UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2006

or

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from         to

Commission File Number: 001-32869

DYNCORP INTERNATIONAL INC.
(Exact name of registrant as specified in its charter)

 

8445 Freeport Parkway, Suite 400, Irving, Texas 75063
(817) 224-1460
(Address, including zip code, and telephone number, including area code,
of registrant’s principal executive offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o No x

As of August 5, 2006, the registrant had 57,000,000 shares of its Class A common stock, par value $0.01 per share, outstanding.

DYNCORP INTERNATIONAL INC.

TABLE OF CONTENTS

 

PART I—FINANCIAL INFORMATION

ITEM 1.                FINANCIAL STATEMENTS

DYNCORP INTERNATIONAL INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)

		June 30, 2006					March 31, 2006
		(unaudited)
Assets
Current assets:
Cash and cash equivalents			$	16,169			$	20,573
Receivables, net of allowances for doubtful accounts of $6,230 and $8,479 at June 30, 2006 and March 31, 2006, respectively			473,798				440,195
Prepaid expenses and other current assets			41,931				43,733
Deferred tax asset			1,044				795
Total current assets			532,942				505,296
Property and equipment at cost, less accumulated depreciation of $1,964 and $1,296 at June 30, 2006 and March 31, 2006, respectively			11,483				8,769
Other assets:
Goodwill			420,180				420,180
Tradename			18,318				18,318
Customer-related intangibles, net of accumulated amortization of $53,065 and $43,471 at June 30, 2006 and March 31, 2006, respectively			237,316				246,910
Other intangibles, net of accumulated amortization of $4,588 and $3,671 at June 30, 2006 and March 31, 2006, respectively			7,158				7,453
Deferred financing costs, net of accumulated amortization of $3,853 and $3,261 at June 30, 2006 and March 31, 2006, respectively			16,399				17,469
Deferred income taxes			14,728				11,518
Other assets			1,921				3,176
Total other assets			716,020				725,024
Total assets			$	1,260,445			$	1,239,089
Liabilities and Shareholders’ Equity
Current liabilities:
Current portion of long-term debt			$	3,450			$	2,588
Current portion of other long-term liabilities			301				—
Accounts payable and accrued expenses			150,487				143,668
Accrued payroll and employee costs			73,892				65,586
Other accrued liabilities			45,117				33,845
Income taxes payable			5,616				8,280
Total current liabilities			278,863				253,967
Long-term debt—less current portion			629,270				658,963
Other long-term liabilities			2,638				—
Shares subject to mandatory redemption Series A preferred stock, stated value $195,550; 350,000 shares authorized; 190,550 shares issued and outstanding; redemption value of $219,821 at March 31, 2006; and no shares authorized at June 30, 2006			—				219,821
Commitments and contingencies
Shareholders’ equity:
Preferred stock, $0.01 par value—50,000 shares authorized; no shares outstanding			—				—
Common stock, $0.01 par value—232,000 shares and 32,000 shares authorized; 57,000 shares and 32,000 shares issued and outstanding at June 30, 2006 and March 31, 2006, respectively			570				320
Additional paid-in capital			350,056				102,097
(Accumulated deficit) retained earnings			(617		)		4,139
Accumulated other comprehensive loss			(335		)		(218		)
Total shareholders’ equity			349,674				106,338
Total liabilities and shareholders’ equity			$	1,260,445			$	1,239,089

 

See notes to condensed consolidated financial statements.

1

DYNCORP INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE MONTHS ENDED JUNE 30, 2006 AND JULY 1, 2005
(In thousands, except per share data)

		For the Three Months Ended
		June 30, 2006			July 31, 2005
		(unaudited)
Revenues		$	537,684		$	425,055
Costs of services (excluding depreciation and amortization disclosed below)		470,334			378,590
Selling, general and administrative		27,405			19,159
Depreciation and amortization		11,137			10,685
Operating income		28,808			16,621
Other expense (income):
Interest expense		14,814			13,837
Interest on mandatory redeemable shares		3,002			4,051
Loss on debt extinguishment and preferred stock		9,201			—
(Income) loss from joint ventures		(446		)	68
Interest income		(150		)	—
Income (loss) before income taxes		2,387			(1,335		)
Provision for income taxes		3,004			639
Net loss		$	(617	)	$	(1,974	)
Net loss per common share:
Basic and diluted		$	(0.01	)	$	(0.06	)
Average common shares outstanding:
Basic and diluted		47,934			32,000

 

See notes to condensed consolidated financial statements.

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DYNCORP INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE THREE MONTHS ENDED JUNE 30, 2006 AND JULY 1, 2005
(In thousands)

		For the Three Months Ended
		June 30, 2006			July 1, 2005
		(unaudited)
Cash flows from operating activities:
Net loss		$	(617	)	$	(1,974	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		11,400			10,894
Premium paid on redemption of senior subordinated notes		2,657			—
Premium paid on redemption of preferred stock		5,717			—
Deferred financing cost amortization		1,579			714
Non-cash interest expense (redeemable preferred stock dividend)		—			4,051
Recovery of losses on accounts receivable		(2,250		)	—
Income from equity joint ventures		(446		)	(20		)
Deferred income taxes		(3,459		)	(109		)
Compensation expense related to Class B equity participation		695			—
Changes in current assets and liabilities:
Accounts receivable		(31,353		)	46,088
Prepaid expenses and other current assets		1,802			356
Accounts payable and accruals		23,612			(8,182		)
Redeemable preferred stock dividend		(3,695		)	—
Income taxes payable		(2,665		)	555
Net cash provided by operating activities		2,977			52,373
Cash flows from investing activities:
Purchase of property and equipment		(2,557		)	(446		)
Payment for computer software upgrade		(622		)	—
Other assets		(354		)	(466		)
Net cash used in investing activities		(3,533		)	(912		)
Cash flows from financing activities:
Proceeds from equity offering, net		346,446			—
Redemption of preferred stock		(216,126		)	—
Special dividend		(100,000		)	—
Premium paid on redemption of senior subordinated notes		(2,657		)	—
Premium paid on redemption of preferred stock		(5,717		)	—
Payment of deferred financing costs		(500		)	—
Borrowings related to prepaid insurance, net		3,537			—
Payment on acquisition debt		(28,831		)	(863		)
Payments on credit facility		—			(35,000		)
Purchase of interest rate cap		—			(483		)
Net cash used in financing activities		(3,848		)	(36,346		)
Net (decrease) increase in cash and cash equivalents		(4,404		)	15,115
Cash and cash equivalents, beginning of period		20,573			13,474
Cash and cash equivalents, end of period		$	16,169		$	28,589

 

See notes to condensed consolidated financial statements.

3

DYNCORP INTERNATIONAL INC.
CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(In thousands)

		Common Stock									Additional Paid-In					Retained Earnings (Accumulated					Accumulated Other Comprehensive
		Shares				Amount					Capital					Deficit)					Loss					Total
Balance at March 31, 2006			32,000				$	320				$	102,097				$	4,139				$	(218	)		$	106,338
Comprehensive income:
Net loss												—					(617		)			—				(617		)
Interest rate cap												—					—					(2		)		(2		)
Currency translation adjustment												—					—					(115		)		(115		)
Comprehensive loss												—					(617		)			(117		)		(734		)
Equity offering, net			25,000				250					343,125					—					—				343,375
Mandatory dividend on Class B common stock			—				—					(95,861		)			(4,139		)			—				(100,000		)
Deferred compensation expense on Class B equity of DIV Holding LLC			—				—					695					—					—				695
Balance at June 30, 2006 (unaudited)			57,000				$	570				$	350,056				$	(617	)			$	(335	)		$	349,674

 

See notes to condensed consolidated financial statements.

4

DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
(In thousands, except per share data)

Note 1—Description of Business and Organization, Basis of Presentation and Principles of Consolidation

Description of Business and Organization

DynCorp International Inc., through its subsidiaries (together, the “Company”), provides defense and technical services and government outsourced solutions primarily to U.S. government agencies throughout the United States and internationally. Key offerings include aviation services, such as maintenance and related support, as well as base maintenance/operations and personal and physical security services. Primary customers include the U.S. Departments of Defense and State, but also include other government agencies, foreign governments and commercial customers.

On February 11, 2005, Computer Sciences Corporation and DynCorp, the Company’s former parent, sold DynCorp International LLC to DynCorp International Inc., a newly formed entity controlled by The Veritas Capital Fund II, L.P. and its affiliates (“Veritas Capital”). The Company has no operations independent of DynCorp International LLC. The primary reason for the Company’s acquisition of DynCorp International LLC (the “2005 Acquisition”) and the most significant factor contributing to the goodwill value is the Company’s ability to leverage its infrastructure and management expertise in addressing the government outsourcing trend. Prior to the 2005 Acquisition, the entities to be sold were reorganized under DynCorp International LLC by transfers of net assets and other wholly owned legal entities by companies under common control. The reorganization was recorded at historical cost and accounted for on an “as if pooled” basis. Accordingly, the accompanying consolidated financial statements give retroactive effect to such transactions as of the beginning of the first period presented. All significant intercompany balances and transactions were eliminated.

Equity Offering

On May 9, 2006, the Company consummated an equity offering of 25,000 shares of its Class A common stock, par value $0.01 per share, at a price of $15.00 per share (the “Equity Offering”), less the underwriters’ discount of 6% per share. On May 4, 2006, the Class A common stock listed on the New York Stock Exchange under the symbol “DCP.”  The gross proceeds from the Equity Offering of $375,000, together with cash on hand, were used: (i) to redeem all of the Company’s outstanding preferred stock, of which $222,823 in stated amount, including accrued and unpaid dividends thereon, was outstanding as of May 9, 2006; (ii) to pay a special Class B distribution in the amount of $100,000, representing a return of capital of $95,861 to DIV Holding LLC, the holder of the Company’s common stock; (iii) to redeem $27,968 of the Company’s senior subordinated notes on June 8, 2006; (iv) to pay prepayment penalties of $8,374, $5,717 of which represented prepayment penalties on the Company’s preferred stock and $2,657 of which represented prepayment penalties on the Company’s senior subordinated notes; and (v) to pay transaction expenses of approximately $35,000, including an underwriters’ commission of $22,500, a fee of $5,000 to Veritas Capital and $7,500 of miscellaneous fees and expenses related to the Equity Offering.

Basis of Presentation

The condensed consolidated financial statements include the accounts of the Company and its domestic and foreign subsidiaries. These condensed consolidated financial statements have been prepared by the Company, without audit, pursuant to U.S. generally accepted accounting principles (“GAAP”) for

5

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that all disclosures are adequate to make the information presented not misleading. These condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and the related notes thereto included in the Company’s Annual Report (File No. 001-0824791) on Form 10-K, filed with the Securities and Exchange Commission (the “SEC”) on June 29, 2006.

In the opinion of management, all adjustments necessary to fairly present the Company’s financial position at June 30, 2006 and March 31, 2006, the results of operations for the three months ended June 30, 2006 and July 1, 2005, and cash flows for the three months ended June 30, 2006 and July 1, 2005, have been included. The results of operations for the three months ended June 30, 2006 are not necessarily indicative of the results to be expected for the full fiscal year or for any future periods. The Company uses estimates and assumptions required for preparation of the financial statements. The estimates are primarily based on historical experience and business knowledge and are revised as circumstances change. However, actual results could differ from the estimates.

The Company reports its results on a 52/53 week fiscal year with the fiscal year ending on the Friday closest to March 31. The three months ended July 1, 2005 was a 13-week period from April 2, 2005 to July 1, 2005. The three months ended June 30, 2006 was a 13-week period from April 1, 2006 to June 30, 2006.

Principles of Consolidation

All intercompany transactions and balances have been eliminated in consolidation. The Company has no active majority-owned subsidiaries. Investments in which the Company owns a 20% to 50% ownership interest are accounted for by the equity method. These investments are in business entities in which the Company does not have control, but has the ability to exercise significant influence over operating and financial policies. The Company has no investments in business entities of less than 20%.

The following table sets forth the Company’s ownership in joint ventures and companies that are not consolidated into the Company’s financial statements as of June 30, 2006 and are accounted for by the equity method. For all of the entities listed below, the Company has the right to elect half of the board of directors (the “Board of Directors”) or other management body. Economic rights are indicated by the ownership percentages listed below.

 

6

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

Recent Accounting Pronouncements

In July 2006, the Financial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting and reporting for income taxes recognized in accordance with Statement of Financial Accounting Standards (“SFAS’’) No. 109, “Accounting for Income Taxes.”  This interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. The requirements of FIN 48 are effective for fiscal periods beginning after December 15, 2006. The Company is currently evaluating the impact of FIN 48.

On May 18, 2006, the State of Texas passed a bill replacing the current franchise tax with a new margin tax that will go into effect on January 1, 2008. The Company estimates that the new margin tax will not have a significant impact on tax expense or deferred tax assets and liabilities.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3.”  SFAS No. 154 provides guidance on the accounting for, and reporting of, accounting changes and error corrections. It establishes, unless impracticable, retrospective application as the required method for reporting a change in accounting principle in the absence of explicit transition requirements specific to the newly adopted accounting principle. SFAS No. 154 also provides guidance for determining whether retrospective application of a change in accounting principle is impracticable and for reporting such a change when retrospective application is impracticable. The provisions of SFAS No. 154 are effective for accounting changes and corrections of errors made in fiscal periods beginning after December 15, 2005. The adoption of SFAS No. 154 did not have any effect on the Company’s consolidated financial statements.

Reclassification

The per share data as of March 31, 2006 has been adjusted to reflect the 64-to-1 stock split and conversion of the Class B common stock to Class A common stock as a result of the Equity Offering.

Note 2—Receivables

Receivables consists of the following:

 

Unbilled receivables consists of costs and fees billable on contract completion or other specified events, the majority of which is expected to be billed and collected within sixty days. Included in unbilled receivables are costs incurred on projects for which the Company has been requested by the customer to

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

begin work under a new contract or extend work under an existing contract, and for which formal contracts or contract modifications have not been executed at the end of the quarter. At June 30, 2006 and March 31, 2006, unbilled receivables included $14,754 and $31,303, respectively, related to this type of unbilled receivables balance. In addition, unbilled receivables includes amounts related to contract retentions that are billed when the Company has negotiated final indirect rates with the U.S. government and, once billed, are subject to audit and approval by outside third parties. Consequently, the timing of collection of retention balances of $7 and $10 as of June 30, 2006 and March 31, 2006, respectively, is outside the Company’s control. Based on the Company’s historical experience, the majority of the retention balance is expected to be collected beyond one year.

Note 3—Other Intangible Assets and Other Assets

A summary of amortizable intangible assets is as follows:

 

 

Amortization expense for customer-related and other intangibles was $9,959 and $11,119 for the three months ended June 30, 2006 and July 1, 2005, respectively. Deferred financing cost is amortized through interest expense. Amortization related to deferred financing costs was $752 and $714 for the three months ended June 30, 2006 and July 1, 2005, respectively. Estimated amortization related to intangible assets at June 30, 2006 for fiscal years 2007 through 2011 is as follows: $33,351, $42,518, $39,348, $39,066 and $35,378, respectively.

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

A summary of other assets is as follows:

 

Note 4—Goodwill and Tradename

The Company operates in two principal operating segments, Field Technical Services (“FTS”) and International Technical Services (“ITS”).

The tradename of $18,318 is assigned to the reportable segments as follows: FTS—$1,040 and ITS—$17,278. The tradename is not amortized for financial reporting purposes but is deductible for tax purposes.

The goodwill of $420,180 is assigned to the reportable segments as follows: FTS—$100,314 and ITS—$319,866. The goodwill is not amortized for financial reporting purposes but is deductible for tax purposes.

Note 5—Cash Flows

Cash payments for interest on indebtedness were $10,226 and $6,562 and for the three months ended June 30, 2006 and July 1, 2005, respectively. Net cash payments for income taxes were $9,134 and $312 and for the three months ended June 30, 2006 and July 1, 2005, respectively. The Company had non-cash investing activities of $191 related to property and equipment purchases that were accrued at June 30, 2006. In addition, the Company had non-cash leasehold improvements of $3,015 related to one lease at June 30, 2006.

Note 6—Derivatives

Derivative financial instruments are recognized as either assets or liabilities in the balance sheet and carried at fair value. Gains or losses on derivatives designated as cash flow hedges are initially reported as a component of other comprehensive income and later classified into earnings in the period in which the hedged item also affects earnings.

The Company entered into an interest rate cap effective May 4, 2005 and paid a premium of $483. The interest rate cap has the effect of placing a ceiling on the interest expense the Company could incur on $172,500 of variable debt indexed to the London Interbank Offered Rate at 6.5% plus the applicable floating spread (2.25% at June 30, 2006) as defined by the Company’s senior secured credit facility agreement. The interest rate cap has been designated by the Company as a cash flow hedge. As of June 30, 2006, the fair value of the interest rate cap was $77, which was recorded in the accompanying condensed consolidated balance sheet in other assets with the reduction in fair value, net of tax, recorded in equity as other comprehensive loss.

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

Note 7—Significant Changes in Indebtedness

The table below presents significant changes in the amounts of senior subordinated notes and similar debt:

 

On June 9, 2006, in connection with the Equity Offering, the Company redeemed $27,968 of the $320,000 aggregate principal amount of the senior subordinated notes. The Company also paid $834 in accrued interest through the redemption date and a prepayment penalty of $2,657 related to the senior subordinated notes.

In connection with the Equity Offering, the Company recognized an $827 loss related to the write-off of a portion of the previously capitalized loan cost for the senior subordinated notes.

On June 28, 2006, the Company, through its operating company, DynCorp International LLC, entered into a second amendment and waiver of the Company’s senior secured credit facility, dated February 11, 2005, as amended on January 9, 2006. The second amendment and waiver provided for a senior secured credit facility of $431,551, representing a $90,000 revolver and a $341,551 outstanding term loan. The Company did not have an outstanding balance on the revolver on the date of the second amendment and waiver. The maturity date of the amended senior secured credit facility remains unchanged. The second amendment and waiver also does the following, among other things: (i) decreases the interest rate spread applicable to the term loan under the Company’s senior secured credit facility; (ii) permits the Company to request an increase in its revolving credit facility by an aggregate amount of up to $30,000, provided that none of the existing lenders or any other lender is committed to providing such increase; (iii) increases the amount of capital expenditures permitted under the Company’s senior secured credit facility from $4,000 per fiscal year to $8,000 per fiscal year; (iv) increases the amount of capitalized leases permitted under the Company’s senior secured credit facility; (v) allows for the payment of dividends and the repurchase of the Company’s capital stock in the amount of $10,000, plus, if the Company’s leverage ratio (as defined in the senior secured credit facility) is below 3.25:1.00, 25% of the Company’s excess cash flow (as defined in the senior secured credit facility) for each fiscal year; and (vi) provides for the first excess cash flow payment, as defined by the senior secured credit facility, to commence on the Company’s fiscal year that ends on March 30, 2007.

On June 30, 2006, the Company had $10,232 in outstanding letters of credit.

10

DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

Note 8—Class B Equity Participation

During fiscal year ended March 31, 2006, certain members of management and the outside directors were granted a participating interest in the profits through a plan that granted them Class B interests in an affiliate, DIV Holding LLC. DIV Holding LLC conducts no operations and was established for the primary purpose of holding the equity of the Company. At June 30, 2006, the aggregate individual grants were approximately 6.4% of the Class B interests of DIV Holding LLC. Pursuant to the terms of the operating agreement governing DIV Holding LLC, the holders of Class B interests are entitled to receive up to 7.5% of all distributions made by DIV Holding LLC after the holders of the Class A interests in DIV Holding LLC have received a return of their invested capital, provided that the holders of the Class A interests have received an 8% per annum internal rate of return (compounded annually) on their invested capital. The Class B interests are subject to a five-year vesting schedule with any unvested interest reverting to the holders of Class A interests in the event the Class B interests are forfeited or repurchased. The Company retained an independent party to conduct a fair value analysis of the Class B interests granted to management and the outside directors. Based on this analysis, the fair value of the Class B interests granted to certain members of management and the outside directors was determined to be $7,589. In accordance with SFAS No. 123(R) “Share-Based Payment,” the Company records compensation expense based on the fair value and commensurate with its graded vesting schedules. For the three months ended June 30, 2006, the Company recognized non-cash compensation expense of $695.

Assuming each grant fully vests, the Company will recognize additional non-cash compensation expense as follows:

 

Note 9—Shareholders’ Equity

On May 3, 2006, the Company amended and restated its certificate of incorporation with the Secretary of State of the State of Delaware. The amended and restated certificate of incorporation authorized the Company to issue up to:

(1)   50,000 shares of preferred stock, par value $0.01 per share; and

(2)   232,000 shares of Class A common stock, par value $0.01 per share.

The new shares of preferred and common stock have rights identical to the preferred stock and the Class A common stock of the Company outstanding immediately before filing the amendment. At June 30, 2006, the Company had no preferred stock outstanding and 57,000 shares of Class A common stock outstanding.

Stock Split

The Company authorized a 64-to-1 stock split for the 500 shares of the Company’s Class B common stock outstanding as of May 3, 2006.

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

Mandatory Conversion of the Class B Common Stock

Upon the payment of mandatory dividends to the holders of the Company’s Class B common stock and the expiration of the underwriters’ overallotment option from the Equity Offering, each share of Class B common stock then issued and outstanding was automatically converted into one fully paid and nonassessable share of Class A common stock.

Mandatory Dividend

Prior to the closing of the Equity Offering, the Board of Directors declared a mandatory dividend, payable in cash and subject to the consummation of the Equity Offering, to the holders of record on May 3, 2006 of the then-outstanding shares of the Company’s Class B common stock, in an aggregate amount of $100,000. The Company completed the Equity Offering and paid the mandatory dividend on May 9, 2006.

Note 10—Shares Subject to Mandatory Redemption

In connection with the Equity Offering, the Company redeemed all of its outstanding $0.01 par value
Series A-1 and Series A-2 preferred stock for $222,823, including accrued and unpaid dividends as of the date of redemption of May 9, 2006. In addition, the Company paid $5,717 in prepayment penalties for the early redemption of the preferred stock.

Note 11—Earnings Per Share

Basic earnings per share is based on the weighted average number of common shares outstanding during each period. Diluted earnings per share is based on the weighted average number of common shares outstanding and the effect of all dilutive common stock equivalents during each period. The Company did not have any anti-dilutive stock. The following table reconciles the numerators and denominators used in the computations of both basic and diluted earnings per share (“EPS”):

 

Note 12—Commitments, Contingencies and Litigation

Commitments

The Company has operating leases for the use of certain property and equipment. Operating leases are noncancelable, cancelable only by the payment of penalties or cancelable upon one month’s notice. All lease payments are based on the lapse of time but include, in some cases, payments for insurance,

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

maintenance and property taxes. There are no purchase options on operating leases at favorable terms, but most leases have one or more renewal options. Certain leases on real estate property are subject to annual escalations for increases in utilities and property taxes. Lease rental expense amounted to $22,117 and $1,774 for the three months ended June 30, 2006 and July 1, 2005, respectively.

Minimum fixed rentals required for the next five years and thereafter under operating leases in effect at March 31, 2006 are as follows:

 

The Company has no significant long-term purchase agreements with service providers.

Contingencies

The primary financial instruments that potentially subject the Company to concentrations of credit risk are accounts receivable. Departments and agencies of the U.S. federal government account for all but minor portions of the Company’s customer base, thereby minimizing credit risk. Furthermore, the Company continuously reviews all accounts receivable and records provisions for doubtful accounts as needed.

Litigation

The Company and its subsidiaries and affiliates are involved in various lawsuits and claims that have arisen in the normal course of business. In most cases, the Company has denied, or believes it has a basis to deny, liability. The Company has recorded its best estimate of the aggregate liability that will result from these matters and believes that these matters are adequately reserved. While it is not possible to predict with certainty the outcome of litigation, it is the opinion of the Company’s management, based in part upon opinions of counsel, insurance in force and the facts currently known, that liabilities in excess of those recorded, if any, arising from such matters would not have a material adverse effect on the results of operations, consolidated financial condition or liquidity of the Company over the long term.

In addition, the Company is occasionally the subject of investigations by various agencies of the U.S. government. Such investigations, whether related to U.S. government contracts or conducted for other reasons, could result in administrative, civil or criminal liabilities, including repayments, fines or penalties being imposed upon the Company, or could lead to suspension or debarment from future U.S. government contracting. In management’s opinion, there are no outstanding issues of this nature at June 30, 2006 that will have a material adverse effect on the Company’s consolidated financial condition, results of operations or liquidity.

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

On September 11, 2001, a class action lawsuit seeking $100,000 on behalf of approximately 10,000 citizens of Ecuador was filed against DynCorp International LLC and several of its former affiliates in the U.S. District Court for the District of Columbia. The action alleges personal injury, property damage and wrongful death as a consequence of the spraying of narcotic plant crops along the Colombian border adjacent to Ecuador. The spraying operations are conducted under a Department of State contract in cooperation with the Colombian government. The terms of the Department of State contract provide that the Department of State will indemnify DynCorp International LLC against third-party liabilities arising out of the contract, subject to available funding. The Company is also entitled to indemnification by Computer Sciences Corporation in connection with this lawsuit, subject to certain limitations. Additionally, any damage award would have to be apportioned between the other defendants and the Company.

On May 29, 2003, Gloria Longest, a former accounting manager for the Company, filed suit against DynCorp International LLC under the False Claims Act and the Florida Whistleblower Statute, alleging that DynCorp International LLC submitted false claims to the government under the International Narcotics and Law Enforcement Affairs contract with the Department of State. The action, titled U.S. ex rel. Longest v. DynCorp and DynCorp International LLC, was filed in the U.S. District Court for the Middle District of Florida under seal. The case was unsealed in 2005, and the Company learned of its existence on August 15, 2005 when it was served with the complaint. After conducting an investigation of the allegations made by the plaintiff, the U.S. government did not join the action. The complaint does not demand any specific monetary damages; however, in the event that a court decides against the Company in this lawsuit, that result could have a material adverse effect on the Company’s operating performance.

Note 13—Segment and Geographic Information

The Company’s business primarily involves providing worldwide maintenance support to U.S. military aircraft and various defense technical services. The Company is organized into two segments, FTS and ITS. FTS primarily offers aviation services, including maintenance and modifications, training, aftermarket logistics support, avionics upgrades, field installations, and aircraft operations and training. ITS primarily offers base maintenance/operations and personal and physical security services. The Company provides services domestically and in foreign countries under contracts with the U.S. government and some foreign customers. The risks associated with the Company’s foreign operations relating to foreign currency fluctuation and political and economic conditions in foreign countries have not had a significant negative impact on the Company. The Company operates principally within a regulatory environment subject to governmental contracting and accounting requirements, including Federal Acquisition Regulations, Cost Accounting Standards and audits by various U.S. federal agencies.

The Company’s FTS operating segment provides long-term aviation services and engineering and logistics support, ranging from daily fleet maintenance to extensive modification and overhauls on aircraft, weapons systems and support equipment. FTS generates revenue under long-term contracts that are typically three to ten years in duration. Based on revenues, Contract Field Teams is the most significant program in the FTS operating segment. The Company and its predecessors have participated in this program for 54 consecutive years. This program deploys highly mobile, quick-response field teams to customer locations worldwide to supplement the Company’s customers’ workforce, including generally providing mission support to aircraft and weapons systems in addition to depot-level repair.

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

The Company’s ITS operating segment primarily provides outsourced law enforcement training, drug eradication, global logistics, base operations and personal and physical security services to government and commercial customers in foreign jurisdictions. The ITS operating segment has witnessed strong growth as a result of the U.S. government’s trend toward outsourcing critical related functions. In February 2004, as part of the Department of State’s outsourced law enforcement training in the Middle East, the Company was awarded a new Civilian Police contract, which expanded the existing Civilian Police program in place since 1994. As of June 30, 2006, the Company had deployed civilian police officers from the United States to three countries to train and offer logistics support to the local police and assist them with infrastructure and reconstruction.

The DynCorp International Home Office component represents assets not included in a reporting segment and is primarily comprised of cash and cash equivalents, deferred tax assets and liabilities, internally developed software, fixed assets, unallocated general corporate costs, and depreciation and amortization related to the long-lived assets.

The table below presents selected financial information for the respective periods, for the two reportable segments and for financial items that cannot be allocated to either operating segment:

 

The Company evaluates segment performance based primarily on the non-GAAP measure of earnings before interest and taxes (“EBIT”), which includes the effects of corporate expense allocations.  EBIT is a non-GAAP measure that includes operating income, interest income and income (loss) from joint ventures.  Items that the Company does not include in EBIT are financing costs, including interest and debt expense and income taxes, each of which the Company evaluates on a consolidated level. The Company’s management believes EBIT is a useful measurement of the Company’s performance because it provides information that can be used to evaluate the effectiveness of the Company’s business from an operational perspective, exclusive of the costs to finance those activities and exclusive of income taxes, neither of which is directly relevant to the efficiency of those operations.

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DYNCORP INTERNATIONAL INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Unaudited)
(In thousands, except per share data)

EBIT should not be considered an alternative to, or a more meaningful indicator of the Company’s operating performance than, operating income or net income as determined in accordance with GAAP.  In addition, EBIT may not be comparable to a similarly titled measure of another company.  A reconciliation of earnings before interest and taxes to net income is as follows:

 

* * * * *

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ITEM 2.              MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

References to the “Company,” “us” or “we” refer to DynCorp International Inc. and its consolidated subsidiaries. The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the financial statements and the notes thereto contained elsewhere in this report. Certain information contained in the discussion and analysis set forth below includes forward-looking statements that involve risks and uncertainties.

Special Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements, written, oral or otherwise made, represent the Company’s expectation or belief concerning future events. Forward-looking statements involve risks and uncertainties. Without limiting the foregoing, the words “believes,” “thinks,” “anticipates,” “plans,” “expects” and similar expressions are intended to identify forward-looking statements. The Company cautions that these statements are further qualified by important economic, competitive, governmental and technological factors that could cause our business, strategy or actual results or events to differ materially, or otherwise, from those in the forward-looking statements, including, without limitation, changes in the demand for services that the Company provides; additional work awarded under the Civilian Police and International Narcotics and Law Enforcement contracts; pursuit of new commercial business in the United States and abroad; activities of competitors; changes in significant operating expenses; changes in availability of capital; general economic and business conditions in the United States; acts of war or terrorist activities; variations in performance of financial markets; estimates of contract values; anticipated revenues from indefinite delivery, indefinite quantity contracts; expected percentages of future revenues represented by fixed-price and time-and-materials contracts; and statements covering our business strategy, those described in “Risk Factors” and other risks detailed from time to time in the Company’s reports filed with the SEC. Accordingly, such forward-looking statements do not purport to be predictions of future events or circumstances and therefore there can be no assurance that any forward-looking statement contained herein will prove to be accurate. The Company assumes no obligation to update the forward-looking statements.

Overview

Company Background

We provide specialized mission-critical outsourced technical services to civilian and military government agencies. Our specific global expertise is in law enforcement training and support, security services, base operations and aviation services and operations. We also provide logistics support for all of our services. Our predecessors have provided services to numerous U.S. government departments and agencies since 1951. We operated as a separate subsidiary of Computer Sciences Corporation from March 2003 until February 2005. On February 11, 2005, Computer Sciences Corporation and DynCorp sold our Company to DynCorp International Inc., a newly formed entity controlled by Veritas Capital.

Backlog and New Orders

We track contracted backlog in order to assess our current business development effectiveness and to assist us in forecasting our future business needs and financial performance. Backlog consists of orders and priced options under our contracts. We define contracted backlog as the estimated value of contract modifications received from customers that have not been recognized as revenue. Our backlog consists of funded and unfunded backlog. Funded backlog is based upon amounts actually appropriated by a customer

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for payment of goods and services less actual revenue recorded as of the measurement date under that appropriation. Unfunded backlog is the actual dollar value of unexercised contract options. Most of our U.S. government contracts allow the customer the option to extend the period of performance of a contract for a period of one or more years. These options may be exercised at the sole discretion of the customer. Historically, it has been our experience that the customer has exercised contract options.

Firm funding for our contracts is usually made for only one year at a time, with the remainder of the years under the contract expressed as a series of one-year options. As is the case with the base period of our U.S. government contracts, option periods are subject to the availability of funding for contract performance. The U.S. government is legally prohibited from ordering work under a contract in the absence of funding. Our historical experience has been that the government generally has funded the option periods of our contracts.

New orders represent new contracts, or additional work added under existing contracts, received during the periods presented below.

The following table sets forth our contracted backlog and new orders (dollars in millions) as of the dates indicated:

 

 

Estimated Remaining Contract Value

The following table sets forth our estimated remaining contract value (dollars in millions) as of the dates indicated:

 

Our estimated remaining contract value represents the backlog plus management’s estimate of future revenues under indefinite delivery, indefinite quantity contracts that have not been funded, or award term periods that have not yet been earned. These future revenues would be our estimate of revenue that would occur from the end of currently funded task orders until the end of the indefinite delivery, indefinite quantity contracts. Our estimated remaining contract value is based on our experience under contracts, and we believe our estimates are reasonable. However, there can be no assurance that our existing contracts will result in actual revenues in any particular period or at all. These amounts could vary depending upon government budgets and appropriations.

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Results of Operations

The following table (dollars in thousands) sets forth, for the periods indicated, our historical results of operations:

 

Three Months Ended June 30, 2006 Compared To Three Months Ended July 1, 2005

Consolidated

Revenues.   Total revenues increased from $425.1 million for the three months ended July 1, 2005 to $537.7 million for the three months ended June 30, 2006, an increase of $112.6 million or 26.5%. For the three months ended June 30, 2006 and July 1, 2005, approximately 42%, 35% and 23% and approximately 28%, 41% and 31% of our revenues were derived from fixed-price, time-and-materials, and cost-reimbursement contracts, respectively.

Revenues from our ITS segment increased from $255.6 million for the three months ended July 1, 2005 to $355.0 million for the three months ended June 30, 2006, an increase of $99.4 million or 38.9%. The International Narcotics and Law Enforcement Air-Wing (“Air-Wing”) program increased $39.2 million. The Department of State awarded our current contract under the Air-Wing program during May 2005. As part of the new contract, we successfully transitioned many of the activities under this program from cost-reimbursement to fixed-price. Due to increased flight hour activity in Latin America, revenues under the Air-Wing program increased for the three months ended June 30, 2006, compared to the three months ended July 1, 2005. Additional factors contributing to the increase in revenues included: (i) providing helicopter support under the Air-Wing program for ground eradication efforts in Afghanistan; and (ii) transitioning from cost-reimbursement to fixed-price. Our Civilian Police program contributed $38.5 million to the increase in revenues. The Civilian Police program benefited from the increased number of international police liaison officers deployed in Iraq and Afghanistan during the three months ended June 30, 2006, compared to the three months ended July 1, 2005. In addition, while supporting the Iraq effort, we benefited from operations and maintenance support efforts, as well as additional procurement activities. The Logistic Support programs’ revenue increased by $17.0 million, compared to the three months ended July 1, 2005. The increase within the Logistics Support programs is primarily due to the added work under the Africa Peacekeeping contract with the Department of State. These increases were partially offset by a reduction in services under the Worldwide Personal Protective Services program. We recently lost four task orders under which we provided personal security services in

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Israel, Haiti, Afghanistan and central Iraq. These lost orders contributed to a decrease in revenues of $14.0 million for the three months ended June 30, 2006, compared to the three months ended July 1, 2005.

Revenues from our FTS segment increased from $169.5 million for the three months ended July 1, 2005 to $182.7 million for the three months ended June 30, 2006, an increase of $13.2 million or 7.8%. The FTS increase was primarily driven by an increase in the number of Global Air Traffic Management avionics modification under the Life Cycle Contractor Support program of $8.6 million and an increase in personnel and the level of effort under the Contract Field Team program of $8.4 million. Partially offsetting this increase was the Army Prepositioned Stocks Afloat program, which decreased by $5.2 million mainly because the U.S. government reduced its funding.

Costs of services.   Costs of services are comprised of direct labor, direct material, subcontractor costs, other direct costs and overhead. Other direct costs include travel, supplies and other miscellaneous costs. Costs of services increased from $378.6 million for the three months ended July 1, 2005 to $470.3 million for the three months ended June 30, 2006, an increase of $91.7 million or 24.2%. As a percentage of revenue, costs of services dropped from 89.1% in the three months ended July 1, 2005 to 87.4% for the three months ended June 30, 2006. This reduction as a percentage of revenue was due to the following: (i) strong performance on fixed-price task orders under the Civilian Police and the Air-Wing programs; and (ii) improved contract mix resulting from a larger proportion of higher-margin fixed-price and time-and-materials contracts as opposed to lower-margin cost-reimbursement contracts.

Selling, general and administrative expenses.   Selling, general and administrative expenses primarily relate to functions such as management, legal, financial accounting, contracts and administration, human resources, management information systems, purchasing and business development. Selling, general and administrative expenses for the three months ended July 1, 2005 were $19.2 million and increased to $27.4 million for the three months ended June 30, 2006, an increase of $8.2 million or 42.7%. In addition, as a percentage of revenue, selling, general and administrative expenses increased from 4.5% for the three months ended July 1, 2005 to 5.1% for the three months ended June 30, 2006. Factors contributing to higher selling, general and administrative expenses for the three months ended June 30, 2006 include: (i) an increase of $4.6 million in segment general and administrative costs necessary to support the growth of our segments, primarily ITS; (ii) an increase of $3.1 million in corporate administrative costs, primarily the result of developing these functions as an independent company; and (iii) an increase of $2.7 million in business development costs. Offsetting the increase in selling, general and administrative expenses is a benefit of $2.3 million related to the collection of an accounts receivable previously written off as bad debt.

Depreciation and amortization.   Depreciation and amortization increased from $10.7 million for the three months ended July 1, 2005 to $11.1 million for the three months ended June 30, 2006, an increase of $0.4 million or 3.7%. This increase was primarily due to higher depreciation expense.

Interest expense.   Interest expense increased from $13.8 million for the three months ended July 1, 2005 to $14.8 million for the three months ended June 30, 2006. The interest expense incurred related to our senior secured credit facility and our senior subordinated notes. This interest expense includes interest costs applicable to the quarter as well as amortization of deferred financing fees. The increase in interest expense is due to the increase in variable interest rates, compared to the three months ended July 1, 2005, despite our lower outstanding average balance during the three months ended June 30, 2006. Our average interest rate on the senior secured credit facility for the three months ended June 30, 2006 was 7.7%, compared to 6.4% for the three months ended July 1, 2005.

Interest on mandatory redeemable shares.   Interest on the mandatory redeemable shares, or preferred stock, was $3.0 million for the three months ended June 30, 2006, compared to $4.1 million for the three months ended July 1, 2005. All of our outstanding preferred stock was redeemed in connection with our Equity Offering in May 9, 2006, resulting in a shorter time outstanding, compared to the three months

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ended July 1, 2005. In addition, we had preferred stock stated value of $195.6 million and $125.0 million at June 30, 2006 and July 1, 2005, respectively.

Loss on debt extinguishment and preferred stock.   In conjunction with our Equity Offering in May 2006, we incurred: (i) a premium of $5.7 million associated to the redemption of all of our outstanding preferred stock; (ii) a premium of $2.7 million related to the redemption of a portion of our senior subordinated notes; and (iii) the write-off of $0.8 million in deferred financing costs associated with the early retirement of a portion of our senior subordinated notes.

Income tax expense.   We had income tax expense for the three months ended June 30, 2006 of $3.0 million, which is an increase of $2.4 million or 400.0% from income tax expense of $0.6 million for the three months ended July 1, 2005. The increase is primarily due to the $2.1 million in income tax expense related to the premium paid on our preferred stock in connection with the Equity Offering. This premium is considered a discreet item for tax purposes and is not deductible. Income tax expense before consideration of the discreet item was $0.9 million, with an effective tax rate of 38.9%.

Results by Segment

We evaluate segment performance based primarily on the non-GAAP measure of EBIT, which includes the effects of corporate expense allocations. EBIT is a non-GAAP measure that includes operating income, other income and income (loss) from joint ventures. Items that we do not include in EBIT are financing costs, including interest and debt expense and income taxes, each of which we evaluate on a consolidated level. We believe EBIT is a useful measurement of our performance because it provides information that can be used to evaluate the effectiveness of our business from an operational perspective, exclusive of the costs to finance those activities and exclusive of income taxes, neither of which is directly relevant to the efficiency of those operations.

EBIT should not be considered an alternative to, or a more meaningful indicator of our operating performance than, operating income or net income as determined in accordance with GAAP. In addition, our EBIT may not be comparable to a similarly titled measure of another company.

The following table (dollars in thousands) sets forth the revenues and earnings before interest and taxes for our ITS and FTS operating segments, both in dollars and as a percentage of our consolidated revenues for segment revenue and as a percentage of segment specific revenue for segment earnings before interest and taxes, for the three months ended June 30, 2006, compared to the three months ended July 1, 2005.

 

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International Technical Services

Revenues.   Revenues from our ITS segment increased from $255.6 million for the three months ended July 1, 2005 to $355.0 million for the three months ended June 30, 2006, an increase of $99.4 million or 38.9%. Revenues from our Air-Wing program increased $39.2 million. The Department of State awarded our current contract under the Air-Wing program during May 2005. As part of the new contract, we successfully transitioned many of the activities under this program from cost-reimbursement to fixed-price. Due to increased flight hour activity in Latin America, revenues under the Air-Wing program increased for the three months ended June 30, 2006, compared to the three months ended July 1, 2005. Additional factors contributing to the increase in revenues included: (i) providing helicopter support under the Air-Wing program for ground eradication efforts in Afghanistan during the three months ended June 30, 2006; and (ii) transitioning from cost-reimbursement to fixed-price. Our Civilian Police program contributed $38.5 million to the increase in revenues. The Civilian Police program benefited from the increased number of international police liaison officers deployed in Iraq and Afghanistan during the three months ended June 30, 2006, compared to the three months ended July 1, 2005. In addition, while supporting the Iraq effort, we benefited from operations and maintenance support efforts, as well as additional procurement activities. The Logistic Support programs’ revenue increased by $17.0 million, compared to the three months ended July 1, 2005. The increase within the Logistics Support programs is primarily due to the added work under the Africa Peacekeeping contract with the Department of State. These increases were partially offset by a reduction in services under the Worldwide Personal Protective Services program. We recently lost four task orders under which we provided personal security services in Israel, Haiti, Afghanistan and central Iraq. These lost orders contributed to a decrease in revenues of $14.0 million for the three months ended June 30, 2006, compared to the three months ended July 1, 2005.

Earnings before interest and taxes.   Earnings before interest and taxes for the three months ended June 30, 2006 were $25.9 million, an increase of $15.7 million, or 153.9%, from $10.2 million for the three months ended July 1, 2005. Earnings before interest and taxes as a percentage of revenue for the three months ended June 30, 2006 and July 1, 2005 was 7.3% and 4.0%, respectively. The increase as a percentage of revenue is due to the following: (i) strong performance on fixed-price task orders under the Civilian Police and Air-Wing programs; and (ii) improved contract mix resulting from a larger proportion of higher-margin fixed-price and time-and-materials contracts as opposed to lower-margin cost-reimbursement contracts.

Field Technical Services

Revenues.   Revenues from our FTS segment increased from $169.5 million for the three months ended July 1, 2005 to $182.7 million for the three months ended June 30, 2006, an increase of $13.2 million or 7.8%. The FTS increase was primarily driven by an increase in the number of Global Air Traffic Management avionics modifications under the Life Cycle Contractor Support program of $8.6 million and an increase in personnel and the level of effort under the Contract Field Team program of $8.4 million. Partially offsetting this increase was the Army Prepositioned Stocks Afloat program, which decreased by $5.2 million mainly because the U.S. government reduced its funding.

Earnings before interest and taxes.   Earnings before interest and taxes for the three months ended June 30, 2006 were $4.7 million, a decrease of $3.0 million, or 39.0%, from $7.7 million for the three months ended July 1, 2005. Earnings before interest and taxes as a percentage of revenue for the three months ended June 30, 2006 was 2.6% compared to 4.5% for the three months ended July 1, 2005. The primary factors contributing to the decrease are: (i) incurred operating losses of $1.9 million from delivering services to the U.S. Army under our Life Cycle Contractor Support program; and (ii) incurred operating losses of $2.4 million due to operational issues in executing the cost structure outlined in the original proposal for our AH-1/UH-1 services.

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Liquidity and Capital Resources

The following table sets forth cash flow data for the periods indicated therein (dollars in thousands):

 

Cash Flows

Operating Activities.   Cash and cash equivalents as of June 30, 2006 were $16.2 million compared to $20.6 million as of March 31, 2006. Net cash provided by operating activities for the three months ended June 30, 2006 was $3.0 million, while net cash provided by operating activities for the three months ended July 1, 2005 was $52.4 million. Operating cash flow for the first quarter of fiscal 2006 reflected unusually high cash collections, which resulted in a $46.1 million source of cash. The first quarter of fiscal 2007 experienced unfavorable timing of cash collections, which resulted in a use of cash of $31.4 million and is expected to reverse during subsequent quarters. The days sales outstanding improved to 80.2 days for the three months ended June 30, 2006, compared to 80.6 days for the three months ended July 1, 2005. Other factors impacting operating cash flow during the three months ended June 30, 2006 included: (i) one-time cash payments of $3.7 million for interest related to the Company’s preferred stock; and (ii) payment of special cash bonuses subsequent to our Equity Offering of $3.125 million in the aggregate to our executive officers and certain other members of management. These bonuses rewarded management for their efforts in connection with the successful consummation of our Equity Offering.

Investing Activities.   Net cash used in investing activities was $3.5 million and $0.9 million for the three months ended June 30, 2006 and July 1, 2005, respectively. For the three months ended June 30, 2006 and July 1, 2005, the primary use of cash was to purchase property and equipment.

Financing Activities.   Net cash used in financing activities was $3.8 million and $36.3 million for the three months ended June 30, 2006 and July 1, 2005, respectively. The cash used during the three months ended June 30, 2006 included: (i) gross proceeds received from the Equity Offering of $375.0 million; (ii) payment of Equity Offering costs of $30.0 million; (iii) partial redemption of senior subordinated notes of $28.8 million, including accrued interest; (iv) redemption of all outstanding preferred stock and related accrued and unpaid interest of $228.5 million; (v) payment of special Class B distribution of $100.0 million and (vi) borrowings related to prepaid insurance of $3.5 million. The cash used in financing activities during the three months ended July 1, 2005 was due to the $35.0 million repayment of borrowings under our revolving credit facility, the $0.9 million scheduled repayment of our bank note borrowings and the $0.5 million purchase of an interest rate cap that limits our exposure to upward movements in variable rate debt.

Based on our current level of operations, we believe our cash flow from operations and our available borrowings under our senior secured credit facility will be adequate to meet our liquidity needs for at least the next twelve months. We cannot be assured, however, that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our senior secured credit facility in an amount sufficient to enable us to repay our indebtedness, including the senior subordinated notes, or to fund our other liquidity needs. Servicing our indebtedness will require a significant amount of cash. Our ability to generate sufficient cash depends on numerous factors beyond our control, and we may be unable to generate sufficient cash flow to service our debt obligations, including making payments on the senior subordinated notes.

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