MANTECH INTERNATIONAL CORP - Quarter Report: 2004 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

or

For the transition period from                      to                     

Commission File No. 000-49604

ManTech International Corporation

(Exact name of registrant as specified in its charter)

(703) 218-6000

(Registrant’s telephone number, including area code)

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

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

                                          x Yes ¨ No

As of November 1, 2004, there were issued and outstanding 17,320,616 shares of our Class A Common Stock and 15,075,293 shares of our Class B Common Stock.

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MANTECH INTERNATIONAL CORPORATION

FORM 10Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

INDEX

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PART I – FINANCIAL INFORMATION

MANTECH INTERNATIONAL CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Thousands)

See notes to condensed consolidated financial statements.

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MANTECH INTERNATIONAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Thousands except Per Share Amounts)

See notes to condensed consolidated financial statements.

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MANTECH INTERNATIONAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in Thousands)

See notes to condensed consolidated financial statements.

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MANTECH INTERNATIONAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Thousands)

See notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2004

(Dollars in thousands, except per share amounts or where otherwise noted)

UNAUDITED

1. Introduction and Overview

ManTech International Corporation (depending on the circumstances, “ManTech”, “we” or “our”) is a leading provider of innovative technologies and solutions for mission-critical national security programs for the intelligence community, the Department of Defense, the Department of State, the Department of Justice, the Department of Homeland Security and other federal government customers. Our expertise includes software development, enterprise security architecture, information assurance, intelligence operations support, network and critical infrastructure protection, information technology, communications integration and engineering support. With more than 5,400 highly qualified employees, we operate in the United States and over 40 countries worldwide.

2. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and note disclosures normally included in the annual financial statements, prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to those rules and regulations. We recommend that you read these unaudited condensed consolidated financial statements in conjunction with the financial statements and related notes included in our annual report on Form 10-K for the fiscal year ended December 31, 2003, previously filed with the SEC. We believe that the unaudited condensed consolidated financial statements in this Form 10-Q reflect all adjustments that are necessary to fairly present the financial position, results of operations and cash flows for the interim periods. The results of operations for such interim periods are not necessarily indicative of the results for the full year.

Stock-Based Compensation—As permitted under Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, we account for our stock-based compensation plan using the intrinsic value method under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. For the quarter ended September 30, 2004, we recognized pre-tax compensation expense of approximately $14 thousand. No compensation cost was recognized for issuances under the plan in the quarter ended September 30, 2003, and the exercise price of all other options granted pursuant to the plan was not less than 100% of the fair market value of the shares on the date of grant. In accordance with the provisions of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, the following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share data).

We typically issue 10-year options that vest annually over a three-year period from the date of grant. For disclosure purposes, the fair value of each option is estimated on the date of grant using the Black-Scholes option-pricing model. The following weighted-average assumptions were used for option grants during the three months ended September 30, 2004 and 2003, respectively: dividend yield of zero percent; expected volatility of 44.0% and 34.9%; expected average lives of 3 years; and risk-free interest rates of 2.89% and 2.20%.

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3. Earnings per Share

Basic earnings per share has been computed by dividing net income by the weighted average number of common shares outstanding during each period. Shares issued during the period and shares re-acquired during the period, if any, are weighted for the portion of the period for which they were outstanding. Diluted earnings per share have been computed in a manner consistent with that of basic earnings per share, while giving effect to all potentially dilutive common shares that were outstanding during each period. The weighted average number of common shares outstanding is computed as follows:

Options to purchase 2.4 million and 0.1 million shares of common stock were outstanding at September 30, 2004 and September 30, 2003, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive.

4. Goodwill and Other Intangibles

Effective January 1, 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS 142 requires, among other things, the discontinuance of goodwill amortization. Under SFAS 142, goodwill is to be reviewed at least annually for impairment; we have elected to perform this review annually during the second quarter each calendar year. These reviews resulted in no adjustments in goodwill.

During 2004, we completed the purchase price allocation of the assets acquired in the Integrated Data Systems Corporation (IDS) transaction. Pursuant to the valuation, there was no change to the amount of the total intangible assets; however, we reclassified $4.6 million of the allocated purchase price from goodwill to other intangibles for amounts related to contract backlog, customer relationships and capitalized software. The impact related to adjustments in amortization expense for these intangibles was not significant.

In February and June 2004, we acquired certain assets from Affiliated Computer Services, Inc. (ACS), for $6.5 million and $1.5 million, respectively. The assets acquired from ACS include contracts for providing support to the U.S. Air Force and North Atlantic Treaty Organization (NATO), as well as the employees who had worked on the contracts. In September 2004, we completed the allocation of the $8.0 million total purchase price, classifying $5.0 million in goodwill and $3.0 million in other intangibles based on an independent appraisal. As a result of this classification we recorded a reduction of amortization expense of $673 thousand during the third quarter of 2004. Recognition of goodwill is largely attributed to the highly-skilled employees we obtained from the ACS acquisitions. No liabilities were assumed as a result of these acquisitions.

The components of goodwill and other intangibles are as follows (in thousands):

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As of September 30, 2004, we had intangibles that consisted of the following (in thousands):

For the three months ended September 30, 2004, we had aggregate amortization expense of $0.3 million. We estimate that we will have the following amortization expense for the future periods indicated below (in thousands):

5. Business Segment and Geographic Area Information

ManTech operates as one segment, delivering a broad array of information technology and technical services solutions under contracts with the U.S. Government, state and local governments, and commercial customers. Our U.S. Government customers typically exercise independent contracting authority, and even offices or divisions within an agency or department may directly, or through a prime contractor, use our services as a separate customer, so long as that customer has independent decision-making and contracting authority within its organization. For example, under a blanket purchasing agreement that we have with one of the Army’s contracting agencies, program managers throughout the Army and from other services and defense agencies are able to purchase a wide range of our solutions. Even though task orders under this agreement together accounted for 14.4% and 8.0% of our revenues for the quarters ended September 30, 2004 and September 30, 2003, respectively, no single task order represented more than 6.3% and 4.8% of our revenues during those same periods. One customer, noted below, accounted for 8.5% and 10.9% of our accounts receivable as of September 30, 2004 and December 31, 2003, respectively. In addition, there were no sales to any customers within a single country (except for the United States) where the sales accounted for 10% or more of total revenue. We treat sales to U.S. Government customers as sales within the United States regardless of where the services are performed. Substantially all assets of continuing operations were held in the United States for the periods ended September 30, 2004 and 2003. Revenues by geographic customer and the related percentages of total revenues for the periods ended September 30, 2004 and 2003 were as follows (in thousands):

Our ManTech MSM Security Services, Inc. (MSM) subsidiary conducts personal security investigations (PSI’s) pursuant to our contract with the Defense Security Service (DSS). In response to the government’s request to substantially increase the number of cases assigned to us, from 35 cases per day to 425 per day, we significantly expanded our operations at MSM. However, these cases proved to be significantly more complex than anticipated, requiring substantially more work to complete these cases than our prior experience indicated. An adjustment to reduce unbilled revenue by $11.3 million was recorded in the second quarter of 2004 due to a change in estimate of revenue earned and level of work to be completed under this contract. We made a further

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reduction of unbilled revenue of $1.9 million to reflect our revised estimate of remaining workflow under this contract during the same period. Because of the fixed-price nature of the contract, the increased costs associated with this contract reduced our earnings and, for the second quarter of 2004, these adjustments resulted in an approximate $13.2 million reduction in operating income, a $7.9 million reduction in net income, and a $0.25 reduction in earnings per share for the changes in estimate. In addition, the final contract results will depend on many factors, including negotiations with the customer; we estimated future costs on this contract could exceed expected revenues by a range of approximately $4 million to $7 million. Accordingly, we recorded an estimated contract loss of $4.7 million for this contract in the second quarter of 2004, which reflects our best estimate of loss under the circumstances, due to estimated future contract costs exceeding expected revenues. During the third quarter of 2004, we utilized approximately $3.1 million of the $4.7 million estimated contract loss. On September 27, 2004, the government requested us to close out the DSS contract and cease investigative work on PSI’s that had been assigned to us under this contract and to submit both completed and incomplete investigations. The final settlement for payment with respect to incomplete investigations will depend on our negotiations with the customer. At September 30, 2004, the total receivable balance for this contract was $18.1 million, including $15.5 million in unbilled. The following table is in thousands:

The DSS contract loss for the three months ended September 30, 2004 was attributable to expenses that had not been included in the estimated contract loss. These expenses are largely attributable to general and administrative expenses, and severance expenses. Disclosure items required under SFAS No. 131 including interest revenue, interest expense, depreciation and amortization and expenditures for segment assets are not applicable, as we review those items on a consolidated basis.

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6. Revenues and Receivables

ManTech delivers a broad array of information technology and technical services solutions under contracts with the U.S. Government, state and local governments, and commercial customers. Revenues from the U.S. Government under prime contracts and subcontracts, as compared to total contract revenues, were approximately 98.2% and 97.8% for the periods ended September 30, 2004 and 2003, respectively. The components of contract receivables are as follows (in thousands):

Revenues recorded in excess of milestone billings on fixed-price contracts consist of amounts not expected to be billed within the next month. Amounts currently billable consist principally of amounts to be billed within the next month. Indirect costs incurred in excess of provisional billing rates on U.S. Government contracts are generally billable at actual rates less a reduction of 0.5% of the actual general and administrative rate base before a Defense Contract Audit Agency (DCAA) audit is completed. The balance remaining, as well as any retainage, is billable upon completion of the DCAA audit. Revenues recorded in excess of estimated contract value or funding are billable upon receipt of contractual amendments or other modifications. At September 30, 2004, the amount of receivables that we expect to collect after one year is $6.4 million.

7. Stockholders’ Equity

Follow-on Public Offering — ManTech closed its follow-on public offering on December 20, 2002. Our net proceeds were approximately $90.9 million, after deducting the estimated expenses related to the offering and the portion of the underwriting discount payable by us. Proceeds from the offering were used in 2003 to fund our acquisition of IDS and MSM, on February 28, 2003 and March 5, 2003, for $62.7 million and $4.9 million, respectively.

8. Commitments and Contingencies

Payments to us on cost-reimbursable contracts with the U.S. Government are provisional payments subject to adjustment upon audit by the DCAA. Audits through 2001 have been completed and resulted in no material adjustments. The audits for 2002 and 2003 are not expected to have a material effect on the results of future operations.

In the ordinary course of business, ManTech is involved in certain governmental and legal proceedings, claims and disputes, and has litigation pending under several suits. Management believes that the ultimate resolution of these matters will not have a material effect on our financial position or results of operations.

9. Acquisitions

Integrated Data Systems Corporation — On February 28, 2003, we acquired 100 percent of the outstanding common stock of IDS. The results of operations for IDS have been included in our consolidated financial statements since that date. Founded in 1990, IDS delivers technology solutions and products in four core areas: software development, systems engineering/networking, information assurance, and government acquisition/procurement support software. IDS has developed secure, advanced messaging and collaboration applications and solutions in support of a wide variety of national security networks and systems. IDS is also one of Microsoft’s leading certified partners supporting U.S. Government classified intelligence community programs.

The cash purchase price of approximately $62.7 million, net of cash on hand of $2.8 million, and excluding $1.0 million of acquisition-related costs, is subject to an earnout provision. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, as adjusted for the completion of the valuation of assets (in thousands):

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Intangible assets acquired included: contract rights, customer relationships and software in the amounts of $1.8 million, $10.1 million and $270 thousand, respectively. Amounts are being amortized using weighted average lives of 2 years, 12.5 years and 2.5 years, respectively.

ManTech MSM Security Services, Inc. — On March 5, 2003, ManTech acquired 100 percent of the outstanding common stock of MSM, a Maryland-based provider of PSI services to the U.S. Government. Pursuant to the acquisition agreement, we included the results of operations for MSM in its consolidated financial statements effective March 1, 2003. MSM specializes in PSI services for the U.S. Government, having completed over 250,000 background investigations since its founding in 1978. MSM has active investigation contracts to support various federal government agencies.

The cash purchase price was approximately $4.9 million, which excludes $0.2 million of acquisition-related costs and an earnout provision.

Acquisition of Certain Assets from Affiliated Computer Services, Inc. — On February 8, 2004, ManTech acquired certain operations from ACS, a provider of systems engineering, network administration, program management, and communications systems support to Department of Defense customers for $6.5 million. The assets acquired from ACS include contracts for providing support to the U.S. Air Force Electronic Systems Center’s Information Technology Services Program. Services provided through these contracts include information technology services, such as program management, systems engineering, network engineering and administration, test and evaluation, and data management.

On June 1, 2004, we acquired additional assets from ACS for $1.5 million. The assets acquired from ACS include contracts for providing support to NATO.

The following table summarizes the estimated fair value of the assets acquired at the date of acquisition, based on an independent appraisal. No liabilities were assumed.

10. Debt

On February 25, 2004, we executed the Amended and Restated Credit and Security Agreement with Citizens Bank of Pennsylvania, KeyBank National Association, Branch Banking and Trust Company of Virginia, Chevy Chase Bank, F.S.B., and Riggs Bank, N.A., in order to increase the capacity available under our prior loan agreement. The agreement initially provides for a $125 million revolving credit facility that can be increased to $200 million. The maturity date of the agreement is February 25, 2009. Under the agreement, we are required to maintain specified financial covenants relating to asset coverage, fixed charge coverage, and debt coverage. The agreement also places limitations on additional borrowings, mergers, and related-party transactions, payment of dividends, and contains limitations with respect to capital expenditures. Borrowings under the agreement are collateralized by our assets and bear interest at the London Inter-Bank Offer Rate (LIBOR), or the lender’s base rate, plus market-rate spreads that are determined based on a company leverage ratio calculation. As of September 30, 2004, we were in compliance with all covenants under the Credit Agreement.

Introduction and Overview

ManTech is a leading provider of innovative technologies and solutions for mission-critical national security programs for the intelligence community, the Department of Defense, the Department of State, the Department of Justice, the Department of Homeland Security and other federal government customers. Our expertise includes software development, enterprise security architecture, information assurance, intelligence operations support, network and critical infrastructure protection, information technology, communications integration and engineering support. With more than 5,400 highly qualified employees, we operate in the United States and over 40 countries worldwide.

We derive revenue primarily from contracts with U.S. Government agencies that are focused on national security. As a result, funding for our programs and services are generally linked to trends in U.S. Government spending in the areas of defense, intelligence and homeland security. Leading up to and following the terrorist events of September 11, 2001, the U.S. Government substantially increased its overall defense, intelligence and homeland security budgets. Hence, our focus on national security corresponds with our customers’ objective to safeguard the nation. Our business has also benefited from the U.S.

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Government’s increased need for specialized support of ongoing and mission-critical operations, due in part to the growing complexity of technology. In the third quarter of 2004, our revenue was increased by $17.2 million as a result of our expansion of the logistical readiness, telecommunications, infrastructure, maintenance, repair and sustainment support provided in military deployed environments with U.S. and allied forces in support of peace-keeping efforts worldwide.

During the second quarter of 2004, we faced challenges associated with our personnel security investigations (PSI’s) business at our ManTech MSM Security Services, Inc. (MSM) subsidiary. In response to the government’s request to substantially increase the number of cases assigned to us, from 35 cases per day to 425 cases per day, pursuant to our contract with the Defense Security Service (DSS), we significantly expanded our operations at MSM. However, these cases proved to be significantly more complex than anticipated, requiring substantially more work to complete than our prior experience indicated. Because of the fixed-price nature of the contract, the increased costs associated with this contract reduced our earnings and, for the second quarter, we recorded an estimated contract loss of $4.7 million for this contract. Out of the $4.7 million estimated contract loss, we utilized approximately $3.1 million in the third quarter of 2004. On September 27, 2004, the government requested us to close out the DSS contract and cease investigative work on PSI’s that had been assigned to us under this contract and to submit both completed and incomplete investigations. The final settlement for payment with respect to incomplete investigations will depend on our negotiations with the customer. At September 30, 2004, the total receivable balance net of reserves for this contract was $18.1 million, including $15.5 million in unbilled.

During the third quarter of 2004, our other operations had revenues of $207.4 million, including $8.5 million from the operations purchased from ACS. This third quarter revenue represents a 22.9% increase or $38.7 million over the results for our other operations during the comparable period of 2003. Approximately $30.2 million of the increase was primarily due to an increase in our work under contracts with the Department of Defense and various intelligence agencies. For these operations, cost of services grew by 21.9%, as we added personnel from recent acquisitions and experienced higher pass-though costs in the quarter. Operating income for these operations grew by 39.2%, to $17.6 million, including $1.0 million related to operations purchased from ACS, and net income for these operations grew by 43.8% to $10.2 million.

The following table presents certain operational performance measures for our MSM subsidiary, our other businesses (i.e., excluding MSM), and ManTech on a consolidated basis. This information provides additional insight into the impact of MSM’s performance on ManTech’s consolidated results for the three and nine months ended September 30, 2004.

Three Months Ended September 30, 2004 Compared to the Three Months Ended September 30, 2003

Our increase in revenue is ultimately as a result of the increased spending for national security and homeland security. We also generated an increase in revenue resulting from the recent acquisition of operations from ACS. Revenue in our business, excluding MSM, grew to $207.4 million during the quarter, from $168.8 million for the same period last year.

Revenues

Revenues increased 16.3% to $211.3 million for the three months ended September 30, 2004, compared to $181.6 million for the same period in 2003. Part of this increase in revenue was due to the operations purchased from ACS in the first and second quarters of 2004, which added $8.5 million in revenue. Our revenue was increased by $17.2 million as a result of our expansion of the logistical readiness, telecommunications, infrastructure, maintenance, repair and sustainment support provided in military

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deployed environments with U.S. and allied forces in support of peace-keeping efforts worldwide. An additional $13.0 million of the increase in revenue was due to the other contracts with the Department of Defense and various intelligence agencies. Offsetting these increases was a decrease in revenues of $9.0 million on MSM, compared to the same period in 2003. We derived approximately 44.6% of our revenue for the three months ended September 30, 2004 from work under GSA schedule contracts, compared with approximately 43.9% for the same period in 2003. Subcontracts accounted for 13.9% of our revenue for the three months ended September 30, 2004, compared with 10.2% for the same period in 2003. We anticipate that quarterly revenues for our contracts with the Department of Defense and various intelligence agencies will continue at this level, or slightly higher levels, largely because of the United States’ continuing efforts on the war on terrorism, and the specialized advanced information technology skills that we offer.

Cost of services

Cost of services increased 19.6% to $176.4 million for the three months ended September 30, 2004, compared to $147.5 million for the same period in 2003. Over $7 million of this increase in cost of services was incurred on contracts purchased from ACS. An additional $21.7 million of this increase in cost of services was generated through contracts with the Department of Defense and various intelligence agencies. As a percentage of revenues, cost of services increased 2.3%, to 83.5% for the three months ended September 30, 2004, compared to 81.2% for the same period in 2003. Direct labor costs increased by 23.6%, primarily due to additional personnel from acquisitions, direct new hires and increased salaries. For the three months ended September 30, 2004, other direct costs increased by 11.5% over third quarter 2003, from $59.8 million to $66.7 million. As a percentage of revenues, other direct costs decreased slightly from 32.9% for the three months ended September 30, 2003 to 31.6% for the same period in 2004.

Gross profit

Gross profit increased 2.2% to $34.9 million for the three months ended September 30, 2004, compared to $34.1 million for the same period in 2003. Gross profit margin was 16.5% for the three months ended September 30, 2004, compared to 18.8% for the same period in 2003. Gross profit for the third quarter 2004 was impacted by a $9.0 million decrease in revenue from MSM, while cost of services only decreased $1.8 million for MSM. Time-and-materials contracts and fixed-price contracts comprised 72.0% of revenues for the three months ended September 30, 2004, compared with 66.5% for same period in 2003.

General and administrative

General and administrative expenses increased 22.3% to $20.5 million for the three months ended September 30, 2004, compared to $16.7 million for the same period in 2003. The increased expenses reflect additional management personnel and infrastructure related to our acquisitions and expansions that are necessary to support the growth of our business. As a percentage of revenues, general and administrative expenses increased to 9.7% for the three months ended September 30, 2004, compared to 9.2% for the same period in 2003.

Depreciation and amortization

Depreciation and amortization expense decreased 28.5% to $0.8 million for the three months ended September 30, 2004, compared to $1.2 million for the same period in 2003. This decrease was due primarily to a reverse of amortization expenses related to the operations purchased from ACS. The independent appraisal of the assets acquired from ACS was completed during third quarter 2004, which resulted in a $5.0 million addition to goodwill and a $5.0 million reduction in amortizable intangible assets.

Income from operations

Income from operations decreased 16.3% to $13.6 million for the three months ended September 30, 2004, compared with income of $16.2 million for the same period in 2003. Income from operations is lower, primarily due to the $9.0 million decrease in revenues at MSM that resulted in a $2.4 million net loss at MSM for the quarter ended September 30, 2004.

Interest Income (Expense), net

Interest expense, net, decreased to $523 thousand for the three months ended September 30, 2004, compared with $618 thousand for the same period in 2003. The decrease in interest expense is a result of interest revenue from letters of credit granted as discussed in the Off-Balance Sheet Arrangements section. The average levels of indebtedness were approximately $31.4 million and $25 million, in the three months ended September 30, 2004 and September 30, 2003, respectively.

Other Income (Expense)

Other income for the third quarter of 2004 of $162 thousand consisted primarily of income from an investment in a joint venture offset by foreign currency conversion losses. In the third quarter of 2003, a $58 thousand loss was due primarily to investment in a joint venture.

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Net income

Net income decreased 15.3% to a $7.8 million for the three months ended September 30, 2004, compared to $9.2 million in net income for the same period in 2003. The decrease resulted from $2.6 million less in operating income, offset by decreased income tax expense of $0.9 million. Our effective tax rate for the three months ended September 30, 2004 and September 30, 2003 was 40.9% and 40.7%, respectively.

Nine Months Ended September 30, 2004 Compared to Nine Months Ended September 30, 2003

Revenues

Revenues increased 20.9% to $612.6 million for the nine months ended September 30, 2004, compared to $506.8 million for the same period in 2003. Our revenue was increased by $47.5 million as a result of our expansion of the logistical readiness, telecommunications, infrastructure, maintenance, repair and sustainment support provided in military deployed environments with U.S. and allied forces in support of peace-keeping efforts worldwide. Approximately $30.0 million of this increased revenue is attributable to year-to-date revenues from acquisitions of IDS in early 2003, and from operations purchased from ACS in the first and second quarters of 2004. In addition, we derived approximately $10 million in revenue from our contract to support relocation of a U.S. Army Special Operations Command Center. The remaining amount of increase is due to increased work from Department of Defense and various intelligence agencies. Offsetting these increases was $11.8 million decrease in revenues at MSM as previously discussed.

We derived approximately 44.1% of our revenues for the nine months ended September 30, 2004 from work under GSA schedule contracts, compared with approximately 40.0% for the same period in 2003. Subcontracts accounted for 13.4% of our revenue for the nine months ended September 30, 2004, compared with 10.2% for the same period in 2003.

Cost of services

Cost of services increased 27.5% to $524.8 million for the nine months ended September 30, 2004, compared to $411.6 million for the same period in 2003. As a percentage of revenues, cost of services increased from 81.2% to 85.7%, or 4.5% of revenue. The increase by 4.5% of revenue is due primarily to the $11.8 million decrease in revenues at MSM and a $16.6 million increase in cost of services at MSM, which includes the $4.7 million contract loss recorded in the second quarter of 2004. Excluding MSM, cost of services as a percentage of revenue remained the same at 81.8% for both 2004 and 2003. Direct labor costs excluding MSM increased by 22.1% due to an increase in personnel, primarily related to our acquisitions and direct new hires and increased salaries. For the nine months ended September 30, 2004, other direct costs including MSM increased by 30.3% over the first nine months of 2003, from $162.5 million to $211.7 million. This increase was attributable to an increase in pass-through costs in 2004 over 2003, the $4.7 million contract loss noted above, year-to-date results from IDS, and costs incurred on contracts purchased from ACS. As a percentage of revenues, other direct costs including MSM increased to 34.6% for the nine months ended September 30, 2004 from 32.1% for the same period in 2003. Over $25 million of this increase in cost of services is attributable to a full three quarters of cost from IDS, and cost incurred on operations purchased from ACS during the first and second quarters of 2004.

Gross profit

Gross profit decreased 7.7% to $87.8 million for the nine months ended September 30, 2004, compared to $95.2 million for the same period in 2003. Gross profit margin decreased to 14.3% for the nine months ended September 30, 2004, compared to 18.8% for the same period in 2003. The decrease in the gross profit margin was primarily the result of the $11.8 million decrease in revenues at MSM and a $16.6 million increase in cost of services, noted above. This profit reduction was partially offset by a one-time profit of $1.0 million on a fixed-price contract attributable to performance improvements taken in the first quarter of 2004. Time-and-materials and fixed-price contracts comprised 70.7% of revenues for the nine months ended September 30, 2004, compared with 64.9% for the same period in 2003.

General and administrative

General and administrative expenses increased 24.9% to $59.6 million for the nine months ended September 30, 2004, compared to $47.7 million for the same period in 2003. The increased expenses reflect additional management personnel and infrastructure related to our acquisitions that support the growth of the business. In addition, we recorded $800 thousand in costs related to terminating a lease agreement for an idle facility. As a percentage of revenues, general and administrative expenses increased to 9.7% for the nine months ended September 30, 2004 from 9.4% for the same period in 2003.

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Depreciation and amortization

Depreciation and amortization expense increased 6.3% to $3.6 million for the nine months ended September 30, 2004, compared to $3.4 million for the same period in 2003. The increase resulted primarily from an additional $0.2 million of amortization of intangible assets established in connection with our recent acquisitions.

Income from operations

Income from operations decreased 44.1% to $24.7 million for the nine months ended September 30, 2004, compared with $44.2 million for the same period in 2003. The decrease was primarily a result of the losses at MSM, noted above.

Net income

Net income decreased 44.3% to $14.0 million for the nine months ended September 30, 2004, compared to $25.1 million for the same period in 2003. Our effective tax rate for the three months ended September 30, 2004 and September 30, 2003 was 40.9% and 40.6%, respectively.

Backlog

At September 30, 2004 and December 31, 2003, our backlog was $1.5 billion and $1.5 billion, respectively, of which $466 million and $375 million, respectively, was funded backlog. At September 30, 2003, our backlog was $1.5 billion, of which $411 million was funded backlog. Backlog and funded backlog represent estimates that we calculate on a consistent basis. Additional information on how we determine backlog is included in our annual report on Form 10-K for the fiscal year ended December 31, 2003, previously filed with the SEC.

Liquidity and Capital Resources

Our primary source of liquidity is cash provided by operations and our $125.0 million revolving credit facility. At September 30, 2004, we had outstanding loans of $25.0 million under the credit facility. Generally, cash provided by operating activities is adequate to fund our operations. We maintain a $25.0 million outstanding loan balance, related to our interest rate swap agreements, which has a fixed rate of 6.83%. In addition, due to fluctuations in our cash flows and the growth in the operations, it is necessary from time to time to borrow above the $25.0 million level. In the future, we may borrow greater amounts in order to finance acquisitions or major new contract start ups. Net proceeds of $67.6 million from our follow-on public offering in 2002 were used to fund our acquisitions and related expenses of IDS and MSM during the first quarter of 2003.

Net cash flows from operating activities

Cash provided by operating activities for the nine months ended September 30, 2004 was $19.7 million, compared to $8.7 million of cash provided by operating activities for the nine months ended September 30, 2003. In the nine months ended September 30, 2004, cash provided by operating activities was increased and is primarily the result of improvement in billing and collection processes of newly-acquired subsidiaries’ contracts receivables and increase in accrued liabilities.

Net cash flows from investing activities

Cash used in investing activities of operations was $14.7 million for the nine months ended September 30, 2004, compared to $72.5 million for the same period in 2003. Investing activities in the first nine months of 2004 included the acquisitions of certain assets from ACS for $8.0 million, a $2.9 million payment for an earnout on a prior year’s acquisition, and purchases of property of $4.1 million. Investing activities in the first nine months of 2003 included the acquisitions of IDS and MSM for $62.7 million and $4.9 million, respectively; purchases of property and equipment of $2.8 million; and investments in intellectual property of $1.5 million. Investing activities have primarily consisted of investments in intellectual property, acquisitions of businesses, and purchases of property and equipment. In the future, we expect to continue with selective acquisitions that are consistent with our strategic plan for growth.

Net cash flows from financing activities

Cash provided by financing activities was $3.1 million for the nine months ended September 30, 2004, compared to cash used in financing activities of $0.08 million for the nine months ended September 30, 2003. The net cash provided in the first nine months of 2004 resulted primarily from a decrease in our borrowings of $182 thousand and proceeds from the exercise of stock options of $3.2 million. The cash provided by financing activities was primarily used for the acquisitions. The net cash used in the first nine months of 2003 resulted primarily from our payment of the final installment of a not-to-compete financing offset by proceeds received from employees upon the exercise of stock options.

Credit Agreement

On February 25, 2004, we executed the Amended and Restated Credit and Security Agreement with Citizens Bank of Pennsylvania, KeyBank National Association, Branch Banking and Trust Company of Virginia, Chevy Chase Bank, F.S.B., and Riggs Bank, N.A., in order to increase the capacity available under our prior loan agreement. The agreement initially provides for a $125 million revolving credit facility that can be increased to $200 million. The maturity date of the agreement is February 25,

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2009. Under the agreement, we are required to maintain specified financial covenants relating to asset coverage, fixed charge coverage, and debt coverage. The agreement also places limitations on additional borrowings, mergers, and related-party transactions, payment of dividends, and contains limitations with respect to capital expenditures. Borrowings under the agreement are collateralized by our assets and bear interest at the London Inter-Bank Offer Rate (LIBOR), or the lender’s base rate, plus market-rate spreads that are determined based on a company leverage ratio calculation. To manage our exposure to the fluctuations in these variable interest rates, we executed an interest swap in December 2001. The swap agreement has a notional principal amount of $25.0 million and currently has a fixed LIBOR rate of 6.83%. As of September 30, 2004, we were in compliance with all material covenants under the Credit Agreement.

We believe the capital resources available to us under our credit agreements and cash from our operations are adequate to fund our ongoing operations and to support the internal growth we expect to achieve for at least the next 12 months. We anticipate financing our external growth from acquisitions and our longer-term internal growth through one or more of the following sources: cash from operations; additional borrowing; issuance of equity; use of the existing revolving facility; or a refinancing of our credit facilities.

Off-Balance Sheet Arrangements

Effective September 20, 2003, our lenders issued two letters of credit to Fianzas Guardiana Inbursa, S.A. (FGI) on behalf of GSE Systems, Inc. (GSE). The first letter of credit supports an advance payment bond of approximately $1.8 million, issued by FGI to a customer of GSE’s power business, and has a term of 30 months. The second letter of credit supports a performance bond of approximately $1.3 million issued by FGI to the same customer, and has a term of 42 months. FGI can draw upon both letters of credit in the event that the performance bonds are drawn on by the customer, which would only occur in the event of a contractual default by GSE. In the event that the letters of credit are drawn upon, we have entered into a collateral agreement with GSE whereby GSE has agreed to indemnify us from any and all costs, damages, claims, actions, demands, losses and expenses (including the value of the letters of credit drawn upon, reasonable attorneys’ fees, collection fees or enforcement fees). In exchange for issuing the letters of credit, we received 100,000 warrants to purchase GSE’s common stock at the market price of GSE’s common stock on the close of business on July 8, 2003, and will receive a 7% annual fee, payable on a quarterly basis, calculated on the total amount of the then-existing value of the letters of credit.

In accordance with Financial Accounting Standards Board Interpretation No. 45, we have established a $3.1 million long-term liability for these guarantees and have increased the carrying value of our investment in GSE by an equivalent amount.

George J. Pedersen, our Chairman of the Board and Chief Executive Officer, and John A. Moore, our Executive Vice President, each beneficially own shares and options of GSE stock representing less than 5% of GSE. Messrs. Pedersen and Moore also both serve on GSE’s board of directors and are members of its compensation committee.

Discontinued Operations

In September 2001, we decided to exit certain lines of business involving foreign operations or operations that primarily serve commercial customers. Since then, we have disposed of several of our businesses and have classified them as discontinued operations in our consolidated financial statements. We disposed all of these businesses prior to December 31, 2002, except our Australia-based software solutions business, which we sold in February 2003.

Critical Accounting Estimates and Policies

Critical accounting policies are defined as those policies that reflect significant judgments and uncertainties, and can potentially result in materially different results under different assumptions and conditions. Application of these policies is particularly important to the portrayal of our financial condition and results of operations.

Revenue Recognition and Cost Estimation

We recognize revenue when persuasive evidence of an arrangement exists, services have been rendered, the contract price is fixed or determinable, and collectibility is reasonably assured. We have a standard internal process that we use to determine whether all required criteria for revenue recognition have been met. This standard internal process includes a monthly review of contract revenues and expenses by several levels of management. This review covers, among other matters, progress against schedule, project staffing and levels of effort, risks and issues, subcontract management, incurred and estimated costs, and disposition of prior action items, and is designed to determine whether the overall progress on a contract is consistent with the effort expended and revenue recognized to date.

Our revenues consist primarily of payments for the work of our employees, and to a lesser extent, the pass through of costs for materials and subcontract efforts under contracts with our customers. Cost of services consists primarily of compensation expenses for program personnel, the fringe benefits associated with this compensation, and other direct expenses incurred to complete programs, including cost of materials and subcontract efforts.

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We derive the majority of our revenue from cost-plus-fixed-fee, cost-plus-award-fee, firm-fixed-price, or time-and-materials contracts. Absent evidence to the contrary, we recognize revenue as follows: revenues for cost-reimbursement contracts are recorded as reimbursable costs are incurred, including a pro-rata share of the contractual fees. For time-and-material contracts, revenue is recognized to the extent of billable rates times hours delivered plus material and other reimbursable costs incurred. For long-term fixed-price production contracts, revenue is recognized at a rate per unit as the units are delivered, or by other methods to measure services provided. Revenue from other long-term fixed-price contracts is recognized ratably over the contract period or by other appropriate methods to measure services provided. Contract costs are expensed as incurred except for certain limited long-term contracts noted below. For long-term contracts which are specifically described in the scope section of American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) No. 81-1, “Accounting for Performance of Construction Type and Certain Production-Type Contracts,” or other appropriate accounting literature we apply the percentage of completion method. Under the percentage of completion method, income is recognized at a consistent profit margin over the period of performance based on estimated profit margins at completion of the contract. This method of accounting requires estimating the total revenues and total contract cost at completion of the contract. During the performance of long-term contracts, these estimates are periodically reviewed and revisions are made as required. The impact on revenue and contract profit as a result of these revisions is included in the periods in which the revisions are made. This method can result in the deferral of costs or the deferral of profit on these contracts. Because we assume the risk of performing a fixed-price contract at a set price, the failure to accurately estimate ultimate costs or to control costs during performance of the work could result, and in some instances has resulted, in reduced profits or losses for such contracts. Estimated losses on contracts at completion are recognized when identified. In certain circumstances, revenues are recognized when contract amendments have not been finalized. Prior to agreeing to commence work directed by the customer and before receipt of the written modification or amendment to the existing contract, we require the completion of an internal memo that assesses the probability of the modification being executed in a timely fashion and our ability to subsequently collect payment from the customer.

Contract revenue recognition inherently involves estimation. Examples of estimates include the contemplated level of effort to accomplish the tasks under contract, the cost of the effort, and an ongoing assessment of our progress toward completing the contract. From time to time, as part of our standard management processes, facts develop that require us to revise our estimated total costs or revenues. In most cases, these revisions relate to changes in the contractual scope of our work. To the extent that a revised estimate affects contract profit or revenue previously recognized, we record the cumulative effect of the revision in the period in which the facts requiring the revision become known. Anticipated losses are recognized in the accounting period in which they are first determined.

Goodwill

Goodwill represents the excess of cost over the fair value of net tangible and identifiable intangible assets of acquired companies. Effective January 1, 2002, we adopted SFAS No. 142, and no longer amortize goodwill; rather, we review goodwill at least annually for impairment. We have elected to perform this review annually during second quarter of each calendar year and no adjustments were necessary.

Other Matters

Our significant accounting policies, including the critical policies listed above, are described in the notes to the consolidated financial statements for the year ended December 31, 2003, included in our Annual Report on Form 10-K for the same period, filed with the SEC on March 15, 2004.

Forward-Looking Statements

This quarterly report on Form 10-Q contains forward-looking statements that involve substantial risks and uncertainties, many of which are outside of our control. ManTech believes these statements to be within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases, you can identify these statements by forward-looking words such as “may,” “will,” “should,” “expect,” “plan,” “intend,” “anticipate,” “believe,” “estimate,” “continue” and other similar words. You should read statements that contain these words carefully because they discuss our future expectations, make projections of our future results of operations or financial condition or state other “forward-looking” information.

We believe that it is important to communicate our future expectations to our investors. However, there may be events in the future that we are not able to predict accurately or control. The factors that could cause actual results to differ materially from anticipated results include, but are not limited to, the following:

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These and other risk factors are more fully described and discussed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003, filed with the SEC on March 15, 2004, and from time to time, in our other filings with the SEC. The statements in this quarterly report are made as of the date of this quarterly report, and we undertake no obligation to update any of the forward looking statements made herein, whether as a result of new information, future events, changes in expectations or otherwise.

Our exposure to market risk relates to changes in interest rates for borrowings under our senior term loan and revolving credit facility. These borrowings bear interest at variable rates. As of September 30, 2004, we had $25.0 million in borrowings outstanding under our revolving credit facility. A hypothetical 10% increase in interest rates would have increased our interest expense for the nine months ended September 30, 2004 by less than $0.1 million.

In December 2001, we entered into an interest swap agreement in order to reduce our exposure associated with the market volatility of fixed London Inter-Bank Offer Rate (LIBOR) interest rates. This agreement has a notional principal amount of $25.0 million and, as of September 30, 2004, had a rate of 6.83%. This agreement is a hedge against revolving debt of $25.0 million, which bears interest at monthly floating LIBOR plus 1.00%. At stated monthly intervals the difference between the interest on the floating LIBOR-based debt and the interest calculated in the swap agreement are settled in cash. The value of the swap at September 30, 2004 was a negative $3.8 million.

We do not use derivative financial instruments for speculative or trading purposes. We invest our excess cash in short-term, investment grade, interest-bearing securities. Our investments are made in accordance with an investment policy approved by the board of directors. Under this policy, no investment securities can have maturities exceeding one year, and the average maturity of the portfolio cannot exceed 90 days.

As of September 30, 2004, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer (our principal executive officer and principal financial officer, respectively), management evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 of the Exchange Act. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective, as of September 30, 2004, such that the information relating to us that is required to be disclosed in our reports filed with the SEC (i) is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

There were no significant changes in our internal control over financial reporting during the three months ended September 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II – OTHER INFORMATION

From time to time, we are subject to legal proceedings, investigations, claims and disputes that arise in the ordinary course of its business. Although we cannot predict the outcomes of these and other legal proceedings, investigations, claims and disputes, based on the information now available to us, we do not believe that the ultimate resolution of these matters, either individually or in the aggregate, will have a material adverse effect on our business, prospects, financial condition or operating results.