Integral Systems (ISYS) 10-Q 2006 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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 December 31, 2005

or

¨ 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 0-18603

INTEGRAL SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Maryland	52-1267968
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)
5000 Philadelphia Way, Lanham, MD	20706
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code (301) 731-4233

(Former name, address and fiscal year, if changed since last report)

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  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

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

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

Registrant had 10,815,008 shares of common stock outstanding as of January 26, 2006.

INTEGRAL SYSTEMS, INC.

TABLE OF CONTENTS

		Page No.
PART I. FINANCIAL INFORMATION:
Item 1.	Financial Statements
	Consolidated Balance Sheets – December 31, 2005 (unaudited) and September 30, 2005	1
	Unaudited Consolidated Statements of Operations – Three Months Ended December 31, 2005 and December 31, 2004	3
	Unaudited Consolidated Statement of Stockholders’ Equity - Three Months Ended December 31, 2005	4
	Unaudited Consolidated Statements of Cash Flow – Three Months Ended December 31, 2005 and December 31, 2004	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	14
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	27
Item 4.	Controls and Procedures	27
PART II. OTHER INFORMATION:
Item 1.	Legal Proceedings	28
Item 2.	Unregistered Sale of Equity Securities and Use of Proceeds	28
Item 6.	Exhibits	29

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2005 and September 30, 2005

	December 31, 2005		September 30, 2005
	(unaudited)
ASSETS
CURRENT ASSETS
Cash	$	24,807,475	$	24,775,460
Marketable securities		32,716,000		32,716,000
Accounts receivable, net of allowances for doubtful accounts		18,125,523		19,162,918
Unbilled receivables		18,554,819		17,915,939
Employee and other receivables		434,844		87,655
Notes receivable		303,530		378,055
Prepaid expenses		434,735		585,740
Inventories		3,849,901		2,223,373
Deferred income tax		878,066		878,066
TOTAL CURRENT ASSETS		100,104,893		98,723,206
FIXED ASSETS
Land		2,327,329		2,327,329
Electronic equipment		4,505,861		4,642,158
Furniture & fixtures		611,564		659,612
Leasehold improvements		1,725,380		1,706,393
Software purchases		694,107		808,520
SUBTOTAL - FIXED ASSETS		9,864,241		10,144,012
Less: accumulated depreciation		3,660,129		4,240,409
TOTAL FIXED ASSETS		6,204,112		5,903,603
OTHER ASSETS
Notes receivable		267,708		267,708
Intangible assets, net		547,314		362,493
Goodwill		49,887,473		41,011,844
Software development costs, net		2,201,693		2,601,693
Deposits, deferred charges, and other		674,584		325,736
TOTAL OTHER ASSETS		53,578,772		44,569,474
TOTAL ASSETS	$	159,887,777	$	149,196,283

The accompanying notes are an integral part of these consolidated financial statements.

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INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2005 and September 30, 2005

	December 31, 2005			September 30, 2005
	(unaudited)
LIABILITIES & STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable	$	8,524,472		$	6,360,140
Accrued expenses		14,811,132			14,722,834
Capital leases payable		15,865			25,119
Billings in excess of revenue		7,238,825			7,088,015
Income taxes payable		1,496,198			188,285
TOTAL CURRENT LIABILITIES		32,086,492			28,384,393
LONG TERM LIABILITIES
Deferred income taxes		125,644			125,644
TOTAL LONG TERM LIABILITIES		125,644			125,644
STOCKHOLDERS’ EQUITY
Common Stock, $.01 par value, 40,000,000 shares authorized, and 10,661,162 and 10,447,623 shares issued and outstanding at December 31, 2005 and September 30, 2005, respectively		106,612			104,476
Additional paid-in capital		96,673,772			91,963,338
Retained earnings		30,914,177			28,575,843
Accumulated other comprehensive income		(18,920	)		42,589
TOTAL STOCKHOLDERS’ EQUITY		127,675,641			120,686,246
TOTAL LIABILITIES & STOCKHOLDERS’ EQUITY	$	159,887,777		$	149,196,283

The accompanying notes are an integral part of these consolidated financial statements.

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INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

	Three Months Ended December 31,
	2005			2004
Revenue	$	29,257,590		$	21,919,534
Cost of Revenue
Direct labor		5,590,352			4,561,857
Overhead costs		4,742,618			3,961,090
Travel and other direct costs		538,583			513,629
Direct equipment & subcontracts		8,981,195			5,747,894
Total cost of revenue		19,852,748			14,784,470
Gross Margin		9,404,842			7,135,064
Selling, general & administrative		3,399,831			3,772,006
Research & development		743,301			782,770
Product amortization		400,000			645,409
Intangible asset amortization		216,238			68,750
Income From Operations		4,645,472			1,866,129
Other Income (Expense)
Interest income		378,049			213,067
Interest expense		(1,175	)		(1,485	)
Gain on sale of marketable securities		—			53,761
Miscellaneous, net		(167,701	)		(307,263	)
Total Other Income (Expense)		209,173			(41,920	)
Income Before Income Taxes		4,854,645			1,824,209
Provision for Income Taxes		1,784,191			638,822
Net Income	$	3,070,454		$	1,185,387
Weighted Avg. Number of Common Shares:
Basic		10,670,647			10,045,127
Diluted		10,936,265			10,368,603
Earnings per Share (Basic)	$	0.29		$	0.12
Earnings per Share (Diluted)	$	0.28		$	0.11
Cash Dividends per Share	$	0.05		$	0.04

The accompanying notes are an integral part of these consolidated financial statements.

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INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

FOR THE THREE MONTHS ENDED DECEMBER 31, 2005

(Unaudited)

	Number of Shares		Common Stock At Par Value			Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income			Total
Balance September 30, 2005	10,447,623		$	104,476		$	91,963,338		$	28,575,843		$	42,589		$	120,686,246
Net income	—			—			—			3,070,454			—			3,070,454
Effect of currency translation	—			—			—			—			(61,509	)		(61,509	)
Total Comprehensive Income	—			—			—			—			—			3,008,945
Repurchased Shares	(18,500	)		(185	)		(156,495	)		(197,065	)					(353,745	)
Shares issued to acquire net assets of Lumistar LLC	224,931			2,249			4,732,099									4,734,348
Stock options exercised	7,108			72			132,354			—			—			132,426
Declared dividends	—			—			—			(535,055	)		—			(535,055	)
Stock option compensation							2,476									2,476
Balance December 31, 2005	10,661,162		$	106,612		$	96,673,772		$	30,914,177		($	18,920	)	$	127,675,641

The accompanying notes are an integral part of these consolidated financial statements.

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INTEGRAL SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Three Months Ended December 31, 2005 and 2004

(Unaudited)

	For the Three Months Ended December 31,
	2005			2004
Cash flows from operating activities:
Net income	$	3,070,454		$	1,185,387
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,151,097			1,088,068
Stock option compensation		2,476			—
Gain on sale of marketable securities		—			(53,761	)
Loss on disposal of fixed assets		—			1,300
Changes in operating assets and liabilities, net:
Accounts receivable and other receivables		1,478,953			1,344,614
Prepaid expenses and deposits		(187,843	)		225,433
Inventories		(891,191	)		230,139
Accounts payable		474,010			(934,950	)
Accrued expenses		(264,622	)		(544,728	)
Billings in excess of revenue		150,810			950,930
Income taxes payable, net		1,307,913			(26,827	)
Total adjustments		3,221,603			2,280,218
Net cash provided by operating activities, net of effects of acquisition		6,292,057			3,465,605
Cash flows from investing activities:
Sale of marketable securities		—			147,521
Issuance of Notes Receivable		—			(54,906	)
Proceeds from payments on notes receivable		74,525			32,039
Acquisition of fixed assets		(621,985	)		(620,758	)
Acquisition of Lumistar, LLC, including cash, 224,931 shares of common stock valued at $4,734,348, and $42,340 of acquisition costs		(4,885,445	)		—
Software development costs		—			(288,603	)
Net cash used in investing activities		(5,432,905	)		(784,707	)
Cash flows from financing activities:
Proceeds from issuance of common stock		132,426			2,831,937
Stock repurchases		(353,745	)		—
Dividend payments		(535,055	)		—
Capital lease obligation payments		(9,254	)		(8,503	)
Net cash (used in) provided by financing activities		(765,628	)		2,823,434
Effect of currency translations		(61,509	)		85,302
Net increase in cash		93,524			5,504,332
Cash – beginning of year		24,775,460			18,198,832
Cash – end of period	$	24,807,475		$	23,788,466

The accompanying notes are an integral part of these consolidated financial statements.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Basis of Presentation

The interim financial statements include the accounts of Integral Systems, Inc. (the “Company”) and its wholly owned subsidiaries, SAT Corporation (“SAT”), Newpoint Technologies, Inc. (“Newpoint”), Real Time Logic, Inc. (“RT Logic”), Lumistar, Inc. (“Lumistar”), and Integral Systems Europe (“ISI Europe”). All significant intercompany accounts and transactions have been eliminated in consolidation.

In the opinion of management, the financial statements reflect all adjustments consisting only of normal recurring accruals necessary for a fair presentation of results for such periods. The financial statements, which are condensed and do not include all disclosures included in the annual financial statements, should be read in conjunction with the consolidated financial statements of the Company for the fiscal year ended September 30, 2005. The results of operations for any interim period are not necessarily indicative of results for the full year.

2. Acquisition of Net Assets of Lumistar, LLC.

On October 3, 2005, Lumistar, Inc. (the “Acquisition Subsidiary”), a newly-formed subsidiary of Real Time Logic, Inc. (“RT Logic”), a subsidiary of Integral Systems, Inc. (the “Company”), acquired substantially all of the assets of Lumistar, LLC (the “Seller”) relating to the Seller’s business of providing system level and board level telemetry acquisition products (the “Business”) pursuant to an Asset Purchase Agreement dated as of October 3, 2005 by and among the Company, RT Logic, the Acquisition Subsidiary, the Seller and certain members of the Seller. The primary reason for acquiring Lumistar was to expand the Company’s existing products to Lumistar’s client base. The initial purchase price was $10 million, including cash paid of $5 million and 224,931 shares of the Company’s common stock at an estimated value of $5 million. During November 2005, the Company recorded a $423,000 reduction in goodwill resulting from a $266,000 adjustment in the value of the 224,931 shares of common stock issued to the Seller as well as a $157,000 purchase price adjustment that will be paid to the Company from funds escrowed at closing. The value of the 224,931 shares of common stock was determined based on the average market price of the Company’s common shares over the 2-day period before and after the terms of the acquisition were agreed to and announced. The number of common shares issued to the Seller at the closing was determined based on the average closing price per share of the Company’s common stock over the 30-day trading period ending on September 30, 2005. The adjusted purchase price was $9,577,453, including cash paid of $4,843,105 and the Company’s common stock at a value of $4,734,348. The acquisition was accounted for using the purchase method of accounting under the guidance in FASB Statement 141, Business Combinations. Accordingly, operating results have been consolidated since October 3, 2005 and the initial purchase price has been allocated to assets acquired and liabilities assumed as follows:

Current assets	$	2,162,964
Property and equipment		213,383
Goodwill		8,833,289
Intangibles		401,059
Other assets		10,000
Total assets acquired		11,620,695
Current liabilities		2,043,242
Net assets acquired	$	9,577,453

The identified intangible assets will be amortized on a straight-line basis over an estimated useful life of approximately 4 years for the technology ($159,500) and up to 9 months for the customer related intangibles ($241,559). Goodwill, which represents the excess of the purchase price over the fair value of tangible and identified intangible assets acquired, is not being amortized but will be reviewed annually for impairment, or more frequently if impairment indicators arise, in accordance with Statement of Financial Accounting Standard No. 142, “Goodwill and Other

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

2. Acquisition of Net Assets of Lumistar, LLC (continued).

Intangible Assets” (“SFAS 142”). In part, goodwill reflects the competitive advantages the Company expects to realize from introducing its existing products into Lumistar’s client base.

The Seller may also be entitled to contingent consideration payments on the Business’s pre-tax earnings for a period of up to four years after the closing. Any contingent earn-out payments may be payable fifty percent in cash and fifty percent in stock and will be recorded as additional goodwill.

3. Accounts Receivable

Accounts receivable at December 31, 2005 and September 30, 2005 consist of the following:

	Dec. 31, 2005			Sept. 30, 2005
Billed	$	18,265,523		$	19,302,918
Unbilled		18,554,819			17,915,939
Other		434,844			87,655
Reserve		(140,000	)		(140,000	)
Total	$	37,115,186		$	37,166,512

The Company’s accounts receivable consist of amounts due on prime contracts and subcontracts with the U.S. Government and contracts with various commercial and international organizations. Unbilled accounts receivable consist principally of amounts that are billed in the month following the incurrence of cost, amounts related to indirect cost variances on cost reimbursable type contracts or amounts related to milestones that are delivered under fixed price contracts. Substantially all unbilled receivables are expected to be billed and collected within one year.

The reserve for doubtful accounts is determined based upon management’s best estimate of potentially uncollectible accounts receivable.

In June 2004 and May 2005, Integral Systems filed claims in the amount of $1.8 million and $319,000, respectively, against National Oceanic and Atmospheric Administration (“NOAA”). The claims arose under a contract from NOAA to provide the Data Collection System Automated Processing System II (DAPS-II System). Integral Systems has submitted appeals to the General Services Board of Contract Appeals (“GSBCA”) related to these claims. A hearing date has not been set for the appeal. In August 2005, the Company filed another claim against NOAA in the amount of $135,000. This claim arose under a contract from NOAA to perform software and hardware upgrades on NOAA’s Polar Acquisition and Control Subsystem. As of December 31, 2005, unbilled receivables included approximately $1.2 million associated with these claims. This amount is based on management’s best estimate at December 31, 2005. At this time, the Company believes the receivable related to these claims is recoverable. The company is currently negotiating the claims with NOAA and as a result, has temporarily suspended its appeals with the GSBCA.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

4. Inventories

Inventories are priced at the lower of cost or market using the first in, first-out (FIFO) method of accounting. Obsolete inventory is written off and its value is removed from inventory at the time its obsolescence is determined. Inventories consist of the following:

	December 31, 2005		September 30, 2005
Finished Goods	$	2,627,263	$	2,004,158
Work in process		—		—
Raw Materials		1,222,638		219,215
Total	$	3,849,901	$	2,223,373

5. Line of Credit

The Company has a line of credit agreement with a local bank for $10.0 million for general corporate purposes. Borrowings under the line are due on demand with interest at the London Inter-Bank Offering Rate (LIBOR), plus a spread of 1.5 to 2.4% based on the ratio of funded debt to earnings before interest, taxes and depreciation (EBITDA). The line of credit is secured by the Company’s billed and unbilled accounts receivable, inventory, equipment, and insurance proceeds and has certain financial covenants, including minimum net worth and liquidity ratios. The Company had no balance outstanding at December 31, 2005 under the line of credit. The line of credit expires on February 28, 2007.

The Company also has access to a $2.0 million equipment lease line of credit that had a balance of approximately $15,865 at December 31, 2005. The outstanding balance is payable over a 5-month period and bears interest at a rate of 8.8% per annum.

6 Stock-Based Compensation

Effective October 1, 2005, the Company adopted the provisions of Statement of Financial Accounting Standard No. 123R, Share-Based Payment (“SFAS 123R”). This statement requires compensation costs related to share-based payments, including stock options, to be recognized in the Consolidated Statement of Operations based on their fair values. The expense is recognized over the requisite service period of the award. The Company previously recognized expense for stock-based compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB 25”). Accordingly, compensation expense was recognized for the excess, if any, of the stock price on the grant date over the option exercise price. No compensation expense was recorded under APB 25 for awards granted under the Company’s employee stock option plan as all options issued had exercise prices at least equal to the fair value of the stock on the grant date. The pro forma effects upon net income and earnings per share for stock options are disclosed below in this Note 4 to the financial statements per FASB Statement No. 123, “Accounting for Stock-Based Compensation.” The Company adopted the modified prospective application in implementing SFAS 123R. Under this transition method compensation costs recorded in the first quarter of fiscal year 2006 include the cost for all share based awards granted prior to October 1, 2005 which had not yet vested as of that date. The expense is based on the grant-date fair value of these awards as calculated for pro forma disclosures under Statement 123 and uses the Black-Scholes valuation model. In using the modified prospective application, prior interim period financial statements were not adjusted to show the effect of compensation costs and the related tax effects as though they had been accounted for using FASB Statement No. 123.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

6. Stock-Based Compensation (continued)

As a result of adopting SFAS 123R the Company included approximately $2,500 of share-based compensation expense in the Consolidated Statements of Operations for the three month period ended December 31, 2005. The Company did not record any tax benefits associated with its share-based compensation expense in the three month period ended December 31, 2005. The effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123R to stock-based employee compensation in the prior year comparable period is as follows:

		Three Months Ended December 31,
		2004
Net income, as reported		$	1,185,387
Deduct: Total stock-based employee compensation expense determined under fair value-based method for all awards net of tax effect of $230,668			(447,768	)
Add: Stock-based employee compensation included in net income, net of tax effect of $0			—
Pro forma net income		$	737,619
Earnings per share:
As reported	- basic	$	0.12
	- diluted	$	0.11
Pro forma	- basic	$	0.07
	- diluted	$	0.07

Cash received from the exercise of options under all Company Stock Option Plans for the three months ending December 31, 2005 and 2004 was $132,494 and $2,831,938 respectively. The Company currently plans to satisfy future stock option exercises under these plans with registered shares available to be issued.

On August 19, 2005, the Board of Directors approved resolutions to accelerate the vesting of all outstanding unvested options previously awarded to employees and officers of the Company effective August 31, 2005. However, holders of incentive stock options had the option to decline the acceleration of their options to prevent changing the status of the incentive stock options to a non-qualified stock option for federal income tax purposes. Holders of options to purchase 4,772 shares elected to decline the accelerated vesting. Options to purchase 453,268 shares of stock with exercise prices ranging from $16.13 to $22.96 were accelerated.

The primary purpose of the accelerated vesting was to eliminate future compensation expense the Company would otherwise recognize in its statement of operations with respect to these options upon the adoption of SFAS No. 123R. The acceleration of the vesting of these options resulted in the Company recording a non-cash stock compensation expense of approximately $1.2 million during the Company’s fourth quarter of fiscal year 2005 using the intrinsic value method. However, the related future compensation expense to be recorded upon adoption of SFAS 123R that was eliminated as a result of the acceleration of the vesting of these options is approximately $4.1 million.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

6. Stock-Based Compensation (continued)

Effective May 1, 2002, the Company established the 2002 Stock Option Plan, which was amended and restated effective May 1, 2005, to create additional incentives for the Company’s employees, consultants and directors to promote the financial success of the Company. The Stock Option Committee of the Board of Directors has sole authority to select full-time employees, directors or consultants to receive awards of options for the purchase of stock under this plan. The maximum number of shares of common stock that may be issued pursuant to the Amended and Restated 2002 Stock Option Plan is 1,150,000. The exercise price of each option is set at the stock’s closing price on the date the option is granted by the Stock Option Committee of the Board of Directors. Options expire no later than ten years from the date of grant (five years for greater-than-10% owners) or three months after employment ceases, whichever occurs first, and vest from one to five years.

Prior to adoption of the 2002 Stock Option Plan, which was effective May 25, 1988 and amended on January 1, 1994 and May 8, 1998, the Company established the 1988 Stock Option Plan. This plan was created to provide additional incentives for the Company’s employees, consultants and directors to promote the financial success of the Company. The Stock Option Committee of the Board of Directors has sole authority to select full-time employees, directors or consultants to receive awards of options for the purchase of stock under this plan. At September 30, 2005, the maximum number of shares of common stock which may be issued pursuant to the 1988 Stock Option Plan was 1,800,000. The exercise price of each option was set at the stock’s closing price on the date the option was granted by the Stock Option Committee of the Board of Directors. Options expire no later than ten years from the date of grant (five years for greater-than 10% owners) or three months after employment ceases, whichever comes first, and vest from one to five years. Pursuant to the approval by stockholders at the April 17, 2002 Annual Meeting of the Shareholders, no further options were granted after April 30, 2002 under the 1988 Stock Option Plan.

The following table summarizes the Company’s activity for all of its stock option awards during the three months ended December 31, 2005:

	Shares		Weighted Average Exercise Prices
Options outstanding September 30, 2005	1,038,490		$	19.43
Granted	—			—
Exercised	(7,108	)	$	18.64
Cancelled	(3,300	)	$	19.65
Options outstanding December 31, 2005	1,028,082		$	19.43

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

6. Stock-Based Compensation (continued)

The following table summarizes additional information about stock options outstanding at December 31, 2005:

	Options Outstanding				Options Exercisable
Exercise Price Per Share	Number of Shares	Weighted- Average Remaining Life	Weighted- Average Exercise Price		Number Exercisable	Weighted- Average Exercise Price
$15.00 – 19.99	626,320	3.10 Years	$	18.25	621,548	$	18.25
$20.00 – 25.00	401,762	1.91 Years	$	21.26	401,762	$	21.26
	1,028,082	2.64 Years	$	19.43	1,023,310	$	19.43

The weighted-average grant date fair value of options which were granted during the three months ended December 31, 2005 and 2004 was $0 and $9.89, respectively. The fair value of the options granted was estimated on the date of the grant using the Black-Scholes options pricing model. The following table shows the assumptions used for the grants that occurred in each three month period.

	2005	2004
Expected volatility	N/A	56.9	%
Risk free interest rate	N/A	3.48	%
Dividend yield	N/A	.57	%
Expected lives	N/A	5.00 years

As of December 31, 2005, there was $29,845 of unrecognized compensation expense related to remaining non-vested stock options that will be recognized over a weighted average period of 3.0 years. The total fair value of options which vested during the three month period ending December 31, 2005 and 2004 was $0 and $43,445, respectively.

7. Recent Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-01, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” The EITF reached a consensus about the criteria that should be used to determine when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss and how that criteria should be applied to investments accounted for under SFAS No. 115, “Accounting in Certain Investments in Debt and Equity Securities.” EITF 03-01 also included accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. Additionally, EITF 03-01 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the Financial Accounting Standards Board (FASB) delayed the accounting provisions of EITF 03-01; however, the disclosure requirements remain effective for annual reports ending after June 15, 2004. The Company will evaluate the impact of EITF 03-01 once final guidance is issued.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

7. Recent Accounting Pronouncements (continued)

In November, 2004 the FASB published Statement of Financial Accounting Standards No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. Statement 151 amends the guidance in Chapter 4, “Inventory Pricing” of ARB No. 43 and clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Statement 151 requires that those items be recognized as current-period charges. Statement 151 also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. Statement 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Statement 151 was effective for the Company’s 2006 fiscal year and upon adoption did not have a material impact on the Company’s financial statements.

8. Business Segment Information

The Company is organized in four reportable segments as follows:

• Ground Systems - Government

• Ground Systems - Commercial

• Space Communications Systems

• Corporate

The Ground Systems – Government segment provides ground systems products and services to the Federal Government. It is currently the Company’s largest segment in terms of revenue and consists of the Company’s core command and control business for government applications. Its primary customers are the U.S. Air Force and NOAA.

The Ground Systems – Commercial segment provides ground systems products and services to commercial enterprises and international governments and organizations. It consists of the Company’s core command and control business for commercial applications and three of the Company’s wholly owned subsidiaries as follows:

• SAT and Newpoint, acquired by the Company in August 2000 and January 2002, respectively, offer complementary ground system components and systems. This includes turnkey systems, hardware and software for satellite and terrestrial communications signal monitoring, network and ground equipment monitoring and control and satellite data processing.

• ISI Europe, the Company’s wholly owned subsidiary formed in March 2001, with headquarters in Toulouse, France, serves as the focal point for the support of all of the Company’s European business.

The Space Communications Systems segment includes the Company’s wholly owned subsidiary, RT Logic (RT), which designs and builds satellite communications equipment and systems, principally for military applications. This equipment is used in satellite tracking stations, control centers, spacecraft factories and range operations. The segment also includes the Company’s recently acquired (October 3, 2005) wholly owned and indirect subsidiary, Lumistar, Inc. (Lumistar). Lumistar provides system level and board level telemetry products.

The Corporate segment is the Company’s “all other” segment. It includes the Company’s Product Division, which is responsible for the Company’s core command and control product line (EPOCH IPS); business areas in the development stage (none currently exist); and businesses being disbanded (the Company’s Antenna Division). The Product Division licenses the Company’s EPOCH IPS product line to other operating segments and to third-party customers. It is also the segment responsible for EPOCH IPS maintenance and support revenue and expenses.

The Company evaluates the performance of each segment based on operating income. There are no inter-segment allocations of overhead.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

8. Business Segment Information (continued)

Summarized financial information by business segment is as follows:

	Three Months Ended December 31, 2005			Three Months Ended December 31, 2004
Revenue
Ground Systems–Government	$	13,861,068		$	9,735,175
Ground Systems–Government intersegment		—			—
Ground Systems–Commercial		4,690,425			4,255,424
Ground Systems–Commercial intersegment		89,384			86,953
Space Communication Systems		9,907,507			6,887,090
Space Communication Systems intersegment		1,210,208			496,003
Corporate		798,590			1,041,845
Corporate intersegment		1,296,225			870,500
Elimination of intersegment Sales		(2,595,817	)		(1,453,456	)
Total Revenue	$	29,257,590		$	21,919,534
Operating Income
Ground Systems–Government	$	1,309,453		$	723,955
Ground Systems–Government intersegment		—			—
Ground Systems–Commercial		558,147			120,182
Ground Systems–Commercial intersegment		—			(12,256	)
Space Communication Systems		2,720,408			1,782,943
Space Communication Systems intersegment		—			—
Corporate		57,464			(760,951	)
Corporate intersegment		(1,960	)		(6,369	)
Elimination of intersegment Operating Income		1,960			18,625
Total Operating Income	$	4,645,472		$	1,866,129
Total Assets
Ground Systems–Government	$	18,180,807		$	19,554,577
Ground Systems–Commercial		11,021,248			14,131,315
Space Communication Systems		78,389,611			55,150,505
Corporate		77,743,723			60,564,977
Elimination of intersegment accounts receivable		(25,447,612	)		(13,405,997	)
Total Assets	$	159,887,777		$	135,995,377

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

Overview

The Company builds satellite ground systems for command and control, integration and test, data processing, and simulation. Since its inception in 1982, the Company has provided ground systems for over 205 different satellite missions for communications, science, meteorology, and earth resource applications. The Company has an established domestic and international customer base that includes government and commercial satellite operators, spacecraft and payload manufacturers, and aerospace systems integrators.

The Company has developed innovative software products that reduce the cost and minimize the development risk associated with traditional custom-built systems. The Company believes that it was the first to offer a comprehensive commercial off-the-shelf (“COTS”) software product line for command and control. As a systems integrator, the Company leverages these products to provide turnkey satellite control facilities that can operate multiple satellites from any manufacturer. These systems offer significant cost savings for customers that have traditionally purchased a separate custom control center for each of their satellites.

The Company is organized into four reportable segments as follows:

Ground Systems – Government

This segment provides ground systems products and services to the Federal Government. It is the Company’s largest segment in terms of revenue and consists of the Company’s core command and control business for government applications. Its primary customers are the U.S. Air Force and the National Oceanic and Atmospheric Administration (NOAA).

Ground Systems – Commercial

This segment provides ground systems products and services to commercial enterprises and international governments and organizations. It consists of the Company’s core command and control business for commercial applications and three of the Company’s wholly owned subsidiaries as follows:

SAT Corporation (“SAT”) and Newpoint Technologies, Inc. (“Newpoint”), acquired by the Company in August 2000 and January 2002 respectively, offer complementary ground system components and systems. This includes turnkey systems, hardware and software for satellite and terrestrial communications signal monitoring, network and ground equipment monitoring and control and satellite data processing.

ISI Europe, the Company’s wholly owned subsidiary formed in March 2001, with headquarters in Toulouse, France, serves as the focal point for the support of all of the Company’s European business.

Space Communications Systems

This segment includes the Company’s wholly owned subsidiary, Real Time Logic, Inc. (“RT Logic”), which designs and builds satellite communications equipment and systems, principally for military applications. This equipment is used in satellite tracking stations, control centers, spacecraft factories and range operations. The segment also includes the Company’s recently acquired (October 3, 2005) wholly owned subsidiary, Lumistar, Inc. (“Lumistar”), which acquired substantially all of the assets of Lumistar LLC on October 3, 2005. Lumistar provides system level and board level telemetry products.

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Corporate

This segment is the Company’s “all other” segment. It includes the Company’s Product Division, which is responsible for the Company’s core command and control product line (EPOCH IPS); business areas in the development stage (none currently exist); and businesses being disbanded (the Company’s Antenna Division). The Product Division licenses the Company’s EPOCH IPS product line to other operating segments and to third-party customers. It is also the segment responsible for EPOCH IPS maintenance and support revenue and expenses.

All significant intra-segment and inter-segment revenues and expenses have been eliminated in consolidation as appropriate.

Recent Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments.” The EITF reached a consensus about the criteria that should be used to determine when an investment is considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss and how that criteria should be applied to investments accounted for under SFAS No. 115, “Accounting in Certain Investments in Debt and Equity Securities.” EITF 03-01 also included accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. Additionally, EITF 03-01 includes new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the Financial Accounting Standards Board (FASB) delayed the accounting provisions of EITF 03-01; however, the disclosure requirements remain effective for annual reports ending after June 15, 2004. The Company will evaluate the impact of EITF 03-01 once final guidance is issued.

In November, 2004 the FASB published Statement of Financial Accounting Standards No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4. Statement 151amends the guidance in Chapter 4, “Inventory Pricing” of ARB No. 43 and clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Statement 151 requires that those items be recognized as current-period charges. Statement 151 also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. Statement 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Statement 151 was effective for the Company’s 2006 fiscal year and upon adoption did not have a material impact on the Company’s financial statements.

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COMPARISON OF THE THREE MONTHS ENDED DECEMBER 31, 2005 AND 2004

Results of Operations

The components of the Company’s income statement as a percentage of revenue are depicted in the following table for the three months ended December 31, 2005 and 2004:

	Three Months Ended December 31,
	2005		% of Revenue	2004			% of Revenue
	(in thousands)			(in thousands)
Revenue	$	29,258	100.0	$	21,920		100.0
Cost of Revenue		19,853	67.9		14,785		67.4
Gross Margin		9,405	32.1		7,135		32.6
Operating Expenses
Selling, General & Admin. (SG&A)		3,400	11.6		3,772		17.2
Research and Development		744	2.5		783		3.7
Product Amortization		400	1.4		645		2.9
Amortization-Intangible Assets		216	0.7		69		0.3
Income from Operations		4,645	15.9		1,866		8.5
Other Income (Expense) (net)		209	0.7		(42	)	(0.2	)
Income Before Income Taxes		4,854	16.6		1,824		8.3
Income Taxes		1,784	6.1		639		2.9
Net Income	$	3,070	10.5	$	1,185		5.4

Revenue

The Company earns revenue, both as a prime contractor and a subcontractor, from sales of its products and services through contracts that are funded by the U.S. Government as well as commercial and international organizations.

For the three months ended December 31, 2005 and 2004, the Company’s revenues were generated from the following sources:

	Three Months Ended December 31,
Revenue Type	2005		2004
U.S. Government Revenue (all segments)
U.S. Air Force	58	%	49	%
NOAA	4		11
Other U.S. Government Users	13		13
Subtotal	75		73
Commercial Revenue (all segments)	25		27
Total	100	%	100	%

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On a consolidated basis, revenue increased 33.5%, or $7.3 million, to $29.2 million for the three months ended December 31, 2005, from $21.9 million for the three months ended December 31, 2004. Revenue for the three-month periods ended December 31, 2005 and 2004 for each of the Company’s segments is shown in the following table:

	Three Months Ended December 31,						Increase/ (Decrease)
Segment	2005			2004
	(in thousands)			(in thousands)			(in thousands)
Revenue
Ground Systems – Government	$	13,861		$	9,735			4,126
Ground Systems – Commercial
Command & Control		2,873			2,761			112
Newpoint		924			693			231
SAT		1,096			956			140
Intra-Segment Elimination		(113	)		(67	)		(46	)
Ground Systems – Commercial		4,780			4,343			437
Space Communications Systems		11,118			7,383			3,735
Corporate
Product Group		1,272			954			318
Antenna		477			671			(194	)
Other		346			288			58
Corporate		2,095			1,913			182
Elimination		(2,596	)		(1,454	)		(1,142	)
Total Revenue	$	29,258		$	21,920		$	7,338

Revenue increases in the Company’s Ground Systems—Government segment between the three months ended December 31, 2005 and 2004 primarily relate to increased revenues from the U.S. Air Force. The Company’s RAIDRS contract with the U.S. Air Force, which was awarded in February 2005, was responsible for virtually the entire revenue increase.

Revenue increases for the Company’s Ground Systems – Commercial segment resulted from increased backlog and increased product shipments to customers. All operating units in the segment posted higher revenues during the three months ended December 31, 2005 compared to the three months ended December 31, 2004.

Revenue increases for the Company’s Space Communications Systems segment resulted from increased backlog and increased product shipments to customers. Further, current period revenues from Lumistar of approximately $2.5 million were incremental to the segment’s revenue totals for the three months ended December 31, 2005, as the Company did not acquire Lumistar until October 2005.

In the Company’s Corporate segment, the Product Group recorded increased license revenues between the periods being compared.

Antenna Division revenues declined approximately $190,000 between the periods being compared because the Company has not been pursuing new business for this operation since the summer of 2004. The principal operating assets of the division were sold in November 2004 to LJT & Associates, Inc. Revenues for the Antenna Division are expected to continue to decline throughout the fiscal year as the Division’s residual contracts are completed.

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Cost of Revenue/Gross Margin

The Company computes gross margin by subtracting cost of revenue from revenue. Included in cost of revenue are direct labor expenses, overhead charges associated with the Company’s direct labor base and other costs that can be directly related to specific contract cost objectives, such as travel, consultants, equipment, subcontracts and other direct costs.

Gross margins on contract revenues vary depending on the type of product or service provided. Generally, license revenues related to the sale of the Company’s COTS products have the greatest gross margins because of the minimal associated marginal costs to produce. By contrast, gross margins rates for equipment and subcontract pass-throughs seldom exceed 15%. Engineering service gross margins typically range between 20% and 40%. These definitions and ratios generally apply across all segments, although margins on equipment costs for the Space Communications Systems segment are generally greater than the equipment margins in the other segments because that segment’s business is composed of internally developed hardware products.

During the three months ended December 31, 2005, cost of revenue increased by 34.3%, or $5.1 million, compared to the same period during the prior year, increasing from $14.8 million during the three months ended December 31, 2004 to $19.9 million during the three months ended December 31, 2005. Gross margin increased from $7.1mllion to $9.4 million, an increase of $2.3 million or 31.8%, during the periods being compared. Cost of revenue and gross margin for the three months ended December 31, 2005 and 2004 for each of the Company’s segments are shown in the following table:

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	Three Months Ended December 31,						Increase/ (Decrease)
Segment	2005			2004
	(in thousands)			(in thousands)			(in thousands)
Cost of Revenue
Ground Systems – Government	$	11,131		$	7,441		$	3,690
Ground Systems – Commercial
Command & Control		2,300			2,173			127
Newpoint		437			317			120
SAT		604			463			141
Intra-Segment Elimination		(46	)		(30	)		(16	)
Ground Systems – Commercial		3,295			2,923			372
Space Communications Systems		6,583			4,266			2,317
Corporate
Product Group		743			460			283
Antenna		347			844			(497	)
Other		342			282			60
Corporate		1,432			1,586			(154	)
Elimination		(2,588	)		(1,431	)		(1,157	)
Total Cost of Revenue		19,853			14,785		$	5,068
Gross Margin
Ground Systems – Government	$	2,730		$	2,294		$	436
Ground Systems – Commercial
Command & Control		573			588			(15	)
Newpoint		487			376			111
SAT		492			493			(1	)
Intra-Segment Elimination		(67	)		(37	)		(30	)
Ground Systems – Commercial		1,485			1,420			65
Space Communications Systems		4,535			3,117			1,418
Corporate
Product Group		529			494			35
Antenna		130			(173	)		303
Other		4			6			(2	)
Corporate		663			327			336
Elimination		(8	)		(23	)		15
Total Gross Margin	$	9,405		$	7,135		$	2,270

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The higher gross margin for the Company’s Ground Systems - Government segment is primarily attributable to increased revenues and the elimination of certain losses on NOAA contracts. However, gross margin as a percentage of revenue for the Ground Systems - Government segment decreased from 23.6% for the three months ended December 31, 2004 to 19.7% for the three months ended December 31, 2005 principally as a result of a greater mix of low margin equipment and subcontracts costs in the segment’s cost of revenue mix during the period ended December 31, 2005. The RAIDRS contract in particular, is an equipment and subcontract intensive program, so this trend in relatively low gross margin rates for the Ground Systems - Government segment is likely to continue in future periods.

The higher gross margin for the Company’s Ground Systems – Commercial segment primarily relates to increased revenue from the segment’s Newpoint Division. Other operating units in the segment (Command & Control and SAT) experienced flat gross margins on a period-to-period comparison.

The Space Communications System segment experienced an increase in gross margin due to increased revenue. Approximately $800,000 of the $1.4 million quarter to quarter increase is attributable to Lumistar.

In the Corporate segment, the Product Group experienced a higher gross margin on a period-to-period basis because of increased license revenue. Antenna Division losses from the three months ended December 31, 2004 were eliminated in the three-month period ended December 31, 2005.

Operating Expenses

Operating expenses for the three months ended December 31, 2005 and 2004 for each of the Company’s segments are shown in the following table:

	Three Months Ended December 31,						Increase/ (Decrease)
Segment	2005			2004
	(in thousands)			(in thousands)			(in thousands)
Operating Expenses
Ground Systems – Government	$	1,421		$	1,570		($	149	)
Ground Systems – Commercial
Command & Control		324			484			(160	)
Newpoint		324			371			(47	)
SAT		301			484			(183	)
Intra-Segment Elimination		(22	)		(27	)		5
Ground Systems – Commercial		927			1,312			(385	)
Space Communications Systems		1,815			1,334			481
Corporate
Product Group		663			921			(258	)
Antenna		18			61			(43	)
Other		(74	)		112			(186	)
Corporate		607			1,094			(487	)
Elimination		(10	)		(41	)		31
Total Operating Expenses	$	4,760		$	5,269		($	509	)

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Operating expenses in the Company’s Ground Systems – Government segment decreased by approximately $150,000 for the three months ended December 31, 2005 compared to the three months ended December 31, 2004 principally due to decreased bid and proposal expenses.

Operating expenses in the Company’s Ground Systems – Commercial segment decreased by approximately $390,000 for the three months ended December 31, 2005 compared to the three months ended December 31, 2004 due partly to a decreased allocation of bid and proposal expenses in the segment’s Command & Control Division. Operating expenses at SAT and Newpoint were down approximately $180,000 and $50,000, respectively during the periods being compared. SAT’s decrease primarily related to lower R&D expenditures incurred during the current three-month period compared to the same three month period last fiscal year.

Operating expenses in the Space Communications Systems segment increased approximately $480,000 during the current period compared to the first quarter of the last fiscal year. A little more than half of the increase is attributable to operating expenses from Lumistar, which had no operating expenses during the three months ended December 31, 2004. Increased R&D spending at RT Logic accounted for most of the remaining increase in operating expenses from this segment.

Operating expenses in the Corporate segment decreased by approximately $490,000 principally due to the decreased selling expenses and product amortization costs in the Product Division. Operating expenses in the Corporate – Other unit decreased by approximately $190,000 between the three months ended December 31, 2005 and the three months ended December 31, 2004 principally because the Company is no longer actively marketing its Skylight product.

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Income from Operations

Income from operations for the three months ended December 31, 2005 and 2004 for each of the Company’s segments is shown in the following table:

	Three Months Ended December 31,						Increase/ (Decrease)
Segment	2005			2004
	(in thousands)			(in thousands)			(in thousands)
Income from Operations
Ground Systems – Government	$	1,309		$	724		$	585
Ground Systems – Commercial
Command & Control		249			104			145
Newpoint		163			5			158
SAT		191			9			182
Intra-Segment Elimination		(45	)		(10	)		(35	)
Ground Systems – Commercial		558			108			450
Space Communications Systems		2,720			1,783			937
Corporate
Product Group		(134	)		(427	)		293
Antenna		112			(234	)		346
Other		78			(106	)		184
Corporate		56			(767	)		823
Elimination		2			18			(16	)
Total Income from Operations	$	4,645		$	1,866		$	2,779

Income from operations during the periods compared increased by almost $590,000 in the Company’s Ground Systems – Government segment as a result of increased gross margins coupled with decreased operating expenses.

Income from operations during the periods compared increased by approximately $450,000 in the Company’s Ground Systems – Commercial segment as a result of increased gross margins coupled with decreased operating expenses.

The Space Communications Systems segment recorded increased income from operations principally due to gross margin increases resulting from increased sales partially offset by increased operating expenses. Included in current period income from operations was approximately $540,000 contributed from Lumistar.

In the Corporate segment, the Product Group had an operating loss of approximately $130,000 for the three months ended December 31, 2005 compared to an operating loss of approximately $430,000 for the three months ended December 31, 2004. The decrease is primarily due to lower amortization expense coupled with increased license revenue. Although the Product Group still recorded an operating loss for the quarter ended December 31, 2005, a large portion of the revenue generated in the Company’s ground systems business (both Government and Commercial) is a result of its EPOCH IPS product line, which the Company believes distinctly and favorably distinguishes it from its competitors.

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Operating losses in the Antenna Division were eliminated in the current three-month period.

In summary, all segments (including the Corporate segment) posted operating income during the current three month period and all segments achieved operating income improvement during the three months ended December 31, 2005 compared to the three months ended December 31, 2004.

Other Income (Expense)

Other income increased between the quarters being compared, primarily because of increased interest income.

Income Before Income Taxes/Net Income

Income before income taxes increased approximately 166.2% during the three months ended December 31, 2005 compared to the amounts posted during the first quarter of last fiscal year, primarily as a result of improved operating income as discussed above.

The Company’s effective tax rate increased from 35.0% for the three months ended December 31, 2004 to 36.7% for the three months ended December 31, 2005 principally due to a lower percentage of tax exempt income compared to total income before income taxes in the current period.

As a result of the above, net income increased to approximately $3.1 million during the three months ended December 31, 2005 from $1.2 million during the three months ended December 31, 2004.

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OUTLOOK

This outlook section contains forward-looking statements, all of which are based on current expectations. There is no assurance that the Company’s projections will in fact be achieved and these projections do not reflect any acquisitions or divestitures that may occur in the future. Reference should be made to the various important factors listed under the heading “Forward-Looking Statements” that could cause actual future results to differ materially.

At this time, the Company has a backlog of work to be performed and it may receive additional contract awards based on proposals in the pipeline, although the estimated backlog under the Company’s government contracts is not necessarily indicative of revenues that will actually be realized under the contracts. Management believes that operating results for future periods will improve based on the following assumptions:

• Demand for satellite technology and related products and services will continue to expand; and

• Sales of its software products and engineering services will continue to increase.

As disclosed in its Form 10-K for the fiscal year ended September 30, 2005, the Company was anticipating that operating results for fiscal year 2006 in its entirety, will exceed results for fiscal year 2005 for revenue, operating income, net income and fully diluted earnings per common share by approximately 15%, 45%, 55% and 53% respectively.

Although the Company cannot provide any assurances as to the fiscal year 2006 forecasted results described above, the Company currently believes these results are achievable because:

• The Company’s existing backlog in its Ground Systems – Government segment indicates growth in revenue and operating income.

• The Company does not anticipate a significant fiscal year 2006 charge for non-recurring compensation related to stock options.

• The Company does not anticipate fiscal year 2006 losses associated with its Antenna Division.

• The Company believes that its acquisition of substantially all of the assets of Lumistar LLC will be immediately accretive to operating results.

After analyzing its results for the three months ended December 31, 2005, the Company believes that it is on target to meet these goals for fiscal year 2006 in its entirety.

LIQUIDITY AND CAPITAL RESOURCES

Since the Company’s inception in 1982, it has been profitable on an annual basis and has generally financed its working capital needs through internally generated funds, supplemented by borrowings under the Company’s general line of credit facility with a commercial bank and the proceeds from the Company’s initial public offering in 1988. In June 1999, the Company supplemented its working capital position by raising approximately $19.7 million (net) through the private placement of approximately 1.2 million shares of its common stock. In February 2000, the Company raised an additional $40.9 million (net) for use in connection with potential acquisitions and other general corporate purposes through the private placement of 1.4 million additional shares of its common stock. With respect to the capital raised in the private placements, at December 31, 2005, $15,506,000 was invested in variable rate State of Maryland debt securities, and $17,210,000 was invested in Banc of America Securities LLC Auction Rate Securities.

For the three months ended December 31, 2005, operating activities provided the Company approximately $6.3 million of cash. The Company used approximately $5.4 million in investing activities and $765,000 in financing activities. Included in the $5.4 million of investing activities is approximately $4.9 million for the acquisition of substantially all of the assets of Lumistar, LLC and $620,000 used for the purchase of fixed assets. The Company also repurchased approximately $350,000 of its Common Stock during the period.

- 24 -

The Company has a line of credit agreement with a local bank for $10.0 million for general corporate purposes. Borrowings under the line are due on demand with interest at the London Inter-Bank Offering Rate (LIBOR), plus a spread of 1.5 to 2.4% based on the ratio of funded debt to earnings before interest, taxes and depreciation (EBITDA). The line of credit is secured by the Company’s billed and unbilled accounts receivable, inventory, equipment, and insurance proceeds and has certain financial covenants, including minimum net worth and liquidity ratios. The Company had no balance outstanding at December 31, 2005 under the line of credit. The line of credit expires February 28, 2007.

The Company’s Board of Directors declared a cash dividend of $.05 per share to all stockholders of record as of close of business on December 19, 2005. The dividend was paid on January 4, 2006 in the amount of $535,055. In addition, the Company’s Board of Directors declared a cash dividend of $.05 per share to all stockholders of record as of close of business on March 2, 2006. The dividend will be paid on or about March 29, 2006.

The Company also has access to a $2.0 million equipment lease line of credit that had a balance of approximately $15,865 at December 31, 2005. The outstanding balance is payable over a 5-month period and bears interest at a rate of 8.8% per annum.

Looking forward to the remainder of fiscal year 2006, the Company anticipates that it will require liquidity for the following major expenditures:

• Up to an additional $10.0 million for the construction of RT Logic’s new corporate headquarters in Colorado Springs.

• Approximately $3.8 million for the cash component related to the third and final contingent payment period to the former shareholders of RT Logic.

The Company intends to cause RT Logic Tract TT2, LLC, a wholly owned subsidiary of RT Logic, to secure a loan of approximately $9.0 million, which will be guaranteed by RT Logic, for the construction of RT Logic’s new corporate headquarters. Otherwise, the Company currently anticipates that its current cash balances, amounts available under its lines of credit and net cash provided by operating activities will be sufficient to meet its working capital and other capital expenditure requirements for at least the next twelve months.

The Company believes that inflation did not have a material impact on the Company’s revenues or income from operations during the three months ended December 31, 2005 or in past fiscal years.

OFF-BALANCE SHEET ARRANGEMENTS

The Company has no “off-balance sheet arrangements” as such term is defined in Item 303(a)(4)(ii) of Regulation S-K.

FORWARD LOOKING STATEMENTS

Certain of the statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations section, including those under the headings “Outlook” and “Liquidity and Capital Resources,” and in other parts of this 10-Q, are forward looking. In addition, from time to time, the Company may publish forward-looking statements relating to such matters as anticipated financial performance, business prospects, technological developments, new products, research and development activities and similar matters. Forward-looking statements can be identified by the use of forward-looking terminology such as “may”, “will”, “believe”, “expect”, “anticipate”, “estimate”, “continue”, or other similar words, including statements as to the intent, belief, or current expectations of the Company and its

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directors, officers, and management with respect to the Company’s future operations, performance, or positions or which contain other forward-looking information. These forward-looking statements are predictions. No assurances can be given that the future results indicated, whether expressed or implied, will be achieved. The Company’s actual results may differ significantly from the results discussed in the forward-looking statements. While the Company believes that these statements are and will be accurate, a variety of factors could cause the Company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company’s statements. The Company’s business is dependent upon general economic conditions and upon various conditions specific to its industry, and future trends cannot be predicted with certainty. Particular risks and uncertainties that may affect the Company’s business, other than those described elsewhere herein, include the following:

• A significant portion of the Company’s revenue is derived from contracts or subcontracts funded by the U.S. Government, which are subject to termination without cause, government regulations and audits, competitive bidding, and the budget and funding process of the U.S. Government.

• The presence of competitors with greater financial resources and their strategic response to the Company’s new services.

• The potential obsolescence of the Company’s services due to the introduction of new technologies.

• The response of customers to the Company’s marketing strategies and services.

• The Company’s commercial contracts are subject to strict performance and other requirements.

• The intense competition in the satellite ground system industry could harm the Company’s financial performance.

• With respect to the Company’s acquisition strategy, integration of the companies and assets the Company has acquired or, if the Company is able to identify and acquire one or more businesses, may acquire, may be costly and may result in a decrease in the value of the Company’s common stock.

• The Company may not have adequately assessed the risks inherent in the companies or assets it has acquired or correctly assessed the potential contribution of those companies or assets to its financial performance, and in the future the Company may not adequately assess the risks inherent in a particular acquisition candidate or correctly assess the candidate’s potential contribution to the Company’s financial performance.

• The Company may need to divert more management resources to integration of an acquired business or assets than it planned, which may adversely affect its ability to pursue other more profitable activities.

• The difficulties of integrating an acquired business or assets may be increased by the necessity of coordinating geographically separated organizations, integrating personnel with disparate backgrounds and combining different corporate cultures.

• The Company may not eliminate as many redundant costs as it anticipated in selecting the companies or assets it has acquired or may acquire.

• The companies or assets the Company has acquired or may acquire may have liabilities or adverse operating issues that the Company failed to discover through its diligence prior to the acquisition.

• Changes in activity levels in the Company’s core markets.

• The Company may not be able to effectively manage any continued growth.

• The business is subject to risks associated with international transactions.

• The Company depends upon intellectual property rights and risk having its rights infringed.

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• The estimated backlog is not necessarily indicative of revenues that will actually be realized under the contracts.

• The Company’s quarterly operating results may vary significantly from quarter to quarter.

• The market price of the Company’s common stock may be volatile.

These forward-looking statements are based upon a variety of assumptions relating to the business of the Company, which may not be realized. Because of the number and range of the assumptions underlying the Company’s forward-looking statements, many of which are subject to significant uncertainties and contingencies beyond the reasonable control of the Company, some of the assumptions inevitably will not materialize and unanticipated events and circumstances may occur subsequent to the date of this document. These forward-looking statements are based on current information and expectation, and the Company assumes no obligation to update. Therefore, the actual experience of the Company and the results achieved during the period covered by any particular forward-looking statement should not be regarded as a representation by the Company or any other person that these estimates will be realized, and actual results may vary materially. There can be no assurance that any of these expectations will be realized or that any of the forward-looking statements contained herein will prove to be accurate.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

While the Company currently does not have significant European operations, its customer base is expanding outside the U.S. and therefore certain contracts now and in the future will likely be denominated in currencies other than the U.S. dollar. As a result, the Company’s financial results could be affected by factors such as foreign currency exchange rates for contracts denominated in currencies other than the U.S. dollar. To mitigate the effect of changes in foreign currency exchange rates, the Company may hedge this risk by entering into forward foreign currency contracts. As of December 31, 2005, virtually all of the Company’s contracts were denominated in U.S. dollars, and the Company did not have any outstanding hedge agreements. As the Company enters into new foreign currency based contracts in the future, the Company may employ similar hedging contracts.

ITEM 4. CONTROLS AND PROCEDURES

a. Disclosure Controls and Procedures

As required by Rule 13a-15 under the Securities Exchange Act of 1934 (the “Exchange Act”), the Company’s management carried out an evaluation of the effectiveness of the Company’s disclosure controls and procedures, as of the end of the fiscal quarter subject to this quarterly report. This evaluation was carried out under the supervision and with the participation of the Company’s management, including the Company’s chief executive officer and chief financial officer. Based upon that evaluation, the Company’s chief executive officer and chief financial officer concluded that the Company’s disclosure controls and procedures are effective. Disclosure controls and procedures are controls and other procedures of the Company that are designed to ensure that information required to be disclosed by the Company in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act 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 disclosures.

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b. Changes in Internal Controls Over Financial Reporting

As required by Rule 13a-15 under the Exchange Act, the Company’s management carried out an evaluation of any changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. This evaluation was carried out under the supervision and with the participation of the Company’s management, including the chief executive officer and chief financial officer. Based upon that evaluation, the Company concluded that there was no change in the Company’s internal control over financial reporting during this period that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. 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 board of directors, 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. Internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

The Securities and Exchange Commission (the “Commission”) and NASDAQ have informally inquired with the Company about the circumstances related to Bonnie K. Wachtel’s refusal to stand for re-election as a director of the Company. The Company is cooperating fully with the Commission and NASDAQ.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

(c) Issuer Purchases of Equity Securities

Period	(a) Total Number of Shares Purchased	(b) Average Price Paid per Share		(c) Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs	(d) Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs (1)
October 1 to October 31, 2005	—		—	361,371	571,387
November 1 to November 30, 2005	—		—	361,371	571,387
December 1 to December 31, 2005	18,500	$	19.12	379,871	552,887
Total	18,500	$	19.12	379,871	552,887

(1) On September 23, 2002, the Company announced a plan to repurchase up to 932,758 shares of its common stock. The stock repurchase program will be transacted over an indefinite period of time and purchases will be made as management and the Board of Directors deem prudent.

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ITEM 6. EXHIBITS

Exhibits

3.1	Articles of Restatement of the Company (Incorporated by reference to the Registration Statement on Form S-3 (File No. 333-82499) filed with the Commission on July 8, 1999).
3.2	Amended and Restated Bylaws of the Company (Incorporated by reference to the Company’s Annual Report on Form 10-K for the Fiscal Year ended September 30, 2000 filed with the Commission on December 21, 2000).
11.1	Computation of Per Share Earnings.
31.1	Certification Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934, as amended.
31.2	Certification Pursuant to Rule 13a-14(a) Under the Securities Exchange Act of 1934, as amended.
32.1	Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

SIGNATURES

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

INTEGRAL SYSTEMS, INC.

    (Registrant)

Date:	February 9, 2006	By:	/s/ THOMAS L. GOUGH
			Thomas L. Gough
			President
Date:	February 9, 2006	By:	/s/ ELAINE M. BROWN
			Elaine M. Brown
			Executive Vice President & Chief Financial Officer

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