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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, 2004

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 10,089,194 shares of common stock outstanding as of January 31, 2005.

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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, 2004 and September 30, 2004

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, 2004 and September 30, 2004

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 STATEMENT OF STOCKHOLDERS’ EQUITY

FOR THE THREE MONTHS ENDED DECEMBER 31, 2004

(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, 2004 and 2003

(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. (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, 2004. The results of operations for any interim period are not necessarily indicative of results for the full year.

Accounts receivable at December 31, 2004 and September 30, 2004 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 commercial and international organizations. Unbilled accounts receivable consist principally of amounts that are billed in the month following the incurrence of cost, amounts related to indirect cost variances on cost reimbursable type contracts or amounts related to milestones that are delivered under fixed price contracts. Substantially all unbilled receivables are expected to be billed and collected within one year.

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

In June 2004, the Company filed a claim in the amount of approximately $1.8 million against the National Oceanic Atmospheric Administration (NOAA) of the U.S. Department of Commerce. The claim arose under a contract from NOAA to provide the Data Collection System Automated Processing System II (DAPS-II System). Additional costs and revenue were incurred and recognized in the performance of this contract during the first quarter of Fiscal Year 2005. As of December 31, 2004, unbilled accounts receivable includes approximately $1.3 million associated with the claim.

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

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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, inventory, equipment, and insurance proceeds and has certain financial covenants, including minimum net worth and liquidity ratios. The Company had no balance outstanding at December 31, 2004 under the line of credit. At December 31, 2004, the line had a maturity date of February 28, 2006. In January 2005, the maturity of the line was extended from February 28, 2006 to February 28, 2007.

The Company also has access to a $2.0 million equipment lease line of credit that had a balance of approximately $51,700 at December 31, 2004. The outstanding balance is payable over a 17-month period and bears interest at a rate of 8.8% per annum.

In December 2004, Financial Accounting Standard Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) 123 (Revised 2004), “Shared-Based Payment”. Revised SFAS 123 addresses the requirements of an entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The cost of such award will be recognized over the period during which an employee is required to provide services in exchange for the award. The Company will be required to adopt this Statement during the fourth quarter of fiscal year 2005 and is currently evaluating the impact that this pronouncement will have on its future operations and financial reporting.

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

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation for the three months ended December 31, 2004 and 2003 is as follows:

These pro forma 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 additional stock options issued in future years.

Effective October 1, 2004, the Company reorganized its operations into four reportable segments. The primary purpose of the reorganization was to place the Company’s commercially oriented operations under common marketing and management leadership and to more efficiently sell and promote its products to common customers. The four segments are:

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

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

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

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INTEGRAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

(Unaudited)

The Space Communications Systems segment, consisting exclusively of the Company’s wholly owned subsidiary, RT Logic, designs and builds satellite communications equipment and systems, principally for military applications. This equipment is used in satellite tracking stations, control centers, spacecraft factories and range operations.

The Corporate segment is the Company’s “all other” segment. It includes the Company’s Product Division, which is responsible for the Company’s core command and control product line (EPOCH IPS); business areas in the development stage (currently the Company’s Skylight product); and businesses being disbanded (the Company’s Antenna Division and the Company’s Integration and Test (I&T) Division). The Product Division licenses the Company’s EPOCH IPS product line to other operating segments and to third party customers. It is also the segment responsible for EPOCH IPS maintenance and support revenue and expenses.

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

On November 17, 2004, the Company disposed of the intellectual property rights, inventory and certain other assets of Antenna Systems division to LJT & Associates, Inc. of Montgomery, Alabama (LJT), effective as of November 1, 2004. As consideration, LJT agreed to pay the Company $215,000 and executed a promissory note requiring payment of that sum in eight equal installments of $26,875 due on July 1 and January 1 beginning on July 1, 2005. As additional consideration, LJT agreed to make future contingent payments to the Company for the period beginning November 1, 2004 through December 31, 2006. The contingent payments are calculated every December 31 beginning December 31, 2005 based on pretax income as defined in the acquisition agreement. Under the asset sale agreement, the Company will continue to fulfill its obligations under existing customer contracts but will engage LJT as a subcontractor to perform the actual work. The Company did not record a material gain or a loss as a result of this transaction.

In addition, the Company loaned to LJT the sum $100,000 to assist with initial expenses arising from use of the acquired assets in operations. As consideration, LJT agreed to pay the Company $100,000 and executed a promissory note requiring payment of that sum in installments to coincide with milestone payments on a certain contract. Integral disbursed the loan to LJT by issuing a cash disbursement in the amount of $54,906, which represents the loan balance after deducting the net assumed obligations with an aggregate total of $45,094.

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

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Summarized financial information by business segment is as follows:

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

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

Overview

Integral Systems, Inc. (the “Company”) builds satellite ground systems and equipment 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 commercial off-the-shelf (“COTS”) software product line for command and control. As a systems integrator, the Company leverages these products to provide turnkey satellite control facilities that can operate multiple satellites from any manufacturer. These systems offer significant cost savings for customers that have traditionally purchased a separate custom control center for each of their satellites.

Effective October 1, 2004, the Company reorganized its operations into four reportable segments. The primary purpose of the reorganization was to place the Company’s commercially oriented operations under common marketing and management leadership and to more efficiently sell and promote its products to common customers. The four segments are:

Ground Systems – Government

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

Ground Systems – Commercial

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

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

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

Space Communications Systems

This segment, consisting exclusively of the Company’s wholly owned subsidiary, RT Logic, designs and builds satellite communications equipment and systems, principally for military applications. This equipment is used in satellite tracking stations, control centers, spacecraft factories and range operations.

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Corporate

This segment is the Company’s “all other” segment. It includes the Company’s Product Division, which is responsible for the Company’s core command and control product line (EPOCH IPS); business areas in the development stage (currently the Company’s Skylight product); and businesses being disbanded (the Company’s Antenna Division and the Company’s Integration and Test (I&T) Division). The Product Division licenses the Company’s EPOCH IPS product line to other operating segments and to third party customers. It is also the segment responsible for EPOCH IPS maintenance and support revenue and expenses.

All intra-segment and inter-segment revenues and expenses have been eliminated in consolidation as appropriate. Operating results for periods prior to October 1, 2004 have been reclassified for comparative purposes. In order to provide year to year reporting continuity, the Company has elected to provide additional disclosures for SAT and Newpoint through the end of fiscal year 2005.

COMPARISON OF THE THREE MONTHS ENDED DECEMBER 31, 2004 AND 2003

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, 2004 and 2003:

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.

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For the three months ended December 31, 2004 and 2003, the Company’s revenues were generated from the following sources:

On a consolidated basis, revenue increased 9.3%, or $1.8 million, to $21.9 million for the three months ended December 31, 2004, from $20.1 million for the three months ended December 31, 2003. Revenue for the three-month periods ended December 31, 2004 and 2003 for each of the Company’s segments is shown in the following table:

Revenue decreases in the Company’s Ground Systems - Government segment between the three months ended December 31, 2004 and 2003 primarily relate to decreased backlog and revenues from NOAA of approximately $900,000, partially offset by increased sales volume from the Company’s contracts with the U.S. Air Force (specifically the CCS-C and SCNC contracts).

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Revenue increases for the Company’s Ground Systems – Commercial segment (other than SAT) resulted from increased backlog and increased product shipments to customers. SAT’s revenue decrease relates to decreased backlog and order shipments during the three months ended December 31, 2004 compared to the three months ended December 31, 2003.

Revenue increases for the Company’s Space Communications Systems segment resulted from increased backlog and increased product shipments to customers.

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

Antenna Division revenues declined slightly between the periods being compared because the Company has not been pursuing new business for this operation since the summer of 2004. The principal operating assets of the division were sold in November 2004 to LJT & Associates, Inc. Notwithstanding, the Company continues to remain contractually responsible for existing Antenna orders and the Company estimates that Antenna revenues for fiscal year 2005 in its entirety will be greater than revenues recorded in fiscal year 2004 for the division due to existing backlog that should be fulfilled during the current fiscal year.

The Company disbanded its I&T division during the fourth quarter of fiscal year 2004 and accordingly, no revenues were recorded for this division during the first quarter of fiscal year 2005.

Cost of Revenue/Gross Margin

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

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

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During the three months ended December 31, 2004, cost of revenue increased by 10.1%, or $1.4 million, compared to the same period during the prior year, increasing from $13.4 million during the three months ended December 31, 2003 to $14.8 million during the three months ended December 31, 2004. Gross margin increased from $6.6 million to $7.1 million, an increase of $500,000, or 7.7%, during the periods being compared. Cost of revenue and gross margin for the three months ended December 31, 2004 and 2003 for each of the Company’s segments are shown in the following table: