta subsidiary might enable the Company to pay such dividends. The Company is therefore changing the accrual from $4.0 million to $13.4 million, the result of which will be to increase the Company’s negative shareholder equity by the difference between those two amounts, $9.4 million, by recording an additional $9.4 million charge to interest expense for the second quarter of 2006, resulting in a balance of $82.2 million (pro forma as of April 30, 2006) for the principal amount and all accrued dividends on the Public Preferred Stock. This action is a change in accounting estimate as defined in SFAS 154, “Accounting Changes and Error Corrections” which replaces APB No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” See pro forma disclosures at Note 6 – Contingencies and Subsequent Events.

Borrowing Capacity

At September 30, 2005,March 31, 2006, the Company had outstanding debt and long-term obligations of $101.8$103.3 million, consisting of $8.6$7.4 million under the Facility, $5.2 million in subordinated debt, $9.9$9.7 million in capital lease obligations and $78.1$81.0 million in redeemable preferred stock classified as liability in accordance with FAS 150.

Based on current requirements, management considersThe Company budgeted EBITDA of $(3.0) million for the three months ended March 31, 2006, and excluding non-budgeted legal costs of $2.7 million, achieved $(2.8) million of EBITDA for the period. Subsequent to March 31, 2006, approximately $1.2 million of such legal costs have been reimbursed by the Company’s borrowing capacityinsurers. Total expenses related to litigation were (exclusive of any such reimbursement) $3.5 million for the first quarter of 2006, and $4.1 million for the 12 months ending December 31, 2005. Such extraordinary legal expenses have adversely affected cash flow.

The Company derives substantially all of its revenue from U.S. Government contracting, and as such it is annually subject to the seasonality of the U.S. Government purchasing. As the U.S. Government fiscal year ends on September 30, it is not uncommon for U.S. Government agencies to award extra tasks in the weeks immediately prior to the end of its fiscal year in order to avoid the loss of unexpended fiscal year funds. As a result of this cyclicality, the Company has historically experienced higher revenues in its third and fourth fiscal quarters, ending September 30, and December 31, respectively, with the pace of orders substantially reduced during the January to June time period. During the three month period ending March 31, 2006, this seasonal reduction in orders and extraordinary litigation expense, have combined to adversely affect the Company’s EBITDA and cash flows. As the anticipated U.S. Government orders are realized during the third and fourth quarters of 2006, the Company, based upon current projected EBITDA, believes its liquidity will improve during these periods. The Company further believes such projected improvements in its liquidity later in 2006 will be sufficient to fundgenerate adequate amounts of cash to meet the Company’s needs for operating expenses, debt service requirements, and planned capital expenditures for 2006.

The Company is actively working with its capitalvendors, partners and liquidity needs.subcontractors to mitigate the effect of these cash flow constraints during this period. Additionally, as discussed in Note 3 – Debt Obligations, the Company and Wells Fargo Foothill have amended the Senior Revolving Credit Facility to provide the Company with a four-month over-advance in the amount of $3 million. There can be no assurances as to the continuing ability of the Company to successfully work with vendors, partners and subcontractors or Wells Fargo Foothill to mitigate these current cash flow constraints.

These consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As described in Note 3 – Debt Obligations, the Company has obtained waivers and less restrictive cash flow covenants with respect to its Senior Revolving Credit Facility. Although no assurances can be given, the Company expects that it will be in compliance throughout the term of the amended credit facility with respect to the financial and other covenants. Also, as more fully described in Note 4 – Redeemable Preferred Stock, the Company has engaged Jefferies Quarterdeck, a nationally known investment bank, to explore strategic alternatives for the sale of its Xacta subsidiary or one or more lines of business of its Xacta subsidiary. The Company intends to vigorously pursue such a process, with the objective, if such a process could yield sufficient cash proceeds, of using the proceeds to partially or completely recapitalize its balance sheet, although, as stated above, there can be no assurance whether, or as to the time frame in which, the strategic process with respect to the Company’s Xacta subsidiary might enable the Company to retire its debt obligations and/or pay dividends and/or partially or completely retire its redeemable preferred stock. While the Company intends to make every effort to successfully consummate such a transaction, including by assisting a proposed purchaser in obtaining necessary regulatory approvals, there can be no certainty as to the timeframe of such process completion or the amount of proceeds that would be realized as a result of such transaction.

Contractual Obligations and Off-Balance Sheet Arrangements

The following summarizes the Company’s contractual obligations at September 30, 2005,March 31, 2006, both on and off balance sheet, and their anticipated impact upon the Company’s liquidity and cash flow in future periods (in thousands):

Recent Accounting Pronouncements

In January 2003, the FASB issued FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity, if equity investors in an entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 resulting in multiple effective dates in 2003 and 2004 based on the nature as well as the creation date of the variable interest entity. The revised FIN 46 will be effective for non-SPE variable interest entities created prior to February 1, 2003 no later than the first quarter of 2004. For variable interest entities created or acquired after January 31, 2003, the provisions of FIN 46 must be applied. The adoption of FIN 46 did not materially affect the results of operations or financial position of the Company. For further discussion, see Note 2 - Investment in Enterworks.

In November 2004,June 2005, the FASB issued Statement No. 151, “Inventory Costs - an amendment of ARB154, “Accounting Changes and Error Corrections,” which replaces APB Opinion No. 43, Chapter 4.20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” Statement No. 151 clarifies154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting guidance included in Accounting Research Bulletin (“ARB”) No. 43, Chapter 4, “Inventory Pricing” related to abnormal amounts of idle facility expense, freight, handling and spoilage costs.principle. Statement No. 151154 also requires that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for prospectively as a change in estimate, and correction of errors in previously issued financial statements should be termed a “restatement.” Statement No. 154 is effective for inventory costs incurred duringaccounting changes and correction of errors made in fiscal years beginning after JuneDecember 15, 2005. The potential effect of Statement No. 151 on the financial statements is currently being considered.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. SFAS No. 123(R) must be2005, and was adopted by the Company byon January 1, 2006. See disclosures under the third quarter of 2005. In April 2005, the effective date was amended for calendar year companies until the beginning of 2006. The Company currently accounts for share-based compensation using APB No. 25’s intrinsic value method“Reclassifications and accordingly, recognizes no compensation cost for employee stock options. The Company is in the process of determining which transitional method it will elect upon the adoption of SFAS No. 123(R).

Restatements” caption.

In December 2004, the FASB issued Statement No. 153, “Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29,” which eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets that do not culminate an earning process under APB Opinion No. 29, “Accounting for Nonmonetary Transactions.” Statement No. 153 requires that the measurement be based on the recorded amount of the assets relinquished for nonmonetary exchanges that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This standard is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard has not yet affected the Company’s financial position or results of operations. The potential effect of Statement No. 153 on thein future financial statements is currently being considered.

In June 2005,November 2004, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections”, which replaces APB Opinion151, “Inventory Costs - an amendment of ARB No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.43, Chapter 4.” Statement No. 154151 clarifies the accounting guidance included in Accounting Research Bulletin (“ARB”) No. 43, Chapter 4, “Inventory Pricing” related to abnormal amounts of idle facility expense, freight, handling and spoilage costs. This statement requires that a voluntary change in accounting principlethose items be applied retrospectively with all prior period financial statements presentedrecognized as current-period charges regardless of whether they meet the criterion of “so abnormal,” as specified by ARB No. 43. In addition, this statement requires that allocation of fixed production overhead to the costs of conversion be based on the new accounting principle.normal capacity of the production facilities. Statement No. 154 also requires that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for prospectively as a change in estimate, and correction of errors in previously issued financial statements should be termed a “restatement.” Statement No. 154151 is effective for accounting changes and correction of errors made ininventory costs incurred during fiscal years beginning after DecemberJune 15, 2005. The adoption of this standard has not yet affected the Company’s financial position or results of operations. The potential effect of Statement No. 154 on the151 in future financial statements is currently being considered.

Forward-Looking Statements

This AnnualQuarterly Report on Form 10-Q contains forward-looking statements. For this purpose, any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. There are a number of important factors that could cause the Company’s actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth below under the caption “Certain Factors That May Affect Future Results.”

Certain Factors That May Affect Future Results

The following important factors could cause actual results to differ materially from those indicated by forward-looking statements made in this Quarterly Report on Form 10-Q and presented elsewhere by management from time to time.

A number of uncertainties exist that could adversely affect the Company’s future operating results, including, without limitation, general economic conditions that may include the cost and continued availability of the Company to secure adequate capital and financing to support its business; the ability to attract and retain personnel; the impact of adverse economic conditions on the Company’s customers and suppliers; the ability to sell assets or to obtain alternative sources of commercially reasonable refinancing for the Company’s debt; or the ability to successfully restructure the Company without costly and/or extended litigation related to such restructuring. Additional uncertainties include the Company’s ability to convert contract backlog to revenue, the success of the Company’s investment in Enterworks and Xacta and the Company’s access to ongoing development, product support and viable channel partner relationships with its partners and suppliers.

While in the past the Company has not experienced contract terminations with the U.S. Government, the U.S. Government can terminate at its convenience. Should such a termination occur the Company’s operating results could be adversely impacted. Additionally, receivables under certain government contracts are based on provisional rates that permit recovery of indirect costs not exceeding certain limits. These indirect costs are subject to audit on an annual basis by the Defense Contract Audit Agency. When final determination and approval of the indirect cost rates have been made, revenue and/or receivables may be adjusted accordingly.

Due to heightened security awareness and the ongoing military and peacekeeping actions in Iraq and Afghanistan, all U.S. Government programs, especially those pertaining to national security, have been subject to extensive review and reprioritization as evidenced by the Homeland Defense Act, and the continued funding requirements of the U.S. activities in Iraq and Afghanistan. While the Company believes its products and services are well positioned to benefit from such reprioritization of U.S. Government demands, the magnitude of recent and prospective events pertaining to national security serves to emphasize how the Company’s high percentage of revenue derived from business with the U.S. Government could alternatively be dramatically, swiftly and adversely impacted.

In addition, as a high percentage of the Company’s revenue is derived from business with the U.S. Government, the Company’s operating results could also be adversely impacted should the U.S. Government’s annual budget not be approved in a timely fashion.

The Company has many patents and patents pending, trademarks and copyrights and other valuable proprietary information and has taken reasonable and prudent steps to protect its intellectual property. With regard to the Company’s wholly-owned subsidiary, Xacta, whose software products require constant monitoring as it develops future releases and creates additional intellectual property, vigilant oversight of such intellectual property rights is imperative. All of the Company’s propriety solutions require constant oversight with regard to the development and protection of their respective intellectual property. Accordingly, any event that brings into question the Company’s ownership of its intellectual property and propriety solutions could materially and adversely impact the Company.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Company is exposed to interest rate volatility with regard to its variable rate debt obligations under its Senior Credit Facility. Effective April 2005, interest on the interest rateFacility is charged at 1% over the Wells Fargo “prime rate” plus 1% (as of September 30, 2005March 31, 2006 the Wells Fargo “prime rate” was 6.75%7.75%), or 5.75%, whichever is higher. The effective average interest rates, including all bank fees, for the first ninethree months of 2006 and 2005 were 9.9% and 2004 were 9.4% and 9.5%, respectively. The Facility had an outstanding balance of $8.6$7.4 million at September 30, 2005.March 31, 2006.

Item 4. Controls and Procedures

The Company’s chief executive officer and chief financial officer have evaluated the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e)) and Rule 15d-15(e) under the Exchange Act), as of September 30, 2005,March 31, 2006, and concluded that those disclosure controls and procedures are effective in timely alerting them to any material changes in information required to be included in the Company’s periodic Securities and Exchange Commission filings.

Since such evaluation, such officers are unaware of any material subsequentThere were no changes in the Company’s internal controls over financial reporting during the last fiscal quarter that have materially affected, or in other factors that couldare reasonably likely to materially affect, the Company’s internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses.