Headquartered in Columbia, Maryland, Integral Systems is “a leader in the secure management, delivery and distribution of data and information from space and terrestrial-based platforms into networks for military, government and commercial satellite and aerospace customers.” According to the company’s 10-K (Annual Report)—

Our revenues are derived primarily from customers in the aerospace and defense industry, particularly the Command, Control, Communications, Computers, Intelligence, Surveillance and Reconnaissance (“C4ISR”) market, and to a lesser extent, customers in other industries such as telecommunications and media. The aerospace and defense community is comprised of major government operations (including defense, civil, and homeland security) and large-scale commercial operators including satellite operators, communications companies, and other media companies. The C4ISR market primarily services the Department of Defense (‘DoD’), the intelligence community, and other governmental agencies by providing complex, networked, mission-critical systems enabling command and control of data collection, analysis and dissemination from multiple sources as well as managing key tactical communications and decision support systems. While overall defense spending is expected to grow at a slower rate than in previous administrations, we believe that the C4ISR market, and our role within it will continue to see funding priority resulting in stable or moderate growth in the marketplace. We believe that these programs, integrating advanced electronics and software to enhance the capabilities of current systems and provide the integration of multiple sensor and battle management platforms will continue to be required as the U.S. defense budget continues to respond to the current and future security environment.

That sounds promising, doesn’t it? Integral Systems seems to have found a sweet, stable market niche in one of the fastest growing areas of the aerospace and defense marketplace. Which is a good thing, since about three-quarters (72%) of company revenue comes from sales to the U.S. Government. Reflecting its key niche, 2010 revenues are up, from $160 million to $178 million.

So why can’t Integral Systems make a profit? Why did the company record a $1.5 million loss from operations, and a $2.4 million net loss?

Naturally, the answer to such a question is both long and complex. But let’s note a few—admittedly superficial—facts that may lead toward an answer to our question.

First, we note that the company made several recent acquisitions in its Product Group segment. The acquisitions created an integration challenge, according to this story at SpaceNews.com. The story reported—

Integral in 2010 incurred costs related to its acquisition of CVG-Avtec. [CEO Paul] Casner said this acquisition took management’s attention away from other aspects of the business and is in part responsible for what he said were disappointing financial results.

‘There’s no two ways about it, this has been a tough year and our shareholders have shouldered much of the burden,’ Casner said.

Casner said the Satcom Solutions division did not perform to expectations in 2010, in part because of the CVG-Avtec acquisition. He referred to the division’s results as ‘the elephant in the room’ at Integral. Part of the problem, he said, was delayed contract awards and a mix of contracts that, taken together, resulted in lower profitability.

We took a look at Integral’s 10-K and noted that the Products Group segment saw a revenue increase of more than 40%, but that the revenue increase was offset by a 60% increase in segment operating expenses. According to management, the increase in operating expenses was attributable to—

… an increase in corporate allocated expenses of $8.2 million, an increase in operating expense of $3.6 million incurred by the SATCOM Solutions division, $1.9 million relating to the satID division, which was acquired in the second quarter of Fiscal Year 2009, $2.1 million of overhead expense associated with the reclassification to selling, general, and administrative expense, $0.3 million relating to an increase in selling expense, and $0.3 million relating to research and development.

We don’t have all the details, but we also noted that the company’s percentage of fixed-price contract work increased, from a 2009 level of 55% to a 2010 level of 67%. The accounting changes described above, coupled with an increase in fixed-price work, would certainly tend to negatively impact operating results.

One lesson that might be learned here is to consider the impact of an acquisition on such items as allocated corporate expenses before deciding to make the acquisition. If the new revenue and headcount attracts more corporate costs, then the existing project portfolio will become more expensive. If the work is firm fixed-price, then the company will see degradation in project gross margins.

But of course that’s not the whole story—nor do we mean to imply that we can tell the whole story in this article. Again, we are simply noting some interesting points that came to our attention while researching the company.

We also noted that the company has faced some legal problems in its recent past. According to the 10-K report—

On March 1, 2007, we learned that the Securities and Exchange Commission (the “SEC”) had issued a formal order of investigation regarding the Company, and we and subsequently certain of our then officers received subpoenas in connection with the investigation. The investigation by the SEC and a related inquiry by NASDAQ included questions as to whether Gary A. Prince was acting as a de facto executive officer of the Company prior to his promotion to the position of Executive Vice President and Managing Director of Operations of the Company in August 2006. The investigation and inquiry also included questions as to whether Mr. Prince was practicing as an accountant before the SEC while an employee of the Company. Mr. Prince agreed with the SEC in 1997 to a permanent injunction barring him from practicing as an accountant before the SEC, as part of a settlement with the SEC related to Mr. Prince’s guilty plea to charges brought against him for conduct principally occurring in 1988 through 1990 while he was employed by Financial News Network, Inc. and United Press International. In March 2007, we terminated the employment of Mr. Prince. Under the supervision of a Special Committee established by the Board, the Company also took other remedial action and provided full cooperation to the SEC in the investigation.

On July 30, 2009, the SEC and the Company each announced that a final administrative settlement had been reached concluding the SEC’s investigation as to the Company. Under the administrative settlement the Company… consented to a ‘cease and desist’ order requiring future compliance with certain provisions of the Securities Exchange Act and the SEC Exchange Act rules. The order does not require the Company to pay a monetary penalty. The SEC states in the order that in determining to accept the settlement it considered both the remediation efforts promptly undertaken by the Company, and the cooperation the SEC staff received from the Company. Shortly after the settlement with the SEC, representatives of the Company met with various officials at NASDAQ. As a result of that meeting the Company learned that the NASDAQ inquiry had been closed out with no actions required of the Company.

In conjunction with its announcement of the administrative settlement, the SEC also disclosed that it was instituting separate civil actions against Mr. Prince and two other former officers of the Company. The Company has indemnification obligations to these individuals pursuant to the terms of separate Indemnification.

Certainly, company management was distracted by the potentially damaging SEC investigation and legal actions, by the NASDAQ inquiry, and by the ongoing civil actions against the former company executives. But that’s not the whole story, either. The company also had significant problems with its DCAA auditors.

The company reported in its 10-K—

Our Military & Intelligence Group cost-plus contracts are driven by pricing based on cost incurred to perform services under contracts with the U.S. government. Cost-based pricing is determined under the Federal Acquisition Regulation, which provide guidance on the types of costs that are allowable in establishing prices for goods and services and allowability and allocability of costs to contracts awarded by the U.S. government. We have incurred allocable costs that we believe are allowable and reimbursable under our cost-plus-fee contracts, and that are included in our revenue. These costs are subject to audit by the Defense Contract Audit Agency (“DCAA”); therefore, revenue recognized on our cost-plus contracts is subject to adjustment upon audit by DCAA. We established a revenue rate reserve of $6.6 million for costs incurred for which ultimate reimbursement is uncertain. The Incurred Cost Submission (“ICS”) for our Columbia-based government operations has been audited by the DCAA through the Fiscal Year ended September 30, 2005. The ICS for our RT Logic subsidiary has been audited by the DCAA through September 30, 2006. The ICS for our SATCOM Solutions division has been audited by the DCAA through December 31, 2005. Newpoint, SAT, and Lumistar are not currently subject to audits by the DCAA. ….

In the fourth quarter of Fiscal Year 2010, the DCAA formally issued a Report on Audit of Post Award Accounting Systems (the “Accounting Systems Audit Report”) that found, as of January 27, 2010, our accounting system to be inadequate and identified certain significant deficiencies in our accounting systems, controls, policies and procedures. As a result of this determination … our administrative contracting officers are required to consider, with respect to cost-plus contracts, whether it is appropriate to suspend a percentage of progress payments or reimbursement of costs proportionate to the estimated cost risk to the U.S. government, considering audit reports or other relevant input, until we submit a corrective action plan acceptable to the contracting officers and correct the deficiencies. In addition, in order for us or any other entity to be awarded any new cost-plus contract, the administrative contracting officer must determine that such entity has the necessary operating and accounting controls to be determined ‘responsible’ under the Federal Acquisition Regulation. … We do not believe that the issues raised in the Accounting Systems Audit Report have materially adversely affected our business, financial condition or results of operations up to now, and we do not believe that they will have a material adverse impact on our business, financial condition or results of operations in the future. We are working diligently to resolve these accounting deficiencies and believe that they will be successfully resolved. However, the Accounting Systems Audit Report has the potential to materially adversely impact our ability to obtain future cost-plus contracts from the U.S. government, could result in certain payments under existing cost-plus contracts being delayed or suspended, and the DCAA could, as a result of a subsequent audit, reduce the billing rates that it has provisionally approved, causing us to refund a portion of the amounts we have received with respect to cost-plus contracts.

The SpaceNews.com made much of the company’s DCAA problems. It reported—

The Defense Contract Audit Agency (DCAA) has determined in an audit that Integral Systems has ‘internal control deficiencies’ in the way it handles cost-plus contracts for the Defense Department, which is Integral’s biggest customer.

In a Dec. 8 conference call with investors, Casner said the DCAA audit findings have not affected any contracts or revenue. But in a Dec. 8 filing with the SEC, Integral said the audit could put into jeopardy the company’s future cost-plus contracts with the Defense Department.

Integral Chief Financial Officer Christopher B. Roberts said during the call that the company has made progress in addressing the financial control issues but was not able to complete the job in fiscal year 2010.

We noted that, in addition to the DCAA findings regarding the company’s accounting system internal controls, the company also established a $6.6 million reserve for potential questioned costs related to its incurred costs. When profitability is so tight, that’s gotta hurt.

To sum up, we don’t know this company. We’ve never worked for them or with them, and we don’t know anybody who has. But we look at the company and see a government contractor in trouble, struggling to comply with myriad contract compliance issues while integrating multiple acquisitions and supporting outside investigations and litigation.

We see a company that ought to be making a decent profit while growing each year, but that can’t seem to overcome its challenges. We hope 2011 will be kinder to Integral Systems than 2010 was.