**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**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 March 31, 2007**                                                                                                              |
| ** **                            |
| **OR**                                |
|                                  |                                                                                                                                                           |
| **o**                                 | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                        |
|                                  |                                                                                                                                                           |
|                                  | **For the transition period from            to          ** |
|                                  |                                                                                                                                                           |
| **Commission  File Number 000-51846** |

 

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**CLAYTONHOLDINGS, INC.**

(Exact name of registrant as specified in its charter)

| **Delaware**                              |   | **20-2660764**                        |
|-------------------------------------------|--------|---------------------------------------|
| (State of  incorporation)                 |   | (I.R.S. Employer  Identification No.) |
|                                      |   |                                  |
| **2  Corporate Drive, Shelton, CT**       |   | **06484**                             |
| (Address of  principal executive offices) |   | (Zip Code)                            |

 

Registrant’stelephone number, including area code: **(203) 926-5600**

** **

 

(Former Name, Former Address and Former Fiscal year,if changed since last report)

Indicate by check mark whether the registrant:(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.   Yes  x    No  o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):
| Large  accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|----------------------------|---------------------|-------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o    No  x

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

21,075,778shares of Common Stock, par value $0.01 per share, outstanding as of May 7,2007.

 

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**INDEX**
| Part I.  Financial Information |                          | 1        |
|-------------------------------------|-------------------------------|----------|
|                                |                          |     |
|                                | Item 1.  Financial Statements |     | 1 |
|                                |                          |     |
|                                |                          |     |   | Condensed  Consolidated Balance Sheets as of March 31, 2007 (unaudited) and  December 31, 2006 |   | 1 |
|                                |                          |     |   |   |   |   |
|                                |                          |     |   | Condensed  Consolidated Statements of Operations (unaudited) for the three months ended  March 31, 2007 and 2006 |   | 2 |
|                                |                          |     |   |   |   |   |
|                                |                          |     |   | Condensed  Consolidated Statement of Changes in Stockholders’ Equity (unaudited) for the  three months ended March 31, 2007 |   | 3 |
|                                |                          |     |   |   |   |   |
|                                |                          |     |   | Condensed  Consolidated Statements of Cash Flows (unaudited) for the three months ended  March 31, 2007 and 2006 |   | 4 |
|                                |                          |     |   |   |   |   |
|                                |                          |     |   | Notes  to Condensed Consolidated Financial Statements (unaudited) |   | 6 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item  2. |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   | 21 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item  3. |   | Quantitative  and Qualitative Disclosures About Market Risk |   | 31 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item  4. |   | Controls  and Procedures |   | 31 |
|                                |                          |     |   |   |   |   |
| Part II.  Other Information    |                          | 33       |
|                                |                          |     |
|                                |                          | Item 1.  |   | Legal  Proceedings |   | 33 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item 1A. |   | Risk Factors |   | 33 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item  2. |   | Unregistered  Sales of Equity Securities and Use of Proceeds |   | 33 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item  3. |   | Defaults  Upon Senior Securities |   | 33 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item  4. |   | Submission  of Matters to a Vote of Security Holders |   | 33 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item 5.  |   | Other  Information |   | 33 |
|                                |                          |     |   |   |   |   |
|                                |                          | Item 6.  |   | Exhibits |   | 33 |
|                                |                          |     |   |   |   |   |
| Signatures                          |                          | 34       |
|                                |                          |     |   |   |   |   |
| Exhibit Index                  |                          |     |

 

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**PART I. FINANCIALINFORMATION**

**Item1.  Financial Statements**

**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**
| ** **                                                                                                                                                                                     | ** ** | **March 31, 2007** | ** **  | **December 31, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **(unaudited)**              | ** **  | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                                     |       |                         |        |                            |       |
| Current assets:                                                                                                                                                                                |       |                         |        |                            |       |
| Cash and cash  equivalents                                                                                                                                                                     |       | $                            | 18,353,554  |                            | $          | 22,881,553 |   |
| Restricted cash                                                                                                                                                                                |       | —                       |        | 11,738,871                      |       |
| Accounts  receivable, net of allowance for doubtful accounts of $358,789 and $191,569  as of March 31, 2007 and December 31, 2006, respectively                                                |       | 34,736,378                   |        | 37,452,008                      |       |
| Unbilled  receivables                                                                                                                                                                          |       | 14,968,576                   |        | 14,950,591                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                     |       | 3,447,088                    |        | 3,251,642                       |       |
| Prepaid income  taxes                                                                                                                                                                          |       | 4,859,939                    |        | 1,790,828                       |       |
| Deferred tax  assets                                                                                                                                                                           |       | 544,763                      |        | 571,835                         |       |
| Assets of  discontinued operations                                                                                                                                                             |       | —                       |        | 4,809,342                       |       |
| Total current  assets                                                                                                                                                                          |       | 76,910,298                   |        | 97,446,670                      |       |
|                                                                                                                                                                                           |       |                         |        |                            |       |
| Property and equipment,  net                                                                                                                                                                   |       | 20,412,116                   |        | 19,827,343                      |       |
| Goodwill                                                                                                                                                                                       |       | 69,843,468                   |        | 69,843,468                      |       |
| Intangible assets, net                                                                                                                                                                         |       | 71,795,936                   |        | 74,293,680                      |       |
| Other assets, net                                                                                                                                                                              |       | 1,615,668                    |        | 1,501,430                       |       |
|                                                                                                                                                                                           |       |                         |        |                            |       |
| Total assets                                                                                                                                                                                   |       | $                            | 240,577,486 |                            | $          | 262,912,591 |   |
|                                                                                                                                                                                           |       |                         |        |                            |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                 |       |                         |        |                            |       |
| Current liabilities:                                                                                                                                                                           |       |                         |        |                            |       |
| Long-term debt  and capital lease obligations, current portion                                                                                                                                 |       | $                            | 857,854     |                            | $          | 928,633 |   |
| Accounts payable  and accrued expenses                                                                                                                                                         |       | 16,826,350                   |        | 22,831,882                      |       |
| Servicer escrow  liability                                                                                                                                                                     |       | —                       |        | 11,738,871                      |       |
| Total current  liabilities                                                                                                                                                                     |       | 17,684,204                   |        | 35,499,386                      |       |
|                                                                                                                                                                                           |       |                         |        |                            |       |
| Long-term debt and  capital lease obligations, net of current portion                                                                                                                          |       | 59,257,928                   |        | 64,423,566                      |       |
| Deferred tax  liabilities                                                                                                                                                                      |       | 3,699,173                    |        | 4,088,816                       |       |
| Deferred revenue                                                                                                                                                                               |       | 400,145                      |        | 203,729                         |       |
| Deferred rent                                                                                                                                                                                  |       | 1,754,429                    |        | 968,045                         |       |
| Other long-term  liabilities                                                                                                                                                                   |       | 2,037,335                    |        | —                          |       |
|                                                                                                                                                                                           |       |                         |        |                            |       |
| Total  liabilities                                                                                                                                                                             |       | 84,833,214                   |        | 105,183,542                     |       |
|                                                                                                                                                                                           |       |                         |        |                            |       |
| Commitments and  contingencies                                                                                                                                                                 |       |                         |        |                            |       |
|                                                                                                                                                                                           |       |                         |        |                            |       |
| Stockholders’ equity:                                                                                                                                                                     |       |                         |        |                            |       |
| Common stock,  par value $0.01 per share, 150,000,000 shares authorized and 21,069,738 and  20,688,556 shares issued and outstanding as of March 31, 2007 and December  31, 2006, respectively |       | 210,698                      |        | 206,886                         |       |
| Additional  paid-in capital                                                                                                                                                                    |       | 143,350,392                  |        | 141,255,632                     |       |
| Retained  earnings                                                                                                                                                                             |       | 12,183,182                   |        | 16,266,531                      |       |
| Total  stockholders’ equity                                                                                                                                                               |       | 155,744,272                  |        | 157,729,049                     |       |
| Total liabilities and  stockholders’ equity                                                                                                                                               |       | $                            | 240,577,486 |                            | $          | 262,912,591 |   |

 

The accompanying notes are an integral part of thesestatements.

1

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**
| ** **                                                                             | ** ** | **For the three months ended March 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
|                                                                                   |       |                                                                   |       |   |   |
| Revenue                                                                                |       | $                                                                      | 53,352,165 |   | $ | 53,944,929 |   |
|                                                                                   |       |                                                                   |       |   |   |
| Cost of  services:                                                                     |       |                                                                   |       |   |   |
| Compensation expense                                                                   |       | 25,720,193                                                             |       | 28,511,150 |   |
| Travel and related expenses                                                            |       | 5,543,550                                                              |       | 7,126,568 |   |
| Other direct costs                                                                     |       | 2,477,360                                                              |       | 2,333,412 |   |
| Total cost of services                                                                 |       | 33,741,103                                                             |       | 37,971,130 |   |
|                                                                                   |       |                                                                   |       |   |   |
| Gross profit                                                                           |       | 19,611,062                                                             |       | 15,973,799 |   |
|                                                                                   |       |                                                                   |       |   |   |
| Operating  expenses:                                                                   |       |                                                                   |       |   |   |
| Salaries and benefits                                                                  |       | 5,671,574                                                              |       | 5,028,390 |   |
| Other selling, general and administrative expenses                                     |       | 5,433,158                                                              |       | 4,623,526 |   |
| Depreciation and amortization                                                          |       | 2,055,008                                                              |       | 1,501,468 |   |
| Amortization of intangibles                                                            |       | 2,497,745                                                              |       | 2,541,852 |   |
| Total operating expenses                                                               |       | 15,657,485                                                             |       | 13,695,236 |   |
|                                                                                   |       |                                                                   |       |   |   |
| Income from operations                                                                 |       | 3,953,577                                                              |       | 2,278,563 |   |
|                                                                                   |       |                                                                   |       |   |   |
| Interest  expense, net                                                                 |       | 1,191,942                                                              |       | 3,064,582 |   |
| Loss from  extinguishment of debt                                                      |       | 45,043                                                                 |       | 746,002 |   |
|                                                                                   |       |                                                                   |       |   |   |
| Income (loss)  from continuing operations before income taxes                          |       | 2,716,592                                                              |       | (1,532,021 | ) |
|                                                                                   |       |                                                                   |       |   |   |
| Income tax  (benefit) expense                                                          |       | 1,087,159                                                              |       | (644,007 | ) |
|                                                                                   |       |                                                                   |       |   |   |
| Income (loss)  from continuing operations                                              |       | 1,629,433                                                              |       | (888,014 | ) |
|                                                                                   |       |                                                                   |       |   |   |
| Loss from  discontinued operations:                                                    |       |                                                                   |       |   |   |
| Loss from operations (net of income tax benefit of $588,807 and $136,970, respectively |       | (968,076                                                               | )          | (189,150 | ) |
| Loss on disposal (net of income tax benefit of  $1,791,071)                            |       | (2,944,706                                                             | )          | — |   |
|                                                                                   |       |                                                                   |       |   |   |
| Net loss                                                                               |       | $                                                                      | (2,283,349 | ) | $ | (1,077,164 | ) |
|                                                                                   |       |                                                                   |       |   |   |
| Basic and  diluted income (loss) per share:                                            |       |                                                                   |       |   |   |
| Continuing operations                                                                  |       | $                                                                      | 0.08       |   | $ | (0.07 | ) |
| Discontinued operations                                                                |       | (0.19                                                                  | )          | (0.02 | ) |
| Total                                                                                  |       | $                                                                      | (0.11      | ) | $ | (0.09 | ) |
|                                                                                   |       |                                                                   |       |   |   |
| Weighted average  shares outstanding:                                                  |       |                                                                   |       |   |   |
| Basic                                                                                  |       | 20,795,207                                                             |       | 12,178,806 |   |
| Diluted                                                                                |       | 21,617,922                                                             |       | 12,178,806 |   |

 

The accompanying notes are an integral part of thesestatements.

2

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**(unaudited)**
| ** **                                                                                                     | ** ** | **Number of  shares** | ** ** | **Value**         | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|
| ** **                                                                                                     | ** ** | **Common  Stock**          | ** ** | **Common  Stock** | ** ** | **Additional paid-  in capital** | ** ** | **Retained  Earnings** | ** ** | **Total** | ** ** |
| ** **                                                                                                     | ** ** | ** **                 | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, January  1, 2007                                                                                      |       | 20,688,556                 |       | $                 | 206,886    |   | $ | 141,255,632 |   | $ | 16,266,531 |   | $ | 157,729,049 |   |
|                                                                                                           |       |                       |       |              |       |   |   |   |   |   |   |
| Adjustment for  the cumulative effect as of January 1, 2007 on prior years of the adoption of  FIN 48 (Note 9) |       | —                     |       | —            |       | — |   | (1,800,000 | ) | (1,800,000 | ) |
|                                                                                                           |       |                       |       |              |       |   |   |   |   |   |   |
| Stock based  compensation                                                                                      |       | 165,000                    |       | 1,650             |       | 297,908 |   | — |   | 299,558 |   |
|                                                                                                           |       |                       |       |              |       |   |   |   |   |   |   |
| Exercise of  stock options                                                                                     |       | 216,182                    |       | 2,162             |       | 721,299 |   | — |   | 723,461 |   |
|                                                                                                           |       |                       |       |              |       |   |   |   |   |   |   |
| Tax benefit of  options exercised                                                                              |       | —                     |       | —            |       | 1,075,553 |   | — |   | 1,075,553 |   |
|                                                                                                           |       |                       |       |              |       |   |   |   |   |   |   |
| Net loss for the  three months ended March 31, 2007                                                            |       | —                     |       | —            |       | — |   | (2,283,349 | ) | (2,283,349 | ) |
|                                                                                                           |       |                       |       |              |       |   |   |   |   |   |   |
| Balance, March 31, 2007                                                                                        |       | 21,069,738                 |       | $                 | 210,698    |   | $ | 143,350,392 |   | $ | 12,183,182 |   | $ | 155,744,272 |   |

 

The accompanying notes are an integral part ofthis statement.

3

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**
| ** **                                                                       | ** ** | **For the three months ended March 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                       | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
|                                                                             |       |                                                                   |       |   |   |
| Cash flows from  operating activities:                                           |       |                                                                   |       |   |   |
| Net loss                                                                         |       | $                                                                      | (2,283,349 | ) | $ | (1,077,164 | ) |
| Add: Loss on disposal of discontinued  operations                           |       | 2,944,706                                                              |       | — |   |
|  Loss from discontinued operations                                          |       | 968,076                                                                |       | 189,150 |   |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                                                   |       |   |   |
| Depreciation and amortization                                                    |       | 2,055,008                                                              |       | 1,501,468 |   |
| Amortization of intangibles                                                      |       | 2,497,745                                                              |       | 2,541,852 |   |
| Amortization of debt issuance cost                                               |       | 66,951                                                                 |       | 112,452 |   |
| Adoption of FIN 48                                                               |       | 237,335                                                                |       | — |   |
| Loss from extinguishment of debt                                                 |       | 45,043                                                                 |       | 746,002 |   |
| Stock based compensation                                                         |       | 299,558                                                                |       | 714,872 |   |
| Deferred income taxes                                                            |       | (454,277                                                               | )          | (727,230 | ) |
| Loss (gain) on sale of fixed assets                                              |       | 14,716                                                                 |       | (2,095 | ) |
| Provision for doubtful accounts                                                  |       | 54,559                                                                 |       | — |   |
| Changes in operating assets and liabilities, net of  business combinations:      |       |                                                                   |       |   |   |
|  Accounts receivable                                                        |       | 901,303                                                                |       | (1,197,386 | ) |
|  Unbilled receivables                                                       |       | 139,927                                                                |       | (1,383,956 | ) |
|  Prepaid expenses and other current assets                                  |       | (191,460                                                               | )          | 1,353,077 |   |
|  Prepaid income taxes                                                       |       | (597,563                                                               | )          | 23,241 |   |
|  Due to an affiliated entity                                                |       | —                                                                 |       | 188 |   |
|  Other assets, net                                                          |       | (226,231                                                               | )          | (14,274 | ) |
|  Accounts payable and accrued expenses                                      |       | (5,616,476                                                             | )          | (175,323 | ) |
|  Deferred revenue                                                           |       | 104,400                                                                |       | (438,978 | ) |
|  Deferred rent                                                              |       | 786,241                                                                |       | 21,400 |   |
|  Net cash provided by operating activities                                  |       | 1,746,212                                                              |       | 2,187,296 |   |
|                                                                             |       |                                                                   |       |   |   |
| Cash flows from  investing activities:                                           |       |                                                                   |       |   |   |
| Proceeds from sale of fixed assets                                               |       | 950                                                                    |       | 35,000 |   |
| Capital expenditures                                                             |       | (2,834,967                                                             | )          | (2,955,188 | ) |
| Acquisition of businesses                                                        |       | —                                                                 |       | (6,120,011 | ) |
| Cash held in escrow from acquisition of businesses inclusive  of interest earned |       | —                                                                 |       | (600,656 | ) |
|  Net cash used in investing activities                                      |       | (2,834,017                                                             | )          | (9,640,855 | ) |
|                                                                             |       |                                                                   |       |   |   |
| Cash flows from  financing activities:                                           |       |                                                                   |       |   |   |
| Proceeds from revolving credit facility                                          |       | —                                                                 |       | 7,400,000 |   |
| Repayments of revolving credit facility                                          |       | —                                                                 |       | (7,400,000 | ) |
| Repayments of capital lease obligations                                          |       | (38,287                                                                | )          | (35,172 | ) |
| Repayment of term loan                                                           |       | (5,162,719                                                             | )          | (70,000,000 | ) |
| Deferred charges related to the issuance of debt                                 |       | —                                                                 |       | (74,158 | ) |
| Proceeds from issuance of common stock upon initial public  offering             |       | —                                                                 |       | 146,625,000 |   |
| Underwriting commissions and offering expenses                                   |       | —                                                                 |       | (14,776,320 | ) |
| Redemption of convertible preferred stock                                        |       | —                                                                 |       | (52,764,950 | ) |
| Excess tax benefits from share-based compensation  arrangements                  |       | 1,075,553                                                              |       | — |   |
| Proceeds from the exercise of stock options                                      |       | 723,461                                                                |       | — |   |
|   Net cash (used in) provided by financing  activities                      |       | (3,401,992                                                             | )          | 8,974,400 |   |
|                                                                             |       |                                                                   |       |   |   |
| Cash flows from  discontinued operations (revised - see Note 3):                 |       |                                                                   |       |   |   |
| Operating cash flows                                                             |       | (2,791                                                                 | )          | (233,372 | ) |
| Investing cash flows                                                             |       | —                                                                 |       | (2,522 | ) |
| Financing cash flows                                                             |       | (35,411                                                                | )          | (43,443 | ) |
|                                                                             |       | (38,202                                                                | )          | (279,337 | ) |
|                                                                             |       |                                                                   |       |   |   |
|  Net (decrease) increase in cash and cash  equivalents                      |       | (4,527,999                                                             | )          | 1,241,504 |   |
|                                                                             |       |                                                                   |       |   |   |
| Cash and cash  equivalents at the beginning of the period                        |       | 22,881,553                                                             |       | 7,208,875 |   |
|                                                                             |       |                                                                   |       |   |   |
| Cash and cash  equivalents at the end of the period                              |       | $                                                                      | 18,353,554 |   | $ | 8,450,379 |   |

 

The accompanying notes are an integral part ofthese statements.

4

----

 
| ** **                                           | ** ** | **For the three months ended March 31,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
|                                                 |       |                                                                   |       |   |   |
| Supplementary  disclosures of cash flow information: |       |                                                                   |       |   |   |
| Cash paid during the period for:                     |       |                                                                   |       |   |   |
|                                                 |       |                                                                   |       |   |   |
| Income taxes                                         |       | $                                                                      | 928,562    |   | $ | 79,536 |   |
|                                                 |       |                                                                   |       |   |   |
| Interest                                             |       | $                                                                      | 604,595    |   | $ | 2,234,872 |   |
|                                                 |       |                                                                   |       |   |   |
| Other noncash  investing and financing activities:   |       |                                                                   |       |   |   |
| Assets acquired under capital lease                  |       | $                                                                      | —     |   | $ | 220,279 |   |
| Liabilities  assumed from acquisitions               |       | $                                                                      | —     |   | $ | 1,108,270 |   |

 

The accompanying notes are an integral part ofthese statements.

5

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**CLAYTONHOLDINGS, INC. AND SUBSIDIARIESNOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(unaudited)**

**Note 1—Organization, Description of Business and Basis ofPresentation**

Clayton Holdings, Inc. (collectively with itswholly owned subsidiaries, the “Company”) was formed on March 31, 2005 asa Delaware corporation. The Company was formed to combine two companies whichwere under common control, GRP Holdings, Inc. (“GRP”), a Delawarecorporation, and TMHC Holdings, Inc. (“TMHC”), a Delaware corporation. GRPwas formed to acquire Clayton Services, Inc. (“CSI”) and First MadisonServices, Inc. (“FMS”) from unrelated parties on August 2, 2004. TMHCwas formed to acquire Clayton Fixed Income Services Inc., formerly known as “TheMurrayhill Company” (“CFIS”), from an unrelated party on May 24, 2004.

The Company provides a full suite of outsourcedservices, information-based analytics and specialty consulting for buyers andsellers of, and investors in, mortgage-related loans and securities and other debtinstruments. The Company’s services include (i) transaction management, whichconsists of due diligence, conduit support services, professional staffingservices, and compliance products and services, (ii) credit risk management andsecurities surveillance and (iii) special servicing. The Company usesproprietary technology and processes to provide these services across thelifecycle of a loan, from loan origination, aggregation and securities issuanceto the surveillance and administration of loans and securities. The Companyprovides a majority of its services to participants in the non-agency segmentof the mortgage-backed securities, or MBS, market and the non-conformingmortgage loan market.

***Basis of Presentation***

The accompanying condensed consolidated financialstatements are unaudited. In the opinion of management, all adjustments,consisting of only normal recurring adjustments considered necessary for a fairpresentation, have been included. Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States (“US GAAP”) havebeen condensed or omitted. It is suggested that these unaudited condensedconsolidated financial statements be read in conjunction with the consolidatedfinancial statements, accounting policies and notes included in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2006, which includesaudited financial statements. Results for the interim periods are notnecessarily indicative of results for the full year.

***Initial Public Offering of Common Stock***

On March 29, 2006, the Company sold8,625,000 shares, inclusive of an over-allotment option of 1,125,000shares, of its common stock in an initial public offering (“IPO”) of commonstock at a price to the public of $17.00 per share, for net proceeds ofapproximately $131,800,000 after deducting the underwriting discount andapproximately $4,500,000 of offering expenses. The Company used approximately$130,200,000 of the proceeds to pay down indebtedness and to redeem alloutstanding shares of redeemable preferred stock, which were issued upon theconversion of the Company’s convertible preferred stock. The Company usedthe remaining approximately $1,600,000 for general corporate purposes. Aftergiving effect to this offering, the Company had 20,516,306 shares ofcommon stock outstanding.

Allshare information has been adjusted to reflect a 1-for-4 reverse stock split ofcommon stock and class B common stock, which was consummated onMarch 1, 2006.

**Note 2—Summary of Significant Accounting Policies**

Significant accounting policies followed by theCompany, as summarized below, are in conformity with US GAAP.

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***Principles of Consolidation***

The consolidated financial statements include theaccounts of the Company. All significant intercompany transactions and balanceshave been eliminated in consolidation.

***Use of Estimates***

The preparation of consolidated financial statementsin conformity with US GAAP requires management to make estimates andassumptions that affect the reported amounts of assets, liabilities, revenuesand expenses, as well as the disclosure of contingent assets and liabilities inthe financial statements and accompanying notes. Some of these accounting policiesrequire the application of significant judgment by management in the selectionof appropriate assumptions for determining these estimates. By their nature,these judgments are subject to an inherent degree of uncertainty; therefore,the Company cannot give assurance that actual results will not differsignificantly from estimated results. Management bases these judgments on theCompany’s historical experience, management’s forecasts and other availableinformation, as appropriate. The most significant estimates reflected in thefinancial statements include deferred tax assets and liabilities, income taxaccruals, valuation allowance for accounts receivable, unbilled receivables,asset impairments, the valuation of stock options and the valuation of intangibleassets and assessments of their useful lives, and related party transactions.Actual results could differ from estimated amounts. The Company also makesestimates in determining other ordinary accruals.

***Segment Reporting***

The Company hasthree reportable segments which are operated and managed as strategic businessunits: Transaction Management, Special Servicing and Surveillance.  For more information concerning thesebusiness segments, see Note 14.

***Accounts Receivable and Allowance for Doubtful Accounts***

The Company’saccounts receivable are due from customers in the normal course of business.Credit decisions are made based on an evaluation of a customers’ financialcondition. Accounts receivable are generally due within 30 days. Interest isnot charged on delinquent payments.

The Company makesestimates to determine the amount of the allowance for doubtful accountsnecessary to reduce accounts receivable and unbilled receivables to theirexpected net realizable value. The Company estimates the amount of the requiredallowance by reviewing the status of significant past-due receivables and byanalyzing historical bad debt trends and realization adjustments to revenue.Actual collection experience has not varied significantly from estimates, due primarilyto credit policies, the controls and procedures designed to estimaterealization adjustments to revenue and a lack of concentrations of accountsreceivable. Accounts receivable balances are not collateralized.

***Deferred Financing Costs***

The Company amortizes the costs that it incurs toobtain debt financing over the terms of the underlying obligations using theeffective interest method for the portion of the costs associated with termloan debt and using the straight line method for the portion of the costsassociated with the revolving credit facility. The amortization of deferredfinancing costs is included in interest expense. Unamortized deferred financingcosts are included in “other assets, net” in the accompanying condensedconsolidated balance sheets. On February 5, 2007, the Company repaid $5,000,000of its outstanding term loan balance and wrote off a proportionate share of theunamortized deferred financing costs associated with the term loan.  There were no penalties associated with thisrepayment.  In addition, as a result ofthe Company’s IPO (see Note 1) on March 29, 2006, the Company repaid$70,000,000 of principal on its $150,000,000 term loan and wrote off aproportionate share of the unamortized deferred financing costs associated withthe term

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loan.Losses on extinguishment of $45,043 and $746,002 reflecting these write-offsare reflected in the statements of operations for the three months ended March31, 2007 and 2006, respectively. Unamortized deferred financing costs at March31, 2007 and December 31, 2006 were $1,175,699 and $1,287,694,respectively, and are included on the accompanying consolidated balance sheetsin “other assets, net.”

***Escrow andFiduciary Funds***

The Company maintains segregated bank accounts intrust for the benefit of clients for payments on mortgage loans serviced forclients. The Company also maintains bank accounts for the benefit of borrowers’property tax and hazard insurance premium payments that are escrowed byborrowers. These bank accounts totaled $13,869,892 at March 31, 2007, and havebeen excluded from the Company’s assets and liabilities effective January 1,2007, because the Company does not have title to or use of the funds.  The Company believes this treatment ispreferential because it more accurately represents the operations and cashposition of the Company.

At December 31, 2006, the Company maintained arestricted cash balance of $11,738,871. This balance represented funds receivedin connection with certain loan servicing functions the Company performs for acustomer. Such funds are received throughout the month and remitted to thecustomer on a monthly basis. The balance on hand is included in servicer escrowliability in the accompanying condensed consolidated balance sheet at December31, 2006.

***Revenue Recognition***

Revenue is recognized when persuasive evidence of anarrangement exists, the service has been performed, the fee is fixed anddeterminable, and collection of the resulting receivable is reasonably assured.

The Company derives most of its revenues fromprofessional service activities.  Revenues consisting of billed fees andpass-through expenses are recorded as work is performed and expenses areincurred. Revenues also include expenses billed to clients, which includestravel and other out-of-pocket expenses, and other reimbursable expenses. Basedon aggregate volume of all travel expenses incurred for both corporate purposesand client service activities, the Company is eligible to receive certainretroactive volume discounts from several of its travel providers. Such amountsare accrued as earned, are netted against travel and related expenses andhistorically have not been material.  For the three months ended March 31,2007 and 2006, pass-through expenses included in revenues were $5,543,550 and$7,126,568, respectively.

The Company records provisions for fee adjustments anddiscretionary pricing adjustments as a reduction of revenues. Revenuesrecognized, but not yet billed to clients, have been recorded as unbilledreceivables in the accompanying condensed consolidated balance sheets.

***Cost of Services***

Direct cost ofoperations consists primarily of employee compensation and related payrollbenefits, the cost of billable labor assigned to revenue-generating activitiesas well as corresponding travel and related expenses incurred in providing suchservices to clients. Direct cost of operations does not include an allocationof overhead costs.

***Income Taxes***

The Companyrecognizes deferred income tax liabilities and assets for the expected futuretax consequences of events that have been included in the financial statementsor tax returns. Deferred income tax liabilities and assets are determined basedon the difference between the financial statement and the tax basis of assetsand liabilities using enacted tax rates in effect for the year in which thedifferences are expected to reverse. The Company recognizes deferred tax assetsif it is more likely than not that the assets will be realized in future yearsand a valuation allowance on the deferred tax assets if they are deemed to beimpaired.

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The Company adopted FASB Interpretation (“FIN”) No.48, “Accounting for Uncertainty in Income Taxes,” on January 1, 2007 (see Note9).

***Stock-based Compensation***

The Companyadopted the fair value measurement provisions of SFAS No. 123(R), “Share-BasedPayment,” using the prospective method under which the Company recognizes thecompensation expense of a stock-based award to an employee over the vestingperiod based on the fair value of the award on the grant date consistent withthe method described in Note 13.

***Concentration of Credit Risk andSignificant Customers***

At March 31, 2007, 22.4% and 19.9% of the Company’sbilled and unbilled receivables were related to its two largest clients,respectively. At December 31, 2006, 23.1% and 29.2% of the Company’sbilled and unbilled receivables, respectively, were related to its two largestclients.

For the three months ended March 31, 2007 and 2006,revenue from the Company’s largest two clients accounted for an aggregate of20.9% and 25.5% of total revenue, respectively. Revenue from one clientexceeded 10% of revenue for the three months ended March 31, 2007 and 2006.

***Earnings Per Share***

Basic earnings per share is computed by dividing netincome by the weighted-average number of shares of common stock and commonstock equivalents outstanding during the period.  Diluted earnings per share gives effect todilutive options, restricted stock awards and units, and other potential commonstock outstanding during the period.  At March 31, 2007, outstandingoptions to purchase 32,500 common shares had exercise prices in excess of theaverage market price of common shares for the three month period ended March31, 2007.  At March 31, 2006, outstanding options to purchase 815,242common shares had exercise prices in excess of the average market price ofcommon shares for the three month period ended March 31, 2006.  Theseoptions were not included in the computation of diluted earnings per share forthe respective periods because the effect would be antidilutive.

For the three months ended March 31, 2007, 163,350shares of restricted stock are excluded from basic weighted average shares ofcommon stock outstanding and included in dilutive shares of common stock usingthe treasury stock method.  Such shareswill be included in basic weighted average shares of common stock outstandingwhen they are no longer contingent upon the satisfaction of all specifiedconditions.  In addition, at March 31,2007, there were 5,410 deferred stock units issued under the Company’sNon-Employee Directors’ Compensation Plan. These securities have not been included in the diluted earnings pershare calculation because their inclusion would have had an antidilutiveeffect.

The following table presents a reconciliation of thenumerators and denominators of basic and diluted earnings per share for thethree months ended March 31, 2007 and 2006:
| ** **                                                  | ** ** | **For the three months ended** | ** ** | **For the three months ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                  | ** ** | **March 31, 2007**                       | ** ** | **March 31, 2006**                       | ** ** |
| ** **                                                  | ** ** | **Basic**                                          | ** ** | **Diluted**                                        | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Income (loss)  from continuing operations                   |       | $                                                  | 1,629,433  |                                               | $          | 1,629,433 |   | $ | (888,014 | ) | $ | (888,014 | ) |
| Loss from  discontinued operations                          |       | (3,912,782                                         | )          | (3,912,782                                         | )          | (189,150 | ) | (189,150 | ) |
| Net loss                                                    |       | $                                                  | (2,283,349 | )                                                  | $          | (2,283,349 | ) | $ | (1,077,164 | ) | $ | (1,077,164 | ) |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Weighted average  number of common shares outstanding       |       | 20,795,207                                         |       | 20,795,207                                         |       | 12,178,806 |   | 12,178,806 |   |
| Effect of  dilutive shares                                  |       | —                                             |       | 822,715                                            |       | — |   | — |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Total weighted  average number of common shares outstanding |       | 20,795,207                                         |       | 21,617,922                                         |       | 12,178,806 |   | 12,178,806 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Income (loss)  per share from continuing operations         |       | $                                                  | 0.08       |                                               | $          | 0.08 |   | $ | (0.07 | ) | $ | (0.07 | ) |
| Loss per share  from discontinued operations                |       | (0.19                                              | )          | (0.19                                              | )          | (0.02 | ) | (0.02 | ) |
| Net loss per share                                          |       | $                                                  | (0.11      | )                                                  | $          | (0.11 | ) | $ | (0.09 | ) | $ | (0.09 | ) |

 

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***Adoption of New Accounting Pronouncements***

The Company adopted FASB Interpretation (“FIN”) No.48, “Accounting for Uncertainty in Income Taxes,” on January 1, 2007 (see Note9).

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements.”   SFAS No. 157establishes a common definition for fair value to be applied to US GAAPguidance requiring use of fair value, establishes a framework for measuringfair value, and expands disclosure about such fair value measurements. SFAS No.157 is effective for fiscal years beginning after November 15, 2007. TheCompany is currently assessing the impact of SFAS No. 157 on its consolidatedfinancial position and results of operations.

***Reclassifications***

Certain reclassifications have been made to priorperiods’ financial statements to conform to the current year presentation.  These reclassifications had no effect onpreviously reported results of operations or retained earnings.

**Note 3—Recent Transactions**

***Asset Purchase fromM R Network I, Ltd.***

On February 3, 2006, the Company entered into anasset purchase agreement through a subsidiary pursuant to which the subsidiaryacquired substantially all of the assets and assumed certain liabilities ofM R Network I, Ltd. (formerly d/b/a Mortgage ResourceNetwork and thereafter d/b/a Clayton Lender Solutions, Inc. (“CLS”)) foran aggregate purchase price of $5,344,970. This acquisition was not presented on a pro forma basis because it wasnot deemed to be material.

The purchase price was allocated as follows:
| Accounts receivable                                |   | $          | 952,943   |   |
|----------------------------------------------------|--------|------------|-----------|--------|
| Prepaid expenses                                   |   | 19,030     |      |
| Property and  equipment                            |   | 957,792    |      |
|                                               |   |       |      |
| Goodwill                                           |   | 3,558,177  |      |
| Intangible  assets – customer relationships   |   | 771,000    |      |
| Intangible  assets – noncompetition agreement |   | 74,000     |      |
| Deposit                                            |   | 25,986     |      |
| Liabilities  assumed                               |   | (1,013,958 | )         |
|                                               |   |       |      |
|                                               |   | $          | 5,344,970 |   |

 

***Discontinued Operations***

On March 28, 2007, the Company’s Board ofDirectors approved the recommendation of management that it discontinue theoperations of CLS.  The pre-tax chargerecorded during the first quarter of 2007 in connection with the CLS shutdownwas $4,735,777 ($2,944,706 after tax) and consisted of a pre-tax non-cashimpairment charge related to the impairment of goodwill, intangible assets andproperty and equipment.  CLS is expectedto cease operations by June 30, 2007.

In accordance with SFAS No. 144, any component of theCompany’s business that is disposed of or is classified as held for sale thathas operations and cash flows clearly distinguishable from operations, and forfinancial reporting purposes, and that will be eliminated from the ongoingoperations, should be classified as discontinued operations.  Accordingly, the Company has classified theresults of operations of CLS as discontinued operations in the consolidatedstatement of operations and has restated prior periods.

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Summarized financial information for CLS (discontinuedoperations) is set forth below:
|                               | ** ** | **For the Three Months Ended March 31,** | ** ** |
|-------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                    | ** ** | **2007**                                                               | ** ** | **2006** | ** ** |
| Revenue                       |       | $                                                                      | 543,398    |   | $ | 1,282,683 |   |
| Operating loss                |       | $                                                                      | (1,524,056 | ) | $ | (320,417 | ) |
| Income tax  benefit           |       | $                                                                      | 588,807    |   | $ | 136,970 |   |
| Net loss                      |       | $                                                                      | (968,076   | ) | $ | (189,150 | ) |
| Loss on disposal, net  of tax |       | $                                                                      | (2,944,706 | ) | $ | — |   |

 
|                                          | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------|------------|-----------------------------|------------|
| Net property and  equipment              |       | $                           | 537,523    |   |
| Goodwill                                 |       | 3,558,177                   |       |
| Other  intangibles                       |       | 713,642                     |       |
| Total assets of  discontinued operations |       | $                           | 4,809,342  |   |

 

**Note 4—Cash, Cash Equivalents and Restricted Cash**

At March 31, 2007 and December 31, 2006, theCompany maintained cash and cash equivalent balances in excess of $100,000 attwo separate financial institutions. Accounts at these institutions are insuredby the Federal Deposit Insurance Corporation up to $100,000. At March 31, 2007and December 31, 2006, the cash balances exceeded $100,000 by $19,972,794and $31,862,444, respectively, including restricted cash at December 31, 2006.

**Note 5—Property and Equipment, net**

Property and equipment, net consists of the following:
|                                                 | ** ** | **March 31,  2007** | ** ** | **December 31,   2006** | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|-----------------------------------|------------|
|                                            |       |                     |       |                              |       |
| Computer and  office equipment                  |       | $                        | 10,260,610 |                              | $          | 10,013,263 |   |
| Software                                        |       | 17,862,442               |       | 17,595,533                        |       |
| Furniture and  fixtures                         |       | 3,199,452                |       | 3,196,680                         |       |
| Leasehold  improvements                         |       | 2,260,987                |       | 1,851,453                         |       |
| Website                                         |       | 280,317                  |       | 280,317                           |       |
| Automobiles                                     |       | 112,336                  |       | 112,336                           |       |
|                                            |       | 33,976,144               |       | 33,049,582                        |       |
| Less accumulated  depreciation and amortization |       | 15,945,517               |       | 13,804,706                        |       |
|                                            |       | 18,030,627               |       | 19,244,876                        |       |
| Construction in  progress                       |       | 1,635,050                |       | 65,925                            |       |
| Software under  development                     |       | 746,439                  |       | 516,542                           |       |
|                                            |       | $                        | 20,412,116 |                              | $          | 19,827,343 |   |

 

Included in software at March 31, 2007 andDecember 31, 2006, is $10,510,370 and $10,383,256, respectively, ofinternally developed software placed in service. Software under developmentrepresents other internally developed software that has not yet been placed inservice.

For the three months ended March 31, 2007 and 2006depreciation and amortization expense charged to operations was $2,055,008 and$1,501,468, respectively.

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**Note 6—Goodwill and Other Intangible Assets**

As of March 31, 2007 and December 31, 2006,intangible assets not subject to amortization consisted of goodwill of$69,843,468, and trade names and trademarks of $15,504,917.

At March 31, 2007, the Company’s intangible assetswith identifiable useful lives, which continue to be amortized, consisted ofthe following:
| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer  relationships             |       |                            |       |                          |       |       |       |
| Transaction management and advisory |       | $                               | 36,400,000 |                          | $          | 5,392,593  |       | $ | 31,007,407 |   |
| Staffing services                   |       | 4,300,000                       |       | 1,146,667                     |       | 3,153,333  |       |
| Portfolio management                |       | 10,008,600                      |       | 2,803,692                     |       | 7,204,908  |       |
| Client backlog                      |       | 2,146,200                       |       | 1,225,411                     |       | 920,789    |       |
| Technology                          |       | 26,842,900                      |       | 14,430,731                    |       | 12,412,169 |       |
| Noncompetition  agreements          |       | 3,494,950                       |       | 1,913,026                     |       | 1,581,924  |       |
| Patent                              |       | 20,452                          |       | 9,963                         |       | 10,489     |       |
|                                |       | $                               | 83,213,102 |                          | $          | 26,922,083 |       | $ | 56,291,019 |   |

 

At December 31, 2006, the Company’s intangibleassets with identifiable useful lives, which continue to be amortized,consisted of the following: 
| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer  relationships             |       |                            |       |                          |       |       |       |
| Transaction management and advisory |       | $                               | 36,400,000 |                          | $          | 4,887,037  |       | $ | 31,512,963 |   |
| Staffing services                   |       | 4,300,000                       |       | 1,039,167                     |       | 3,260,833  |       |
| Portfolio management                |       | 10,008,599                      |       | 2,548,308                     |       | 7,460,291  |       |
| Client backlog                      |       | 2,146,200                       |       | 1,118,101                     |       | 1,028,099  |       |
| Technology                          |       | 26,842,900                      |       | 13,088,586                    |       | 13,754,314 |       |
| Noncompetition  agreements          |       | 3,494,950                       |       | 1,734,880                     |       | 1,760,070  |       |
| Patent                              |       | 20,452                          |       | 8,259                         |       | 12,193     |       |
|                                |       | $                               | 83,213,101 |                          | $          | 24,424,338 |       | $ | 58,788,763 |   |

 

In connection with the CLS shutdown, in March 2007 theCompany recorded an impairment charge of $4,735,777 to reflect the write-off ofgoodwill and intangible assets.

In December 2006,the Company recorded an impairment charge of $279,458 to reflect the write-offof certain customer relationships associated with portfolio management.

Amortization expense for the three months ended March31, 2007 and 2006 was $2,497,745 and $2,541,852, respectively.

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**Note 7—Revolving Credit Facility, Long-Term Debt and CapitalLease Obligations**

Long-term debt and capital lease obligations consistof the following: 
|                                         | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Term loans                              |       | $                        | 59,436,279 |                        | $          | 64,598,998 |   |
|                                    |       |                     |       |                        |       |
| Capital lease  obligations              |       | 679,503                  |       | 753,201                     |       |
|                                    |       |                     |       |                        |       |
| Total long-term debt                    |       | 60,115,782               |       | 65,352,199                  |       |
| Less current  portion                   |       | 857,854                  |       | 928,633                     |       |
|                                    |       |                     |       |                        |       |
| Long-term debt,  net of current portion |       | $                        | 59,257,928 |                        | $          | 64,423,566 |   |

 

***Credit Agreement***

OnDecember 8, 2005 the Company entered into a credit agreement (the “CreditAgreement”) with a financial institution. The Credit Agreement provided theCompany with a $150,000,000 term loan, all of which was funded at closing, anda $40,000,000 revolving credit facility, none of which was funded at closing.Subject to the agreement of the lenders to increase their commitments, theCompany had the option to borrow up to an additional $10,000,000 under therevolving credit facility, for an aggregate revolving credit facility of$50,000,000. On January 11, 2006 and April 28, 2006, the Companyexercised its option and amended the Credit Agreement to increase the revolvingcredit facility by $5,000,000 on each date, such that the Company had anaggregate revolving credit facility of $50,000,000 as of, and subsequent to,April 28, 2006.

After the Company’sinitial public offering was completed on March 29, 2006 the Company repaid$70,000,000 of the $150,000,000 outstanding term loan balance without incurringany prepayment penalty. In addition, $7,400,000 which was outstanding under therevolving credit facility was repaid. In February 2007, the Company prepaid$5,000,000 outstanding under the term loan.

The Credit Agreement terminates on December 8,2011. Principal repayments on the term loan of $150,092 are required on aquarterly basis for each quarter through 2010, and the remaining principalbalance at the end of 2010 is repayable in equal quarterly installments during2011. This facility can be used to fund acquisitions requiring cash, as well asto fund short-term liquidity needs. Liquidity needs occasionally arise as aresult of differences in the timing between collecting accounts receivable andmaking disbursements to support operations.

The Credit Agreement is collateralized bysubstantially all of the assets of the Company. The Credit Agreement containscovenants which, among other matters, require the Company to maintain certaininterest coverage, fixed charge and total leverage ratios. These covenantsbecame effective on March 31, 2006. The Company is in compliance withthese covenants as of March 31, 2007. In addition, the Credit Agreement placeslimitations on total annual capital expenditures, indebtedness, liens,dividends and distributions, asset sales, transactions with affiliates,acquisitions and conduct of business, all as defined in the agreement. The CreditAgreement also contains provisions for an increased rate of interest duringperiods of default.

On March 15, 2007, the terms of the Credit Agreementwere amended.  The amendment lowered theinterest rate on borrowings under the Credit Agreement to the applicable Londoninterbank offered rate (“LIBOR”) plus 1.75%, or Prime Rate plus 0.75%, at theCompany’s option.  Prior to theamendment, loans under the Credit Agreement bore interest at LIBOR plus 3.00%or Prime rate plus 2.00%, at the Company’s option.  In addition, the Company is required to pay acommitment fee of 0.5% based on the calculation of the excess of the revolvingcredit loan commitment over the revolving outstanding balance as defined in theCredit Agreement.

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At March 31, 2007 and December 31, 2006, therevolving credit facility had no outstanding balance and there was anoutstanding balance of $59,436,279 and $64,598,998, respectively, under theterm loan with an interest rate of 7.07% and 8.55%, respectively.

On May 4, 2007 the Company repaid $5,000,000outstanding under the term loan.

***Capitalized Lease Obligations***

At March 31, 2007, the Company leased $1,068,087 ofequipment under agreements accounted for as capital leases with accumulateddepreciation of $382,068. The obligations for the equipment required theCompany to make monthly payments through March 2011, with implicitinterest rates from 7.06% to 19.06%.

At December 31, 2006, the Company leased$1,068,087 of equipment under agreements accounted for as capital leases withaccumulated depreciation of $311,169. The obligations for the equipmentrequired the Company to make monthly payments through August 2011, withimplicit interest rates from 7.06% to 19.06%.

**Note 8—Preferred Stock**

On March 29, 2006, the Company completed itsinitial public offering of common stock, resulting in the conversion of theSeries A Convertible Preferred Stock into 2,206,308 shares of commonstock, par value $0.01 per share, and 8,825,241 shares of Series ARedeemable Preferred Stock, and the conversion of 24,185,493 shares ofSeries B Convertible Preferred Stock into 6,046,371 shares of commonstock, par value $0.01 per share, and 24,185,493 shares of Series BRedeemable Preferred Stock. A portion of the proceeds from the initial publicoffering was used to redeem all shares of the Series A RedeemablePreferred Stock and Series B Redeemable Preferred Stock for $52,764,950,and all of the Series A and Series B Redeemable Preferred Stock wereimmediately retired. The difference between the liquidation preference amountof the convertible preferred stock and the redemption amount of the redeemablepreferred stock was allocated to the common stock resulting from the conversionand credited to additional paid-in capital.

**Note 9—Income Taxes**

On January 1, 2007, the Company adopted FIN 48. As aresult of the implementation of FIN 48, the Company recognized an increase of$1,800,000 in the liability for unrecognized tax benefits, which was accountedfor as a decrease to the January 1, 2007 balance of retained earnings. Asof the date of adoption and after the impact of recognizing the increase inliability noted above, the Company’s unrecognized tax benefits totaled$1,943,000, all of which would impact the effective income tax rate ifrecognized.  Within the next twelvemonths, it is not expected that there will be any material changes to thisbalance.

The Company recognizes potential accrued interest andpenalties related to unrecognized tax benefits within its operations in incometax expense. In conjunction with the adoption of FIN 48, the Company recognizedapproximately $64,000 for the payment of interest and penalties atJanuary 1, 2007 which is included as a component of the $1,800,000unrecognized tax benefit noted above. During the three months ended March 31,2007, the Company recognized approximately $18,000 in potential interest andpenalties associated with uncertain tax positions.

The Company and its subsidiaries file income taxreturns in the United States Federal jurisdiction and in various state andforeign jurisdictions.  With fewexceptions, the Company is subject to U.S. Federal, and to state and localincome tax examinations for the tax years 2004 through 2006 and is subject toforeign income tax examinations for the period ended December 31, 2006.

14

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**Note 10—Commitments and Contingencies**

***Operating Leases***

The Company leases its office facilities and certainequipment under operating lease arrangements expiring on various dates through2017, unless terminated earlier. Such leases include fixed or minimum paymentsplus, in some cases, scheduled base rent increases over the term of the leaseand additional rents based on the Consumer Price Index. Certain leases providefor monthly payments of real estate taxes, insurance and other operatingexpenses applicable to the property.

For the three months ended March 31, 2007 and 2006,rent expense was approximately $1,230,102 and $912,071, respectively.

***Litigation***

In the normal course of business, the Company issubject to various legal proceedings and claims, the resolution of which, inmanagement’s opinion, will not have a material adverse effect on the financialposition or the results of operations of the Company.

**Note 11—Common Stock**

Prior to the initial public offering, the Company’soutstanding capital stock consisted of: (i) 3,281,607 shares ofcommon stock, par value $0.01 per share; (ii) 357,020 shares ofClass B common stock, par value $0.01 per share; (iii) 8,825,241shares of Series A Convertible Preferred Stock, par value $0.01 per share;and (iv) 24,185,493 shares of Series B Convertible Preferred Stock,par value $0.01 per share.

In connection with, and upon the completion of, theinitial public offering on March 29, 2006, 8,825,241 shares ofSeries A Convertible Preferred Stock were converted into 2,206,308 sharesof common stock and 8,825,241 shares of Series A Redeemable PreferredStock, and 24,185,493 shares of Series B Convertible Preferred Stock wereconverted into 6,046,371 shares of common stock and 24,185,493 shares ofSeries B Redeemable Preferred Stock.

Upon the consummation of the initial public offering,all outstanding shares of Class B common stock were converted into 357,020shares of common stock, par value $0.01 per share, and each share ofClass B common stock was retired.

Inclusive of an over-allotment option of 1,125,000shares of its common stock, the Company sold 8,625,000 shares of common stockin its initial public offering at a price to the public of $17.00 pershare, for net proceeds of approximately $131,800,000 after deducting the underwritingdiscount and approximately $4,500,000 of offering expenses. After giving effectto this offering and the conversion transactions described above, the Companyhad 20,516,306 shares of common stock outstanding as of March 29, 2006.

On March 29, 2006, in connection with the Company’sinitial public offering, the Fourth Amended and Restated Certificate ofIncorporation, which was adopted by the stockholders prior to the initialpublic offering, was filed with the State of Delaware. The Company’s Certificateof Incorporation was amended to change the authorized capital stock of theCompany from an aggregate of 160,000,000 shares, consisting of(a) 69,673,021 shares of preferred stock, par value $0.01 per share,consisting of Series A Convertible Preferred Stock, Series BConvertible Preferred Stock, Series A Redeemable Preferred Stock andSeries B Redeemable Preferred Stock, (b) 80,326,979 shares of commonstock, consisting of common stock and Class B common stock, and (c) 10,000,000shares of undesignated preferred stock to a total of 160,000,000 shares ofcapital stock consisting of (i) 150,000,000 shares of common stock, parvalue $0.01 per share, and (ii) 10,000,000 shares of undesignatedpreferred stock, par value $0.01 per share.

All share information has been adjusted to reflect a1-for-4 reverse stock split of common stock and Class B common stock,which was consummated on March 1, 2006.

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At March 31, 2007, the Company had 150,000,000 sharesof common stock authorized, of which 21,069,738 and 20,688,556 were issued andoutstanding at March 31, 2007 and December 31, 2006, respectively.

**Note 12—Related Party Transactions**

On March 29, 2006 the Company paid $52,764,950from proceeds from its IPO to redeem from investment funds affiliated with TAAssociates and other preferred stockholders, including Brian L. Libman, adirector of the Company, all of the shares of redeemable preferred stockoutstanding immediately following the conversion of Series A ConvertiblePreferred Stock and Series B Convertible Preferred Stock.

The Company’s chief executive officer, who wasappointed in April 2005, has served on the Board of Directors of anotherpublic company since 1995 and is currently the chairman of this entity’s auditcommittee. This unrelated entity acquires and originates non-conformingresidential and commercial loans. The Company has provided due diligence andprofessional staffing services to this entity. The Company received no revenues from this entity for the three monthsended March 31, 2007 or 2006.

CFIS had contracts to perform Credit RiskManagement services for portfolios managed by a stockholder. Revenues generatedfrom the contracts for the three months ended March 31, 2007 and 2006 wereapproximately $59,974 and $149,747, respectively, and were included in servicefee revenue in the condensed consolidated statements of income and $42,892 and$141,056 were included in accounts receivable at March 31, 2007 andDecember 31, 2006, respectively. Certain of these contracts were cancelled effective December 31, 2006.

**Note 13—Stock Options**

On January 26, 2006, the Company’s Board ofDirectors approved the adoption of the Company’s 2006 Stock Option andIncentive Plan (“2006 Option Plan”), and the 2006 Option Plan was subsequentlyapproved by stockholders on March 8, 2006. The 2006 Option Plan permitsgrants of incentive stock options, non-qualified stock options, stockappreciation rights, deferred stock awards, restricted stock awards,unrestricted stock awards and dividend equivalent rights. The Company reserved1,814,130 shares of common stock for issuance of awards under the 2006 OptionPlan, subject to adjustment for any stock split, dividend or other change inthe Company’s capitalization. Generally, shares that are forfeited or cancelledfrom awards under the 2006 Option Plan will be available for future grants.Stock options granted under the 2006 Option Plan have a maximum term of tenyears from the date of grant and incentive stock option awards have an exerciseprice of no less than the fair market value of the common stock on the date ofgrant, which will be on the last day of the month of the award.  Theoptions generally vest over a period of four years, with 25% of each grantvesting after one year and the remaining shares vesting monthly over thefollowing three years.  The Company issues new shares upon the exercise ofstock options.  Cash received upon theexercise of options for the three months ended March 31, 2007 was $723,461.  There were no option exercises during thethree months ended March 31, 2006.

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Changes in options outstanding during the three monthsended March 31, 2007 are as follows:
|                                                                                           | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------|------------|--------------------------------------------|------------|
| Options  outstanding, January 1, 2007                                                     |       | 1,470,774                  |       | $                                          | 6.33       |   |
|                                                                                      |       |                       |       |                                       |       |
| Granted                                                                                   |       | 15,000                     |       | 16.38                                      |       |
| Exercised                                                                                 |       | 216,182                    |       | 3.32                                       |       |
| Forfeited                                                                                 |       | 45,173                     |       | 8.79                                       |       |
|                                                                                      |       |                       |       |                                       |       |
| Options  outstanding, March 31, 2007                                                      |       | 1,224,419                  |       | $                                          | 6.91       |   |
|                                                                                      |       |                       |       |                                       |       |
| Weighted average  fair value of options granted for the three months ended March 31, 2007 |       |                       |       | $                                          | 6.72       |   |
| Options available for  future grant at March 31, 2007                                     |       | 1,594,360                  |       |                                       |       |

 

The intrinsic value of options exercised in the threemonths ended March 31, 2007 was approximately $3,700,000.

Changes in unvested restricted stock outstandingduring the three months ended March 31, 2007 are as follows:
|                                               | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant  Date Fair Value** | ** ** | **Aggregate Fair  Value at  March 31, 2007** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|-------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
|                                          |       |                       |       |                                                        |       |                                                             |       |
| Unvested shares  outstanding, January 1, 2007 |       | —                     |       | $                                                           | —     |                                                             | $          | — |   |
|                                          |       |                       |       |                                                        |       |                                                             |       |
| Granted                                       |       | 165,000                    |       | 18.48                                                       |       | 2,531,100                                                        |       |
| Vested                                        |       | —                     |       | —                                                      |       | —                                                           |       |
| Cancelled or forfeited                        |       | 1,650                      |       | 18.48                                                       |       | —                                                           |       |
|                                          |       |                       |       |                                                        |       |                                                             |       |
| Unvested shares  outstanding, March 31, 2007  |       | 163,350                    |       | $                                                           | 18.48      |                                                             | $          | 2,505,789 |   |

 

The Company recorded compensation expense ofapproximately $126,000 related to restricted stock for the three months endedMarch 31, 2007.  In addition, theCompany will recognize approximately $2,900,000 of expense related to thesegrants over the remaining vesting period of such shares of 3.83 years.

During the first quarter of 2007, the Company granted5,410 deferred stock awards to newly appointed members of its Board ofDirectors under the Company’s Non-Employee Directors’ Deferred CompensationPlan.  The Company recorded compensationexpense of approximately $10,000 related to these awards for the three monthsended March 31, 2007.  In addition,the Company will recognize approximately $110,000 of expense related to thesegrants over the remaining vesting period of such awards of 11 months.

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The following table summarizes information about stockoptions at March 31, 2007:
| ** **              | ** ** | **March 31, 2007** | ** ** |
|-------------------------|------------|------------------------------|------------|
| ** **              | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
| **Exercise Price** | ** ** | **Number  Outstanding**      | ** ** | **Remaining  Contractual  Life (yrs.)** | ** ** | **Aggregate Intrinsic  Value as of  March 31, 2007** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Aggregate  Intrinsic Value as  of March 31, 2007** | ** ** |
| $ 0.98-0.98        |       | 167,196                      |       | 7.66 |   | $ | 2,401,677 |   | 122,685 |   | $ | 0.98 |   | $ | 1,762,301 |   |
|    4.00-6.00  |       | 608,672                      |       | 7.98 |   | 5,856,046 |   | 491,902 |   | 5.69 |   | 4,744,702 |   |
|    6.36-6.80  |       | 228,781                      |       | 8.46 |   | 1,981,988 |   | 117,128 |   | 6.69 |   | 1,012,943 |   |
|  12.34-17.00       |       | 187,270                      |       | 9.28 |   | 278,830 |   | 6,068 |   | 17.00 |   | — |   |
|  18.71-21.38       |       | 32,500                       |       | 9.47 |   | — |   | 1,353 |   | 20.40 |   | — |   |
|                    |       |                         |       |   |   |   |   |   |   |   |   |   |   |
|                    |       | 1,224,419                    |       | 8.26 |   | $ | 10,518,541 |   | 739,136 |   | 5.19 |   | $ | 7,519,946 |   |
|                         |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted average contractual life of optionsexercisable at March 31, 2007 was 8.0 years.

The weighted average fair value of options grantedduring the three months ended March 31, 2006 was $6.75.  The aggregate intrinsic value of optionsoutstanding and exercisable at March 31, 2006 was approximately $24,200,000 and$13,700,000, respectively.

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Accounting for Stock Based Compensation” which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. This standard requires an issuer to measure the cost ofemployee services received in exchange for an award of equity instruments basedon the grant-date fair value of the award. This eliminates the exception toaccount for such awards using the intrinsic method previously allowable underAccounting Principles Board (“APB”) Opinion No. 25. In March 2005,the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-Based Payment,”which expresses views of the SEC staff about the application of SFASNo. 123(R). SFAS No. 123(R) became effective for annualreporting periods beginning on or after June 15, 2005. The Companypreviously adopted the fair value recognition provisions of SFAS No. 123, “Accountingfor Stock-Based Compensation,” for all awards granted to employees. OnJanuary 1, 2006 the Company adopted SFAS No. 123(R) and it did nothave a material impact on the Company’s financial statements.

The Company completed its initial public offering onMarch 29, 2006. According to the provisions of incentive stock optionagreements between the Company and its employees, the vesting term for certainoptions outstanding as of the date of the IPO accelerated by either one year ortwenty percent, varying in accordance with the terms of the employee’s specificincentive stock option agreement. In addition, 130,208 of performance basedoptions became immediately vested. Therefore, on March 29, 2006 theCompany recognized $611,696 of additional compensation expense from thisaccelerated vesting.

The ongoing effect on consolidated results ofoperations of financial condition will be dependent upon future stock basedcompensation awards granted.  The Company utilizes the Black-Scholes optionvaluation method to calculate the fair market value of the options usingassumptions in effect on the date of the grant, as follows:
| ** **                | ** ** | **Three Months Ended** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | **March 31,  2007**         | ** ** | **March 31,  2006** | ** ** |
| Expected life  (in years) |       | 7.0                              |       | 7.0 |   |
| Risk-free  interest rate  |       | 4.5                              | %          | 4.7 | % |
| Volatility                |       | 28                               | %          | 25 | % |
| Dividend                  |       | 0                                | %          | 0 | % |

 

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For the three months ended March 31, 2007 and 2006 theCompany recognized expenses related to the stock option grants summarized aboveover the vesting period of such options of approximately $164,000 and $715,000,respectively. In addition, the Company will recognize approximately $1,400,000of expense related to these grants over the remaining vesting period of suchoptions.  This expense is expected to be recognized over aweighted-average period of 2.68 years.

**Note14—Segment Information**

**ReportableSegments**

The Company hasorganized its business portfolio into three reportable segments to reflect itsbusiness strategy.  The Company measuresand evaluates its reportable segments based on segment operating income.  The Company generally accounts forintersegment transactions at cost. Segment operating income is equal to gross profit less direct selling,general and administrative (“SG&A”) expenses.  The Company’s segments and their principalactivities consist of the following:

***Transaction Management***

The transactionmanagement segment provides a full range ofoutsourced transaction management services to clients, including:

·                  due diligence services - assisting loan buyers andsellers in making better decisions on how they price portfolios and managerisk;

·                  conduit support services - providing thetechnology and systems required to manage key aspects of a buyer’s loanacquisition pipeline, including overall process management, due diligence,fulfillment, funding and integration with third-party service providers;

·                  compliance products and services - providingproprietary compliance testing engine through the High Cost Analyzer suite tomarket participants including loan originators;

·                  professional staffing services – providing accessto qualified independent mortgage loan professionals to clients to augmenttheir staffs on both a long- and short-term basis; and

·                  consulting services – providing advice toclients on issues related to business process improvement, risk management,regulatory compliance, and technology enablement.

***Special Servicing***

The special servicing segment provides comprehensive loan management fordefaulted and delinquent loans and reverse mortgages, collection management,oversight and reporting, foreclosure and bankruptcy administration, evictionand real estate owned disposition oversight.

***Surveillance***

The surveillance segment provides credit risk management andsurveillance services consisting of the oversight and monitoring of predominantlyresidential non-agency MBS to MBS underwriters, issuers and investors.

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The followingtables provide operating financial information for the Company’s threereportable segments:
| ** **                       | ** ** | **For the Three Months Ended March 31, 2007** | ** ** |
|----------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                       | ** ** | **Transaction  Management**                                                      | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
| ** **                       | ** ** | ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                          |       | $                                                                                | 39,876,979 |   | $ | 1,745,470 |   | $ | 11,729,716 |   | $ | 53,352,165 |   |
| Depreciation and  amortization   |       | 3,199,881                                                                        |       | 397,702 |   | 955,170 |   | 4,552,753 |   |
| Segment  operating income (loss) |       | 10,288,757                                                                       |       | (415,860 | ) | 6,747,095 |   | 16,619,992 |   |
| Capital expenditures             |       | 2,679,754                                                                        |       | 12,526 |   | 2,424 |   | 2,694,704 |   |
|                                  |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                     | ** ** | **For the Three Months Ended March 31, 2006** | ** ** |
|--------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **Transaction  Management**                                                      | ** ** | **Special Servicing** | ** ** | **Surveillance** | ** ** | **Total Segments** | ** ** |
| ** **                     | ** ** | ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                        |       | $                                                                                | 43,540,263 |   | $ | 2,910,469 |   | $ | 7,494,197 |   | $ | 53,944,929 |   |
| Depreciation and  amortization |       | 3,164,696                                                                        |       | 295,777 |   | 582,846 |   | 4,043,319 |   |
| Segment  operating income      |       | 7,448,514                                                                        |       | 1,482,169 |   | 4,321,183 |   | 13,251,866 |   |
| Capital expenditures           |       | 1,638,107                                                                        |       | 92,842 |   | 103,422 |   | 1,834,371 |   |
|                                |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |  |

 

The followingtables are reconciliations of certain segment items to the total consolidatedamount.
|                                                      | ** ** | **For the Three Months Ended** | ** ** |
|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                           | ** ** | **March 31, 2007**                       | ** ** | **March 31, 2006** | ** ** |
| Segment  Operating Income:                           |       |                                               |       |   |   |
| Total  consolidated segment operating income         |       | $                                                  | 16,619,992 |   | $ | 13,251,866 |   |
| Direct selling,  general and administrative expenses |       | 2,991,070                                          |       | 2,721,933 |   |
|                                                 |       |                                               |       |   |   |
| Consolidated  reported gross profit                  |       | $                                                  | 19,611,062 |   | $ | 15,973,799 |   |

 
|                                     | ** ** | **For the Three Months Ended** | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | **March 31, 2007**                       | ** ** | **March 31, 2006** | ** ** |
| Capital  Expenditures:              |       |                                               |       |   |   |
| Total segment  capital expenditures |       | $                                                  | 2,694,704  |   | $ | 1,834,371 |   |
| General assets                      |       | 140,263                                            |       | 1,121,209 |   |
|                                |       |                                               |       |   |   |
| Consolidated  capital expenditures  |       | $                                                  | 2,834,967  |   | $ | 2,955,580 |   |

 

**Note 15—Subsequent Events**

On April 10, 2007,the Company completed the acquisition of Euro Risk Management Limited, Bristol,a credit and risk consultancy operating in the United Kingdom, Italy andHolland.  The total purchase price isestimated to be approximately $3,000,000, subject to adjustment upon preparationof a final closing balance sheet.  Thedetermination of final fair market values, which will be based on the closingbalance sheet, is expected to be completed by June 30, 2007.  In addition, the purchase price may beincreased by up to an additional $2,500,000 based on future earnings.

On May 4, 2007,the Company prepaid $5,000,000 of its outstanding term loan balance.  There were no penalties associated with thispayment.  At March 31, 2007, the$5,000,000 used to make this payment was included in “cash and cash equivalents”in the accompanying condensed consolidated balance sheet.

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

**Forward Looking Statements and Projections**

*This Quarterly Report onForm 10-Q contains forward looking statements. Forward looking statementsrelate to future events or our future financial performance. We generallyidentify forward looking statements by terminology such as “may,” “will,” “should,”“expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,”“believes,” “estimates,” “predicts,” “potential” or “continue” or the negativeof these terms or other similar words. These statements are only predictions.We have based these forward looking statements largely on our currentexpectations and projections about future events and financial trends that webelieve may affect our business, results of operations and financialcondition. The outcome of the events described in these forward lookingstatements is subject to risks, uncertainties and other factors described in “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” elsewhere in this Quarterly Report on Form 10-Q and in our Annual Reporton Form 10-K for the year ended December 31, 2006. Accordingly, you should notrely upon forward looking statements as predictions of future events. We cannotassure you that the events and circumstances reflected in the forward lookingstatements will be achieved or occur, and actual results could differmaterially from those projected in the forward looking statements. The forwardlooking statements made in this Quarterly Report on Form 10-Q relate onlyto events as of the date on which the statements are made. We undertake noobligation to update any forward looking statement to reflect events or circumstancesafter the date on which the statement is made or to reflect the occurrence ofunanticipated events.*

### **Overview**

We provide a full suite of outsourced services,mortgage-related analytics and specialized consulting services for buyers andsellers of, and investors in, mortgage-related loans and securitizations. Ourservices include transaction management, which consists of due diligence andmortgage processing services for buyers of mortgage loans (conduit supportservices), professional staffing services, and compliance products andservices, oversight and reporting on mortgage-backed securities (credit riskmanagement and surveillance), and specialized loan servicing (specialservicing) and consulting services. We provide a majority of our services to participantsin the non-agency mortgage-backed securities, or MBS, market and thenon-conforming mortgage loan market. We believe that several trends support thedemand for our services, including:

·                  thegrowth in outsourced services by capital markets firms and other major mortgageloan market participants;

·                  theincreased complexities and requirements of federal, state and local regulationsapplicable to the mortgage loan industry;

·                  investors’growing demand for operational risk assessment and loan performance data; and

·                  buyerspurchasing smaller pools of loans from a larger number of sellers, supportingthe need for our conduit support services.

Our revenue is also driven by non-agency MBS issuanceand the aggregate number of non-conforming mortgage loan originations. Changesin the volume of non-agency MBS issuances and non-conforming mortgage loanoriginations may impact the number of loans for which we perform ourservices, leading to a corresponding change in gross revenue. We areincreasingly utilizing our centralized underwriting facilities toperform our services which should reduce the amount of per loantravel expenses.

We believe the volume of non-agency MBSsecuritizations and non-conforming mortgage loan originations will be lower in2007 than in 2006.  We expect thesemarkets will experience moderate growth over the long term. We believe therewill be continued demand for and availability of new loan products andincreased home ownership driven in part by first-time homeowners,minorities and immigrants. We face a number of risks in our industry and themarket for our services is highly competitive. Our business is

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drivenin part by the MBS market, the mortgage lending industry and thehousing market, each of which is highly sensitive to trends in the generaleconomy, including interest rates, perceived and actual economic conditions,taxation policies, availability of credit, employment levels, more strictunderwriting guidelines in effect at a given time and wage and salary levels.Adverse changes in any of these trends, the recent downturn in the non-primemortgage loan market, including the failure of additional non-prime lenders, ora decline in the sale of both new and existing homes or in home values, couldlessen the demand for mortgage loans, which could result over time in a reduceddemand for our services and diminish our revenue. A material reduction in thenumber of loans available for securitization may cause our clients toengage us for fewer services, which could have an adverse effect on ourbusiness and results of operations. Moreover, the majority of our business isgenerated through our largest 20 clients. The loss of one or more of theseclients could adversely affect our business and results of operations. Lastly,we are dependent on our independent loan review specialists to perform ourservices. Our business could suffer if we are unable to recruit and retainadditional qualified independent loan review specialists.

**Basis of Presentation**

We were formed as a Delaware corporation inMarch 2005, following the combination of the holding companies of each ofClayton Services and its subsidiaries, including FMS and CFIS. Prior to thecombination, each holding company was controlled by investment funds affiliatedwith TA Associates. In accordance with US GAAP relating to companies undercommon control prior to their combination, the financial statements of thepreviously separate companies under common control are restated on a combinedbasis from the dates of their respective acquisitions by the controllingentity. Accordingly, for accounting purposes, the date of our inception wasMay 24, 2004, the date that investment funds affiliated with TA Associatesacquired CFIS, the first of the combined entities that were brought under commoncontrol.

**Critical Accounting Policies**

*Basis of Presentation*

Our condensed consolidated financial statements areunaudited. In our opinion, all adjustments, consisting of only normal recurringadjustments considered necessary for a fair presentation, have been included.Certain information and footnote disclosures normally included in financialstatements prepared in accordance with US GAAP have been condensed or omitted.It is suggested that these unaudited condensed consolidated financialstatements be read in conjunction with the consolidated financial statements,accounting policies and notes included in our Annual Report on Form 10-K forthe year ended December 31, 2006, which includes audited financial statements.Results for the interim periods are not necessarily indicative of results forthe full year.

In preparing our financial statements in conformitywith US GAAP, we have to make estimates and assumptions about future eventsthat affect the amounts of reported assets, liabilities, revenues and expenses,as well as the disclosure of contingent assets and liabilities in the financialstatements and accompanying notes. Some of our accounting policies require theapplication of significant judgment by management in the selection ofappropriate assumptions for determining these estimates. By their nature, thesejudgments are subject to an inherent degree of uncertainty; therefore, wecannot assure you that actual results will not differ significantly fromestimated results. We base these judgments on our historical experience,management’s forecasts and other available information, as appropriate.

Our most critical accounting policies, which reflectsignificant management estimates and judgment in determining reported amountsin the consolidated financial statements are as follows:

*Revenue Recognition*

Revenue is recognized when persuasive evidence of anarrangement exists, the service has been performed, the fee is fixed anddeterminable, and collection of the resulting receivable is reasonably assured.

22

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We derive most of our revenue from professionalservice activities. Revenue consisting of billed fees and pass-through expensesis recorded as work is performed and expenses are incurred. Revenue alsoincludes expenses billed to clients, which include travel and otherout-of-pocket expenses, and other reimbursable expenses.

We record provisions for fee adjustments anddiscretionary pricing adjustments as a reduction of revenue. Revenuerecognized, but not yet billed to clients, has been recorded as unbilled receivablesin the Company’s consolidated balance sheets.

*Stock-Based Compensation*

In December 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Accounting for Stock Based Compensation” which establishesstandards for transactions in which an entity exchanges its equity instrumentsfor goods or services. On January 1, 2006 we adopted SFAS No. 123(R)and it did not have a material impact on our financial statements.

According to the provisions of our incentive stockoption agreements, the vesting term for certain options outstanding as of thedate of our IPO accelerated by either one year or twenty percent, varying inaccordance with the terms of the employee’s specific incentive stock optionagreement. In addition, 130,208 of performance based options became immediatelyvested. As a result, on March 29, 2006, we recognized $611,696 ofadditional compensation expense from this accelerated vesting.

We granted options to purchase 15,000 shares in thethree months ended March 31, 2007 with an average exercise price of $16.38 pershare.

On January 30, 2007, we granted 165,000 shares ofrestricted stock at the closing stock price on that day of $18.48 per share.

During the three months ended March 31, 2007, wegranted 5,410 deferred stock units to newly appointed members of our Board ofDirectors under the Non-Employee Directors’ Deferred Compensation Plan.

*Valuation of Long-lived AssetsExcluding Goodwill*

We evaluate all of our long-lived assets, includingintangible assets other than goodwill and fixed assets, periodically forimpairment in accordance with SFAS No. 144, Accounting for the Impairment orDisposal of Long-lived Assets (SFAS No. 144). SFAS No. 144 requires thatlong-lived assets be evaluated for impairment when events or changes in factsand circumstances indicate that their carrying value may not be recoverable. Ifevents or circumstances indicate that the carrying value of an asset may not berecoverable, we assess the recoverability of identified intangible assets bycomparing the projected undiscounted net cash flows associated with the relatedasset or group of assets over their remaining lives against their respectivecarrying amounts. The amount of impairment will be measured as the differencebetween the carrying value and the fair value of the impaired asset. Animpairment will be recorded as an operating expense in the period of theimpairment and as a reduction in the carrying value of that asset.

*Accounts Receivable*

We are required to estimate the collectibility of accounts receivable.  A considerable amount of judgment is required in assessing the likelihood of realization of receivables.   Relevant assessment factors include the creditworthiness of the customer, our prior collection history with the customer and related aging of past due balances.  Specific accounts receivable are evaluated when we believe a customer may not be able to meet its financial obligations due to a deterioration of its financial condition or its credit ratings.  The allowance requirements are based on the best facts available and are re-evaluated and adjusted on a regular basis and as additional information is received.

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*Intangible Assets*

Intangible assets consist of customer relationships,technology, trade name and trademarks, non-competition agreements and excess ofcost over fair value of net assets acquired, or goodwill. Customerrelationships are the value of the specifically acquired customerrelationships. Technology is the value of recreating the completed technologyinfrastructure. Trade name and trademarks are the value inherent in therecognition of “Clayton” and the other names that we use. The value of thenon-competition agreements are an appraisal of potential lost revenues that wouldarise from an individual initiating a competing enterprise.

Except for goodwill, trade names and trademarks, allintangible assets are stated at cost less accumulated amortization. The costsattributable to the identified intangibles were based on a number ofsignificant assumptions as determined by us and our independent appraisalexpert. Identifiable intangible assets with finite lives are amortized underthe straight-line method over their applicable estimated useful lives.

We adopted SFAS No. 142 “Goodwill and Other IntangibleAssets” (“SFAS No. 142”), which provides, among other things, that goodwill andintangibles with indefinite lives are no longer amortized but are reviewed forimpairment at least annually (beginning with the first anniversary of theacquisition date). Annual impairment tests were conducted for Clayton Servicesand CFIS in 2006 and there was no impairment to goodwill or intangibles withindefinite lives of either entity.

On March 28, 2007, our Board of Directorsapproved the recommendation of management that it discontinue the operations ofCLS.  As a result, we recorded animpairment charge of $4,735,777 in connection with the CLS shutdown to reflectthe write-off of goodwill, intangible assets and property and equipment.

In December 2006,we recorded an impairment charge of $279,458 to reflect the write-off ofcertain customer relationships associated with portfolio management.

*Income Taxes*

Our effective tax rate is based on pre-tax income,statutory tax rates and tax planning strategies. Significant managementjudgment is required in determining the effective tax rate and in evaluatingour tax position.

Our accompanying Condensed Consolidated Balance Sheetsinclude certain deferred tax assets resulting from deductible temporary differences,which are expected to reduce future taxable income. These assets are based onmanagement’s estimate of realizability based upon forecasted taxable income.Realizability of these assets is reassessed at the end of each reporting periodbased upon our forecast of future taxable income and available tax planningstrategies, and may result in the recording of a valuation reserve. Failure toachieve forecasted taxable income could affect the ultimate realization ofcertain deferred tax assets.

The Company adopted FASB Interpretation (“FIN”) No.48, “Accounting for Uncertainty in Income Taxes,” on January 1, 2007 (see Note9).

Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board of Directors and our Audit Committee has reviewed our disclosures relating to them.

**Revenue**

We generate a majority of our revenue by providingprofessional outsourced services across the lifecycle of a mortgage loan.

Our transaction management services are provided under“time-and-materials” or per file billing arrangements. Under “time-and-materials”arrangements, we bill our clients on an hourly basis with travel and otherreimbursable expenses passed through and recognized as revenue. Under per filebilling

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arrangements,we bill our clients for each file reviewed with travel and other reimbursableexpenses passed through separately or included in the per file rate. Revenuesconsisting of billed fees and pass-through expenses, which include travel andother reimbursable expenses, are recorded as work is performed and expenses areincurred. Revenues recognized, but not yet billed to clients, have beenrecorded as unbilled receivables in our consolidated balance sheets.  For the three months ended March 31, 2007 and2006, transaction management revenue accounted for 74.6% and 80.7%,respectively, of total revenue.

Our credit risk management, surveillance and specialservicing services provide a revenue stream which is generally recurring innature. In a typical MBS transaction for which we provide surveillanceservices, we are engaged by the trustee of an MBS issuance to provide ourservices over the life of the trust and are paid monthly directly from the cashflow of the trust. A majority of our surveillance revenue is based upon anegotiated rate multiplied by the outstanding principal balance of theunderlying mortgage loans in the MBS issuance. These fees are recognized eachmonth as services are rendered. Our special servicing activities are conductedunder annual or multi-year contracts for which we typically receive revenue ona per loan per month basis as well as incentive fees. For the three monthsended March 31, 2007 and 2006, surveillance and special servicing servicesrevenue accounted for 25.4% and 19.3%, respectively, of total revenue.

For the three months ended March 31, 2007 and 2006,revenue from our largest two clients accounted for an aggregate of 20.9% and25.5% of total revenue, respectively. Revenue from one client exceeded 10% ofrevenue for the three months ended March 31, 2007 and 2006, respectively.

**Cost of Services**

*Compensation Expense*

Compensation expense consists primarily ofcompensation for independent loan review specialists and employees directlyinvolved in the delivery of our services, which include our client servicemanagers who manage our engagements. Compensation expense also includes payrollrelated benefits for our direct employees. The professionals we retain from aprofessional employment organization, including our independent loan reviewspecialists, do not receive any employee benefits from us and are onlycompensated for actual hours worked. Our direct cost of operations does notinclude an allocation of overhead costs.

*Travel and Related Expenses*

Travel and related expenses consist of expensesincurred in enabling employees and independent loan review specialists totravel to clients’ sites and are comprised of airfare, hotel and car rentalexpenses. A majority of these expenses is either directly billed to clients orincluded in the per file rates charged. As such, these expenses are directly orindirectly included in our revenue.

*Other Direct Costs*

Other direct costs include the cost of third partymortgage loan services (primarily collateral appraisal fees), outside supportfor our compliance services used in connection with our loan reviews,independent loan review specialist training and miscellaneous non-billabletransaction costs.

**Operating Expenses**

Operating expenses primarily consist of corporateoverhead costs not directly associated with a specific transaction or contract,such as salaries and benefits, marketing and administrative expenses,professional fees and depreciation and amortization expenses.

In connection with becoming a public company, we haveincurred significant additional operating expenses such as increased auditfees, professional fees, directors and officers’ insurance costs, compensationfor our board of directors, and expenses related to hiring additional personneland expanding our administrative functions. Many of these expenses either werenot incurred or were incurred at a lower level by us as a private company.

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*Salaries and Benefits*

Salaries and benefits consist of employee compensationfor those employees who are not directly billable to a particular assignmentincluding costs of administrative, finance, human resources, technology,marketing, business development and executive personnel.

*Other Selling, General and Administrative Expenses*

Other selling, general and administrative expensesconsist of costs such as rent and utilities, marketing, advertising andpromotion expenses, non-reimbursable travel and entertainment, informationtechnology, insurance, education, training and hiring expenses other than forindependent loan review specialists and professional fees consisting of legal,accounting and other consulting fees in connection with the ongoing operationof our business including audit and Sarbanes-Oxley Act of 2002 compliance.

*Depreciation and Amortization*

We incur depreciation and amortization expenses forcosts related to the capitalization of property and equipment and softwaredeveloped for internal use on a straight-line basis over the estimated usefullives of the assets, which range from three to seven years. Leaseholdimprovements and assets under capital lease are amortized over the shorter ofthe estimated useful life of the asset or the lease term.

*Treatment of Goodwill and Amortization of Intangibles*

We also incur amortization expenses for costs relatedto the capitalization of identifiable intangible assets including customerrelationships, technology and non-competition agreements.

We account for acquisitions of companies in accordancewith Statement of Financial Accounting Standards (SFAS) No. 141, *Business Combinations* (SFAS No. 141).We allocate purchase price to tangible assets, intangible assets, andliabilities based on fair values with the excess of purchase price amount beingallocated to goodwill. The allocation of the purchase price to these intangibleassets is based on a number of significant assumptions as determined by us andin the case of material acquisitions our independent appraisal expert,including evaluations of the future income producing capabilities of theseassets and related future expected cash flows. We also make estimates about theuseful lives of the acquired intangible assets. Should different conditionsresult in the determination that the value of the goodwill and acquiredintangible assets has been impaired, we could incur write-downs of goodwill orintangible assets, or changes in the estimation of useful lives of thoseintangible assets. In accordance with SFAS No. 142, *Goodwill and Other Intangible Assets* (SFASNo. 142), goodwill is not amortized, but is subject to annual impairmenttesting which is discussed in greater detail below.

In accordance with SFAS No. 142, goodwill issubject to annual impairment tests or on a more frequent basis if events orconditions indicate that goodwill may be impaired. Goodwill is tested forimpairment at a level of reporting referred to as a reporting unit.  Thefirst step of our annual test is to compare the fair value of our shares to thecarrying value of our net assets of the reporting unit. If we determine thatour carrying value exceeds our fair value, we would conduct a second step tothe goodwill impairment test. The second step compares the implied fair valueof the goodwill (determined as the excess fair value over the fair valueassigned to our other assets and liabilities) to the carrying amount ofgoodwill. When the carrying amount of goodwill exceeds the implied fair valueof goodwill, an impairment loss is recognized.

We evaluate all of our long-lived assets, includingintangible assets other than goodwill and fixed assets, periodically forimpairment in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-lived Assets*(SFAS No. 144). SFAS No. 144 requires that long-lived assets beevaluated for impairment when events or changes in facts and circumstances indicatethat their carrying value may not be recoverable. If events orcircumstances indicate that the carrying value of an asset may not berecoverable, the amount of impairment will be measured as the differencebetween the carrying value and the fair value of the impaired asset. Animpairment will be recorded as an operating expense in the period of theimpairment and as a reduction in the carrying value of that asset.

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In connection with the CLS shutdown, in March 2007 theCompany recorded an impairment charge of $4,735,777 to reflect the write-off ofgoodwill and intangible assets. In December 2006, the Company recorded animpairment charge of $279,458 to reflect the write-off of certain customerrelationships associated with portfolio management.

**Net Interest Expense**

Net interest expense consists of interest paid on ourdebt net of interest received on our cash balances.

Interest expense for the three months ended March 31,2007 and 2006 primarily consisted of interest on our term loan and amortizationof debt issuance costs related to the term loan and revolving line of credit,and interest expense for the three months ended March 31, 2006 also includedinterest on our revolving line of credit. Our term loan had a balance at December 31, 2006 of $64,598,998, and$59,286,188 at March 31, 2007.  Our termloan had a balance of $150,000,000 at December 31, 2005, and $80,000,000 atMarch 31, 2006.

**Loss from Extinguishment of Debt**

Due to the prepayment of $5,000,000 on our term loanduring the three months ended March 31 2007, we wrote-off a portion of the debtissuance costs on the term loan and recognized a loss from extinguishment ofdebt of $45,043.

On March 29, 2006, following our initial publicoffering, we repaid $70,000,000 of the outstanding balance on our $150,000,000term loan and the entire $7,400,000 outstanding balance on our revolving lineof credit. Due to the prepayment of $70,000,000 on our term loan, we wrote-offa portion of the debt issuance costs on the term loan and recognized a loss fromextinguishment of debt of $746,002.

**Results of Operations**

***Comparison of Three Month Periods EndedMarch 31, 2007 and 2006***

**Revenue**

Our consolidated revenue was $53.4 million for thethree months ended March 31, 2007, a decrease of $0.5 million or 1.1%, comparedto revenue of $53.9 million for the three months ended March 31, 2006*.*The decrease was primarily due toreduced due diligence, special servicing and conduit revenues, partially offsetby an increase in surveillance revenue. Our total revenue per loan decreased by 0.5%, as a reduction in revenueper loan in our core due diligence business offset growth in our non-loanrelated surveillance business.  Thenumber of loans serviced during the three months ended March 31, 2007 decreasedby 0.6% as compared to fiscal 2006, as a reduction in loans serviced in ourcore due diligence business, due to the weak subprime market during thequarter, was offset by growth in the number of loans serviced by our conduitsupport services.  Revenues per loan in ourcore due diligence business declined by 7.3% due to an increase in thepercentage of loans serviced in our centralized underwriting facility and anincrease in prevalence of other file reviews, in which we verify a limitednumber of data points in a loan file.

***Transaction Management***

Transaction management revenue was $39.9 million forthe three months ended March 31, 2007, a decrease of $3.6 million or 8.3%,compared to revenue of $43.5 million for the three months ended March 31,2006*.*The decrease was primarilydue to reduced revenues per loan in our core due diligence business as wecontinue to shift clients to our centralized underwriting platform, and in ourconduit support services.

***Special Servicing***

Special servicing revenue was $1.7 million for thethree months ended March 31, 2007, a decrease of $1.2 million or 41.4%,compared to revenue of $2.9 million for the three months ended March 31,2006*.*The decrease was primarilydue to the termination of a tax lien servicing contract during the three monthsended September 30 of 2006 and a reduction in the number of loans serviced forour largest non-performing loan servicing client, following a securitization ofloans by that client in the three months ended December 31, 2006.

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***Surveillance***

Surveillance revenue was $11.7 million for the threemonths ended March 31, 2007, an increase of $4.2 million or 56.0%, compared torevenue of $7.5 million for the three months ended March 31, 2006*.*The increase was primarily due to anincrease in the value of assets monitored and an increase in our putback reviewbusiness.

**Cost of Services**

Our cost of services was $33.7 million for the threemonths ended March 31, 2007, a decrease of $4.3 million or 11.3%, compared tocost of services of $38.0 million for the three months ended March 31, 2006.This decrease was attributable to the specific factors discussed below.

*Compensation Expense.*Compensationexpense was $25.7 million for the three months ended March 31, 2007, adecrease of $2.8 million or 9.8%, compared to compensation expense of$28.5 million for the three months ended March 31, 2006.****** The decrease was primarily dueto a reduction in variable contractor expense in our due diligence business dueto better productivity, an increase in the percentage of loans serviced in ourcentralized underwriting facility and reduced training.

*Travel and Related Expenses.*Traveland related expenses were $5.5 million for the three months ended March 31,2007, a decrease of $1.6 million or 22.5%, compared to travel and relatedexpenses of $7.1 million for the three months ended March 31, 2006. Travel expenses per loan decreased by 21.7%, primarily due to an increase inthe percentage of loans serviced in our centralized underwriting facility.

*Other Direct Costs.*Otherdirect costs were $2.5 million for the three months ended March 31, 2007,an increase of $0.2 million or 8.7%, compared to other direct costs of$2.3 million for the three months ended March 31, 2006. The increase wasprimarily due to an increase in servicing claims in our special servicingbusiness.

**Operating Expenses**

Operating expenses were $15.7 million for the threemonths ended March 31, 2007, an increase of $2.0 million or 14.6%, compared tooperating expenses of $13.7 million for the three months ended March 31,2006. This increase was attributable to the specific factors discussed below.

*Salaries and Benefits.*Salariesand benefits were $5.7 million for the three months ended March 31, 2007, anincrease of $0.7 million or 14.0%, compared to salaries and benefits of$5.0 million for the three months ended March 31, 2006.  Thisincrease was primarily due to the costs of additional business developmentpersonnel added during 2006 and finance personnel added following the Company’sinitial public offering.

*Other Selling, General andAdministrative Expenses.*Other selling, general andadministrative expenses were $5.4 million for the three months ended March 31,2007, an increase of $0.8 million or 17.4%, as compared to selling, general andadministrative expenses of $4.6 million for the three months ended March31, 2006*.  *This increase was due to higher professionalfees, insurance, telecommunications, information technology and occupancyexpenses, partially offset by reduced recruiting and marketing expenses.

*Depreciation and Amortization.*Depreciationand amortization was $2.1 million for the three months ended March 31, 2007, anincrease of $0.6 million or 40.0%, compared to depreciation and amortization of$1.5 million for the three months ended March 31, 2006*.*This increase was primarily due todepreciation recorded on additional property and equipment and softwaredeveloped for internal use.

*Amortization of Intangibles.*Amortizationof intangibles was $2.5 million for the three months ended March 31, 2007 and2006.

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**Interest Expense, net**

Interest expense, net was $1.2 million for the threemonths ended March 31, 2007, a decrease of $1.9 million or 61.3%, compared tointerest expense, net of $3.1 million for the three months ended March 31,2006*.*This decrease was due toreduced borrowings on our term loan and, to a lesser extent, reduced borrowingson our line of credit.  *See “—Liquidity and Capital Resources.”*

**Loss from Extinguishment of Debt**

For the three months ended March 31, 2007, werecognized a loss from extinguishment of debt of $0.05 million due to thewrite-off of debt issuance costs as a result of a $5.0 million prepaymentduring this period.   For the threemonths ended March 31, 2006, we recognized a loss from extinguishment of debtof $0.7 million due to the write-off of debt issuance costs as a result of a$70.0 million prepayment on our term loan following our initial publicoffering.  *See “—Liquidity and Capital Resources.”*

**IncomeTaxes**

Income taxes for the three months ended March 31, 2007were $1.1 million, an increase of $1.7 million, compared to an income taxbenefit of $0.6 million for the three months ended March 31, 2006.  This increase was primarily due to changes intaxable income and our effective tax rate. Our effective tax rate for 2007 was 40.0% as compared with 42.0% for2006.  This decrease was principally dueto disqualified dispositions of incentive stock options during the quarter,which reduced our effective tax rate.

**DiscontinuedOperations**

On March 28, 2007, we committed to discontinue the operations of CLS.  Results for the three months ended March 31, 2007 include a non-cash pre-tax impairment charge of a $4.7 million, relating to impairment of goodwill, intangible assets and property and equipment.  CLS operating results for the three months ended March 31, 2007 included revenue of $0.5 million, an operating loss of $1.5 million, a pre-tax loss of $1.6 million, an income tax benefit of $0.6 million and a net loss of $1.0 million.  CLS operating results for the three months ended March 31, 2006 included revenue of $1.3 million, an operating loss of $0.3 million, a pre-tax loss of $0.3 million and a net loss of $0.2 million.

**Liquidity and Capital Resources**

Historically, we have financed our growth from cashflow from operations and bank borrowings. We believe that funds generated fromoperations, together with existing cash and available borrowings under ourCredit Agreement, will be sufficient to finance our current operations, plannedcapital expenditures and internal growth through at least the next twelvemonths. On March 29, 2006, we issued 8,625,000 shares of common stock,including 1,125,000 shares issued through the exercise of the underwriters’over-allotment option, at a price of $17.00 per share through our initialpublic offering of common stock.

On March 1, 2006, we consummated a 1-for-4reverse stock split of our common stock and class B common stock.

Immediately prior to the completion of the offering,the following transactions occurred:

·                  all of our357,020 outstanding shares of class B common stock converted into 357,020shares of common stock.

·                  ourseries A convertible preferred stock converted into 2,206,308 shares ofcommon stock and 8,825,241 shares of series A redeemable preferred stock.

·                  ourseries B convertible preferred stock converted into 6,046,371 shares ofcommon stock and 24,185,493 shares of series B redeemable preferred stock.

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Our net proceeds of $131.8 million, net of $14.8million of offering expenses and the underwriting discount, were used to:

·                  redeem $52.8 millionof redeemable preferred stock that resulted from the conversion of ourSeries A convertible preferred stock and Series B convertiblepreferred stock immediately prior to the completion of the initial publicoffering.

·                  repay $70.0million owed under the senior term loan portion of our credit facility.

·                  repay $7.4million owed under the revolving credit portion of our credit facility.

·                  fund$1.6 million of working capital.

Our operating activities provided cash of $1.7 millionand $2.2 million in the three months ended March 31, 2007 and 2006,respectively. Cash provided from operations is generated primarily from netincome and the timing of accounts receivable collections and disbursements ofaccounts payable. Cash provided by operations for the three months ended March31, 2007 was generated from a net loss of $2.3 million, which included a $2.9million loss on disposal of discontinued operations and a $1.0 million lossfrom discontinued operations, and $5.2 million of non-cash charges and was negativelyimpacted by a net increase in operating assets of $5.1 million, primarilydue to a decrease in accrued expenses. Cash provided by operations for the three months ended March 31, 2006resulted from a net loss of $1.1 million plus a $0.2 million loss fromdiscontinued operations and $5.6 million of non-cash charges and was negativelyimpacted by a net increase in operating assets of $2.5 million primarily froman increase in the balance of accounts receivable****and unbilled receivables. We believe cash flow fromoperations will be sufficient to finance our current operations for the nexttwelve months.

Our investing activities used cash of $2.8 million and$9.6 million in the three months ended March 31, 2007 and 2006, respectively.Cash used in investing activities in the three months ended March 31, 2007primarily consisted of capital expenditures. Cash used in investing activitiesin the three months ended March 31, 2006 primarily consisted of capitalexpenditures and the acquisition of CLS.

Our financing activities used cash of $3.4 million inthe three months ended March 31, 2007 and provided cash of $9.0 million in thethree months ended March 31, 2006. The principal use of cash from financingactivities in the three months ended March 31, 2007 was the repayment ofprincipal on the term loan, partially offset by proceeds from stock optionexercises and excess tax benefits from share-based compensation arrangements.The principal sources of cash from financing activities in the three monthsended March 31, 2006 were the proceeds from the initial public offeringdescribed above and, to a lesser extent, borrowings under our revolving creditagreement. This was partially offset by the redemption of preferred stock andrepayments of outstanding debt under our credit facility described above.

Cash paid for interest expense was $0.6 million and$2.2 million in each of the three months ended March 31, 2007 and 2006,respectively. In the three months ended March 31, 2007 and 2006, the majorityof interest expense was paid on borrowings outstanding under our term loan. InMay 2007, we prepaid $5.0 million outstanding under the term loan.

***Credit Agreement***

OnDecember 8, 2005, we entered into a $190.0 million senior creditfacility. The credit facility provided for a $150.0 million term loan, anda revolving credit facility of $40.0 million. The credit facility alsoprovided us with an option, subject to the consent of the lenders, to increasethe revolving credit facility by $10.0 million to an aggregate of $50.0 million.We exercised the option to increase our revolving credit facility by $5.0million on each of January 11, 2006 and April 28, 2006, and as ofMarch 31, 2007 we have an aggregate revolving credit facility of$50.0 million. Following our initial public offering in March 2006,we prepaid $70.0 million outstanding under the term loan and repaid $7.4million outstanding under the revolving credit facility.  In February 2007, we prepaid $5.0 millionoutstanding under the term loan.  Anadditional $5.0 million was repaid in May 2007.

The Credit Agreement terminates on December 8,2011. Principal repayments on the term loan of $150,092 are required on aquarterly basis for each quarter through 2010, and the remaining principalbalance at the end of 2010 is repayable in equal quarterly installments during2011. This facility can be used to fund acquisitions requiring cash, as well asto fund short-term liquidity needs. Liquidity needs occasionally arise as aresult of differences in the timing between collecting our accounts receivableand making disbursements to support our operations.

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The Credit Agreement is collateralized bysubstantially all of our assets. The agreement contains covenants which, amongother matters, require us to maintain certain interest coverage, fixed chargeand total leverage ratios. As of March 31, 2007, we were in compliancewith all debt covenants. In addition, the Credit Agreement places limitationson total annual capital expenditures, indebtedness, liens, dividends anddistributions, asset sales, transactions with affiliates, acquisitions andconduct of business, all as defined in the agreement. The Credit Agreement alsocontains provisions for an increased interest rate during periods of default.We do not believe that these covenants will affect our ability to operate ourbusiness.

Loans under the Credit Agreement bear interest at theapplicable LIBOR rate plus 1.75% or Prime Rate plus 0.75%, at our option. Inaddition, we are required to pay a commitment fee of 0.5% based on the calculationof the excess of the revolving credit loan commitment over the outstandingbalance as defined in the Credit Agreement.

At March 31, 2007, there was an outstanding balance of$59.4 million under the term loan and no outstanding balance under the revolvingcredit facility.  In May 2007, we repaid$5.0 million outstanding under the term loan.

***Contractual Obligations***

The following table describes our cash commitments, inthousands, to settle contractual obligations as of March 31, 2007.
| ** **                    | ** ** | **Total** | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** |
|-------------------------------|------------|-----------|------------|-----------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|
| Term loans and  loans payable |       | $         | 59,436     |                        | $          | 450                |       | $                  | 1,201      |                             | $          | 57,785 |   | $ | — |   |
| Capital lease  obligations    |       | 680       |       | 204                         |       | 364                |       | 112                |       | —                           |       |
| Operating lease  obligations  |       | 16,018    |       | 2,615                       |       | 5,395              |       | 2,669              |       | 5,339                            |       |
|                          |       |      |       |                        |       |               |       |               |       |                             |       |
| Total                         |       | $         | 76,134     |                        | $          | 3,269              |       | $                  | 6,960      |                             | $          | 60,566 |   | $ | 5,339 |   |

 

Interest payments due on the above amounts total$18,196.

**Off-Balance-Sheet Arrangements**

As of March 31, 2007, we did not have any significantoff-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) ofRegulation S-K of the SEC.

**Item 3. Quantitative andQualitative Disclosures about Market Risk**

During the three months ended March 31, 2007, therewere no material changes in our market risk exposure. For a discussion of ourmarket risk associated with interest rate risk and equity price risk as ofDecember 31, 2006, see Risk Factors and Management’s Discussion andAnalysis of Financial Condition and Results of Operations contained inour Annual Report on Form 10-K for the year ended December 31, 2006, whichincludes audited financial statements.

**Item 4.  Controls andProcedures**

***Evaluation of Disclosure Controls andProcedures***

Our management,with the participation of our chief executive officer and chief financialofficer, evaluated the effectiveness of our disclosure controls and proceduresas of March 31, 2007.  The term “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e)under the Exchange Act, means controls and other procedures of a company thatare designed to ensure that information required to be disclosed by a companyin the reports that it files or submits under the Exchange Act is recorded,

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processed, summarized andreported, within the time periods specified in the SEC’s rules and forms.Disclosure controls and procedures include, without limitation, controls andprocedures designed to ensure that information required to be disclosed by acompany in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the company’s management, including itsprincipal executive and principal financial officers, as appropriate to allowtimely decisions regarding required disclosure. Management recognizes that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving their objectives and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.  Basedon the evaluation of our disclosure controls and procedures as of March 31,2007, our chief executive officer and chief financial officer concluded that,as of such date, the Company’s disclosure controls and procedures wereeffective at the reasonable assurance level.

***Changes in Internal Control Over FinancialReporting***

There have been nochanges in our internal control over financial reporting during the quarterlyperiod ended March 31, 2007 that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

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**Part II— OTHER INFORMATION**

**Item1.****                       LegalProceedings**

Fromtime to time, we may be party to various claims, suits and complaints.  Currently, there are no such claims, suits orcomplaints that, in our opinion would have a material adverse effect on our business,results of operations and financial condition.

**Item1A.  Risk Factors**

Not applicable.

**Item2.     Unregistered Sales of Equity Securities andUse of Proceeds**

Upontermination, during the three months ended March 31, 2007, employeesforfeited 1,650 unvested shares of restricted stock, as detailed in thefollowing table:
| Period                                         | ** ** | **Total Number of  Shares Forfeited** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|
| March 1,  2007 – March 31, 2007 |       | 1,650                                                |       |

 

**Item3.     Defaults Upon Senior Securities**

Not applicable.

**Item4.     Submission of Matters to a Vote of SecurityHolders**

Not applicable.

**Item5.     Other Information**

Not applicable.

**Item6.     Exhibits**

Theexhibits listed in the Exhibit Index immediately preceding the exhibitsare filed as part of this Quarterly Report on Form 10-Q and suchExhibit Index is incorporated herein by reference.

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|                           | **CLAYTON HOLDINGS, INC.** |
|---------------------------|---------------------------------|
|                      |                            |
| Date:  May  11, 2007 | By:                             | /s/ Frederick C. Herbst |   |
|                      |                            | Frederick C. Herbst |
|                      | * *                        | *Chief Financial Officer* |
|                      |                            | (Duly Authorized Officer and Principal  Financial Officer) |

 

34

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**EXHIBIT INDEX**

Listed and indexed below are all Exhibits filed aspart of this report.
| Exhibit No. | ** ** | **Description**                                                                                                                                                                              |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1             |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002, Rule 13a-14(a)/15d-14(a), by Chief Executive  Officer.                                                   |
|             |       |                                                                                                                                                                                         |
| 31.2             |       | Certification pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002, Rule 13a-14(a)/15d-14(a), by Chief Financial  Officer.                                                   |
|             |       |                                                                                                                                                                                         |
| 32.1*            |       | Certification pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002, by Chief Executive Officer and Chief Financial  Officer. |

 

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* ThisCertification shall not be deemed “filed” for purposes of Section 18 of theSecurities Exchange Act of 1934, or otherwise subject to the liability of thatSection, nor shall it be deemed to be incorporated by reference into any filingunder the Securities Act of 1933 or the Securities Exchange Act of 1934.

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