NCI 10-Q 2006 Q2 Quarterly report

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 QUARTER ENDED JUNE 30, 2006

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

Commission File Number

000-51579

NCI, Inc.

(Exact name of registrant as specified in its charter)

Delaware	20-3211574
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
11730 Plaza America Drive Reston, Virginia	20190-4764
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code:(703) 707-6900

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.    x  Yes    ¨  No

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:)

Large accelerated filer  ¨ Accelerated filer  ¨ Non-accelerated filer  x

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

As of August 1, 2006, there were 7,027,760 shares outstanding of the registrant’s Class A common stock. In addition, there are 6,300,000 shares outstanding of the registrant’s Class B common stock, which are convertible on a one-for-one basis into Class A common stock.

NCI, INC.

		PAGE
PART I:	FINANCIAL INFORMATION	1
Item 1.	Financial Statements	1
	Consolidated Balance Sheets as of December 31, 2005, and June 30, 2006 (unaudited)	1
	Consolidated Statements of Operations (unaudited) for the three and six months ended June 30, 2005 and 2006	2
	Consolidated Statements of Cash Flows (unaudited) for the six months ended June 30, 2005 and 2006	3
	Notes to Consolidated Financial Statements (unaudited)	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	19
Item 4.	Controls and Procedures	19
PART II:	OTHER INFORMATION	21
Item 1.	Legal Proceedings	21
Item 1A.	Risk Factors	21
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	21
Item 3.	Defaults Upon Senior Securities	21
Item 4.	Submission of Matters to a Vote of Security Holders	21
Item 5.	Other Information	21
Item 6.	Exhibits	21
	Signatures	22

PART 1

FINANCIAL INFORMATION

Item 1. Financial Statements

NCI, INC.

CONSOLIDATED BALANCE SHEETS

(amounts in thousands, except per share data)

	As of December 31, 2005			As of June 30, 2006
				(unaudited)
Assets
Current assets:
Cash and cash equivalents	$	12,323		$	17,031
Accounts receivable, net		46,611			42,926
Deferred tax asset, net		4,570			3,179
Prepaid expenses and other current assets		669			779
Total current assets		64,173			63,915
Property and equipment, net		6,031			5,545
Other assets		558			783
Deferred tax asset, net		494			460
Intangible assets, net		1,338			850
Goodwill		17,427			17,427
Total assets	$	90,021		$	88,980
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	$	8,854		$	10,484
Accrued salaries and benefits		9,416			8,488
Other accrued expenses/liabilities		2,936			3,928
Deferred revenue		1,012			566
Distributions payable		5,866			—
Total current liabilities		28,084			23,466
Other liabilities		204			210
Deferred rent		4,562			4,358
Total liabilities		32,850			28,034
Stockholders’ equity:
Class A common stock, $0.019 par value—37,500,000 shares authorized; 7,027,760 shares issued and outstanding		134			134
Class B common stock, $0.019 par value—12,500,000 shares authorized; 6,300,000 shares issued and outstanding		120			120
Additional paid-in capital		57,658			57,581
Deferred compensation		(741	)		(606	)
Retained earnings		—			3,717
Total stockholders’ equity		57,171			60,946
Total liabilities and stockholders’ equity	$	90,021		$	88,980

See accompanying notes

1

NCI, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(amounts in thousands, except per share data)

	Three months ended June 30,						Six months ended June 30,
	2005			2006			2005			2006
Revenue	$	47,503		$	47,857		$	93,875		$	93,891
Operating costs and expenses:
Cost of revenue (exclusive of depreciation and amortization, shown separately below)		40,104			41,096			79,671			80,566
General and administrative expense		3,617			2,939			7,239			6,193
Depreciation and amortization		403			406			801			816
Amortization of intangible assets		267			242			539			488
Total operating costs and expenses		44,391			44,683			88,250			88,063
Operating income		3,112			3,174			5,625			5,828
Interest income		18			208			26			325
Interest expense		(416	)		(19	)		(768	)		(45	)
Income before income taxes		2,714			3,363			4,883			6,108
Income tax expense		118			1,316			220			2,391
Net income	$	2,596		$	2,047		$	4,663		$	3,717
Earnings per common and common equivalent share:
Basic:
Weighted average shares outstanding		6,779			13,328			6,779			13,328
Net income per share	$	0.38		$	0.15		$	0.69		$	0.28
Diluted:
Weighted average shares and equivalent shares outstanding		7,579			13,503			7,571			13,502
Net income per share	$	0.34		$	0.15		$	0.62		$	0.28
Pro forma income tax information: (See Note 10)
Income before taxes	$	2,714					$	4,883
Pro forma provision for income taxes		1,056						1,899
Pro forma net income	$	1,658					$	2,984
Pro forma earnings per common and common equivalent share:
Basic:
Weighted average shares outstanding		6,779						6,779
Pro forma net income per share	$	0.24					$	0.44
Diluted:
Weighted average shares and equivalent shares outstanding		7,237						7,230
Pro forma net income per share	$	0.23					$	0.41

See accompanying notes

2

NCI, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(amounts in thousands)

	Six months ended June 30,
	2005			2006
Cash flows from operating activities
Net income	$	4,663		$	3,717
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,340			1,304
Decrease in cash surrender value of life insurance		334			—
(Gain) loss on sale and disposal of property and equipment		1			(1	)
Stock-based compensation expense		373			57
Deferred income tax benefit		—			1,426
Changes in operating assets and liabilities:
Accounts receivable, net		(474	)		3,685
Prepaid expenses and other assets		(323	)		(336	)
Accounts payable		1,144			1,630
Accrued expenses/other current liabilities		1,300			(385	)
Deferred rent		(165	)		(203	)
Net cash provided by operating activities		8,193			10,894
Cash flows from investing activities
Purchase of property and equipment		(1,080	)		(177	)
Proceeds from sale of property and equipment		4			4
Cash paid for purchase of SES		(1,919	)		—
Net cash used in investing activities		(2,995	)		(173	)
Cash flows from financing activities
Payments on line of credit, net		(708	)		—
Repayments on term loan		(1,400	)		—
Principal payments under capital lease obligations		(139	)		(147	)
Distributions to stockholders		(2,978	)		(5,866	)
Net cash (used in) provided by financing activities		(5,225	)		(6,013	)
Net change in cash and cash equivalents		(27	)		4,708
Cash and cash equivalents, beginning of year		40			12,323
Cash and cash equivalents, end of period	$	13		$	17,031
Supplemental disclosure of cash flow information
Cash paid during the period for:
Interest	$	769		$	45
Income taxes	$	191		$	26
Supplemental disclosure of noncash activities:
Equipment acquired under capital leases	$	70		$	156

See accompanying notes

3

NCI, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements for NCI, Inc. and its wholly-owned subsidiaries (the Company or NCI) as of and for the three and six months ended June 30, 2005 and 2006, have been prepared, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. As a result, certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. In the opinion of management, the accompanying unaudited interim consolidated financial statements reflect all necessary adjustments and reclassifications (all of which are of a normal, recurring nature) that are necessary to a fair statement of the results for the interim periods presented. The information disclosed in the notes to the financial statements for these periods is unaudited. For further information, refer to the financial statements and footnotes included in NCI’s Form 10-K for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. The current period’s results of operations are not necessarily indicative of results that may be achieved for any future period.

2. Business Overview

NCI is a provider of information technology services and solutions to federal government agencies. The Company’s focus is on designing, implementing, maintaining and upgrading secure information technology (IT) systems and networks by leveraging the Company’s skills across four core service offerings: network engineering; information assurance; systems development and integration; and enterprise systems management. The Company provides these services to defense, intelligence and federal civilian agencies. Substantially all of the Company’s revenue was derived from contracts with the federal government, directly as a prime contractor or as a subcontractor. The Company conducts business throughout the United States. In addition, the Company may conduct business internationally in support of federal government contracts.

The Company’s operations are subject to certain risks and uncertainties including, among others, dependence on contracts with federal government agencies, dependence on significant clients, existence of contracts with fixed pricing, dependence on subcontractors to fulfill contractual obligations, current and potential competitors with greater resources, dependence on key management personnel, ability to recruit and retain qualified employees, and uncertainty of future profitability and possible fluctuations in financial results.

3. Summary of Significant Accounting Policies

Basis of Consolidation

The consolidated financial statements include the accounts of wholly-owned subsidiaries.

Reclassifications

Certain amounts for prior years have been reclassified to conform with the current presentation.

Revenue Recognition

The Company generates its revenue from three different types of contractual arrangements: time-and-materials contracts; cost-plus contracts; and fixed-price contracts.

Revenue on time-and-material contracts is recognized based on negotiated billable rates multiplied by the number of hours delivered plus allowable expenses incurred. The Company considers fixed fees under cost-plus contracts to be earned in proportion to the allowable costs incurred in performance of the contract. Revenue for performance based fee incentives is recognized as earned.

The Company has three basic categories of fixed-price contracts: fixed unit price; fixed-price level-of-effort; and fixed-price completion contracts. Revenue on fixed unit price contracts, where specified units are delivered under service arrangements, is recognized as units are delivered based on the specified price per unit. Revenue for fixed-price level-of-effort contracts is recognized based upon the number of units of labor actually delivered multiplied by the negotiated rate for each unit of labor. Revenue on fixed-price completion contracts is recognized on the percentage of completion method using costs incurred in relation to total estimated costs.

4

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

3. Summary of Significant Accounting Policies (continued)

Revenue Recognition (continued)

Contract accounting requires judgment relative to assessing risks, estimating contract revenue and costs, and making assumptions for schedule and technical issues. Due to the size and nature of many of the Company’s contracts, the estimation of total revenue and cost at completion is complicated and subject to many variables. Contract costs include material, labor and subcontracting costs, as well as an allocation of allowable indirect costs. Assumptions have to be made regarding the length of time to complete the contract because costs also include expected increases in wages and prices for materials. For contract change orders, claims or similar items, the Company applies judgment in estimating the amounts and assessing the potential for realization. These amounts are only included in contract value when they can be reliably estimated and realization is considered probable. Estimates of award fees for certain contracts are also a significant factor in estimating revenue and profit rates based on actual and anticipated awards. Anticipated losses on contracts are recognized at the time they become known.

Cash and Cash Equivalents

The Company considers cash on deposit and all highly liquid investments with original maturities of three months or less to be cash and cash equivalents.

Income Taxes

Prior to October 20, 2005, the Company elected, by the consent of its stockholders, to be taxed as an S corporation under Subchapter S of the Internal Revenue Code (the Code) and under relevant sections of the tax law of the various states that conform to the Code. As an S corporation, the net income or loss of the entity was reportable on the personal tax returns of the stockholders. Accordingly, through October 19, 2005, the Company was not subject to federal and certain state corporate income tax. However, the Company was subject to income taxes in certain states in which it conducts business.

In connection with the Company’s initial public offering, effective October 20, 2005, the Company revoked its status as an S corporation and became subject to taxation as a C corporation. Disclosures regarding accounting for income taxes for the three and six months ended June 30, 2006 are in Note 10.

The unaudited pro forma income tax information included in the statements of operations for the three and six months ended June 30, 2005, in the pro forma Earnings per Share calculation discussed below in this Note, and in Note 10, is presented in accordance with Statement of Financial Accounting Standards (SFAS) No. 109,Accounting for Income Taxes(SFAS No. 109), as if the Company were taxed as a C corporation and thus subject to federal and certain state income taxes for that period.

Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles 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 and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

Fair Value of Financial Instruments

Estimated fair values of our financial instruments were determined by management using available market information and appropriate valuation methodologies. Considerable judgment is necessary to interpret market data and develop estimated fair values. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize on disposition of the financial instruments. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.

The carrying values of the Company’s financial instruments, including cash equivalents, accounts receivable, accounts payable, accrued expenses and bank loans approximate their fair values.

Disclosure about fair value of financial instruments is based on pertinent information available to management. Although the Company is not aware of any factors that would significantly affect the reasonable fair value amounts, such amounts have not

5

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

3. Summary of Significant Accounting Policies (continued)

Fair Value of Financial Instruments (continued)

been comprehensively revalued for purposes of these financial statements since that date and current estimates of fair value may differ significantly from the amounts presented herein.

Earnings Per Share

SFAS No. 128, Earnings Per Share, requires presentation of basic and diluted earnings per share. Basic earnings per share exclude dilution and are computed by dividing net income by the weighted average number of common shares outstanding for the period. The computation of earnings per share presented is for both Class A and Class B common stock.

Diluted earnings per share reflect potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Diluted earnings per share include the incremental effect of stock options calculated using the treasury stock method.

The following details the historical and pro forma computation of basic and diluted earnings per common share (Class A and Class B) for the three and six months ended June 30, 2005 and 2006, respectively. The pro forma net income and earnings per share data for the three and six months ended June 30, 2005 are pro forma for C corporation income taxes. (See Note 10)

	Three months ended June 30,				Six months ended June 30,
	2005		2006		2005		2006
	(in thousands, except per share data)				(in thousands, except per share data)
Historical Net Income	$	2,596	$	2,047	$	4,663	$	3,717
Weighted average number of basic shares outstanding during the period		6,779		13,328		6,779		13,328
Dilutive effect of stock options after application of treasury stock method		800		175		792		174
Weighted average number of diluted shares outstanding during the period		7,579		13,503		7,571		13,502
Basic earnings per share	$	0.38	$	0.15	$	0.69	$	0.28
Diluted earnings per share	$	0.34	$	0.15	$	0.62	$	0.28
Pro forma net income	$	1,658			$	2,984
Weighted average number of basic shares outstanding during the period		6,779				6,779
Dilutive effect of stock options after application of treasury stock method		458				451
Weighted average number of diluted shares outstanding during the period		7,237				7,230
Pro forma basic earnings per share	$	0.24			$	0.44
Pro forma diluted earnings per share	$	0.23			$	0.41

Stock-Based Compensation

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004) (SFAS No. 123(R)),“Share-Based Payment,” which requires that compensation costs related to share-based payment transactions be recognized in financial statements. SFAS No. 123(R) eliminates the alternative to use the intrinsic method of accounting provided for in Accounting Principles Board (APB) Opinion No. 25 (APB No. 25),“Accounting for Stock Issued to Employees,” which generally resulted in no compensation expense recorded in the financial statements related to the grant of stock options to employees if certain conditions were met.

Effective January 1, 2006, the Company adopted SFAS No. 123(R) using the prospective method. Under this method, compensation costs for all awards granted after the date of adoption and modifications of any previously granted awards outstanding at the date of adoption are measured at estimated fair value and included in operating expenses over the vesting period during which an employee provides service in exchange for the award. Prior to the adoption of SFAS No. 123(R), the Company accounted for stock-based compensation in accordance with APB No. 25 using the intrinsic-value method. The Company issued non-qualified stock options to employees at various times during 2003 and 2004 with vesting periods

6

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

3. Summary of Significant Accounting Policies (continued)

Stock-Based Compensation (continued)

ranging from zero to seven years and any related expense for the amount by which the fair market value at the date of grant exceeds the exercise price is being amortized over the applicable vesting periods. Under the prospective method, we will continue to apply APB No. 25 in future periods to awards outstanding at the date of adoption.

In adopting SFAS No. 123(R), companies must choose among alternative valuation models and amortization assumptions. The Company uses the Black-Scholes-Merton option pricing model and straight-line amortization of compensation expense over the requisite service period of the grant. The Company will reconsider use of the Black-Scholes-Merton model if additional information becomes available in the future that indicates another model would be more appropriate, or if grants issued in future periods have characteristics that cannot be reasonably estimated using this model.

The following weighted-average assumptions were used for option grants made during the six months ended June 30, 2006:

Expected Volatility. The expected volatility of the Company’s shares was estimated based upon the historical volatility of the Company’s share price. The expected volatility factor used in valuing options granted during the six months ended June 30, 2006 was 35%.

Expected Term. Because the Company does not have significant historical data on employee exercise behavior, we have used the SEC safe-harbor for calculating the expected term by averaging the vesting period and term of the option. The options granted during the six months ended June 30, 2006 have a five-year graded vesting period and a ten-year term, resulting in a 7.5 year expected term for valuation purposes.

Risk-free Interest Rate. The Company bases the risk-free interest rate used in the Black-Scholes-Merton valuation method on the implied yield available on a U.S. Treasury note with a term equal to the expected term of the underlying grants. The risk-free interest rate used in valuing options granted during the six months ended June 30, 2006 was 4.66%.

Dividend Yield. The Black-Scholes-Merton valuation model calls for a single expected dividend yield as an input. The Company has not paid dividends in the past nor does it expect to pay dividends in the future. As such, the Company used a dividend yield percentage of zero.

In prior years, under the intrinsic-value method of APB No. 25, the Company did not include an expected volatility rate in the valuation calculation. Additionally, the Company did not use an expected forfeiture rate when calculating option expense. Under SFAS No. 123(R), the Company has estimated forfeitures and is recognizing compensation expense only for those shares expected to vest.

During the six months ended June 30, 2006, the Company granted stock options to purchase 20,000 shares of Class A common stock at a weighted average exercise price of $13.69 per share, the fair value of Class A common stock on the date of grant. The Black-Scholes-Merton weighted average valuation of the options granted during the six months ended June 30, 2006 was $6.56 per share. These options have a five-year grading vesting period and expire in ten years.

The following table summarizes stock option activity for the six months ended June 30, 2006:

	Options	Weighted average exercise price per share
	(in thousands, except per share data)
Outstanding at December 31, 2005	640	$	7.88
Granted	20		13.69
Forfeited/cancelled	39		7.77
Exercised	—		—
Outstanding at June 30, 2006	621	$	8.07

7

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

3. Summary of Significant Accounting Policies (continued)

Stock-Based Compensation (continued)

Information regarding stock options outstanding at June 30, 2006 is summarized below:

Range of exercise prices	Number of options	Weighted average exercise price		Weighted average remaining contractual life	Options exercisable
	(in thousands)			(in years)	(in thousands)
$1.00 – $2.00	5	$	1.90	7.3	5
$6.00 – $7.00	368		6.65	6.7	5
$10.00 – $11.00	228		10.02	8.4	49
$13.00 – $14.00	20		13.69	9.7	—

The Company recognized stock-based compensation expense of approximately $196,000 and $373,000 ($29,000 and $58,000 in Cost of Revenue and $167,000 and $316,000 in General and Administrative expenses) in the three and six months ended June 30, 2005, respectively, and approximately $48,000 and $57,000 ($20,000 and $2,000 in Cost of Revenue and $28,000 and $55,000 in General and Administrative expenses) in the three and six months ended June 30, 2006, respectively. Of the stock-based compensation expense in the three months and six months ended June 30, 2006, approximately $5,000 and $7,000, respectively, was related to the expense of new options granted during 2006 under SFAS No. 123(R).

Under the prospective method, results for the three and six months ended June 30, 2005 were not restated to include stock-based compensation expense. The table below presents the pro forma effects of recognizing the estimated fair value of stock-based compensation for the three and six months ended June 30, 2005.

	Three months ended June 30, 2005			Six months ended June 30, 2005
	(in thousands, except per share data)
Net income as reported	$	2,596		$	4,663
Add: Stock-based employee compensation expense as reported under APB No. 25 for all awards, net of related tax effects		196			373
Deduct: Stock-based compensation expense determined under SFAS No. 123 for all awards, net of related tax effects		(224	)		(418	)
Pro forma net income	$	2,568		$	4,618
Weighted average number of basic shares outstanding during the period		6,779			6,779
Weighted average number of diluted shares outstanding during the period		7,579			7,571
Pro forma basic earnings per share	$	0.38		$	0.68
Pro forma diluted earnings per share	$	0.34		$	0.61

As of June 30, 2006, there was approximately $710,000 of total unrecognized compensation cost related to unvested stock-based compensation agreements. Of this amount, approximately $606,000 is related to options accounted for under APB No. 25, and approximately $104,000 related to options granted during 2006 and accounted for under SFAS No. 123(R). This cost is expected to be fully amortized over the next five years, with approximately $190,000 per year from 2006 through 2008, approximately $160,000 in 2009, and $30,000 in 2010.

Recent Accounting Pronouncements

In June 2006, the FASB issued FASB Interpretation (FIN) 48,“Accounting for Uncertainty in Income Taxes”. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109. This Interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the effect that the adoption of FIN 48 will have on its financial position and results of operations.

8

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

4. Accounts Receivable

Accounts receivable consist of billed and unbilled amounts at December 31, 2005 and June 30, 2006 as follows:

	As of December 31, 2005		As of June 30, 2006
	(in thousands)
Billed receivables:
Billed receivables	$	29,364	$	24,382
Billable receivables at end of period		16,008		16,778
Total billed receivables		45,372		41,160
Total unbilled receivables		1,924		2,541
Total accounts receivable		47,296		43,701
Less: Allowance for doubtful accounts		685		775
Total accounts receivable, net	$	46,611	$	42,926

Unbilled receivables primarily consist of fees withheld by the client in accordance with the contract terms, items waiting on customer acceptance, and conditions that will be billed upon contract completion and approval of indirect rates.

5. Distributions Payable

In connection with the revocation of the S corporation tax status, the Board of Directors approved a distribution to the stockholders of record on the date of revocation representing the balance of undistributed S corporation earnings through the date of revocation. The distribution amount was determined after giving effect to the operating results through the revocation date with the filing of the final S corporation tax return. In January of 2006, the Company paid approximately $5.9 million in the final distribution of previously undistributed S corporation earnings to the stockholders of record at the S Corporation termination date. This amount is reflected as a current liability as of December 31, 2005.

6. Loan and Security Agreement

On March 14, 2006, the Company entered into a new Loan and Security Agreement (the Agreement). Contemporaneously with the execution of the Agreement, the Company terminated the prior Loan and Security Agreement relating to the Company’s $30.0 million revolving credit facility, $14.0 million term note and $15.0 million time loan.

The borrowing capacity under the Agreement consists of a revolving credit facility with an original principal amount of up to $60.0 million and a swingline facility with an original principal amount of up to $5.0 million. The Agreement also has a $30.0 million accordion feature allowing the Company to increase its borrowing capacity to up to $90.0 million, subject to obtaining commitments for the incremental capacity from existing or new lenders. The outstanding balance of the facility accrues interest based on LIBOR plus an applicable margin, ranging from 100 to 175 basis points, based on a ratio of funded debt to earnings. The credit facility expires on March 14, 2011.

The outstanding borrowings are collateralized by a security interest in substantially all of the Company’s assets. The lenders also require a direct assignment of all contracts at the lenders’ discretion.

The Agreement contains various restrictive covenants that, among other things, restrict the Company’s ability to:

• incur or guarantee additional debt;

• make certain distributions, investments and other restricted payments, including cash dividends on the Company’s outstanding common stock;

• enter into transactions with certain affiliates;

• create or permit certain liens; and

• consolidate, merge or sell assets.

In addition, the Agreement contains certain financial covenants that require the Company to:

• maintain a minimum tangible net worth;

• maintain a minimum fixed charge coverage ratio and a ratio of funded debt to earnings; and

• limit capital expenditures below certain thresholds.

9

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

6. Loan and Security Agreement (continued)

Funds borrowed under the revolving credit facility will be used to finance possible future acquisitions, to provide for working capital expenditures and for general corporate uses. As of June 30, 2006, there were no amounts outstanding under the credit facility.

On August 1, 2006, the Company entered into the First Amendment (the Amendment) to the Loan and Security Agreement dated as of March 14, 2006. In general, the Amendment permits the Company to indemnify and grant liens in favor of surety companies that issue performance bonds guaranteeing performance under certain of federal government contracts, provided that the aggregate amount of work to be performed under all such bonded contracts shall not exceed $20,000,000 at any time.

7. Stockholders’ Equity and Related Items

Reincorporation Transaction

NCI was incorporated in Delaware in July 2005. In September 2005, the Company completed a merger and share exchange as a result of which NCI Information Systems, Inc., a Virginia corporation, became a wholly-owned subsidiary. Pursuant to a share exchange agreement, the majority stockholder of NCI Information Systems, Inc. transferred all of his shares of common stock of NCI Information Systems, Inc. to the Company’s wholly-owned subsidiary, NCI Acquisition, LLC, a Virginia limited liability company. The majority stockholder received one share of Class B common stock in exchange for each share he transferred. NCI Information Systems, Inc. then merged with the wholly-owned subsidiary, with NCI Information Systems, Inc. surviving the merger. As a result of this merger, each issued and outstanding share of common stock of NCI Information Systems, Inc., other than the shares transferred to the wholly-owned subsidiary by the majority stockholder, was converted into one share of Class A common stock. In connection with this merger, NCI assumed all of the issued and outstanding options to acquire capital stock of NCI Information Systems, Inc., and these options became exercisable for shares of the Company’s Class A common stock. As this transaction represented a merger of entities under common control, the transaction was accounted for similar to a pooling-of-interests whereby all financial information prior to the transactions has been restated as if the combined entity existed for the periods presented. The above transactions are collectively referred to herein as the “Reincorporation Transaction.”

Common Stock

As described above, the Company completed the reincorporation of its business in September 2005. As a result, the Company maintains two classes of common stock. In connection with the initial public offering, on October 3, 2005, the Company affected a 1-for-1.9 reverse stock split of both its Class A and Class B common stock. The effect of this reincorporation, including the reverse stock split, has been reflected retroactively in the accompanying consolidated financial statements.

Holders of Class A common stock are entitled to one vote for each share held of record, and holders of Class B common stock are entitled to ten votes for each share held of record, except with respect to any “going private transaction,” as to which each share of Class A common stock and Class B common stock are both entitled to one vote per share. The Class A common stock and the Class B common stock vote together as a single class on all matters submitted to a vote of stockholders, including the election of directors, except as required by law. Holders of common stock are entitled to receive, when and if declared by the board of directors from time to time, such dividends and other distributions in cash, stock or property from our assets or funds legally available for such purposes. Each share of Class A common stock and Class B common stock is equal in respect of dividends and other distributions in cash, stock or property, except that in the case of stock dividends, only shares of Class A common stock will be distributed with respect to the Class A common stock and only shares of Class B common stock will be distributed with respect to Class B common stock.

Each share of Class B common stock is convertible into one share of Class A common stock at any time at the option of the Class B stockholder, and in certain other circumstances.

Stock Options

The Board of Directors of the Company duly adopted and approved the 2003 Performance Incentive Plan on January 31, 2003. The Board of Directors of the Company has adopted the 2005 Performance Incentive Plan (the Plan) which has been approved by the Company’s stockholders, and under which 3,157,895 shares of Class A common stock were reserved for

10

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

7. Stockholders’ Equity and Related Items (continued)

Stock Options (continued)

issuance under the Plan. Stock options granted under the 2003 Performance Incentive Plan, together with certain non-qualified stock options granted to two executives in 2000 and 2001, were assumed under the 2005 Performance Incentive Plan and, thereafter, became exercisable for shares of Class A common stock. The 2005 Performance Incentive Plan provides for the grant of incentive stock options and non-qualified stock options, and the grant or sale of restricted shares of common stock to the Company’s directors, employees and consultants. The Board of Directors of the Company administers the Plan. Of the 3,157,895 shares reserved under the plan, 976,314 shares have been issued under exercised options, 620,762 are outstanding under current option agreements, and 1,560,819 shares are available for future grants.

Stock options granted in 2003 and 2004 under the Plan will fully vest over a period of zero to seven years from the date of grant in accordance with the individual stock option agreement. The achievement of certain performance criteria, or a change in control as defined by the option agreements may accelerate the vesting period. Stock options granted during 2005 and 2006 will fully vest over a period of three to five years from the date of grant in accordance with the individual stock option agreement.

During the first six months of 2005 and 2006, the Company granted options to purchase 78,945 and 20,000 shares of common stock, respectively, to certain employees and directors under the Plan. Stock-based compensation costs related to stock option grants has been reflected in the net income for the three and six months ended June 30, 2005 and 2006.

8. Related Party Transactions

The Company purchased services from Net Commerce Corporation, which is a government contractor wholly-owned by Rajiv Narang, the son of Charles K. Narang, the Chairman and Chief Executive Officer of the Company, under a subcontract and a blanket purchase order. For the three months and six months ended June 30, 2005, the payments for services and expenses incurred under these agreements were approximately $356,000 and $571,000, respectively, of which $91,000 was included in accounts payable at June 30, 2005. For the three months and six months ended June 30, 2006, approximately $96,000 and $198,000 was incurred for services and expenses incurred under these agreements, respectively, of which $45,000 was included in accounts payable as of June 30, 2006.

The Company has used private aircraft to accommodate the travel needs of our executives for Company business. These aircraft are owned, directly or indirectly, by Michael W. Solley, the President and a director of the Company. The Company has reimbursed approximately $6,000 and $36,000 during the three and six months ended June 30, 2005, respectively, and nothing during the three and six months ended June 30, 2006, to Mr. Solley or his affiliates for fees and expenses associated with the business use of these aircraft.

Management believes that all transactions with related parties have been conducted based on then current market conditions.

9. Contingencies

Government Audits

Payments to the Company on federal government contracts are subject to adjustment upon audit by various agencies of the federal government. Audits of costs and the related payments have been performed by the various agencies through 2003 for NCI Information Systems, Inc. and through 2002 for SES. In the opinion of management, the final determination of costs and related payments for unaudited years will not have a material effect on the Company’s financial position, results of operations or liquidity.

Litigation

The Company is party to various legal actions, claims, government inquiries, and audits resulting from the normal course of business. The Company believes that the probability is remote that any resulting liability will have a material effect on the Company’s financial position, results of operations or liquidity.

11

NCI, Inc.

Notes to Consolidated Financial Statements (continued)

10. Income Taxes

In connection with the Company’s initial public offering, the Company’s S corporation status was terminated effective October 20, 2005, and the Company is thereafter subject to federal and state income taxes as a C corporation. Because the Company was an S corporation, deferred taxes were not historically reflected in the financial statements, and the Company was not responsible for these income taxes until the termination of its S corporation status. For informational purposes, the statements of income for the three month and six month periods ended June 30, 2005 include a pro forma provision for income taxes that would have been recorded if the Company had been a C corporation during this period when the Company’s S Corporation election was in effect, calculated in accordance with SFAS No. 109.

The differences between the provision for income taxes at the statutory U.S. federal income tax rate and those reported in the pro forma provision for income tax information for the three and six month periods ending June 30, 2005 and the income tax provision recorded for the three and six month periods ending June 30, 2006, relate to the impact of state and local income taxes and other differences. Other differences include, among other items, the nondeductible portion of meals and entertainment, nondeductible penalties and fines, nondeductible dues, and nondeductible officers’ life insurance premiums, as well as any tax-exempt items of income.

The reconciliation between statutory U.S. federal income tax rates and those reported in the consolidated statements of income for the unaudited pro forma income tax information for the three and six months ended June 30, 2005 and the unaudited income tax provision for the three and six months ended June 30, 2006 is as follows:

	2005		2006
Statutory federal income tax rate	34.0	%	34.0	%
State and local taxes, net of federal taxes	4.8		4.7
Other	0.1		0.4
	38.9	%	39.1	%

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

Forward Looking Statements

There are statements made herein which may not address historical facts and, therefore, could be interpreted to be forward looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Such statements are subject to factors that could cause actual results to differ materially from anticipated results. The factors that could cause actual results to differ materially from those anticipated include, but are not limited to, the following: regional and national economic conditions in the United States, including conditions that result from terrorist activities or war; changes in interest rates; currency fluctuations; failure to achieve contract awards in connection with recompetes for present business and/or competition for new business; the risks and uncertainties associated with client interest in and purchases of new products and/or services; continued funding of U.S. Government or other public sector projects, based on a change in spending patterns, or in the event of a priority need for funds, such as homeland security, turmoil in the Middle East, the war on terrorism or rebuilding Iraq; government contract procurement (such as bid protest, small business set asides, etc.) and termination risks; individual business decisions of our clients; the financial condition of our clients; paradigm shifts in technology; competitive factors such as pricing pressures and competition to hire and retain employees (particularly those with security clearances); our ability to complete and implement acquisitions appropriate to achievement of our strategic plans; material changes in laws or regulations applicable to our businesses, particularly legislation affecting (i) government contracts for services, (ii) outsourcing of activities that have been performed by the government, (iii) delays related to agency specific funding freezes, (iv) competition for task orders under Government Wide Acquisition Contracts (GWACS) and/or schedule contracts with the General Services Administration; and (iv) expensing of stock options; our own ability to achieve the objectives of near term or long range business plans; and other risks described in the Company’s Securities and Exchange Commission filings.

Overview

We are a provider of information technology services and solutions to federal government agencies. We focus on designing, implementing, maintaining and upgrading secure IT systems and networks. Our technology and industry expertise enables us to provide a full spectrum of services and solutions that assist our clients in achieving their program goals. We deliver a wide range of complex services and solutions by leveraging our skills across four core service offerings:

network engineering;

information assurance;

systems development and integrations; and

enterprise systems management.

We generate substantially all of our revenue from federal government contracts. We report operating results and financial data as one operating segment. Funding for our contracts and task orders is generally linked to trends in federal government spending by defense, intelligence and federal civilian agencies. The following table shows our revenue from the client groups listed as a percentage of total revenue for the periods shown.

	Three months ended June 30,				Six months ended June 30,
	2005		2006		2005		2006
Department of Defense and intelligence agencies (1)	72.8	%	78.6	%	73.0	%	78.2	%
Federal civilian agencies (1)	26.7	%	21.2	%	26.5	%	21.6	%
Commercial and state & local entities	0.5	%	0.2	%	0.5	%	0.2	%

(1) Percentages may not reflect disclosure in prior filings as a result of the reclassification during the second quarter of 2006 of a contract awarded in third quarter 2005, that was initially classified as a federal civilian agency contract, as a Department of Defense and intelligence agency contract.

Revenue

Substantially all of our revenue is derived from services and solutions provided to the federal government, primarily by our employees and, to a lesser extent, our subcontractors. In some cases, our revenue includes third-party hardware and software that we purchase and integrate as a part of our overall solutions. The level of hardware and software purchases we make for clients may vary from period to period depending on specific contract and client requirements.

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Contract Types

Our services and solutions are provided under three types of contracts: time-and-materials; cost-plus; and fixed-price. Our contract mix varies from year to year due to numerous factors including our business strategies and federal government procurement objectives.

The following table shows our revenue from each of these types of contracts as a percentage of our total revenue for the periods shown.

	Three months ended June 30,				Six months ended June 30,
	2005		2006		2005		2006
Time-and-materials	57.5	%	44.6	%	59.4	%	45.7	%
Cost-plus	26.5	%	29.1	%	25.7	%	30.5	%
Fixed-price	16.0	%	26.3	%	14.9	%	23.8	%

Time-and-materials contracts. Under time-and-materials contracts, we are reimbursed for labor at fixed hourly rates and generally reimbursed separately for allowable materials, other direct costs and out-of-pocket expenses. Our actual labor costs may vary from the negotiated hourly rates if, in a constricted labor market, we need to hire additional employees at higher wages or increase the compensation paid to existing employees, or in a weak labor market, we are able to hire employees at lower than expected rates. To date, we have not experienced any material variations in the negotiated hourly rates on our time-and-material contracts and our actual labor costs in connection with those contracts. To the extent that our actual labor costs under a time-and-materials contract vary significantly from the negotiated hourly rates, we may generate more or less than the targeted amount of profit.

Cost-plus contracts. Under cost-plus contracts, we are reimbursed for costs that are determined to be allowable and allocable to the contract and receive a fee, which represents our profit. Cost-plus fixed fee contracts specify the contract fee in dollars. Cost-plus incentive fee and cost-plus award fee contracts provide for increases or decreases in the contract fee, within specified limits, based upon actual results as compared to contractual targets for factors such as cost, quality, schedule and performance.

Fixed-price contracts. Under fixed-price contracts, we perform specific tasks for a predetermined price. We have three basic categories of fixed-price contracts: fixed unit price; fixed-price level-of-effort; and fixed-price completion contracts. Compared to time-and-materials and cost-plus contracts, fixed-price contracts generally offer higher profit margin opportunities but involve greater financial risk because we bear the impact of potential cost overruns in return for the full benefit of any cost savings. The majority of our work under fixed-price contracts is fixed-price level-of-effort work, which has a lower risk than fixed-price completion contracts, such as software development.

Our revenue and profit under any of these contract types with additional incentive-fee arrangements may vary significantly from quarter to quarter due to our actual performance results and the timing of incentive fee notifications.

Operating Expenses

Cost of Revenue

Cost of revenue primarily includes direct costs incurred to provide our services and solutions to clients. The most significant portion of these costs is salaries and wages, plus associated fringe benefits including stock-based compensation, of our employees directly serving clients, in addition to the related management, facilities and infrastructure costs. Cost of revenue also includes the costs of subcontractors and outside consultants, third-party materials, such as hardware or software that we purchase and provide to the client as part of an integrated solution, and any other related direct costs, such as travel expenses. These other direct costs are incurred in response to specific client tasks, and vary from period to period. Changes in the mix of services and equipment provided under our contracts can result in variability in our contract margins.

General and Administrative Expenses

General and administrative expenses include the salaries and wages, plus associated fringe benefits including stock-based compensation, of our employees not performing work directly for clients. Among the functions covered by these costs are facilities, corporate business development, bid and proposal, contracts administration, finance and accounting, legal, corporate governance, and executive and senior management.

Depreciation and Amortization

Depreciation and amortization includes the depreciation of computers, furniture and other equipment, the amortization of third party software we use internally, and leasehold improvements.

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Amortization of Intangible Assets

Amortization of intangible assets includes the amortization of identifiable intangible assets over their estimated useful lives. Non-compete agreements are generally amortized straight-line over the term of the agreement, while contracts and related client relationships are amortized proportionately against the acquired backlog.

Provision for Income Taxes

Prior to October 20, 2005, the Company elected, by the consent of its stockholders, to be taxed as an S corporation under Subchapter S of the Internal Revenue Code (the Code) and under relevant sections of the tax law of the various states that conform to the Code. Under our S corporation election, all items of income and expense were “passed through” and taxed at the stockholder level for federal tax purposes. As a result, NCI was not required to record a provision for federal income taxes. However, we have recorded a provision for state income taxes for those states that do not recognize the S corporation status. For all periods after October 20, 2005, the Company is taxed as a C corporation and is recording a provision for estimated taxes on that basis.

Results of Operations

The following table sets forth certain items from our consolidated statements of operations and expresses each item as a percentage of revenue for the periods indicated.

	As a percentage of revenue Three months ended June 30,				As a percentage of revenue Six months ended June 30,
	2005		2006		2005		2006
	(unaudited)				(unaudited)
Revenue	100.0	%	100.0	%	100.0	%	100.0	%
Operating costs and expenses:
Cost of revenue	84.4		85.9		84.9		85.8
General and administrative expenses	7.6		6.1		7.7		6.6
Depreciation and amortization	0.8		0.9		0.8		0.9
Amortization of intangible assets	0.6		0.5		0.6		0.5
Total operating costs and expenses	93.4		93.4		94.0		93.8
Operating income	6.6		6.6		6.0		6.2
Interest income	0.0		0.4		0.0		0.3
Interest expense	(0.9	)	(0.0	)	(0.8	)	(0.0	)
Income before taxes	5.7		7.0		5.2		6.5
Provision for income taxes (1)	0.2		2.7		0.2		2.5
Net income	5.5	%	4.3	%	5.0	%	4.0	%

(1) Provision for income taxes for the periods ending June 30, 2005 only reflects taxes paid as an S corporation.

Three Months Ended June 30, 2006 Compared to Three Months Ended June 30, 2005

Revenue: For the three months ended June 30, 2006, total revenue increased by 0.7% or $0.4 million, over the same period a year ago. This increase was primarily due new task orders under our GWAC contract vehicles, primarily ITES and NETCENTS, as well as growth under an intelligence program. These increases were partially offset by funding reductions on some intelligence and civilian contracts.

Cost of revenue:Cost of revenue increased 2.5%, or $1.0 million, for the three months ended June 30, 2006, as compared to the same period a year ago. The increase was attributable to an increase in subcontractor and other direct costs and the increase in revenue. As a percentage of revenue, cost of revenue was 85.9% and 84.4% for the quarters ended June 30, 2006 and 2005, respectively. The 1.5% increase in cost of revenue as a percentage of revenue for the quarter ended June 30, 2006 compared to the quarter ended June 30, 2005 resulted primarily from an increase in subcontractor and other direct costs as a percentage of cost of revenue.

General and Administrative Expenses: General and administrative expense decreased 18.8%, or $0.7 million, for the three months ended June 30, 2006, as compared to the same period a year ago. This reduction was attributable to lower stock compensation expense, lower bid and proposal costs, and a reduction of other expenses, including IPO related costs. As a percentage of revenue, general and administrative expenses were 6.1% and 7.6% for the quarters ended June 30, 2006 and 2005, respectively.

Depreciation and Amortization:Depreciation and amortization expense was approximately $0.4 million for each of the quarters ended June 30, 2006 and 2005.

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Amortization of Intangible Assets: Amortization of intangible assets was approximately $0.2 million and $0.3 million, respectively, for the quarters ended June 30, 2006 and 2005. The decrease is due to lower amortization associated with the contracts and client relationships intangible related to the SES acquisition, which is being amortized using an accelerated amortization method.

Operating income: For the three months ended June 30, 2006, operating income was $3.2 million, or 6.6% of revenue, compared to $3.1 million, or 6.6% of revenue, for the three months ended June 30, 2005. Award fee notices, which have a direct impact on operating income, received in the three months ending June 30, 2006 were approximately $250,000 lower than those received in the same period in the prior year. The lower general and administrative costs offset the higher cost of revenue and lower award fees. Operating income, as a percent of revenue, was consistent between the two periods.

Interest Income/Expense: The decrease in interest expense of $0.4 million and increase in interest income of $0.2 million for the quarter ended June 30, 2006 compared to the quarter ended June 30, 2005 was attributable to proceeds from our initial public offering in October 2005. The proceeds paid down all of our existing bank debt, thereby significantly reducing our interest expense, and our excess cash has been invested in high quality, highly liquid investments, increasing our interest income.

Income Taxes: The increase in income taxes of $1.2 million is the result of our conversion from an S corporation to a C corporation for income tax purposes. For the three months ended June 30, 2005, we have recorded a provision for state income taxes for only those states that do not recognize the S corporation status. The effective tax rate reflected for the three months ended June 30, 2006 is 39.1%. This effective rate is higher than the federal statutory rate primarily due to state and local taxes and certain non-deductible expenses.

Six Months Ended June 30, 2006 Compared to Six Months Ended June 30, 2005

Revenue: Revenue was $93.9 million for each of the six-month periods ending June 30, 2006 and 2005. While revenue is comparable between the two periods, we have experienced growth on a number of our existing programs and received a number of new task orders under our NETCENTS and ITES contracts. This growth was offset by the loss of a subcontract in support of the Army of approximately $2.3 million, and approximately $7.3 million in funding reductions on a number of civilian and intelligence programs.

Cost of revenue:Cost of revenue increased 1.1%, or $0.9 million, for the six months ended June 30, 2006 compared to the same period in the prior year. As a percentage of revenue, cost of revenue is 85.8% for the six months ended June 30, 2006, compared to 84.9% for the same period of the prior year. This increased cost of revenue, in both dollars and as a percent of revenue, is due to increased subcontractor and other direct costs.

General and Administrative Expenses:General and administrative expense decreased 14.4%, or $1.0 million, for the six months ended June 30, 2006, as compared to the six months ended June 30, 2005. This reduction was attributable to lower stock compensation expense, lower bid and proposal costs, and a reduction of other expenses, including IPO related costs. As a percentage of revenue, general and administrative expenses were 6.6% and 7.7% for the six months ended June 30, 2006 and 2005, respectively.

Depreciation and Amortization:Depreciation and amortization expense was approximately $0.8 million for each of the six-month periods ending June 30, 2006 and 2005.

Amortization of Intangible Assets: Amortization of intangible assets was approximately $0.5 million for each of the six-month periods ending June 30, 2006 and 2005.

Operating income: For the six months ended June 30, 2006, operating income was $5.8 million, or 6.2% of revenue, compared to $5.6 million, or 6.0% of revenue, for the six months ended June 30, 2005. Award fee notices, which have a direct impact on operating income, received in the six months ending June 30, 2006 were approximately $400,000 lower than those received in the same period in the prior year. The lower general and administrative costs offset the higher cost of revenue and lower award fees, resulting in the higher operating margin.

Interest Income/Expense: The decrease in interest expense of $0.7 million and increase of interest income of $0.3 million for the six months ended June 30, 2006 compared to the six months ended June 30, 2005, is the result of initial public offering completed in October 2005. The proceeds were used to pay down all of our existing bank debt and the excess cash has been invested in high quality liquid investments, thereby reducing interest expense and increasing interest income.

Income Taxes: The increase in income taxes of $2.2 million is the result of our conversion from an S corporation to a C corporation for income tax purposes. For the six months ended June 30, 2005, we have recorded a provision for state income taxes for only those states that do not recognize the S corporation status. The effective tax rate reflected for the six months ended June 30, 2006 is 39.1%. This effective rate is higher than the federal statutory rate primarily due to state and local taxes and certain non-deductible expenses.

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Effects of Inflation

We generally have been able to price our contracts in a manner to accommodate the rates of inflation experienced in recent years. Under our time-and-materials contracts, labor rates are usually adjusted annually by predetermined escalation factors. Cost-plus contracts automatically adjust for changes in cost. For our fixed-price contracts, we include a predetermined escalation factor to account for projected increases in costs. Historically, we generally have not been materially adversely affected by inflation.

Liquidity and Capital Resources

Our primary liquidity needs are for financing working capital, investing in capital expenditures and making selective strategic acquisitions. Historically, we have relied primarily on our cash flow from operations, borrowings under our credit facility and proceeds from our initial public offering to provide the capital for our liquidity needs. We expect the combination of our current cash and cash equivalent balances, cash flow from operations and the available borrowing capacity on our credit facility to continue to meet our normal working capital and capital expenditure requirements. As part of our growth strategy, we may pursue acquisitions that could require us to raise additional external capital or increase our borrowings.

Cash flow: The following table sets forth our sources and uses of cash for the six months ended June 30, 2005 and 2006.

	Six months ended June 30,
	2005			2006
	(in thousands)
Net cash provided by operating activities	$	8,193		$	10,894
Net cash used in investing activities		(2,995	)		(173	)
Net cash provided by (used in) financing activities		(5,225	)		(6,013	)
Net (decrease) increase in cash	$	(27	)	$	4,708

Operating cash flow is primarily affected by the overall profitability of our contracts, our ability to invoice and collect from our clients in a timely manner, and our ability to manage our vendor payments. We bill most of our clients and prime contractors monthly after services are rendered. Cash provided by operating activities for the six months ended June 30, 2006 was the result of net income of $3.7 million, depreciation and other non-cash items of $2.8 million, and net changes in operating assets and liabilities of $4.4 million, primarily due to decreased receivables and increases in accounts payable. Cash provided by operating activities for the six months ended June 30, 2005 was the result of net income of $4.6 million, depreciation and other non-cash items of $2.0 million, and a net increase in accounts payable and accrued expenses of $2.4 million.

Cash flow used in investing activities consists primarily of capital expenditures and acquisitions. The $173,000 used in investing activities for the six months ended June 30, 2006 is primarily for capital expenditures, whereas the $3.0 million in cash used for investing activities for the six months ended June 30, 2005 represents a $1.9 million payout for the final SES acquisition payments and $1.1 million in capital expenditures, the majority of which was due to leasehold improvements to expand government certified facilities to pursue additional classified business.

Cash flow used in financing activities consists primarily of proceeds from and payments on our loans, capital lease payments and distributions to our stockholders. During the six months ended June 30, 2006, we paid the final distribution to our S corporation stockholders of $5.9 million. During the six months ended June 30, 2005, we paid a net $0.7 million on our line of credit, paid $1.4 million on our term loan, and paid out $3.0 million in distributions to the S corporation stockholders.

Credit Agreement: The borrowing capacity under our Loan and Security Agreement (the Agreement) consists of a revolving credit facility with an original principal amount of up to $60.0 million and a swingline facility with an original principal amount of up to $5.0 million. The Agreement also has a $30.0 million accordion feature allowing us to increase our borrowing capacity to up to $90.0 million, subject to obtaining commitments for the incremental capacity from existing or new lenders. The credit facility expires on March 14, 2011. Funds borrowed under the revolving credit facility will be used to finance possible future acquisitions, to provide for working capital expenditures and for general corporate uses. As of June 30, 2006, there were no amounts outstanding under the credit facility.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements.

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Critical Accounting Policies

Our significant accounting policies are described in Note 3 to our accompanying consolidated financial statements. We consider the accounting policies related to revenue recognition to be critical to the understanding of our results of operations. We prepare our financial statements in conformity with U.S. generally accepted accounting principles. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. If any of these estimates or judgments proves to be incorrect, our reported results could be materially affected.

Revenue Recognition

Our revenue recognition policy addresses our three different types of contractual arrangements: time-and-materials contracts; cost-plus contracts; and fixed-price contracts.

Time-and-Materials Contracts:Revenue on time-and-materials contracts is recognized based on negotiated billable rates multiplied by the number of hours delivered plus allowable expenses incurred during the period.

Cost-Plus Contracts: Revenue on cost-plus contracts is recognized based on the allowable costs incurred during the period, plus any recognizable earned fee. Revenue associated with fixed fees under cost-plus contracts is considered earned in proportion to the allowable expenses incurred in performance of the contract.

Fixed-Price Contracts: The Company has three categories of fixed-price contracts: fixed unit price; fixed-price level-of-effort; and fixed-price completion contracts. Revenue on fixed unit price contracts, where specified units are delivered under service arrangements, is recognized as units are delivered based on the specified price per unit. Revenue for fixed-price level-of-effort contracts is recognized based upon the number of units of labor actually delivered multiplied by the negotiated rate for each unit of labor. Revenue on fixed-price completion contracts is recognized on the percentage of completion method using costs incurred in relation to total estimated costs.

For contracts with performance based incentives or award fees, revenue is recognized as earned. Certain fees are not recognized until award notification is received, which may result in revenue and profit variability from quarter to quarter.

Contract accounting requires judgment relative to assessing risks, estimating contract revenues and costs, and making assumptions for schedule and technical issues. Due to the size and nature of certain of our contracts that require the use of estimates or related assumptions, the estimation of total revenue and cost at completion is subject to many variables. Contract costs include material, labor and subcontracting costs, as well as an allocation of allowable indirect costs. Assumptions have to be made regarding the length of time to complete the contract because costs also include expected increases in wages and prices for materials. We apply judgment in estimating the amounts and assessing the potential for realization. Further, we utilize a number of management processes to monitor contract performance and revenue estimates, including quarterly management reviews of contract estimates. These amounts are only included in contract value when they can be reliably estimated and realization is considered probable. Estimates of award fees related to performance on certain contracts, which are generally awarded at the discretion of the client, as well as penalties related to contract performance, are considered in estimating sales and profit rates. Incentives and penalties are recorded when there is sufficient information for us to assess anticipated performance. Anticipated losses on contracts are recognized at the time they become known.

From time to time, circumstances develop or actual amounts are determinable that require us to revise our total estimated costs or revenue expectations. We record the effect of any revisions to our estimated total costs and revenue in the period in which circumstances requiring revision become known. Consequently, operating results could be affected by revisions to prior accounting estimates. Historically, these changes relate to changes in the contractual scope of our work, and have not significantly impacted the expected profit rate on a contract. We do not expect that revisions to our estimates and assumptions would have a material effect on the Company’s consolidated results of operations, cash flows or financial position.

Stock-Based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004) (SFAS No. 123(R)),“Share-Based Payment,” using the prospective method. Under this method, compensation costs for all awards granted after the date of adoption and modifications of any previously granted awards outstanding at the date of adoption are measured at estimated fair value and included in operating expenses over the vesting period during which an employee provides service in exchange for the award. Prior to the adoption of SFAS No. 123(R), the Company accounted for stock-based compensation in accordance with APB No. 25 using the intrinsic-value method. Under the prospective method, we will continue to apply APB No. 25 in future periods to awards outstanding at the date of adoption. The Company

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issued non-qualified stock options to employees at various times during 2003 and 2004 with vesting periods ranging from zero to seven years and any related expense for the amount by which the fair market value at the date of grant exceeds the exercise price is being amortized over the applicable vesting periods. During 2005 and 2006, the Company issued incentive stock options and non-qualified stock options to employees and directors with vesting periods ranging from three to five years.

In adopting SFAS No, 123(R), companies must choose among alternative valuation models and amortization assumptions. The Company has elected to use the Black-Scholes-Merton option pricing model and straight-line amortization of compensation expense over the requisite service period of the grant. In valuing stock option grants, we use an expected volatility factor based on the historical volatility of the Company’s stock, an expected term equal to the vesting period plus the term of the option divided by two, a risk-free interest rate based on the implied yield available on a U.S. Treasury note with a term equal to the expected term of the underlying grant, a dividend yield of zero based on the Company’s expectation to not pay dividends in the future, and an estimated forfeiture rate.

We estimated stock-based compensation expense from existing stock option agreements to be approximately $190,000 per year from 2006 through 2008, approximately $160,000 in 2009, and $30,000 in 2010.

Goodwill and the Amortization of Intangible Assets

Our accounting policy regarding acquisitions is in accordance with SFAS No. 141, Business Combinations, whereby the net tangible and identifiable intangible assets acquired and liabilities assumed are recognized at their estimated fair market values at the date of acquisition. At the time of the acquisition, all intangibles including the contracts and related client relationships and non-compete agreements are reviewed to determine the term of amortization for each intangible asset.

Our accounting policy regarding goodwill and the amortization of intangible assets requires that goodwill be reviewed periodically for impairment and no longer be amortized against earnings. Annually, on October 1, we perform a fair value analysis of our reporting units using valuation techniques prescribed in Statement of Financial Accounting Standards (SFAS) No. 142.

Long-lived assets are reviewed for impairment whenever events or circumstances indicate that the carrying amount of an asset many not be fully recoverable in accordance with SFAS No. 144, Accounting for the Impairment of Long-Lived Assets. An impairment loss is recognized if the sum of the long-term undiscounted cash flows is less than the carrying amount of the long-lived asset being evaluated. Any write-downs are treated as permanent reductions in the carrying amount of the assets. Contract rights are amortized proportionately against the acquired backlog. Non-compete agreements are amortized over their estimated useful lives.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our exposure to market risk relates to changes in interest rates for borrowings under our Loan and Security Agreement. Since we had no outstanding bank debt during the three and six months ended June 30, 2006, a change in interest rates would have had no impact on our interest expense or cash flow.

Additionally, we are subject to credit risks associated with our cash and cash equivalents, short-term investments and accounts receivable. We believe that the concentration of credit risks with respect to cash equivalents and investments are limited due to the high credit quality of these investments. Our investment policy that requires we invest excess cash in high quality investments which preserve principal, provide liquidity, and minimize investment risk. We also believe that our credit risk associated with accounts receivable is limited as they are primarily with the federal government or prime contractors working for the federal government.

Item 4. Controls and Procedures

Quarterly Evaluation. Management carried out an evaluation as of June 30, 2006 of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. This evaluation was done under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer. Rules adopted by the SEC require that management present the conclusions of the Chief Executive Officer and Chief Financial Officer about the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this quarterly report.

CEO and CFO Certifications. Included as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q are forms of “Certification” of the Company’s Chief Executive Officer and Chief Financial Officer. The forms of Certification are required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002. This section of the Quarterly Report on Form 10-Q that you are currently reading is the information concerning the evaluation referred to in the Section 302 certifications. This information should be read in conjunction with the Section 302 certifications for a more complete understanding of the topics presented.

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Disclosure Controls and Procedures and Internal Control over Financial Reporting. Management is responsible for establishing and maintaining adequate disclosure controls and procedures and internal control over financial reporting. Disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed in the Company’s reports filed or submitted under the Securities Exchange Act of 1934, such as this Quarterly Report on Form 10-Q, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures are also designed to provide reasonable assurance that such information is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

Internal control over financial reporting is a process designed by, or under the supervision of, the Company’s Chief Executive Officer and Chief Financial Officer, and effected by the Company’s management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the Company’s assets;

provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of management or the Company’s Board of Directors; and

provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material adverse effect on the Company’s financial statements.

Limitations on the Effectiveness of Controls. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, do not expect that the Company’s disclosure controls and procedures or the Company’s internal control over financial reporting will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management’s override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Scope of the Assessments. The assessment by the Company’s Chief Executive Officer and the Company’s Chief Financial Officer of the Company’s disclosure controls and procedures included a review of procedures and discussions with other employees in the Company’s organization. In the course of the assessments, management sought to identify data errors, control problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. The assessments of the Company’s disclosure controls and procedures is done on a periodic basis so that the conclusions can be reported in the Company’s Quarterly Reports on Form 10-Q and Annual Reports on Form 10-K. The Company’s key controls related to its internal control over financial reporting are updated on a periodic basis by management and other personnel in the Company’s accounting department.

Evaluation of the Effectiveness of Disclosure Controls and Procedures. Based upon the evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of June 30, 2006, the Company’s disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting. The Company made no change to its internal control over financial reporting during the three months ended June 30, 2006, that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.

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PART II

OTHER INFORMATION

Item 1. Legal Proceedings

The Company is party to various legal actions, claims, government inquiries, and audits resulting from the normal course of business. The Company believes that the probability is remote that any resulting liability will have a material effect on the Company’s financial position, results of operations or liquidity.

Item 1A. Risk Factors

No significant changes from those discussed in “Risk Factors” included in NCI, Inc.’s Form 10-K, filed with the Securities and Exchange Commission on March 30, 2006.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

An Annual Meeting of Stockholders was held on June 14, 2006 (the “Annual Meeting”). The following proposals were voted upon at the Annual Meeting:

Proposal 1 The election of seven directors to serve a one year term, or until their respective successors have been duly elected and qualified.

Proposal 2 To ratify the appointment of Ernst & Young LLP as the Company’s independent registered public accounting firm for the current fiscal year.

A summary of the voting for proposal voted upon at the Annual Meeting is as follows:

Proposal	For	Against or Withheld	Abstain	Broker Non-Votes
Proposal 1
Charles K. Narang	68,928,651	267,501	—	—
James P. Allen	69,075,334	120,818	—	—
John E. Lawler	69,051,534	144,618	—	—
Paul V. Lombardi	69,075,334	120,818	—	—
J. Patrick McMahon	69,075,034	121,118	—	—
Michael W. Solley	69,075,534	120,618	—	—
Daniel R. Young	69,075,234	120,918	—	—
Proposal 2	69,195,852	100	200	—

Item 5. Other Information

None.

Item 6. Exhibits

Exhibits

10.1	First Amendment to Loan and Security Agreement, dated August 1, 2006, by and among NCI, Inc., as the Parent Borrower, each of the Subsidiary Borrowers identified on the signature pages thereto, the several banks and financial institutions from time to time parties to the agreement, and SunTrust Bank as the Administrative Agent.
31.1	Section 302 Certification of the Chief Executive Officer
31.2	Section 302 Certification of the Chief Financial Officer
32.1	Section 906 Certification of the Chief Executive Officer
32.2	Section 906 Certification of the Chief Financial Officer

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized.

NCI, Inc.
Registrant
Date: August 8, 2006	By:	/s/ Charles K. Narang
		Charles K. Narang
		Chairman of the Board,
		Chief Executive Officer and Director (Principal Executive Officer)
Date: August 8, 2006	By:	/s/ Judith L. Bjornaas
		Judith L. Bjornaas
		Senior Vice President
		Chief Financial Officer
		(Principal Financial and Accounting Officer)

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