SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549 _____________________ FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended May 31, 1998 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For The Transition Period From _____________ To _____________ _____________________ Nichols Research Corporation Commission File Number 0-15295 (Exact name of registrant as specified in its charter) _____________________ DELAWARE 63-0713665 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification no.) 4040 Memorial Parkway, South Huntsville, Alabama 35802-1326 (256) 883-1140 (Address, including zip code, of principal offices) _____________________ NO CHANGE (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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practical date. COMMON STOCK, $.01 PAR VALUE 13,271,712 SHARES OUTSTANDING ON May 31, 1998 _____________________ FORM 10-Q NICHOLS RESEARCH CORPORATION QUARTERLY REPORT FOR THE PERIOD ENDED MAY 31, 1998 INDEX Part I.FINANCIAL INFORMATION Item 1.Financial Statements Condensed Consolidated Statements of Income for the Three Months and Nine Months Ended May 31, 1998 and May 31, 1997 (Unaudited) Condensed Consolidated Balance Sheets as of May 31, 1998 and August 31, 1997 (Unaudited) Condensed Consolidated Statements of Changes in Stockholders' Equity for the Nine Months Ended May 31, 1998 and May 31, 1997 (Unaudited) Condensed Consolidated Statements of Cash Flows for the Nine Months Ended May 31, 1998 and May 31, 1997 (Unaudited) Notes to Condensed Consolidated Financial Statements (Unaudite) Item 2.Management's Discussion and Analysis of Financial Condition and Results of Operations Part II OTHER INFORMATION Item 1. Legal Proceedings Item 6. Exhibits and Reports on Form 8-K Signatures FORM 10-Q NICHOLS RESEARCH CORPORATION PART I - FINANCIAL INFORMATION Item 1 - Financial Statements CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) For the Three Months Ended For the Nine Months Ended Ended Ended May 31, May 31, May 31, May 31, 1998 1997 1998 1997 -------------------------------------------- (amounts in thousands except share data) Revenues............................. $113,429 $94,032 $284,910 $268,853 Costs and expenses: Direct and allocable costs......... 95,859 83,052 238,491 237,571 General and administrative expenses.......................... 9,112 5,851 24,807 16,360 Amortization of intangibles........ 1,196 515 3,372 1,534 Purchased in-process research and development.......... 2,000 - 2,000 - -------------------------------------------- Total costs and expenses........ 108,167 89,418 268,670 255,465 Operating profit..................... 5,262 4,614 16,240 13,388 Other income (expense): Interest expense ................... (84) (69) (272) (405) Other income, principally interest.. 162 277 744 760 Equity in earnings of unconsolidated affiliates.......... 61 140 351 420 Minority interest in consolidated subsidiaries.......... (183) 34 (677) (196) -------------------------------------------- Income before income taxes........... 5,218 4,996 16,386 13,967 Income taxes......................... 1,983 1,814 6,227 5,070 -------------------------------------------- Net income........................... $ 3,235 $ 3,182 $ 10,159 $ 8,897 ============================================ Earnings per common share............ $ .24 $ .27 $ .77 $ .77 ============================================ Earnings per common share assuming dilution................... $ .24 $ .26 $ .74 $ .73 Weighted average common shares....... 13,233,833 11,698,417 13,142,654 11,623,020 ============================================ Weighted average common shares and common equivalent shares....... 13,746,487 12,209,607 13,645,757 12,246,427 ============================================ NOTE: The Company has not declared or paid dividends in any of the periods pre- sented. All references to the number of shares and per share amounts have been restated to reflect the effect of a three-for-two stock split effective October 21, 1996. See accompanying notes. FORM 10-Q NICHOLS RESEARCH CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) May 31, August 31, 1998 1997 -------------------------- ASSETS (amounts in thousands) Current assets: Cash and temporary cash investments............ $ 7,678 $ 23,354 Accounts receivable ........................... 106,912 93,425 Deferred income taxes ......................... 2,102 2,102 Other ......................................... 3,528 3,311 -------------------------- Total current assets ........................ 120,220 122,192 Long-term investments .......................... 2,525 3,738 Property and equipment: Computers and related equipment................ 27,688 21,956 Furniture, equipment and improvements ......... 11,230 9,666 Equipment - contracts ......................... 5,771 5,771 -------------------------- 44,689 37,393 Less accumulated depreciation.................. 22,990 18,715 -------------------------- Net property and equipment................... 21,699 18,678 Deferred income taxes .......................... 749 - Goodwill and other intangibles (net of accumulated amortization) .................... 55,517 48,130 Software development costs (net of accumulated amortization) .................... 4,241 4,271 Investment in affiliates ....................... 9,473 8,363 Other assets ................................... 1,540 783 -------------------------- Total assets ................................... $ 215,964 $ 206,155 ========================== NOTE: All references to the number of shares and per share amounts have been restated to reflect the effect of three-for-two stock split effective October 21, 1996. See accompanying notes. FORM 10-Q NICHOLS RESEARCH CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) CONTINUED May 31, August 31, 1998 1997 ------------------------ LIABILITIES AND STOCKHOLDERS' EQUITY (amounts in thousands except per share data) Current liabilities: Accounts payable ............................ $ 25,058 $ 28,448 Accrued compensation and benefits............ 18,336 11,388 Income taxes payable ........................ 757 369 Current maturities of long-term debt......... 761 761 Borrowing on line of credit ................. - 10,000 Deferred revenue ............................ 5,903 3,114 Other ....................................... 608 1,534 ------------------------ Total current liabilities.................. 51,423 55,614 Deferred income taxes......................... 1,816 1,816 Long-term debt: Industrial development bonds................. 1,335 1,558 Long-term notes ............................. 1,979 2,467 ------------------------ Total long-term debt....................... 3,314 4,025 Minority interest in consolidated subsidiaries ................................ 984 307 Stockholders' equity: Common stock, par value $.01 per share Authorized - 30,000,000 and 20,000,000 shares, respectively Issued - 13,440,212 and 13,137,657 shares, respectively............................... 134 131 Additional paid-in capital .................. 93,887 90,015 Retained earnings ........................... 65,694 55,535 Less cost of treasury stock - 168,500 shares...................................... (1,288) (1,288) ------------------------ Total stockholders' equity............... 158,427 144,393 ------------------------ Total liabilities and stockholders' equity.... $ 215,964 $206,155 ========================= NOTE: All references to the number of shares and per share amounts have been restated to reflect the effect of a three-for-two stock split effective October 21, 1996. See accompanying notes. FORM 10-Q NICHOLS RESEARCH CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (UNAUDITED) Additional Total Common Stock Paid-In Retained Treasury Stockholder's Shares Amount Capital Earnings Stock Equity -------------------------------------------------------------------- (amounts in thousands except share data) For the Nine Months Ended May 31, 1998 ------------------------------------------ Balance, August 31, 1997 13,137,657 $ 131 $ 90,015 $ 55,535 $ (1,288) $144,393 Exercise of stock options 227,509 2 2,296 - - 2,298 Employee stock purchases 75,046 1 1,576 - - 1,577 Net income - - - 10,159 - 10,159 ---------------------------------------------------------------------- Balance, May 31, 1998 13,440,212 $ 134 $ 93,887 $ 65,694 $ (1,288) $158,427 ====================================================================== For the Nine Months Ended May 31, 1997 ------------------------------------------ Balance, August 31, 1996 11,651,018 $ 117 $ 59,071 $ 55,061 $ (1,288) $112,961 Exercise of stock options 205,615 2 1,854 - - 1,856 Employee stock purchases 58,752 - 1,133 - - 1,133 Net income - - - 8,897 - 8,897 ---------------------------------------------------------------------- Balance, May 31, 1997 11,915,358 $ 119 $ 62,058 $ 63,958 $ (1,288) $124,847 ====================================================================== NOTE: All references to the number of shares and per share amounts have been restated to reflect the effect of a three-for-two stock split effective October 21, 1996. See accompanying notes. FORM 10-Q NICHOLS RESEARCH CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) For the Nine Months Ended ------------------------- May 31, May 31, 1998 1997 (amounts in thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net income.................................. $ 10,159 $ 8,897 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation ............................. 4,275 2,920 Amortization of intangibles .............. 3,372 1,534 Equity in earnings of unconsolidated affiliates............................... (351) (420) Minority interest ........................ 677 281 Deferred income taxes .................... (749) - Purchased in-process research and development.............................. 2,000 - Changes in assets and liabilities net of effects of acquisitions: Accounts receivable ...................... (9,140) (37,758) Other assets ............................. (698) (2,337) Accounts payable ......................... (6,474) 25,172 Accrued compensation and benefits......... 6,291 3,190 Income taxes payable ..................... 388 (200) Other current liabilities ................ 1,127 429 -------------------------- Total adjustments ........................ 718 (7,189) -------------------------- Net cash provided by operating activities............................. 10,877 1,708 CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of property and equipment.......... (7,061) (3,242) Purchase of long-term investment............ (100) (75) Purchase of capitalized software............ (557) Payments for acquisitions, net of cash acquired.................................. (12,266) - Payments for investment in affiliates....... (1,028) (4,271) Proceeds from long-term investments......... 1,295 275 -------------------------- Net cash used by investing activities..... (19,717) (7,313) FORM 10-Q NICHOLS RESEARCH CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (CONTINUED) For the Nine Months Ended May 31, May 31, 1998 1997 ------------------------- (amounts in thousands) CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock...... 3,875 2,989 Proceeds from line of credit borrowings..... - 15,000 Payments on line of credit borrowings....... (10,000) (15,000) Payments of long-term debt.................. (711) (628) -------------------------- Net cash provided (used) by financing activities............................... (6,836) 2,361 -------------------------- Net decrease in cash........................ (15,676) (3,812) Cash and temporary cash investments at beginning of period ........................ 23,354 21,419 -------------------------- Cash and temporary cash investments at end of period............................... $ 7,678 $ 17,607 ========================== NON-CASH TRANSACTIONS: Adjustment to purchase price allocation...... $ - $ 200 See accompanying notes. FORM 10-Q NICHOLS RESEARCH CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) May 31, 1998 Note 1 - Basis of Presentation --------------------- The condensed consolidated financial statements (and all other information in this report) have not been examined by independent auditors, but in the opinion of the Company, all adjustments, consisting of the normal recurring accruals necessary for a fair presentation of the results for the period, have been made. The condensed consolidated financial statements include the accounts of Nichols Research Corporation and its majority-owned subsidiaries and joint ventures. All significant intercompany balances and transactions have been eliminated in consolidation. The Company's earnings in unconsolidated affiliates and joint ventures are accounted for using the equity method. Note 2 - Stock Split ----------- On October 9, 1996 the Board of Directors declared a three-for- two stock split which was paid to shareholders of record on October 21, 1996. The split was effected on November 4, 1996 by a stock dividend of one share for every two shares of common stock outstanding, with cash paid in lieu of fractional shares based on the stock value on record date. All references to the number of shares and per share amounts have been restated to reflect the effect of the split for all periods presented. Note 3 - Acquisition ----------- On April 15, 1998 the Company acquired 100% of the outstanding stock of Mnemonic Systems, Inc. (MSI). MSI is a systems integration company serving clients primarily within the U.S. Department of Justice. Aggregate consideration of approximately $12.3 million was paid at closing. Additional consideration is contingent upon achieving specified operating results during the twelve months following acquisition as defined in the purchase agreement. The acquisition was accounted for using the purchase method of accounting. The allocation of the excess purchase price to intangible assets includes $2.0 million to in-process research and development and $9.9 million to goodwill. The purchased in-process research and development was expensed in the third quarter and is included in the condensed consolidated statements of income for the three months and nine months ended May 31, 1998. The goodwill amount is being amortized using the straight-line method over an estimated useful life of fifteen years. FORM 10-Q NICHOLS RESEARCH CORPORATION Note 4 - Investment in Affiliates ------------------------ The Company increased its capital investment in Intertech Management Group, Inc. by approximately $528,000. As of May 31, 1998 the Company holds a 35% interest at an aggregate cost of approximately $5,663,000. The Company increased its capital investment in NCCIM, LLC by $500,000. As of May 31, 1998 the Company holds a 50% interest at an aggregate cost of approximately $1,345,000. Note 5 - Line of Credit -------------- The Company renegotiated its bank line of credit in November, 1997. The agreement provides for unsecured borrowings up to $100,000,000. The credit agreement provides for interest at London Interbank Offered Rate (LIBOR) plus a margin ranging from 0.325% to 0.450% and a facility fee, payable quarterly, of approximately 0.125% on the unused portion of the line of credit. The short-term commitment agreement ($50,000,000) is renewable annually and the long-term commitment agreement ($50,000,000) is renewable in November, 2000. There were no outstanding borrowings on this line of credit at May 31, 1998. Note 6 - New Pronouncements ------------------ In 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128, Earnings per Share. Statement 128 replaced the previously reported primary and fully diluted earnings per share with earnings per common share and earnings per common share assuming dilution. Unlike primary earnings per common share, earnings per common share excludes any dilutive effects of options, warrants, and convertible securities. Earnings per common share assuming dilution is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods have been presented, and where necessary, restated to conform to the Statement 128 requirements. FORM 10-Q NICHOLS RESEARCH CORPORATION Note 7 - Earnings Per Share ------------------ The following table sets forth the computation of earnings per common share and earnings per common share assuming dilution: For the Three Months For the Nine Months Ended Ended May 31, May 31, May 31, May 31, 1998 1997 1998 1997 ------------------------------------------------ Numerator: Net income and income available to common stockholders and income available to common stockholders after assumed conversions......... $ 3,235,000 $ 3,182,000 $10,159,000 $ 8,987,000 ================================================ Denominator: Denominator for earnings per common share-weighted average common shares....... 13,233,833 11,698,417 13,142,654 11,623,020 Effect of dilutive securities: Employee stock options.... 512,654 511,190 503,103 623,407 Denominator for earnings per common share assuming dilution - adjusted weighted average common shares and assumed conversions......... 13,746,487 12,209,607 13,645,757 12,246,427 ================================================ Earnings per common share..... $ .24 $ .27 $ .77 $ .77 ================================================ Earnings per common share assuming dilution............ $ .24 $ .26 $ .74 $ .73 ================================================ Note 8 - Reclassification ---------------- Certain prior period amounts have been reclassified to conform with the current period's presentation. FORM 10-Q NICHOLS RESEARCH CORPORATION Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations Overview and Business Environment --------------------------------- The Company is a leading provider of technical and information technology (IT) services, inlcuding information processing, systems development and systems integration. The Company provides these services to a wide range of clients, including the Department of Defense (DoD), other federal agencies, state and local governments, healthcare and insurance organizations, and commercial enterprises. The Company's business strategy consists of three key elements: (i) maintain the Company's leadership in technology; (ii) apply the Company's technology to create solutions for new clients; and (iii) make strategic acquisitions and investments to expand the business of the Company and gain industry knowledge. The Company's business and financial performance are subject to risks and uncertainties, including those discussed below. The Company is organized in four strategic business units, reflecting the particular market focus of each line of business. The Defense and Intelligence unit, formerly Nichols Federal, provides technical services primarily to U.S. government defense agencies. The Government Information Technology unit, formerly Nichols InfoFed, provides information and technology solutions and services to a variety of governmental agencies. Nichols InfoTec provides information and technology services to various commercial clients, other than healthcare clients. Nichols TXEN provides information services to clients in the healthcare and insurance industries. The Company is currently evaluating whether the services and products provided to the insurance industry should continue to be included with Nichols TXEN or reorganized into Nichols InfoTec. For the nine months ended May 31, 1998, the percentage of total revenues attributable to the four business units was approximately 55% for Defense and Intelligence, 24% for Government Information Technology, 10% for Nichols InfoTec, and 11% for Nichols TXEN. Expansion through acquisitions is an important component of the Company's overall business strategy. The Company has successfully completed nine strategic acquisitions and investments since September 1, 1994. The Company's continued ability to grow by acquisitions is dependent upon, and may be limited by, the availability of compatible acquisition candidates at reasonable prices, the Company's ability to fund or finance acquisitions on acceptable terms, and the Company's ability to maintain or enhance the profitability of any acquired business. As part of the Company's business strategy to enter new markets, the Company intends to pursue large systems integration contracts in both the government and commercial markets, although competition for such contracts is intense and many of FORM 10-Q NICHOLS RESEARCH CORPORATION the Company's competitors have greater resources than the Company. While such contracts are working capital intensive, requiring large equipment and software purchases to be funded by the Company before payment from the customer, the Company believes such contracts offer attractive revenue growth and margin expansion opportunities for the Company's range of technical expertise and capabilities. The Company's revenues and earnings may fluctuate from quarter to quarter based on such factors as the number, size, and scope of projects in which the Company is engaged, the contractual terms and degree of completion of such projects, expenditures required by the Company in connection with such projects, any delays incurred in connection with such projects, employee utilization rates, the adequacy of provisions for losses, the accuracy of estimates of resources required to complete ongoing projects, and general economic conditions. Under certain contracts, the Company is required to purchase, integrate and deliver to the customer large amounts of computer processing systems and other equipment. Revenues are accrued as costs to deliver these systems are incurred, and as a result, quarterly revenues will be impacted by fluctuations related to equipment purchases which occur on a periodic basis depending on contract terms and modifications. The Company's services are provided primarily through three types of contracts: fixed-price, time-and-materials and cost- reimbursement contracts. Fixed-price contracts require the Company to perform services under a contract at a stipulated price. Time-and-materials contracts reimburse the Company for the number of labor hours expended at an established hourly rate negotiated in the contract, plus the cost of materials incurred. Under cost-reimbursement contracts, the Company is reimbursed for all actual costs incurred in performing the contract to the extent that such costs are within the contract ceiling and allowable under the terms of the contract, plus a fee or profit. EXCEPT FOR HISTORICAL INFORMATION CONTAINED HEREIN, THIS QUARTERLY REPORT CONTAINS FORWARD-LOOKING STATEMENTS AS DEFINED IN SECTION 21E OF THE SECRUITIES EXCHANGE ACT OF 1934. SUCH FORWARD-LOOKING STATEMENTS ARE SUBJECT TO VARIOUS RISKS AND UNCERTAINTIES THAT COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. THESE RISKS AND UNCERTAINTIES ARE DISCUSSED IN FORE DETAIL IN THE COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED AUGUST 31, 1997, AND IN THE MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS SECTION OF THIS QUARTERLY REPORT. THESE FORWARD-LOOKING STATEMENTS CAN BE GENERALLY IDENTIFIED AS SUCH BECUASE THE CONTENT OF THE STATEMENTS WILL USUALLY CONTAIN SUCH WORDS AS THE COMPANY OR MANAGEMENT "BELIEVES," "ANTICIPATES," "EXPECTS," "HOPES," AND WORDS OF SIMILAR IMPORT. SIMILARILY, STATEMENTS THAT DESCRIBE THE COMPANY'S FUTURE PLANS, OBJECTIVES, GOALS OR STRATEGIES ARE FORWARD-LOOKING STATEMENTS. FORM 10-Q NICHOLS RESEARCH CORPORATION Results of Operations --------------------- The following table sets forth, for the periods indicated, the percentage which certain items in the consolidated statements of income bear to consolidated revenues: For the Three For the Nine Months Ended Months Ended May 31, May 31, May 31, May 31, 1998 1997 1998 1997 ---------------------------------------- Revenues......................... 100.0% 100.0% 100.0% 100.0% Costs and expenses: Direct and allocable costs...... 84.5 88.3 83.7 88.3 General and administrative expenses....................... 8.0 6.2 8.7 6.1 Amortization of intangibles..... 1.1 0.6 1.2 0.6 Purchased in-process research and development................ 1.8 - 0.7 - ---------------------------------------- Total costs and expenses..... 95.4 95.1 94.3 95.0 ---------------------------------------- Operating profit................. 4.6 4.9 5.7 5.0 Interest expense................. (0.0) (0.0) (0.1) (0.2) Other income, principally interest........................ 0.1 0.3 0.3 0.3 Equity in earnings of unconsolidated affilites........ 0.0 0.1 0.1 0.2 Minority interest in consolidated subsidiaries....... (0.1) (0.0) (0.2) (0.1) ---------------------------------------- Income before income taxes....... 4.6 5.3 5.8 5.2 Income taxes..................... 1.7 1.9 2.2 1.9 ---------------------------------------- Net income....................... 2.9% 3.4% 3.6% 3.3% ======================================== The Company had a backlog of approximately $1.1 billion, including options of $766.1 million, at May 31, 1998. The Company had a backlog of approximately $1.2 billion, including options of $684.4 million, at May 31, 1997. Backlog represents the amount of revenues expected to be realized from awarded contracts. Therefore, the amount in backlog is typically less than the face amount of the contract. The amount includes estimates based on the Company's experience with similar awards and customers and estimates of revenues that would be recognized from the performance of options, under existing contracts, that may be exercised by the customer. These estimates are reviewed periodically and are adjusted based on the latest available FORM 10-Q NICHOLS RESEARCH CORPORATION information. Historically, these adjustments have not been significant. Because contracts in backlog are typically multi- year contracts, an increase in backlog may not translate into proportional revenue growth in any future period. The table below presents contract award and backlog data for the periods indicated: May 31, May 31, 1998 1997 ---------------------- (amounts in thousands) Contract award amount....... $ 174,996 $ 444,309 Backlog (with options)...... $1,138,331 $1,201,087 Backlog (without options)... $ 372,212 $ 516,681 FORM 10-Q NICHOLS RESEARCH CORPORATION Comparison of Operating Results for Fiscal Third Quarter 1998 with Fiscal Third Quarter 1997 Revenues. Revenues increased $19.4 million (20.6%) for the three months and $16.1 million (6.0%) for the nine months ended May 31, 1998 as compared to the three months and nine months ended May 31, 1997. The Defense and Intelligence unit, which represents approximately 55% of consolidated revenue for the nine months ended May 31, 1998, reported an increase of $10.4 million ( 7.0%) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997, primarily as a result of continued growth in existing contract base. The Government Information Technology unit,representing approximately 24% of consolidated revenue for the nine months ended May 31, 1998, reported a decrease of $31.3 million (31.6%) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997. The decrease is due to a reduction in the number of hardware systems integrated during the current period.Nichols InfoTec revenues increased $15.1 million (127%) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997, primarily as a result of SAP software sales and integration services as well as the award of new contracts in the third quarter ended May 31, 1998. Nichols TXEN revenues have increased $21.9 million (209%) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997 primarily as a result of the acquisition of TXEN, Inc. completed in August 1997. Operating Profit. In the third fiscal quarter the Company expensed, pre-tax, $2 million of purchased in-process research and development activities related to the acquisition of Mnemonic Systems, Inc. (MSI). Operating profit, including the $2 million write-off of purchased in-process research and development, increased $0.6 million (14.0%) for the three months and $2.9 million (21.3%) for the nine months ended May 31, 1998 as compared to the three months and nine months ended May 31, 1997. Operating profit, excluding the $2 million write-off of purchased in-process research and development, increased $2.6 million (57.4%) for the three months and $4.9 million (36.2%) for the nine months ended May 31, 1998 as compared to the three months and nine months ended May 31, 1997. Direct and allocable costs during fiscal year 1998 have decreased as a percent of revenues compared to fiscal year 1997 as a result of fewer hardware purchases for systems integration contracts. General and administrative expense increased $8.5 million (51.6%) for the nine months ended May 31, 1998 compared to the nine months ended May 31, 1997, primarily as a result of the acquisition of TXEN, Inc. completed in August 1997. Amortization of intangibles increased $1.8 million (119.8%) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997 primarily as a result of the amortization of the FORM 10-Q NICHOLS RESEARCH CORPORATION intangibles recorded with the TXEN, Inc. acquisition completed in August 1997. The $2 million pre-tax write-off of purchased in-process research and development activities related to the MSI acquisition, represents 0.7% of total costs and expenses for the nine months ended May 31, 1998. Total costs and expenses were 95.4% of revenues for the three months and 94.3% for the nine months ended May 31, 1998 as compared to 95.1% for the three months and 95.0% for the nine months ended May 31, 1997. Operating Margin. Operating margin, including the $2 million write-off of purchased in-process research and development, was 4.6% for the three months and 5.7% for the nine months ended May 31, 1998 as compared to 4.9% for the three months and 5.0% for the nine months ended May 31, 1997. Operating margin, excluding the $2 million write-off of purchased in-process research and development was 6.4% for the three months and nine months ended May 31, 1998. Defense and Intelligence realized a 5.4% operating margin for the nine months ended May 31, 1998 as compared to 4.6% for the nine months ended May 31, 1997 which decrease was primarily because of the adverse affect of the completion of two significant contracts in fiscal 1997. Government Information Technology realized operating margins, excluding the $2 million write-off of purchased in-process research and development, of 6.2% for the nine months ended May 31, 1998 as compared to 5.2% for the nine months ended May 31, 1997. The improved margins are the result of increased margins on modifications awarded to existing contracts during fiscal year 1998. The $2 million write-off of purchased in-process research and development related to MSI is associated with Government Information Technology and represents a decrease of 0.7% operating margin for the nine months ended May 31, 1998. Nichols InfoTec realized operating margins of 6.2% for the nine months ended May 31, 1998 as compared to 9.8% for the nine months ended May 31, 1997. The decrease is attributable to expenses incurred in acquiring and training staff for new client projects and development of additional sales and marketing infrastructure. Nichols TXEN realized operating margins of 11.7% for the nine months ended May 31, 1998 as compared to 3.0% for the nine months ended May 31, 1997. The improved margins are the result of the managed care operations acquired with the acquisition of TXEN, Inc. completed in August 1997. Other Income (Expense). Other income (expense) decreased $426,000 for the three months and $433,000 for the nine months ended May 31 , 1998 as compared to the three months and nine months ended May 31, 1997. Other income includes equity in earnings of unconsolidated affiliates and interest income; other expense includes interest expense and minority interest. Interest income is from the investment of the Company's cash reserves. Substantially all available cash is invested in interest-bearing accounts or fixed income instruments. Interest expense is primarily from the long-term borrowings of the Company and the commitment fee on unused line of credit. Equity in earnings of unconsolidated affiliates for the nine months ended May 31, 1998 primarily represents the Company's share of the earnings of NCCIM, LLC a joint venture, 50% of which is owned by the Company; while the comparable amount for the nine months ended May 31, 1997 primarily represents the Company's share of earnings of TXEN, Inc. As of August 1997, TXEN, Inc. became a wholly-owned subsidiary of the Company. Minority interest primarily represents the minority partner's share of earnings of Nichols ENTEC, LLC a joint venture, 60% of which is owned by the Company. The increase in minority interest of $0.5 million for the nine months ended May 31, 1998 as compared to the nine months ended May 31,1997 is primarily the result of an increase in SAP software sales and integration services in this Nichols InfoTec unit. Income Taxes. Income taxes as a percentage of income before taxes was 38.0% for the nine months ended May 31, 1998 as compared to 36.3% for the nine months ended May 31, 1997. The increase is primarily a result of the differences between financial and taxable income related to the amortization of intangibles. Net Income. Net income, including the $2 million pre-tax write-off of purchased in-process research and development, increased $0.1 million (1.7%) for the three months and $1.3 million (14.2%) for the nine months ended May 31, 1998 as compared to the three months and nine months ended May 31, 1997. Net income, excluding the $2 million pre-tax write-off of purchased in-process research and development, increased $0.9 million (51.2%) for the three months and $1.9 million (37.8%) for the nine months ended May 31, 1998 as compared to the three months and nine months ended May 31, 1997. The increases are a result of the discussions above. Earnings Per Common Share Assuming Dilution. Earnings per common share assuming dilution, including the $2 million pre-tax write-off of purchased in-process research and development for the three months and nine months ended May 31, 1998 were $0.24 and $0.74 as compared to $0.24 and $0.73 for the three months and nine months ended May 31, 1997. Earnings per common share assuming dilution, excluding the $2 million pre-tax write-off of purchased in-process research and development for the three months and nine months ended May 31, 1998 were $0.33 and $0.84. Net income, including the $2 million pre-tax write-off of purchased in-process research and development, increased $1.3 million (14.2%) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997. Net income, excluding the $2 million pre-tax write-off of purchased in- process research and development, increased $1.9 million (37.8%) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997. Weighted average common shares and common equivalent shares increased 11.4% (1,399,330 shares) for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997. Liquidity And Capital Resources ------------------------------- Historically, the Company's positive cash flow from operations and available credit facilities have provided adequate liquidity and working capital to fully fund the Company's operational needs and support the acquisition program. Working capital was $68.8 million and $79.8 million at May 31, 1998 and 1997, respectively. Operating activities provided cash of $10.9 million and $1.7 million for the nine months ended May 31, 1998 and 1997, respectively. FORM 10-Q NICHOLS RESEARCH CORPORATION Investing activities used cash of $19.7 million and $7.3 million for the nine months ended May 31, 1998 and 1997, respectively. Financing activities used cash of $6.8 million for the nine months ended May 31, 1998 and provided cash of $2.4 million for the nine months ended May 31, 1997. Cash provided by operating activities increased $9.2 million for the nine months ended May 31, 1998 as compared to the nine months ended May 31, 1997. The increase is the result of increased net income ($1.3 million), an increase in the non-cash adjustments to reconcile net income to net cash provided by operations ($4.9 million) and changes in operating assets and liabilities, net of the effects of acquisitions ($3.0 million). Cash used for investing activities was $19.7 million for the nine months ended May 31, 1998. The Company acquired all of the capital stock of Mnemonic Systems, Inc. for aggregate consideration of approximately $12.3 million. Purchases of property and equipment were $7.1 million and $3.2 million for the nine months ended May 31, 1998 and 1997, respectively. The Company realized net proceeds of $1.3 million from the maturity of long-term investments. An additional $1.0 million capital investment was made for affiliates accounted for using the equity method. Cash used for financing activities was $6.8 million for the nine months ended May 31, 1998. The primary use of cash for financing activities was during the first fiscal quarter of 1998 for the repayment of $10 million indebtedness under the bank line of credit. The Company realized proceeds from the sale of common stock of $3.9 million and $3.0 million for the nine months ended May 31, 1998 and 1997, respectively. The Company renegotiated its bank line of credit in November, 1997. The agreement provides for unsecured borrowings up to $100,000,000. The credit agreement provides for interest at London Interbank Offered Rate (LIBOR) plus a margin ranging from 0.325% to 0.450% and a facility fee, payable quarterly, of approximately 0.125% on the unused portion of the line of credit. The short-term commitment agreement ($50,000,000) is renewable annually and the long-term commitment agreement ($50,000,000) is renewable in November, 2000. There were no outstanding borrowings on this line of credit at May 31, 1998. The Company is regularly evaluating potential acquisition candidates and expects to complete other transactions this fiscal year. The purchase price allocation for TXEN, Inc. was finalized during the first fiscal quarter of 1998. Of the total purchase prince of $43.8 million, $29.9 million was allocated to the following intangibles: $15.4 million to goodwill, $12.7 million to other intangibles and $1.8 million to capitalized software development. Goodwill and other intangibles of $27.4 million are being amortized using the straight-line method over an estimated useful life of twenty years. Other intangibles of $0.7 million are being amortized using the straight-line method over an estimated useful life of seven years. The amount allocated to capitalized software development is being amortized using the straight-line method over an estimated useful life of five years. The acquisition of MSI was completed during the third fiscal quarter of 1998. The MSI acquisition resulted in the write-off of $2 million, pre-tax, purchased in-process research and development and the recording of approximately $9.9 million in goodwill which is being amortized using the straight- line method over an estimated useful life of fifteen years. The Company is evaluating the realignment of certain business areas, including the insurance business activities, in the fourth quarter of fiscal 1998. In connection with this evaluation, it will be determined whether any required reductions in the carrying amount of certain intangibles will be required. The Company continues to actively pursue contracts for information system development and computer system integration activities, which could require the Company to acquire substantial amounts of computer hardware for resale or lease to customers. The timing of payments to suppliers and payments from customers under the Company's system integration contracts could cause cash flows from operations to fluctuate from period to period. The Company believes that its existing capital resources, together with available borrowing capacity, will be sufficient to fund operating needs, finance acquisitions of property and equipment, and make strategic acquisitions. Recent Accounting Pronouncements -------------------------------- In February 1997, the Financial Accounting Standards Board (FASB) issued Statement No. 128, Earnings Per Share. The overall objective of Statement No. 128 is to simplify the calculation of earnings per share (EPS) and achieve comparability with recently issued international accounting standards. The company has reported using the new EPS basis beginning in the second quarter ending February 28, 1998 and has restated all prior period EPS amounts to conform to the provisions of Statement No. 128. Effects of Inflation -------------------- Substantially all contracts awarded to the Company have been based on proposals which reflect estimated cost increases due to inflation. Historically, inflation has not had a significant impact on the Company. FORM 10-Q NICHOLS RESEARCH CORPORATION PART II - OTHER INFORMATION Item 1 - Legal Proceedings On May 31, 1996, the Company purchased all of the capital stock of Advanced Marine Enterprises, Inc. (AME), pursuant to an agreement which provides indemnification of the Company by the sellers against all damages arising out of litigation pending against AME. One of the pending cases was PRC, Inc. v. AME, et al., instituted on January 2, 1996, in the Circuit Court of Arlington, Virginia, Chancery No. 96.1, wherein PRC, Inc. alleged that, among other matters, AME and certain of its employees conspired to illegally acquire the PRC Engineering Department, including its employees, customers, property and proprietary information. The trial of the action resulted in a judgment against the defendants which was appealed to the Supreme Court of Virginia wherein the decree of the trial court was affirmed in part, reversed in part, and remanded. This matter was settled on June 17, 1998, by a payment of $5,158,119.39 to PRC from an escrow account funded by the sellers. Pursuant to a purchase agreement dated April 15, 1998, the Company purchased all of the capital stock of Mnemonic Systems, Inc. (MSI), from Artis B. Isaac (Isaac). The purchase agreement contains an indemnity from Isaac in favor of the Company against damages arising out of that certain litigation pending in the United District Court for the District of Columbia captioned Otto B. Isaac and Kathryn Isaac, Plaintiffs, v. Mnemonic Systems Inc. and Artis B. Isaac, Defendants instituted on August 8, 1996, wherein the plaintiffs alleged, among other matters, breach of contract, promissory estoppel, fraud, and negligent misrepresentation in connection with the employment of Otto B. Isaac by MSI and the subsequent termination of such employment relationship. MSI and Isaac have denied the allegations and have counterclaimed for breach of contract and fraud. In addition to the contractual indemnity, an escrow account funded by the seller in the amount of approximately $800,000 exists to secure Isaac's indemnity obligation to the Company, which the Company believes will be adequate to cover the potential liability associated with this litigation. On July 1, 1998, Forensic Technology WAI, Inc. (Forensic), filed suit against MSI in United States District Court for the Eastern District of Virginia, Alexandria Division, seeking injunctive relief, as well as monetary damages. Forensic has alleged that the Drugfire system offered by MSI and used for the examination of fired cartridges infringes a United States patent issued to Forensic on August 5, 1997. MSI believes that the Drugfire system is non-infringing, and that there are various grounds for invalidating the Forensic patent. The Company has made a claim for indemnity from Isaac pursuant to the contractual indemnity provisions of the purchase agreement. FORM 10-Q NICHOLS RESEARCH CORPORATION Item 6 - Exhibits and Reports on Form 8-K (a)Exhibits. Exhibit No. Description ----------- ----------- 10 Mnemonic Systems, Inc. Stock Purchase Agreement 27 Financial Data Schedule (b)The Company has not filed any reports on Form 8-K for the nine months ended May 31,1998. FORM 10-Q NICHOLS RESEARCH CORPORATION SIGNATURES MANAGEMENT REPRESENTATION The accompanying unaudited Consolidated Balance Sheets at May 31, 1998, and August 31, 1997 as well as the Consolidated Statements of Income, Consolidated Statements of Changes in Stockholders' Equity and Consolidated Statements of Cash Flows for the nine months ended May 31, 1998 and 1997, have been prepared in accordance with instructions to Form 10-Q and do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting only of normal recurring accruals, considered necessary for a fair presentation have been included. July 14, 1998 By:/s/ Allen E. Dillard ---------------------- ----------------------- Date Allen E. Dillard Vice President and Chief Financial Officer (Principal Finance and Accounting Officer) 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 thereunto duly authorized. NICHOLS RESEARCH CORPORATION July 14, 1998 By:/s/ Allen E. Dillard ------------------- -------------------- Date Allen E. Dillard Vice President and Chief Financial Officer (Principal Finance and Accounting Officer)