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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(mark one)

For the quarterly period ended December 31, 2003 or             

For the transition period from              to             

Commission file number  0-18603

INTEGRAL SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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

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

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

Indicate by checkmark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

Registrant had 9,956,044 shares of common stock outstanding as of January 30, 2004.

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INTEGRAL SYSTEMS, INC.

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2003 and September 30, 2003

ASSETS

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

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INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2003 and September 30, 2003

LIABILITIES & STOCKHOLDERS’ EQUITY

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

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INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

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

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INTEGRAL SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

FOR THE THREE MONTHS ENDED DECEMBER 31, 2003

(Unaudited)

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

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INTEGRAL SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

Three Months Ended December 31, 2003 and 2002

(Unaudited)

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

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

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

In the opinion of management, the financial statements reflect all adjustments consisting only of normal recurring accruals necessary for a fair presentation of results for such periods. The financial statements, which are condensed and do not include all disclosures included in the annual financial statements, should be read in conjunction with the consolidated financial statements of the Company for the fiscal year ended September 30, 2003. The results of operations for any interim period are not necessarily indicative of results for the full year.

Certain accounts in the prior period financial statements have been reclassified for comparative purposes to conform with the presentation in the current year financial statements.

Accounts receivable at December 31, 2003 and September 30, 2003 consist of the following:

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

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

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The Company has a line of credit agreement with a local bank for $10.0 million for general corporate purposes. Borrowings under the line are due on demand with interest at the London Inter-Bank Offering Rate (LIBOR), plus a spread of 1.5 to 2.4% based on the ratio of funded debt to earnings before interest, taxes and depreciation (EBITDA). The line of credit is secured by the Company’s billed and unbilled accounts receivable and has certain financial covenants, including minimum net worth and liquidity ratios. The line expires February 29, 2004. The Company had no balance outstanding at December 31, 2003 under the line of credit. The Company is in the process of renewing the line of credit.

The Company also has access to a $2.0 million equipment lease line of credit that had a balance of approximately $85,000 at December 31, 2003. The outstanding balance is payable over a 29-month period from lease inception and bears interest at a rate of 8.8% per annum.

Inventory consists of service parts and materials and is stated at the lower of cost or market using the first-in, first-out (FIFO) method of accounting.

The Company recognizes expense for stock-based compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Accordingly, compensation cost is recognized for the excess of the estimated fair value of the stock at the grant date over the exercise price, if any.

The effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation for the three months ended December 31, 2003 is as follows:

These proforma amounts are not necessarily indicative of future effects of applying the fair value-based method due to, among other things, the vesting period of the stock options and the fair value of the additional stock options issued in future years.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The Company periodically uses foreign currency exchange contracts to hedge risk associated with its European long-term contracts. Under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” all derivative instruments must be recorded on the balance sheet as an asset or liability with any gain or loss recorded as a component of accumulated other comprehensive income until recognized in earnings. The fair value of the exchange contracts is based upon quoted market prices. If a derivative does not qualify for hedge accounting the gain or loss is recorded through earnings. For the three months ended December 31, 2003, the Company recorded as accumulated other comprehensive income an unrealized loss of $196,858. The Company also recorded a realized gain of $14,440 during the same period.

With the acquisition of RT Logic, the Company now operates in four business segments:

Integral Systems, Inc. and ISI Europe build satellite ground systems for command and control, integration and test, data processing, and simulation.

Through its wholly owned subsidiary SAT, the Company offers turnkey systems and software for satellite and terrestrial communications signal monitoring.

The Company provides equipment monitoring and control software to satellite operators and the telecommunications industry through its wholly owned subsidiary Newpoint (acquired January 2002).

Through its wholly owned subsidiary RT Logic (acquired October 2002), the Company manufactures telemetry processing components and systems for military applications, including tracking stations, control centers, and range operations.

The accounting policies of the segments are the same as those described in Note 1. The Company evaluates the performance of each segment based on operating income. There are no inter-segment allocations of overhead and all corporate-level expenses are included in the Satellite Ground Systems segment.

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

Summarized financial information by business segment is as follows:

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

Overview

Integral Systems, Inc. builds satellite ground systems for command and control, integration and test, data processing, and simulation. Since its inception in 1982, the Company has provided ground systems for over 190 different satellite missions for communications, science, meteorology, and earth resource applications. The Company has an established domestic and international customer base that includes government and commercial satellite operators, spacecraft and payload manufacturers, and aerospace systems integrators.

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

Through its wholly owned subsidiary SAT, acquired in August 2000, the Company also offers turnkey systems and software for satellite and terrestrial communications signal monitoring.

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

On January 30, 2002, the Company acquired Newpoint. Newpoint provides equipment monitoring and control software to satellite operators and the telecommunications industry.

In October 2002, the Company acquired RT Logic. RT Logic manufactures telemetry processing components and systems for military applications, including tracking stations, control centers, and range operations.

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COMPARISON OF THE THREE MONTHS ENDED DECEMBER 31, 2003 AND 2002

Results of Operations

The components of the Company’s income statement as a percentage of revenue are depicted in the following table for the three months ended December 31, 2003 and December 31, 2002:

Revenue

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

For the three months ended December 31, 2003 and 2002, the Company’s revenues were generated from the following sources:

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On a consolidated basis, revenue increased 2.5%, or $480,000, to $20.1 million for the three months ended December 31, 2003, from $19.6 million for the three months ended December 31, 2002. Revenue for the three-month periods ended December 31, 2003 and 2002 for each of the Company’s segments is shown in the following table:

Revenue decreases in the Company’s Satellite Ground Systems segment pertain to continued depressed conditions in the overall commercial satellite market which caused revenues from the Company’s commercial clients to decrease approximately $1.0 million between the quarters being compared. Revenues derived from the Company’s NOAA customer also decreased by approximately $1.9 million between the periods being compared due to decreased orders from this Government customer. Offsetting these decreases were approximately $1.0 million in increased revenues resulting from the Company’s contracts with the U.S. Air Force (specifically the CCS-C and SCNC programs) that were awarded in the Spring of 2002. The Company also recorded approximately $700,000 of revenue during the three months ended December 31, 2003 relating to its newly established Antenna division. There were no such revenues recorded during the corresponding three-month period last fiscal year.

Revenue increases for SAT and RT Logic resulted from increased order bookings, while revenue decreases at Newpoint resulted from late deliveries by equipment suppliers for Newpoint’s Mercury product.

Despite the year-to-year variances, revenue levels for all Company operations are generally on target with Company guidance provided to investors in December 2003 and are consistent with internally generated operating plans.

Cost of Revenue/Gross Margin

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

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

During the three months ended December 31, 2003, cost of revenue decreased by 3.7% or $520,000, compared to the same period during the prior year, decreasing from $13.9 million during the three months ended December 31, 2002 to $13.4 million during the three months ended December 31, 2003. Gross margin increased from $5.6 million to $6.6 million, an increase of $1.0 million, or 17.9% during the

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periods being compared. Cost of revenue and gross margin for the three months ended December 31, 2003 and 2002 for each of the Company’s segments are shown in the following table:

The lower gross margin for the Company’s Satellite Ground Systems segment is primarily attributable to three factors, all of which are believed by the Company to be non-recurring in nature:

As a result of the above, gross margin as a percentage of revenue for the Satellite Ground Systems segment declined from 20.3% to 19.3%.

The increase in gross margin at SAT is due to the increase in revenue noted above, while the increased Gross Margin at Newpoint relates to the effect of cost-cutting measures implemented at the end of fiscal year 2003.

The increase in gross margin at RT Logic pertains to increased revenue levels and a higher content of production oriented contracts that typically generate higher gross margins for this segment than non-production oriented jobs.

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Operating Expenses

Operating Expenses for the three months ended December 31, 2003 and 2002 for each of the Company’s segments are shown in the following table: