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


                                                                       Six Months Ended
                                                                           June 30,
                                                                2009                      2008
(in millions)                                               $       % (2)           $ (1)      % (2)
GAAP operating income (loss)                              $ 7.3        5.3 %        $ (3.4 )     (3.1 )%
Provision for litigation                                                               8.8        7.9 %
Non-GAAP operating income                                                           $  5.4        4.8 %

GAAP income (loss) before provision for income taxes      $ 6.6        4.8 %        $ (3.5 )     (3.2 )%
Provision for litigation                                                               8.8        7.9 %
Non-GAAP income before provision for income taxes                                   $  5.3        4.7 %

GAAP provision for income taxes                           $ 2.8       41.9 %  (3)   $  0.1       (2.5 )% (3)
Tax benefit for provision for litigation                                               2.1       24.1 %  (3)
Non-GAAP provision for income taxes                                                 $  2.2       41.9 %  (3)

GAAP net income (loss)                                    $ 3.8        2.8 %        $ (3.6 )     (3.2 )%
Provision for litigation, net of tax benefit                                           6.7        6.0 %
Non-GAAP net income                                                                 $  3.1        2.7 %

(1) Totals may not add due to rounding.
(2) Represents a percentage of total revenue of $138.2 million and $111.8 million for the six months ended June 30, 2009 and 2008, respectively, excluding the percentages for provision 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 six months ended June 30, 2009.

Industry

We are cognizant of changing priorities of the federal government. Federal agencies are focusing their procurement activities on execution of President Obama administration's broad array of policy initiatives. Cyber-security and information assurance, a shift in defense acquisition priorities and processes, financial stabilization, investment in health care IT and military health care programs and energy independence stand out as top federal priority areas for increased funding.

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 second quarter of 2009, 38 percent of our revenues were from fixed price contracts, compared with 33 percent in the second quarter of 2008. 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 are being addressed. 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 2008, we recorded improved operating results absent the effect of the provision for litigation which, when included, resulted in a net loss. 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.

CRITICAL ACCOUNTING POLICIES

There are business risks specific to the industries in which we operate. These risks include: estimates of costs to complete contract obligations, changes in government policies and procedures, government contracting issues and risks associated with technological development. The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements. Estimates and assumptions also affect the amount of revenue and expenses during the reported period. Actual results could differ from those estimates.

The use of alternative estimates and assumptions and changes in business strategy or market conditions may significantly impact our assets or liabilities, and potentially result in a different impact to our results of operations.

For information regarding our critical accounting policies, refer to the section titled "Critical Accounting Policies" in Part II, Item 7 of our 2008 Form 10-K. There have been no material changes from the critical accounting policies previously disclosed in our most recent Form 10-K.

RESULTS OF OPERATIONS

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

                                                                    Three Months Ended June 30,
                                                                 2009                         2008
(in millions)                                             $ (1)         %              $ (1)         %
 Contract revenue                                         $ 68.1        97.8 %         $ 53.7        97.1 %
 Product sales                                               1.5         2.2              1.6         2.9
 Total revenue                                            $ 69.6       100.0 %         $ 55.3       100.0 %

 Gross profit on contract revenue (3)                     $ 11.1        16.3 %         $  8.1        15.1 %
 Gross profit (loss) on product sales (3)                   (0.1 )      (3.4 )%           0.2        12.1 %
 Total gross profit (3)                                     11.1        15.9 %            8.3        15.0 %

 Selling, general and administrative                         6.4         9.2 %            5.1         9.3 %
 Amortization of intangible assets                           1.0         1.4 %            0.5         0.9 %
 Operating income                                            3.7         5.3 %            2.6         4.8 %
 Interest expense, net                                      (0.5 )      (0.7 )%          (0.1 )      (0.3 )%
 Other income, net                                           0.3         0.4 %            0.2         0.4 %
 Provision for income taxes                                  1.5        41.5 %  (2)       1.1        40.6 %  (2)
 Net income                                               $  2.1         2.9 %         $  1.6         2.9 %



                                                                      Six Months Ended June 30,
                                                                 2009                          2008
(in millions)                                              $ (1)         %               $ (1)         %
 Contract revenue                                         $ 135.3        97.9 %         $ 108.5        97.1 %
 Product sales                                                2.9         2.1               3.3         2.9
 Total revenue                                            $ 138.2       100.0 %         $ 111.8       100.0 %

 Gross profit on contract revenue (3)                     $  22.4        16.5 %         $  16.7        15.4 %
 Gross profit (loss) on product sales (3)                    (0.2 )      (8.2 )%            0.3         8.9 %
 Total gross profit (3)                                      22.1        16.0 %            17.0        15.2 %

 Selling, general and administrative                         12.8         9.3 %            10.5         9.4 %
 Provision for litigation                                       -         0.0 %             8.8         7.9 %
 Amortization of intangible assets                            1.9         1.4 %             1.0         0.9 %
 Operating income (loss)                                      7.3         5.3 %            (3.4 )      (3.1 )%
 Interest expense, net                                       (1.1 )      (0.8 )%           (0.3 )      (0.3 )%
 Other income, net                                            0.3         0.2 %             0.2         0.2 %
 Provision for income taxes                                   2.8        41.9 %   (2)       0.1        (2.5 )%  (2)
 Net income (loss)                                        $   3.8         2.8 %         $  (3.6 )      (3.2 )%

(1) Totals may not add due to rounding.
(2) The percentage of provision 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 revenues of $69.6 million and $55.3 million in the three months ended June 30, 2009 and 2008, respectively. Total revenues for the second quarter of 2009 represent an increase of $14.3 million, or 26.0% of total revenue, from the same period in 2008. Our revenues for the six months ended June 30, 2009 and 2008 were $138.2 million and $111.8 million, respectively, representing an increase of $26.4 million, or 23.6% of total revenue, from the same period in 2008. The organic growth rate for the three and six months ended June 30, 2009 was 4.2% and 4.4%, respectively. Our computation of organic growth adds Kadix's second quarter and first half of 2008 revenue of $11.6 and $20.6 million, respectively, to the Company's reported revenues for such periods.

Contract Revenues

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

                                                  Three Months Ended               Three Months Ended June 30,
                                                  March 31, 2009 (1)               2009                   2008
(in millions)                                     $ (2)          % (2)      $ (2)       % (2)      $ (2)       % (2)
National defense and intelligence agencies      $    37.2          55.3 %   $ 36.5        53.6 %   $ 37.2        69.2 %
Federal civilian agencies                            10.8          16.1       11.0        16.2        6.8        12.7
Homeland Security                                    13.1          19.5       13.7        20.1        1.6         3.0
State and local government agencies                   5.8           8.7        6.5         9.5        7.4        13.7
Other                                                 0.3           0.5        0.4         0.6        0.8         1.4
Total contract revenues                         $    67.2         100.0 %   $ 68.1       100.0 %   $ 53.7       100.0 %



                                                         Six Months Ended June 30,
                                                       2009                    2008
   (in millions)                                 $ (2)       % (2)       $ (2)       % (2)
   National defense and intelligence agencies   $  73.7        54.5 %   $  78.1        72.0 %
   Federal civilian agencies                       21.8        16.1        13.4        12.4
   Homeland Security                               26.8        19.8         2.9         2.7
   State and local government agencies             12.3         9.1        12.6        11.6
   Other                                            0.7         0.5         1.4         1.3
   Total contract revenues                      $ 135.3       100.0 %   $ 108.5       100.0 %

(1) Amounts for the three months ended March 31, 2009 have been reclassified to conform to current period presentation.
(2) Totals may not add due to rounding.

The decrease in revenues from national defense and intelligence agencies in the three and six months ended June 30, 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 wind down of the U.S. Navy Trident Missile program.

The increase in revenues from federal civilian agencies and homeland security in the three and six months ended June 30, 2009 compared to the same period in 2008 was primarily due to added revenues related to the Kadix acquisition, supplemented by new contract and task order awards received in the second half of 2008 and in 2009.

The decrease in revenues from state and local government agencies in the three and six months ended June 30, 2009 compared to the same period in 2008 was primarily due to lower revenues from the State of Ohio contract, which is now completed, partially offset by 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 from the State of Ohio contract, which is now completed, were $0.5 million in the first half of 2009, compared with $12.1 million for all of 2008.

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

                                                              Three Months Ended           Six Months Ended
                                                                   June 30,                    June 30,
                                                             2009            2008          2009          2008
 Time and materials                                               44 %            46 %         45 %         50 %
 Cost reimbursable                                                18              21           18           20
 Fixed price, including service type contracts                    38              33           37           30
                                                                 100 %           100 %        100 %        100 %

 Prime contract                                                   71 %            64 %         71 %         62 %
 Sub-contract                                                     29              36           29           38
                                                                 100 %           100 %        100 %        100 %

Prime contract revenues increased in the three and six months ended June 30, 2009 compared to the same periods 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, including contracts received through the Kadix acquisition.

Product Sales

Product sales for our Metrigraphics segment were $1.5 million and $1.6 million in the three months ended June 30, 2009 and 2008, respectively, and $2.9 and $3.3 million, respectively, in the first half then ended. The decrease in product sales was primarily due to lower orders for products other than medical device components, reflecting general economic conditions.

Funded Backlog

Our funded backlog was $138.3 million at June 30, 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 $8.3 million for the three months ended June 30, 2009 and 2008, respectively, resulting in a gross margin of 15.9% and 15.0%, respectively. For the six months ended June 30, 2009 and 2008, the total gross profit was $22.1 million and $17.0 million, respectively, resulting in a gross margin of 16.0% and 15.2%, respectively.

Our gross profit and gross margin on contract revenue increased to $11.1 million and 16.3% in the second quarter of 2009 from $8.1 million and 15.1% in the second quarter of 2008. For the six months ended June 30, 2009 and 2008, the gross profit on contract revenue was $22.4 million and $16.7 million, respectively, resulting in a gross margin of 16.5% and 15.4%, respectively. The improvement was due to the addition of higher margin services provided by the acquired Kadix operations, improved labor utilization and a shift from subcontract 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 $0.1 million and $0.2 million for the three and six months ended June 30, 2009, respectively, compared to gross profit of $0.2 million and $0.3 million for the same three and six month periods in 2008. The decrease in gross profit was primarily attributable to lower revenues.

Selling, general and administrative expenses

Selling, general and administrative expenses were $6.4 million and $5.1 million in the three months ended June 30, 2009 and 2008, respectively, and $12.8 million and $10.5 million for the respective six months then ended.

Selling, general and administrative expenses as a percent of total revenue in the second quarter of 2009 and 2008 was 9.2% and 9.3%, respectively, and 9.3% and 9.4% for the respective six months then ended. Selling, general and administrative expenses in 2009 were higher compared to 2008 as a result of added costs to support the acquired Kadix operations and higher legal fees.

Provision for litigation

During the first quarter of 2008, we increased the accrual for litigation to $9.0 million based on the March 2008 court ruling on the U.S. Government's motion for summary judgment. Further discussion related to this litigation is referenced in Note 14 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 June 30, 2009 and 2008, respectively, and $1.9 million and $1.0 million for the respective six months then ended. The increase in amortization expense primarily relates to intangible assets acquired as the result of 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 $0.8 million for the third quarter and $0.6 million for the fourth quarter, a total of $1.4 million.

Interest expense, net

We incurred interest expense of $0.5 million and $0.1 million in the three months ended June 30, 2009 and 2008, respectively, and $1.1 million and $0.3 million for the respective six months then ended. 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

We recorded income tax provisions of $1.5 million and $1.1 million in the three months ended June 30, 2009 and 2008, respectively, and $2.8 million and $0.1 million in the respective six months then ended. The effective income tax rate was 41.9% in the first half of 2009 and 2008, excluding the tax effect of the $8.8 million litigation provision recorded in 2008. The Company estimated the tax benefits associated with the first quarter 2008 litigation provision at $2.1 million. This estimate was revised in the third quarter of 2008 based on the proposed terms of the settlement agreement with the Department of Justice.

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 June 30, 2009, the borrowing capacity available under our revolver was $25.0 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 . . .