Edgar Filing: GSE SYSTEMS INC

form10q_3q08.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X]	Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarterly Period Ended September 30, 2008.

[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Transition Period from to .

001-14785

(Commission File Number)

GSE SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Delaware				52-1868008
(State of incorporation)				(I.R.S. Employer Identification Number)

1332 Londontown Blvd., Suite 200, Sykesville, MD 21784

(Address of principal executive office and zip code)

Registrant's telephone number, including area code: (410) 970-7800

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 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 check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer [ ]	Accelerated filer [ X ]	Non-accelerated filer [ ]	Smaller reporting company [ ]
		(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in rule 12(b)-2 of the Exchange Act).Yes [ ] No [X]

There were 15, 965,346 shares of common stock, with a par value of $.01 per share outstanding as of November 7, 2008.

GSE SYSTEMS, INC.

QUARTERLY REPORT ON FORM 10-Q

INDEX

		PAGE
PART I.	FINANCIAL INFORMATION	3
Item 1.	Financial Statements:
	Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007	3
	Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2008 and September 30, 2007	4
	Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months Ended September 30, 2008 and September 30, 2007	5
	Consolidated Statement of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2008	6
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and September 30, 2007	7
	Notes to Consolidated Financial Statements	8
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25
Item 4.	Controls and Procedures	26
PART II.	OTHER INFORMATION	27
Item 1.	Legal Proceedings	27
Item 1A.	Risk Factors	27
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	27
Item 3.	Defaults Upon Senior Securities	27
Item 4.	Submission of Matters to a Vote of Security Holders	27
Item 5.	Other Information	27
Item 6.	Exhibits	27
	SIGNATURES	28

PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)

	Unaudited
	September 30, 2008			December 31, 2007
ASSETS
Current assets:
Cash and cash equivalents	$	7,513		$	8,172
Restricted cash		2,521			2,228
Contract receivables		11,883			10,721
Prepaid expenses and other current assets		1,019			894
Total current assets		22,936			22,015

Equipment and leasehold improvements, net		1,162			880
Software development costs, net		1,505			1,170
Goodwill		1,739			1,739
Long-term restricted cash		1,990			1,925
Other assets		1,098			635
Total assets	$	30,430		$	28,364

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	1,723		$	1,533
Accrued expenses		733			1,061
Accrued compensation and payroll taxes		1,284			1,613
Billings in excess of revenue earned		3,671			2,270
Accrued warranty		961			724
Other current liabilities		273			103
Total current liabilities		8,645			7,304

Other liabilities		733			695
Total liabilities		9,378			7,999
Commitments and contingencies

Stockholders' equity:
Preferred stock $.01 par value, 2,000,000 shares authorized,
shares issued and outstanding none in 2008 and 2007		-			-
Common stock $.01 par value, 30,000,000 shares authorized,
shares issued and outstanding 15,963,958 in 2008 and
15,508,014 in 2007		160			155
Additional paid-in capital		50,217			49,225
Accumulated deficit		(28,261	)		(28,128	)
Accumulated other comprehensive loss		(1,064	)		(887	)
Total stockholders' equity		21,052			20,365
Total liabilities and stockholders' equity	$	30,430		$	28,364

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

GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(Unaudited)

	Three months ended					Nine months ended
	September 30,					September 30,
	2008		2007			2008			2007

Contract revenue	$	7,001	$	7,526		$	20,639		$	23,769

Cost of revenue		5,023		5,150			14,889			16,345
Gross profit		1,978		2,376			5,750			7,424

Operating expenses:
Selling, general and administrative		1,694		1,813			5,585			5,567
Depreciation		114		59			317			168
Total operating expenses		1,808		1,872			5,902			5,735

Operating income (loss)		170		504			(152	)		1,689

Interest income (expense), net		42		(62	)		76			(425	)
Other income (expense), net		317		(88	)		193			(353	)
Income before income taxes		529		354			117			911

Provision for income taxes		99		51			250			229
Net income (loss)		430		303			(133	)		682

Preferred stock dividends		-		-			-			(49	)

Net income (loss) attributed to common shareholders	$	430	$	303		$	(133	)	$	633

Basic income (loss) per common share	$	0.03	$	0.02		$	(0.01	)	$	0.05

Diluted income (loss) per common share	$	0.03	$	0.02		$	(0.01	)	$	0.04

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

GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(in thousands)
(Unaudited)


	Three months ended					Nine months ended
	September 30,					September 30,
	2008			2007		2008			2007


Net income (loss)	$	430		$	303	$	(133	)	$	682

Foreign currency translation adjustment		(265	)		119		(177	)		88

Comprehensive income (loss)	$	165		$	422	$	(310	)	$	770

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

CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
(in thousands)
(Unaudited)

														Accumulated
	Preferred				Common				Additional					Other
	Stock				Stock				Paid-in		Accumulated			Comprehensive
	Shares		Amount		Shares		Amount		Capital		Deficit			Loss			Total
Balance, January 1, 2008		-	$	-		15,508	$	155	$	49,225	$	(28,128	)	$	(887	)	$	20,365

Stock-based compensation
expense		-		-		-		-		319		-			-			319
Common stock issued for
options exercised, net of
30,645 shares returned to
GSE to pay for employee's
income tax liabilities of $251,000		-		-		194		2		29		-			-			31
Common stock issued for
services provided		-		-		13		-		107		-			-			107
Common stock issued for
warrants exercised		-		-		249		3		537		-			-			540
Foreign currency translation
adjustment		-		-		-		-		-		-			(177	)		(177	)
Net loss		-		-		-		-		-		(133	)		-			(133	)
Balance, September 30, 2008		-	$	-		15,964	$	160	$	50,217	$	(28,261	)	$	(1,064	)	$	21,052

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

GSE SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
	Nine months ended
	September 30,
	2008			2007
Cash flows from operating activities:
Net income (loss)	$	(133	)	$	682
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation		317			168
Capitalized software amortization		195			252
Amortization of deferred financing costs		124			399
Stock-based compensation expense		426			430
Elimination of profit on Emirates Simulation Academy, LLC contract		38			371
Equity loss on investment in Emirates Simulation Academy, LLC		138			-
Changes in assets and liabilities:
Contract receivables		(1,162	)		(2,877	)
Prepaid expenses and other assets		(340	)		(522	)
Accounts payable, accrued compensation and accrued expenses		(638	)		(264	)
Billings in excess of revenues earned		1,401			1,062
Accrued warranty reserves		237			(98	)
Other liabilities		170			155
Net cash provided by (used in) operating activities		773			(242	)

Cash flows from investing activities:
Investment in Emirates Simulation Academy, LLC		(422	)		(128	)
Capital expenditures		(600	)		(258	)
Capitalized software development costs		(530	)		(513	)
Restriction of cash as collateral under letters of credit or guarantees		(548	)		(1,275	)
Release of cash as collateral under letters of credit		190			63
Net cash used in investing activities		(1,910	)		(2,111	)

Cash flows from financing activities:
Proceeds from issuance of common stock due to the exercise
of options and warrants		571			1,260
Deferred financing costs		(88	)		-
Decrease in borrowings under lines of credit		-			(2,155	)
Net proceeds from issuance of common stock and warrants		-			9,235
Tax benefit from option exercises		-			41
Payment of preferred stock dividends		-			(49	)
Payment of ManTech preferred stock dividends		-			(316	)
Net cash provided by financing activities		483			8,016

Effect of exchange rate changes on cash		(5	)		15
Net increase (decrease) in cash and cash equivalents		(659	)		5,678
Cash and cash equivalents at beginning of year		8,172			1,073
Cash and cash equivalents at end of period	$	7,513		$	6,751

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

GSE SYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the Three and Nine Months ended September 30, 2008 and 2007

(Unaudited)

1.	Basis of Presentation and Revenue Recognition

Basis of Presentation

The consolidated financial statements included herein have been prepared by GSE Systems, Inc. (the “Company” or “GSE”) without independent audit. In the opinion of the Company's management, all adjustments and reclassifications of a normal and recurring nature necessary to present fairly the financial position, results of operations and cash flows for the periods presented have been made. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted. The results of operations for interim periods are not necessarily an indication of the results for the full year. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the period ended December 31, 2007 filed with the Securities and Exchange Commission on March 17, 2008.

The Company has only one reportable segment. The Company has a wide range of knowledge of simulation systems and the processes those systems are intended to control and model. The Company’s knowledge is concentrated heavily in simulation technology and model development. The Company is primarily engaged in simulation for the power generation industry and the process industries. Contracts typically range from 12 months to three years.

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as reported amounts of revenues and expenses during the reporting period. The Company’s most significant estimates relate to revenue recognition, capitalization of software development costs, and the recoverability of deferred tax assets. Actual results could differ from these estimates and those differences could be material.

Revenue Recognition

The majority of the Company’s revenue is derived through the sale of uniquely designed systems containing hardware, software and other materials under fixed-price contracts. In accordance with Statement of Position 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts, the revenue under these fixed-price contracts is accounted for on the percentage-of-completion method. This methodology recognizes revenue and earnings as work progresses on the contract and is based on an estimate of the revenue and earnings earned to date, less amounts recognized in prior periods. The Company bases its estimate of the degree of completion of the contract by reviewing the relationship of costs incurred to date to the expected total costs that will be incurred on the project. Estimated contract earnings are reviewed and revised periodically as the work progresses, and the cumulative effect of any change in estimate is recognized in the period in which the change is identified. Estimated losses are charged against earnings in the period such losses are identified. The Company recognizes revenue arising from contract claims either as income or as an offset against a potential loss only when the amount of the claim can be estimated reliably and realization is probable and there is a legal basis of the claim. There were no claims outstanding as of September 30, 2008.

Uncertainties inherent in the performance of contracts include labor availability and productivity, material costs, change order scope and pricing, software modification and customer acceptance issues. The reliability of these cost estimates is critical to the Company’s revenue recognition as a significant change in the estimates can cause the Company’s revenue and related margins to change significantly from the amounts estimated in the early stages of the project.

As the Company recognizes revenue under the percentage-of-completion method, it provides an accrual for estimated future warranty costs based on historical and projected claims experience. The Company’s long-term contracts generally provide for a one-year warranty on parts, labor and any bug fixes as it relates to software embedded in the systems.

The Company’s system design contracts do not normally provide for “post customer support service” (PCS) in terms of software upgrades, software enhancements or telephone support. In order to obtain PCS, the customers must normally purchase a separate contract. Such PCS arrangements are generally for a one-year period renewable annually and include customer support, unspecified software upgrades, and maintenance releases. The Company recognizes revenue from these contracts ratably over the life of the agreements in accordance with Statement of Position 97-2, Software Revenue Recognition.

Revenue from the sale of software licenses which do not require significant modifications or customization for the Company’s modeling tools is recognized when the license agreement is signed, the license fee is fixed and determinable, delivery has occurred, and collection is considered probable.

Revenue for contracts with multiple elements is recognized in accordance with Emerging Issues Task Force Issue 00-21, Accounting for Revenue Arrangements with Multiple Deliverables.

Revenue from certain consulting or training contracts is recognized on a time-and-material basis. For time-and-material type contracts, revenue is recognized based on hours incurred at a contracted labor rate plus expenses.

The following customers have provided more than 10% of the Company’s revenue for the indicated period:

	Three months ended						Nine months ended
	September 30,						September 30,
	2008			2007			2008			2007

American Electric Power		13.1	%		0.3	%		4.8	%		0.2	%
Emerson Process Management		12.8	%		9.5	%		16.8	%		7.3	%
Emirates Simulation Academy, LLC		0.6	%		27.4	%		6.0	%		34.2	%
Westinghouse Electric Company LLC		10.6	%		0.7	%		7.7	%		0.5	%

Contract receivables unbilled totaled $3.2 million and $6.6 million as of September 30, 2008 and December 31, 2007, respectively. In October 2008, the Company invoiced $993,000 of the unbilled amounts.

2.	Basic and Diluted Income (Loss) Per Common Share

Basic income (loss) per share is based on the weighted average number of outstanding common shares for the period. Diluted income (loss) per share adjusts the weighted average shares outstanding for the potential dilution that could occur if stock options, warrants or convertible preferred stock were exercised or converted into common stock. The number of common shares and common share equivalents used in the determination of basic and diluted income (loss) per share were as follows:

(in thousands, except for share amounts)	Three months ended				Nine months ended
	September 30,				September 30,
	2008		2007		2008			2007
Numerator:
Net income (loss)	$	430	$	303	$	(133	)	$	682
Preferred stock dividends		-		-		-			(49	)
Net income (loss) attributed to common stockholders	$	430	$	303	$	(133	)	$	633


Denominator:
Weighted-average shares outstanding for basic
earnings per share		15,920,908		14,943,189		15,683,442			12,568,108
Effect of dilutive securities:
Employee stock options, warrants,
options outside the plan, and
convertible preferred stock		792,308		1,451,543		-			1,935,392
Adjusted weighted-average shares outstanding
and assumed conversions for diluted
earnings per share		16,713,216		16,394,732		15,683,442			14,503,500


Shares related to dilutive securities excluded
because inclusion would be anti-dilutive		146,630		82,500		135,931			72,216

The net income for the nine months ended September 30, 2007 was decreased by preferred stock dividends of $49,000 in calculating the per share amounts. Conversion of outstanding stock options and warrants was not assumed for the nine months ended September 30, 2008 because the impact was anti-dilutive.

3.	Software Development Costs

Certain computer software development costs are capitalized in the accompanying consolidated balance sheets. Capitalization of computer software development costs begins upon the establishment of technological feasibility. Capitalization ceases and amortization of capitalized costs begins when the software product is commercially available for general release to customers. Amortization of capitalized computer software development costs is included in cost of revenue and is determined using the straight-line method over the remaining estimated economic life of the product, not to exceed five years.

Software development costs capitalized were $137,000 and $530,000 for the three and nine months ended September 30, 2008, respectively, and $165,000 and $513,000 for the three and nine months ended September 30, 2007. Total amortization expense was $62,000 and $195,000 for the three and nine months ended September 30, 2008, respectively, and $81,000 and $252,000 for the three and nine months ended September 30, 2007, respectively.

4.	Investment in Emirates Simulation Academy, LLC

On November 8, 2005, the Emirates Simulation Academy, LLC (“ESA”), headquartered in Abu Dhabi, United Arab Emirates, was formed to build and operate simulation training academies in the Arab Gulf Region. These simulation training centers will be designed to train and certify indigenous workers for deployment to critical infrastructure facilities including power plants, oil refineries, petro-chemical plants, desalination units and other industrial facilities. The members of the limited liability company include Al Qudra Holding PJSC of the United Arab Emirates (60% ownership), the Centre of Excellence for Applied Research and Training of the United Arab Emirates (30% ownership) and GSE (10% ownership). At September 30, 2008 and December 31, 2007, GSE’s investment in ESA totaled $729,000 and $445,000, respectively, and was included on the balance sheet in other assets. The Company accounts for its investment in ESA using the equity method. For the three and nine months ended September 30, 2008, the Company recognized a $50,000 and $138,000 equity loss, respectively, on its investment in ESA. The equity loss was recorded in other income (expense), net.

In January 2006, GSE received a $15.1 million contract from ESA to supply five simulators and an integrated training program. A $1.8 million change order was received from ESA in late 2007 increasing the total order value to $16.9 million. For the three months ended September 30, 2008 and 2007, the Company recognized $40,000 and $2.1 million, respectively, of contract revenue on this project using the percentage-of-completion method, which accounted for 0.6% and 27.4% of the Company’s consolidated revenue, respectively. For the nine months ended September 30, 2008 and 2007, the Company recognized $1.2 and $8.1 million, respectively, of contract revenue on this project, which accounted for 6.0% and 34.2%, respectively, of the Company’s consolidated revenue. At September 30, 2008, no backlog remained on the ESA project. In accordance with the equity method, the Company has eliminated 10% of the profit from this contract as the training simulators are assets that will be recorded on the books of ESA, and the Company is thus required to eliminate its proportionate share of the profit included in the asset value. The profit elimination totaled $0 and $105,000 for the three months ended September 30, 2008 and September 30, 2007, respectively, and $38,000 and $371,000 for the nine months ended September 30, 2008 and September 30, 2007, respectively. The profit elimination has been recorded as an other expense in the income statement and as an other liability on the balance sheet. Once ESA begins to amortize the training simulators on their books, GSE will begin to amortize the other liability to other income.

At September 30, 2008 and December 31, 2007, the Company had trade receivables from ESA totaling $2.7 million and $1.0 million, respectively. In the second quarter 2008, the Company invoiced the final billing milestones of the contract; at December 31, 2007, the Company had an unbilled receivable of $2.8 million. The $2.7 million trade receivable due from ESA at September 30, 2008 is more than 120 days past due. The Company was informed by ESA that it is performing a financial and technical review of the entire ESA contract and that no additional payments will be made to the Company until their review is completed in November 2008. The Company has not provided a bad debt reserve against the $2.7 million ESA receivable as it expects payment in full. Under the terms of the contract, the Company provided a $2.1 million performance bond to ESA that will remain outstanding until the end of the warranty period which has been extended to February 28, 2009 from October 31, 2008. The Company has deposited $1.2 million into a restricted, interest-bearing account at the Union National Bank (“UNB”) in the United Arab Emirates as a partial guarantee for the $11.8 million credit facility that UNB has extended to ESA. The guarantee will be in place until the expiration of the ESA credit facility on December 31, 2014 or earlier if ESA pays down and terminates the credit facility.

5.	Stock-Based Compensation

The Company accounts for its stock-based compensation awards under SFAS No. 123R, Share-Based Payment, which requires companies to recognize compensation expense for all equity-based compensation awards issued to employees, directors and non-employees that are expected to vest. Compensation cost is based on the fair value of awards as of the grant date. The Company recognized $142,000 of pre-tax stock-based compensation expense for both the three months ended September 30, 2008 and 2007 under the fair value method in accordance with SFAS No. 123R and recognized $426,000 and $430,000 of pre-tax stock-based compensation expense for the nine months ended September 30, 2008 and 2007, respectively.

6.	Long-term Debt

Line of Credit

On March 28, 2008, the Company entered into two separate revolving line of credit agreements for two-year revolving lines of credit with Bank of America, N.A. (“BOA”), in an aggregate amount of up to $5.0 million. The Company and its subsidiary, GSE Power Systems, Inc., are jointly and severally liable as co-borrowers. The credit facilities are collateralized by substantially all of the Company’s assets and enable the Company to borrow funds to support working capital needs and standby letters of credit. The first line of credit in the principal amount of up to $3.5 million enables the Company to borrow funds up to 90% of eligible foreign accounts receivable, plus 75% of eligible unbilled foreign receivables and 100% of the cash collateral pledged to BOA on outstanding letters of credit. This line of credit is 90% guaranteed by the Export-Import Bank of the United States. The interest rate on this line of credit is based on the daily LIBOR rate plus 150 basis points, with interest only payments due monthly. The second line of credit in the principal amount of up to $1.5 million enables the Company to borrow funds up to 80% of domestic accounts receivable and 30% of domestic unbilled receivables. The interest rate on this line of credit is based on the daily LIBOR rate plus 225 basis points, with interest only payments due monthly. The credit facilities require the Company to comply with certain financial ratios and preclude the Company from paying dividends and making acquisitions beyond certain limits without the bank’s consent. The Company’s available borrowing base under the two lines of credit was $3.7 million at September 30, 2008, none of which had been utilized.

7.	Product Warranty

As the Company recognizes revenue under the percentage-of-completion method, it provides an accrual for estimated future warranty costs based on historical experience and projected claims. The activity in the warranty account for the nine months ended September 30, 2008 is as follows:

(in thousands)

Balance at December 31, 2007	$	724
Warranty provision		569
Warranty claims		(332	)
Balance at September 30, 2008	$	961

8.	Common Stock

At a special shareholder’s meeting on December 13, 2007, the Company’s shareholders approved an amendment to the Company’s Certificate of Incorporation increasing GSE’s authorized common stock by 12 million shares to a total of 30 million shares. In addition, the shareholders approved an amendment to the Company’s 1995 Long-Term Incentive Plan (amended and restated September 25, 2007) (the “Plan”) which increased the number of shares available under the Plan by 1 million shares to a total of 3.5 million shares and extended the life of the Plan by an additional 10 years to June 30, 2018. The Company has reserved 1 million shares of the newly authorized common stock for issuance pursuant to the provisions of the Plan.

On June 22, 2007, the Company raised $9.2 million, net of associated fees of $768,000, through the sale of 1,666,667 shares (the “Shares”) of its common stock, $.01 par value per share, by means of a private placement to selected institutional investors. Each investor received a five-year warrant to purchase GSE common stock (the “Warrant Shares”) equal to 10% of the shares of common stock that each investor purchased at an exercise price of $6.00 per share (the “Warrants”). In aggregate, the Company issued Warrants to purchase a total of 166,667 shares of GSE common stock.

The Company filed its registration statement on Form S-3 with the Securities and Exchange Commission (the “Commission”) in July 2007 covering the offer and sale, from time to time, of the Shares, the Warrant Shares and shares of common stock issuable upon exercise of warrants that may be issued as liquidated damages under the terms of a certain registration rights agreement entered into between the Company and the investors (the “Registration Rights Agreement”) in connection with the private placement. The Registration Statement became effective on August 8, 2007 and, pursuant to the provisions of the Registration Rights Agreement, the Company is obligated to use commercially reasonable efforts to, after the date on which the Registration Statement became effective, cause the Registration Statement to remain continuously effective as to all Shares and Warrant Shares, other than for an aggregate of more than 30 consecutive trading days or for more than an aggregate of 60 trading days in any 12-month period. In the event of a default of the foregoing obligation, the Company will be required to issue to the investors, as liquidated damages, on the date the foregoing default occurs and each monthly anniversary thereafter, a number of warrants (on the same terms as the Warrants) equal to 2% of the number of Shares then held by such investor, not to exceed 10% of the total number of Shares then held by such investor, and thereafter cash, in an amount equal to 2% of the aggregate purchase price paid by the investors, not to exceed 30% of the aggregate purchase price paid by the investors.

At the date of issuance, the fair value of the Warrants was $510,000 and the fair value of the Shares was $9.5 million. The fair value of the Warrants and the Shares was determined by the use of the relative fair value method, in which the $10.0 million gross proceeds was allocated based upon the fair values of the Warrants, as determined by using the Black-Scholes Model, and the Shares, as determined by the closing price of the common stock on the American Stock Exchange on the date the transaction was closed.

The Company paid the placement agent for the Shares and Warrants 6% of the gross proceeds received by the Company from the offering ($600,000). In addition to the placement agent fee, the Company paid $168,000 of other transaction fees related to the offering.

The proceeds were used to pay down the Company’s line of credit and for other working capital purposes.

9.	Series A Convertible Preferred Stock

On February 28, 2006, the Company raised $3.9 million, net of associated fees of $395,000, through the sale of 42,500 shares of Series A Cumulative Convertible Preferred Stock and Warrants by means of a private placement to “accredited investors”, as that term is used in rules and regulations of the Securities and Exchange Commission. The Convertible Preferred Stock was convertible at any time into a total of 2,401,133 shares of GSE common stock at a conversion price of $1.77 per share. Each investor received a five-year warrant to purchase GSE common stock equal to 20% of the shares they would receive from the conversion of the Convertible Preferred Stock, at an exercise price of $1.77. In aggregate, the Company issued warrants to purchase a total of 480,226 shares of GSE common stock. The Convertible Preferred Stockholders were entitled to an 8% cumulative dividend, payable on a semiannual basis every June 30 and December 30. In the first quarter 2007, the Company paid dividends totaling $49,000 to the preferred stockholders. At any time after March 1, 2007, the Company had the right to convert the remaining outstanding Preferred Stock into shares of GSE common stock when the average of the current stock price during the twenty trading days immediately prior to the date of such conversion exceeded 200% of the Series A Conversion Price. On March 7, 2007, the Company sent notice to the holders of the remaining 20,000 outstanding shares of its Preferred Stock that the average current stock price for the prior twenty trading days had exceeded 200% of the Conversion Price, and that the Company was converting the outstanding Preferred Stock into common stock. The 20,000 shares of Preferred Stock converted to 1,129,946 shares of GSE common stock.

10.	Letters of Credit and Performance Bonds

As of September 30, 2008, the Company was contingently liable for four standby letters of credit totaling approximately $3.0 million. The letters of credit represent performance bonds on four contracts and have been cash collateralized.

11.	Income Taxes

In July 2006, the Financial Accounting Standards Board, or FASB, issued Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109, “Accounting for Income Taxes”. FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in the Company’s financial statements. It also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and expanded disclosure with respect to uncertainty in income taxes. The Company adopted the guidance of FIN No. 48 effective January 1, 2007. The adoption of this accounting pronouncement did not have a material effect on the Company’s financial position, results of operations or cash flows. Furthermore, the Company is not aware of any tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits would significantly decrease or increase within the next twelve months.

The Company files in the United States federal jurisdiction and in several state and foreign jurisdictions. Because of the net operating loss carryforwards, the Company is subject to U.S. federal and state income tax examinations from years 1997 forward and is subject to foreign tax examinations by tax authorities for years 2002 and forward. Open tax years related to state and foreign jurisdictions remain subject to examination but are not considered material to our financial position, results of operations or cash flows.

As of September 30, 2008, there have been no material changes to the liability for uncertain tax positions.

The Company does not expect to pay U.S. federal income taxes in 2008, but does expect to pay income taxes in Sweden. In addition, the Company will pay foreign income tax withholding on several non-U.S. contracts. The Company has a full valuation allowance on its deferred tax assets at September 30, 2008.

12.	Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosure requirements regarding fair value measurements. SFAS 157 does not require any new fair value measurements. However, on February 12, 2008 the FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No. 157 (“FSP FAS 157-2”). FSP FAS 157-2 delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities until fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. The implementation of SFAS No. 157 for financial assets and financial liabilities, effective January 1, 2008, did not have a material impact on the Company’s condensed consolidated financial statements. The Company is currently assessing the impact of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on its consolidated financial statements.

In December, 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS 141(R)”), which applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity may not apply it before that date. SFAS 141(R) establishes principles and requirements for how the acquirer: i) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed and any noncontrolling interest in the acquiree; ii) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase; and iii) determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The Company does not expect the adoption of SFAS 141 (R) to have an effect on its results of operations and its financial condition unless it enters into a business combination after January 1, 2009.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements—an amendment of Accounting Research Bulletin No. 51 (“SFAS 160”). SFAS 160 establishes accounting and reporting standards for ownership interests in subsidiaries held by parties other than the parent, the amount of consolidated net income attributable to the parent and to the noncontrolling interest, changes in a parent’s ownership interest and the valuation of retained noncontrolling equity investments when a subsidiary is deconsolidated. SFAS 160 also establishes disclosure requirements that clearly identify and distinguish between the interests of the parent and the interests of the noncontrolling owners. The Company is required to adopt the provisions of SFAS 160 effective January 1, 2009. The Company is currently evaluating the potential impact, if any, of the adoption of SFAS 160 on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an amendment of FASB Statement No. 133”. SFAS No. 161 is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand how and why an entity uses derivative instruments and their effects on an entity's financial position, financial performance, and cash flows. SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is currently evaluating the impact of adopting SFAS No. 161 on its consolidated financial statements.

GSE SYSTEMS, INC. AND SUBSIDIARIES

FORM 10-Q

For the Three and Nine Months ended September 30, 2008 and 2007

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

GSE Systems, Inc. (“GSE Systems”, “GSE” or the “Company”) is a world leader in real-time high fidelity simulation. The Company provides simulation and educational solutions and services to the nuclear and fossil electric utility industry, and the chemical and petrochemical industries. In addition, the Company provides plant monitoring and signal analysis monitoring and optimization software primarily to the power industry. GSE is the parent company of GSE Power Systems, Inc., a Delaware corporation; GSE Power Systems, AB, a Swedish corporation; GSE Engineering Systems (Beijing) Co. Ltd, a Chinese limited liability company; GSE Systems Ltd, a UK limited liability company; and has a 10% minority interest in Emirates Simulation Academy, LLC, a United Arab Emirates limited liability company. The Company has only one reportable segment.

Cautionary Statement Regarding Forward-Looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward looking statements. Forward-looking statements are not statements of historical facts, but rather reflect our current expectations concerning future events and results. We use words such as “expects”, “intends”, “believes”, “may”, “will” and “anticipates” to indicate forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements, including, but not limited to, those factors set forth under Item 1A - Risk Factors of the Company’s 2007 Annual Report on Form 10-K and those other risks and uncertainties detailed in the Company’s periodic reports and registration statements filed with the Securities and Exchange Commission. We caution that these risk factors may not be exhaustive. We operate in a continually changing business environment, and new risk factors emerge from time to time. We cannot predict these new risk factors, nor can we assess the effect, if any, of the new risk factors on our business or the extent to which any factor or combination of factors may cause actual results to differ from those expressed or implied by these forward-looking statements.

If any one or more of these expectations and assumptions proves incorrect, actual results will likely differ materially from those contemplated by the forward-looking statements. Even if all of the foregoing assumptions and expectations prove correct, actual results may still differ materially from those expressed in the forward-looking statements as a result of factors we may not anticipate or that may be beyond our control. While we cannot assess the future impact that any of these differences could have on our business, financial condition, results of operations and cash flows or the market price of shares of our common stock, the differences could be significant. We do not undertake to update any forward-looking statements made by us, whether as a result of new information, future events or otherwise. You are cautioned not to unduly rely on such forward-looking statements when evaluating the information presented in this report.

General Business Environment

The nuclear power industry has been largely dormant for the last thirty years with few opportunities to provide new full scope simulators. The Company’s nuclear simulation business has concentrated mainly on providing services to the installed base of nuclear simulators worldwide. These services are primarily related to upgrading antiquated simulation software and hardware systems, providing new and improved plant and system simulation models, and modifying the simulator to reflect changes in the physical plant. However, over the last several years, the nuclear power industry has experienced a dramatic change, and most energy experts believe the industry is on the verge of a “renaissance”, driven by the gap between the energy that the world is projected to need versus the current capacity, the rising cost of oil, and growing environmental concerns caused by fossil fuels. Government and industry sources and trade journals report that up to 200 new nuclear plants will be built over the next 20 years. In the U.S. alone, applications for accelerated construction and operating licenses have been or are expected to be submitted for 35 new nuclear plants. Each new plant will be required to have a full scope simulator ready for operator training and certification about two years prior to plant operation. In some cases where identical plants share a common site, one simulator will serve both plants. Similar nuclear plant construction programs are underway or planned in China, Russia, Ukraine, Japan and Central Europe to meet growing energy demands. In addition, most U.S. nuclear electric utilities have applied for license extensions and/or power upgrades. These license extensions will lead to significant upgrades to the physical equipment and control room technology which will result in the need to modify or replace the existing plant control room simulators. The Company, having what it believes is the largest installed base of existing simulators, over 60% on a global basis, is well positioned to capture a large portion of this business, although no assurance can be given that it will be successful in doing so. The Company logged approximately $21.1 million in nuclear simulation orders in the nine months ended September 30, 2008.

In 2005, the Company completed an agreement with Westinghouse Electric Company LLC (“Westinghouse”) to become their preferred vendor for the development of simulators for their AP1000 reactor design. As a result of this agreement, GSE is working closely with Westinghouse to cooperate in the development of simulators for the AP1000 design and assist Westinghouse in the verification and validation of the AP1000 Human Machine interface. The Company’s simulation models have been used to help Westinghouse successfully complete several phases of Human Machine Interface testing with customers, potential customers, and U.S. regulators. Westinghouse and its consortium partners received definitive multi-million dollar contracts to provide four AP1000 nuclear power plants in China. The four plants are to be constructed in pairs on China’s eastern coast at Sanmen in Zhejiang province and Haiyang in Shandong province. In September 2007, GSE received an initial contract from Westinghouse to begin work on the Sanmen simulator project in China. In February 2008, the Company received the balance of its multi-million dollar order for the Sanmen project. In April 2008, GSE received a contract from Westinghouse to begin work on the Haiyang simulator project also in China. The Westinghouse agreement is not exclusive and does not prevent the Company from working with other nuclear vendors anywhere in the world.

The Company’s fossil fueled power simulation business has been growing rapidly over the past three years. The transition from obsolete analog control systems to modern digital control systems and the new requirements for complex emission control systems are contributing to the growth the Company is experiencing in this business, coupled with the fact that GSE’s high-fidelity simulation models can be used to validate control schemes and logics for new designs before the control systems are deployed to the field. GSE builds the plant models based upon design specifications supplied by its customers, and the models then drive the actual digital control systems in the factory. This testing can uncover numerous control system discrepancies. By correcting these problems at the factory versus in the field, GSE’s customers can save millions in reduced down time and reduced commissioning time. The Company logged approximately $8.6 million in fossil simulation orders in the nine months ended September 30, 2008.

GSE’s process industries simulation business customers include primarily oil and gas production facilities, oil refining plants, chemical plants and petro-chemical facilities. The increased need for oil and oil based refined products coupled with the rising price of oil is creating a global expansion in oil production facilities. In addition, there is more focus on regular, periodic and systematic training of plant operator personnel which may reduce the risk of operator errors and potentially catastrophic environment disasters and/or loss of life.

Results of Operations

The following table sets forth the results of operations for the periods presented expressed in thousands of dollars and as a percentage of revenues:

(in thousands)	Three months ended September 30,											Nine months ended September 30,
	2008		%			2007			%			2008			%			2007		%
Contract revenue	$	7,001		100.0	%	$	7,526			100.0	%	$	20,639			100.0	%	$	23,769		100.0	%
Cost of revenue		5,023		71.7	%		5,150			68.4	%		14,889			72.1	%		16,345		68.8	%

Gross profit		1,978		28.3	%		2,376			31.6	%		5,750			27.9	%		7,424		31.2	%
Operating expenses:
Selling, general and administrative		1,694		24.3	%		1,813			24.1	%		5,585			27.1	%		5,567		23.4	%
Depreciation		114		1.6	%		59			0.8	%		317			1.5	%		168		0.7	%
Total operating expenses		1,808		25.9	%		1,872			24.9	%		5,902			28.6	%		5,735		24.1	%

Operating income (loss)		170		2.4	%		504			6.7	%		(152	)		(0.7	)%		1,689		7.1	%

Interest income (expense), net		42		0.6	%		(62	)