The following discussion should be read in conjunction with our condensed consolidated financial statements and the related notes. Unless the context otherwise requires, references in this Form 10-Q to "DRC", "we", "us" or "our" refer to Dynamics Research Corporation and its subsidiaries.

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

More specifically, we use the following non-GAAP financial measures: non-GAAP operating profit, non-GAAP income before income taxes, non-GAAP provision for income taxes, non-GAAP net income and non-GAAP earnings per share.

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

• the ability to make more meaningful period-to-period comparisons of our ongoing operating results;

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

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

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

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

The non-GAAP measures we use exclude the provision for litigation charge and its related tax effect that management believes is unusual and outside of our ongoing operations for the period presented.

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

                      RECONCILIATION OF NON-GAAP MEASURES

                                                                    Three Months Ended
                                                                         March 31,
                                                                2009                  2008
(in millions)                                               $       % (2)      $ (1)       % (2)
GAAP operating income (loss)                              $ 3.6        5.3 %   $ (6.1 )     (10.7 )%
Provision for litigation                                                          8.8        15.6 %
Non-GAAP operating income                                                      $  2.8         4.9 %

GAAP income (loss) before provision for income taxes      $ 3.1        4.5 %   $ (6.3 )     (11.1 )%
Provision for litigation                                                          8.8        15.6 %
Non-GAAP income before provision for income taxes                              $  2.5         4.5 %

GAAP provision (benefit) for income taxes                 $ 1.3       42.3 %   $ (1.0 )      16.3 %  (3)
Tax benefit for provision for litigation                                          2.1        24.1 %  (3)
Non-GAAP provision for income taxes                                            $  1.1        43.4 %  (3)

GAAP net income (loss)                                    $ 1.8        2.6 %   $ (5.3 )      (9.3 %
Provision for litigation, net of tax benefit                                      6.7        11.9 %
Non-GAAP net income                                                            $  1.4         2.5 %

(1) Totals may not add due to rounding.
(2) Represents a percentage of total revenue of $68.5 million and $56.5 million in the three months ended March 31, 2009 and 2008, respectively, excluding the percentages for provision (benefit) for income taxes and the tax benefit for provision for litigation.
(3) These amounts represent a percentage of GAAP income (loss) before provision for income taxes, provision for litigation and non-GAAP income before provision for income taxes, respectively.

OVERVIEW

Business

Dynamics Research Corporation, headquartered in Andover, Massachusetts, is a leading provider of innovative engineering, technical, information technology and management consulting services and solutions to federal and state governments. We provide support to our customers in the primary mission areas of IT, Logistics and Readiness, Systems Integration and Technical Services, Command, Control, Computers, Communications, Intelligence, Surveillance and Reconnaissance, Homeland Security, Health and Human Services, Intelligence/Space, Cyber Security, and Public and Environmental Health.

On August 1, 2008, we completed the acquisition of Kadix Systems, LLC. The acquisition has strengthened and expanded our growth as a provider of high-end services and solutions in the homeland security and other federal civilian markets. The operating results of Kadix are included in DRC's results of operations within the Systems and Services segment for the period subsequent to the acquisition date.

We have two reportable business segments: Systems and Services, and Metrigraphics. The Systems and Services segment accounted for approximately 98% of total revenue and the Metrigraphics segment accounted for approximately 2% of total revenue in the three months ended March 31, 2009.

Industry

We are cognizant of changing priorities of the federal government. Homeland security, cyber-security, health care, financial stability and energy independence stand out as top federal priority areas for increased funding. Within the Defense Department, Secretary Gates also has recently outlined his proposal for a shift in defense program priorities that should be favorable to us.

Over the past two years, we have carefully selected for strategic focus several target growth markets that are today within the scope of the new priorities that have been set by President Obama's administration. We are now seeing strong growth in revenues in these markets. Homeland security and certain civilian agencies, primarily those with a financially-oriented mission, now represent nearly 40% of our revenue. We also are seeing growth in cyber security and information assurance work, which currently represents about 10% of our business. We currently are providing management, operational and technical services to clients across the federal sector - Defense, Homeland Security, Intelligence Agencies, and Civilian Agencies. Our distinguishing strength is in the management area, where we are providing an array of solutions, such as business transformation, information assurance assessment and compliance, training, and human capital solutions, helping customers achieve their missions.

In addition to changing federal spending priorities, both President Obama and Secretary Gates have spoken to two specific reform initiatives - procurement reform and "in-sourcing" or strengthening of the federal civilian workforce, both of which are areas served by our training and human capital solutions.

Regarding federal acquisition reform, we have already experienced and are successfully dealing with these changes. Over the past three years, we have seen a marked change in the mix of contract types that reflect the recent trends in the nature of federal procurement. In the first quarter of 2009, 37 percent of our revenues were from fixed price contracts, compared with 26 percent and 18 percent in the first quarters of 2008 and 2006, respectively. In addition, nearly all of our contracts have been awarded through a competitive procurement process.

On the subject of in-sourcing, or the growth in the federal civilian workforce, we see, as do industry analysts and experts, that this growth is likely to come in the form of added acquisition support staff, as well as procurement and contract support specialists, and less likely to be in the type of high-value solutions and services that DRC provides. With the shift in our business mix over the past several years, nearly 90 percent of our revenue now comes from providing solutions and services other than acquisition management, which increasingly has been and continues to be set aside for small businesses. Consequently, we anticipate no significant long-term impact from this federal hiring initiative.

Outlook

Our business is conducted primarily with U.S. Government customers under both short-term and long-term contracts. We have aligned our service offerings to current economic conditions and customer needs. The U.S. Government's budgetary processes give us good visibility regarding future spending and the threat areas that they are addressing. Management believes that our current contracts, and backlog of previously awarded contracts are well aligned with the direction of our customers' future needs, and this provides us with good insight regarding future cash flows. In 2007 and 2008, we recorded improved operating results absent the effect of the provision for litigation which, when included, resulted in a net loss for 2008. Nonetheless, management recognizes that the current economic situation and significant changes in priorities under the new administration likely will result in significant changes in federal spending with increases in some areas and decreases in others. While we may benefit from the increases, certain programs in which we participate may be subject to reductions.

RESULTS OF OPERATIONS

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

                                                     Three Months Ended March 31,
                                                   2009                        2008
(in millions)                               $ (1)         %             $ (1)         %
 Contract revenue                           $ 67.2        98.1 %        $ 54.8        97.0 %
 Product sales                                 1.3         1.9             1.7         3.0
 Total revenue                              $ 68.5       100.0 %        $ 56.5       100.0 %

 Gross profit on contract revenue (3)       $ 11.3        16.8 %        $  8.6        15.6 %
 Gross profit (loss) on product sales (3)     (0.2 )     (13.6 )%          0.1         5.9 %
 Total gross profit (3)                       11.1        16.2 %           8.7        15.3 %

 Selling, general and administrative           6.5         9.4 %           5.4         9.6 %
 Provision for litigation                        -         0.0 %           8.8        15.6 %
 Amortization of intangible assets             1.0         1.4 %           0.5         0.9 %
 Operating income (loss)                       3.6         5.3 %          (6.1 )     (10.7 )%
 Interest expense, net                        (0.6 )      (0.9 )%         (0.1 )      (0.2 )%
 Other income, net                             0.0         0.1 %          (0.1 )      (0.1 )%
 Provision (benefit) for income taxes          1.3        42.3 %  (2)     (1.0 )      16.3 %  (2)
 Net income (loss)                          $  1.8         2.6 %        $ (5.3 )      (9.3 )%

(1) Totals may not add due to rounding.
(2) The percentage of provision (benefit) for income taxes relates to a percentage of income (loss) before income taxes.
(3) These amounts represent a percentage of contract revenues, product sales and total revenues, respectively.

Revenues

We reported total revenue of $68.5 million and $56.5 million in the three months ended March 31, 2009 and 2008, respectively. Total revenues for the first quarter of 2009 represent an increase of $12.0 million, or 21.4%, from the same period in 2008. The organic growth rate for the quarter was 4.6% by adding Kadix's first quarter 2008 revenue of $9.0 million to the 2008 base period.

Contract Revenues

Contract revenues in our Systems and Services segment were earned from the
following sectors:

                                                       Three Months Ended March 31,
                                                        2009                   2008
    (in millions)                                $ (1)       % (1)      $ (1)       % (1)
    National defense and intelligence agencies   $ 36.1        53.7 %   $ 40.9        74.8 %
    Federal civilian agencies                      12.2        18.1        6.6        12.1
    Homeland Security                              12.8        19.1        1.3         2.4
    State and local government agencies             5.8         8.7        5.2         9.6
    Other                                           0.3         0.4        0.6         1.1
    Total contract revenue                       $ 67.2       100.0 %   $ 54.8       100.0 %

(1) Totals may not add due to rounding.

The decrease in revenues from national defense and intelligence agencies in the three months ended March 31, 2009 compared to the same period in 2008 was due to lower revenues from the transition of the U.S. Air Force Electronic Systems Center Information Technology Services Program II contract to the small business set-aside Professional Acquisition Support Services contract and the U.S. Navy Trident Missile.

The increase in revenues from federal civilian agencies and homeland security in the three months ended March 31, 2009 compared to the same period in 2008 was primarily due to added revenues related to the Kadix acquisition and new contracts and task orders won in the second half of 2008.

The increase in revenues from state and local government agencies in the three months ended March 31, 2009 compared to the same period in 2008 was primarily due to revenues from the new child welfare system development project with the State of Tennessee which began in the second quarter of 2008. Revenues from the State of Tennessee contract are currently projected at an estimated $13 million for 2009, compared with $7.0 million for 2008. Revenues with the State of Ohio contract, which is now completed, were $0.5 million in the first quarter of 2009, compared with $12.1 million for 2008.

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

                                                          Three Months Ended
                                                               March 31,
                                                         2009            2008
       Time and materials                                     46 %            55 %
       Cost reimbursable                                      17              19
       Fixed price, including service type contracts          37              26
                                                             100 %           100 %

       Prime contract                                         72 %            54 %
       Sub-contract                                           28              46
                                                             100 %           100 %

Prime contract revenues increased in the three months ended March 31, 2009 compared to the same period in 2008 as a result of an increasing portion of contracts awarded under DRC's agency-wide multiple award schedule indefinite delivery-indefinite quantity contracts.

Product Sales

Product sales for our Metrigraphics segment were $1.3 million and $1.7 million in the three months ended March 31, 2009 and 2008, respectively. The decrease in product sales in the first quarter of 2009 compared to the same period in 2008 was primarily due to lower orders for products other than medical device components, reflecting general economic conditions.

Funded Backlog

Our funded backlog was $142.1 million at March 31, 2009 and $149.2 million at December 31, 2008. We expect that substantially all of our backlog will generate revenue during the subsequent twelve month period.

Gross Profit

Total gross profit was $11.1 million and $8.7 million for the three months ended March 31, 2009 and 2008, respectively, resulting in a gross margin of 16.2% and 15.3% for the first quarters of 2009 and 2008, respectively.

Our gross profit and gross margin on contract revenue increased to $11.3 million and 16.8% in the first quarter of 2009 from $8.7 million and 15.6% in the first quarter of 2008. The improvement was due to the addition of Kadix, improved labor utilization and a shift from sub-contract work to prime contract work, partially offset by an increase in pension expense due to the decline in plan asset performance in 2008.

Our gross loss on product sales was $0.2 million for the three months ended March 31, 2009, compared to gross profit of $0.1 million for the same period in 2008. The decrease in gross profit was primarily attributable to lower revenues.

Selling, general and administrative expenses

Selling, general and administrative expenses were $6.5 million and $5.4 million in the three months ended March 31, 2009 and 2008, respectively. Selling, general and administrative expenses as a percent of total revenue in the first quarter of 2009 and 2008 was 9.4% and 9.6%, respectively. Selling, general and administrative expenses in the first quarter of 2009 were higher than the same period in 2008 as a result of added costs to support the acquired Kadix operations and higher legal fees.

Provision for litigation

During the first quarter and third quarter of 2008, we increased the accrual for litigation to $9.0 million and $15.0 million, respectively, based on the September 2008 tentative settlement agreement. Further discussion related to this settlement is referenced in Note 13 of our Notes to Condensed Consolidated Financial Statements.

Amortization of intangible assets

Amortization expense was $1.0 million and $0.5 million in the three months ended March 31, 2009 and 2008, respectively. The increase in amortization expense primarily relates to intangible assets acquired from our 2008 acquisition of Kadix and is included in the Systems and Services segment. The remaining amortization expense for the current fiscal year is expected to be approximately $2.3 million.

Interest expense, net

We incurred interest expense of $0.6 million and $0.1 million in the three months ended March 31, 2009 and 2008, respectively. The increase in interest expense was due to the addition of the term loan used to finance the Kadix acquisition.

Other income (expense), net

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

Income tax provision (benefit)

We recorded income tax provisions (benefits) of $1.3 million and $(1.0) million in the first quarters of 2009 and 2008 respectively. The effective income tax rate was 42.3% in the first quarter of 2009 and 43.4% in the same period in 2008, excluding the tax effect of the $8.8 million litigation provision recorded. The Company estimated the tax benefits associated with the first quarter 2008 litigation provision at $2.1 million. The decrease in the effective rate excluding the litigation provision was due to relatively lower permanent tax differences estimated for 2009 compared to 2008.

LIQUIDITY AND CAPITAL RESOURCES

The following discussion analyzes liquidity and capital resources by operating, investing and financing activities as presented in our Consolidated Statements of Cash Flows. Our principal sources of liquidity are cash flows from operations and borrowings from our revolving credit facility. At March 31, 2009, the borrowing capacity available under our revolver was $24.7 million.

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

In light of the current economic situation, we have also evaluated our future liquidity needs, both from a short-term and long-term basis. We believe we have sufficient funds to meet our working capital and capital expenditure needs for the short term. Cash on hand plus cash generated from operations along with cash available under credit lines are expected to be sufficient in 2009 to service debt, finance capital expenditures, pay the anticipated settlement of litigation, pay federal and state income taxes and fund the pension plan, if necessary. To provide for long-term liquidity, we believe we can generate substantial positive cash flow, as well as obtain additional capital, if necessary, from the use of subordinated debt or equity. In the event that our current capital resources are not sufficient to fund requirements, we believe our access to additional capital resources would be sufficient to meet our needs.

We anticipate paying the $15.0 million litigation settlement due to the Government in the second quarter of 2009. This litigation settlement is further described in Note 13 of our Notes to Condensed Consolidated Financial Statements of this Form 10-Q. We will use available cash on hand and borrow the remaining portion from our revolver.

We believe that selective acquisitions are an important component of our growth strategy. We may acquire, from time to time, firms or properties that are aligned with our core capabilities and which complement our customer base. We will continue to consider acquisition opportunities that align with our strategic objectives, along with the possibility of utilizing the credit facility as a source of financing.

At March 31, 2009 and December 31, 2008, we had cash and cash equivalents aggregating $4.4 million and $7.1 million, respectively. Our operating practice is to apply cash received against any outstanding revolving credit facility balances. When a revolver balance exists, cash balances at the end of the period generally reflect the timing and size of cash receipts at the end of the period.

Operating activities

Net cash provided by operating activities totaled $3.4 million in the first quarter of 2009 compared to $1.8 million in the first quarter of 2008. The cash provided by operating activities in the first quarter of 2009 was primarily attributable to net earnings realized during the quarter. The cash provided by operating activities in the first quarter of 2008 was primarily attributable to contract receivable collections.

Contract receivables were $71.8 million at March 31, 2009, or 94 days sales outstanding (DSO), compared to $71.4 million, or 95 days at December 31, 2008. Billed receivables decreased $2.1 million in the three months ended March 31, 2009, while unbilled receivables increased $2.4 million. Federal business DSO was 84 days at March 31, 2009 compared to 86 days at December 31, 2008. The difference between consolidated DSO and federal DSO was primarily due to our contracts with the States of Ohio and Tennessee which had aggregate balances outstanding of $11.5 million and $12.7 million at March 31, 2009 and December 31, 2008, respectively.

In February 2008, we were awarded a $25.5 million fixed price contract from the State of Tennessee, which began in the second quarter of 2008 with deployment scheduled to occur in early 2010. The outstanding contract receivable balance of the State of Tennessee contract at March 31, 2009 was $10.2 million and is currently projected to be approximately 17 million at the end of 2009.

Our net deferred tax asset was $6.9 million and $7.7 million at March 31, 2009 and December 31, 2008, respectively. The decrease in the deferred tax asset is due to an increase in unbilled revenue for tax reporting purposes. We paid $0.3 million in income taxes in the first quarter of 2009 and currently anticipate additional income tax payments of $0.6 million in the last three quarters of 2009. The IRS continues to challenge the deferral of income for tax purposes related to unbilled receivables including the applicability of a Letter Ruling issued by the IRS to the Company in January 1976 which granted to us deferred tax treatment of the unbilled receivables. This issue was elevated to the IRS National Office for determination. On October 23, 2008, we received a notification of ruling from the IRS National Office. This ruling provided clarification regarding the IRS position relating to revenue recognition for tax purposes regarding our unbilled receivables. Currently we are working with the IRS on how to apply the ruling to our 2004 deferred tax balance. DRC and the IRS expect to conclude this process during the second quarter of 2009. The resolution with the IRS regarding unbilled receivables could result in a change in

our tax accounting method regarding revenue recognition. This change could result in an acceleration of taxable income and a reversal of certain deferred tax items. We do not believe that any adjustment to taxable income in prior years resulting from this ruling will result in the payment of any interest or penalties.

Share-based compensation was $0.2 million in the first quarter of 2009, compared to $0.4 million in the same period in 2008. As of March 31, 2009 the total unrecognized compensation related to restricted stock awards was $1.3 million to be recognized over 2.2 years.

Non-cash amortization expense of our acquired intangible assets was $1.0 million and $0.5 million in the first quarter of 2009 and 2008, respectively. We anticipate that non-cash expense for the amortization of intangible assets will remain at a comparable quarterly level through the third quarter of 2009 and decrease by approximately $0.4 million in the fourth quarter of 2009 due to intangible assets acquired in previous years becoming fully amortized.

Investing activities

Net cash used in investing activities was $4.5 million and $0.3 million in the first quarters of 2009 and 2008, respectively. The net cash used in 2009 was primarily comprised of additional consideration paid as part of the Kadix . . .