**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 June 30, 2006**                                                                                                               |
|                                  |
| **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:

20,533,832 sharesof Common Stock, par value $0.01 per share, outstanding as of August 2, 2006.

 

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**INDEX**
|                                     | ** **                    | ** **                                                                                                                    | **Page** |
|-------------------------------------|-------------------------------|-------------------------------------------------------------------------------------------------------------------------------|----------|
| Part I.  Financial Information |                          |
|                                |                          |
|                                | Item 1. Financial  Statements |                                                                                                                          |
|                                |                          |                                                                                                                          |     |
|                                |                          | Condensed  Consolidated Balance Sheets as of June 30,  2006 (unaudited) and December 31, 2005                  | 1        |
|                                |                          |                                                                                                                          |     |
|                                |                          | Condensed  Consolidated Statements of Income (unaudited) for the three and six months  ended June 30, 2006 and 2005      | 2        |
|                                |                          |                                                                                                                          |     |
|                                |                          | Condensed  Consolidated Statement of Changes in Stockholders’ Equity (unaudited) for the  six months ended June 30, 2006 | 3        |
|                                |                          |                                                                                                                          |     |
|                                |                          | Condensed  Consolidated Statements of Cash Flows (unaudited) for the six months ended  June 30, 2006 and 2005                 | 4        |
|                                |                          |                                                                                                                          |     |
|                                |                          | Notes to  Condensed Consolidated Financial Statements (unaudited)                                                             | 6        |
|                                |                          |                                                                                                                          |     |
|                                | Item 2.                       | Management’s Discussion  and Analysis of Financial Condition and Results of Operations                                   | 20       |
|                                |                          |                                                                                                                          |     |
|                                | Item 3.                       | Quantitative  and Qualitative Disclosures About Market Risk                                                                   | 31       |
|                                |                          |                                                                                                                          |     |
|                                | Item 4.                       | Controls and Procedures                                                                                                       | 32       |
|                                |                          |                                                                                                                          |     |
| Part II. Other  Information    |                          |
|                                |                          |                                                                                                                          |     |
|                                | Item 1.                       | Legal Proceedings                                                                                                             | 34       |
|                                |                          |                                                                                                                          |     |
|                                | Item  1A.                     | Risk  Factors                                                                                                                 | 34       |
|                                |                          |                                                                                                                          |     |
|                                | Item 2.                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                  | 34       |
|                                |                          |                                                                                                                          |     |
|                                | Item 3.                       | Defaults Upon  Senior Securities                                                                                              | 34       |
|                                |                          |                                                                                                                          |     |
|                                | Item 4.                       | Submission of  Matters to a Vote of Security Holders                                                                          | 34       |
|                                |                          |                                                                                                                          |     |
|                                | Item 5.                       | Other Information                                                                                                             | 34       |
|                                |                          |                                                                                                                          |     |
|                                | Item  6.                      | Exhibits                                                                                                                      | 34       |
|                                |                          |                                                                                                                          |     |
| Signatures                          | 35                            |
|                                |                          |                                                                                                                          |     |
| Exhibit Index                  |                          |

 

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**PART I. FINANCIALINFORMATION**

**Item1.   Financial Statements**

**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                         | ** ** | **June 30, 2006** | ** **  | **December 31, 2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                                                                                                         | ** ** | **(unaudited)**             | ** **  | ** **                      | ** ** |
| **ASSETS**                                                                                                                                                                                                         | ** ** | ** **                  | ** **  | ** **                      | ** ** |
| Current assets                                                                                                                                                                                                     |       |                        |        |                            |       |
| Cash and cash  equivalents                                                                                                                                                                                         |       | $                           | 11,155,491  |                            | $          | 7,208,875 |   |
| Cash held in  escrow                                                                                                                                                                                               |       | 603,247                     |        | —                          |       |
| Restricted cash                                                                                                                                                                                                    |       | 26,201,042                  |        | 4,966,839                       |       |
| Accounts  receivable, net of allowance for doubtful accounts of $126,076 and $72,264                                                                                                                               |       | 39,005,359                  |        | 37,205,223                      |       |
| Unbilled  receivables                                                                                                                                                                                              |       | 16,723,630                  |        | 14,925,988                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                                         |       | 3,088,624                   |        | 3,942,676                       |       |
| Prepaid income  taxes                                                                                                                                                                                              |       | 3,640,006                   |        | 3,730,970                       |       |
| Deferred tax  assets                                                                                                                                                                                               |       | 237,787                     |        | 165,566                         |       |
| Due from  affiliated entities                                                                                                                                                                                      |       | —                      |        | 23,434                          |       |
| Total  current assets                                                                                                                                                                                              |       | 100,655,186                 |        | 72,169,571                      |       |
|                                                                                                                                                                                                               |       |                        |        |                            |       |
| Property and equipment,  net                                                                                                                                                                                       |       | 21,247,011                  |        | 18,175,717                      |       |
| Goodwill                                                                                                                                                                                                           |       | 74,351,639                  |        | 69,843,468                      |       |
| Intangible assets, net                                                                                                                                                                                             |       | 80,442,171                  |        | 84,739,774                      |       |
| Other assets, net                                                                                                                                                                                                  |       | 1,882,734                   |        | 2,576,827                       |       |
|                                                                                                                                                                                                               |       |                        |        |                            |       |
| Total  assets                                                                                                                                                                                                      |       | $                           | 278,578,741 |                            | $          | 247,505,357 |   |
|                                                                                                                                                                                                               |       |                        |        |                            |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                      | ** ** | ** **                  | ** **  | ** **                      | ** ** |
| Current liabilities                                                                                                                                                                                                |       |                        |        |                            |       |
| Long term debt  and capital lease obligations, current portion                                                                                                                                                     |       | $                           | 1,086,944   |                            | $          | 1,639,411 |   |
| Accounts payable  and accrued expenses                                                                                                                                                                             |       | 17,251,516                  |        | 18,842,078                      |       |
| Servicer escrow  liability                                                                                                                                                                                         |       | 26,201,042                  |        | 4,966,839                       |       |
| Total  current liabilities                                                                                                                                                                                         |       | 44,539,502                  |        | 25,448,328                      |       |
|                                                                                                                                                                                                               |       |                        |        |                            |       |
| Long-term debt and  capital lease obligations, net of current portion                                                                                                                                              |       | 79,587,938                  |        | 148,777,172                     |       |
| Deferred tax  liabilities                                                                                                                                                                                          |       | 3,413,408                   |        | 3,381,001                       |       |
| Deferred revenue                                                                                                                                                                                                   |       | 118,319                     |        | 217,888                         |       |
| Deferred rent                                                                                                                                                                                                      |       | 1,034,388                   |        | 1,013,687                       |       |
|                                                                                                                                                                                                               |       |                        |        |                            |       |
| Total  liabilities                                                                                                                                                                                                 |       | 128,693,555                 |        | 178,838,076                     |       |
|                                                                                                                                                                                                               |       |                        |        |                            |       |
| Commitments and  contingencies                                                                                                                                                                                     |       |                        |        |                            |       |
|                                                                                                                                                                                                               |       |                        |        |                            |       |
| Series A convertible  preferred stock, par value $0.01 per share, no shares authorized, issued and  outstanding as of June 30, 2006; 8,825,241 shares authorized, issued and  outstanding as of December 31, 2005  |       | —                      |        | 12,258,319                      |       |
| Series B convertible  preferred stock, par value $0.01 per share, no shares authorized, issued and  outstanding as of June 30, 2006; 24,185,493 shares authorized, issued and  outstanding as of December 31, 2005 |       | —                      |        | 43,866,683                      |       |
| Stockholders’ equity                                                                                                                                                                                          |       |                        |        |                            |       |
| Common stock,  par value $0.01 per share, 150,000,000 and 60,000,000 shares authorized and  20,526,849 and 3,281,607 shares issued and outstanding as of June 30, 2006  and December 31, 2005, respectively        |       | 205,268                     |        | 32,816                          |       |
| Class B common  stock, par value $0.01 per share, no shares authorized, issued and  outstanding as of June 30, 2006; 357,020 shares authorized, issued and  outstanding as of December 31, 2005                    |       | —                      |        | 3,570                           |       |
| Preferred stock,  par value $0.01 per share, 10,000,000 shares authorized, no shares issued and  outstanding as of June 30, 2006                                                                                   |       | —                      |        | —                          |       |
| Additional paid  in capital                                                                                                                                                                                        |       | 140,015,553                 |        | 4,115,827                       |       |
| Retained  earnings                                                                                                                                                                                                 |       | 9,664,365                   |        | 8,390,066                       |       |
| Total  stockholders’ equity                                                                                                                                                                                   |       | 149,885,186                 |        | 12,542,279                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                   |       | $                           | 278,578,741 |                            | $          | 247,505,357 |   |

 

The accompanying notesare an integral part of these statements.

 

1

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**CLAYTONHOLDINGS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME**

**(unaudited)**

 
| ** **                                         | ** ** | **For the three months ended June 30:** | ** ** | **For the six months ended June 30:** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                                              | ** ** | **2005**                                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Revenue                                            |       | $                                                                     | 61,804,034 |                                                                | $          | 49,274,882 |   | $ | 117,031,647 |   | $ | 97,170,559 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Cost of services                                   |       |                                                                  |       |                                                                |       |   |   |   |   |
| Compensation expense                               |       | 31,268,683                                                            |       | 23,472,481                                                          |       | 60,732,450 |   | 46,840,581 |   |
| Travel and related expenses                        |       | 6,753,221                                                             |       | 7,114,991                                                           |       | 13,879,787 |   | 14,469,059 |   |
| Other direct costs                                 |       | 3,040,319                                                             |       | 1,052,995                                                           |       | 5,384,618 |   | 2,365,355 |   |
| Total cost of services                             |       | 41,062,223                                                            |       | 31,640,467                                                          |       | 79,996,855 |   | 63,674,995 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Gross profit                                       |       | 20,741,811                                                            |       | 17,634,415                                                          |       | 37,034,792 |   | 33,495,564 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Operating  expenses                                |       |                                                                  |       |                                                                |       |   |   |   |   |
| Salaries and benefits                              |       | 5,658,190                                                             |       | 5,227,154                                                           |       | 11,030,218 |   | 9,282,144 |   |
| Other selling, general and administrative expenses |       | 5,002,099                                                             |       | 4,946,720                                                           |       | 9,884,722 |   | 8,386,013 |   |
| Depreciation and amortization                      |       | 1,960,929                                                             |       | 1,080,833                                                           |       | 3,499,256 |   | 1,950,622 |   |
| Amortization of intangibles                        |       | 2,601,577                                                             |       | 2,546,661                                                           |       | 5,143,429 |   | 5,093,661 |   |
| Total operating expenses                           |       | 15,222,795                                                            |       | 13,801,368                                                          |       | 29,557,625 |   | 24,712,440 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income from operations                             |       | 5,519,016                                                             |       | 3,833,047                                                           |       | 7,477,167 |   | 8,783,124 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Interest  expense, net                             |       | 1,675,325                                                             |       | 2,008,914                                                           |       | 4,745,609 |   | 3,826,132 |   |
| Loss from  extinguishment of debt                  |       | —                                                                |       | —                                                              |       | 746,002 |   | — |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income before  provision for income taxes          |       | 3,843,691                                                             |       | 1,824,133                                                           |       | 1,985,556 |   | 4,956,992 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income tax  expense                                |       | 1,492,233                                                             |       | 735,748                                                             |       | 711,257 |   | 1,977,944 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Net income                                         |       | $                                                                     | 2,351,458  |                                                                | $          | 1,088,385 |   | $ | 1,274,299 |   | $ | 2,979,048 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Earnings per  share:                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Basic                                              |       | $                                                                     | 0.11       |                                                                | $          | 0.09 |   | $ | 0.08 |   | $ | 0.25 |   |
| Diluted                                            |       | $                                                                     | 0.11       |                                                                | $          | 0.09 |   | $ | 0.07 |   | $ | 0.24 |   |
|                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Weighted average  shares outstanding:              |       |                                                                  |       |                                                                |       |   |   |   |   |
| Basic                                              |       | 20,522,449                                                            |       | 11,887,403                                                          |       | 16,373,676 |   | 11,887,045 |   |
| Diluted                                            |       | 21,522,106                                                            |       | 12,289,073                                                          |       | 17,302,704 |   | 12,266,843 |   |

 

The accompanying notesare an integral part of these statements.

 

2

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

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

**(unaudited)**

 
| ** **                                                                                                                  | ** ** | **Number of shares** | ** ** | **Value**                       | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                  | ** ** | **Common  Stock**              | ** ** | **Class B  Common  Stock** | ** ** | **Common  Stock** | ** ** | **Class B  Common  Stock** | ** ** | **Additional  paid in  capital** | ** ** | **Retained  Earnings** | ** ** | **Total** | ** ** |
| ** **                                                                                                                  | ** ** | ** **                     | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, December  31, 2005                                                                                                 |       | 3,281,607                      |       | 357,020                         |       | $ |  32,816 |   | $ | 3,570 |   | $ | 4,115,827 |   | $ | 8,390,066 |   | $ | 12,542,279 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Issuance of  common stock                                                                                                   |       | 8,625,000                      |       | —                          |       | 86,250 |   | — |   | 131,742,994 |   | — |   | 131,829,244 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Conversion of  convertible preferred stock to redeemable preferred stock and redemption of  redeemable preferred stock, net |       | 8,252,679                      |       | —                          |       | 82,527 |   | — |   | 3,277,523 |   | — |   | 3,360,050 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Conversion of  series B common stock                                                                                        |       | 357,020                        |       | (357,020                        | )          | 3,570 |   | (3,570 | ) | — |   | — |   |   |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Stock based  compensation                                                                                                   |       | —                         |       | —                          |       | — |   | — |   | 853,314 |   | — |   | 853,314 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Exercise of Stock  options                                                                                                  |       | 10,543                         |       | —                          |       | 105 |   | — |   | 25,895 |   | — |   | 26,000 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Net income for  the six months ended June 30, 2006                                                                          |       | —                         |       | —                          |       | — |   | — |   | — |   | 1,274,299 |   | 1,274,299 |   |
|                                                                                                                        |       |                           |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Balance, June 30, 2006                                                                                                      |       | 20,526,849                     |       | —                          |       | $ | 205,268 |   | $ | — |   | $ | 140,015,553 |   | $ | 9,664,365 |   | $ | 149,885,186 |   |

 

The accompanying notes are an integral part of thesestatements.

3

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**
| ** **                                                                                  | ** ** | **For the six months ended June 30:** | ** ** |
|---------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                                            | ** ** | **2005** | ** ** |
|                                                                                        |       |                                                                |       |   |   |
| Cash flows from  operating activities                                                       |       |                                                                |       |   |   |
| Net income                                                                                  |       | $                                                                   | 1,274,299  |   | $ | 2,979,048 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities |       |                                                                |       |   |   |
| Depreciation and amortization                                                               |       | 3,499,256                                                           |       | 1,950,622 |   |
| Amortization of intangibles                                                                 |       | 5,143,429                                                           |       | 5,093,661 |   |
| Amortization of debt issuance cost                                                          |       | 187,488                                                             |       | 300,559 |   |
| Accretion of note                                                                           |       | —                                                              |       | 46,342 |   |
| Loss from extinguishment of debt                                                            |       | 746,002                                                             |       | — |   |
| Stock based compensation                                                                    |       | 853,314                                                             |       | 77,867 |   |
| Deferred income taxes                                                                       |       | (39,814                                                             | )          | (869,268 | ) |
| (Gain) loss on sale of fixed assets                                                         |       | (2,095                                                              | )          | 93,499 |   |
| Provision for doubtful accounts                                                             |       | 208,962                                                             |       | 225,190 |   |
| Changes in operating assets and liabilities, net of  business combinations                  |       |                                                                |       |   |   |
| Accounts receivable                                                                         |       | (1,220,074                                                          | )          | (13,997,007 | ) |
| Unbilled receivables                                                                        |       | (1,797,642                                                          | )          | 1,586,329 |   |
| Prepaid expenses and other current assets                                                   |       | 869,469                                                             |       | 234,320 |   |
| Prepaid income taxes                                                                        |       | 90,964                                                              |       | (437,989 | ) |
| Due to an affiliated entity                                                                 |       | 23,434                                                              |       | 44,803 |   |
| Other assets, net                                                                           |       | (89,253                                                             | )          | — |   |
| Accounts payable and accrued expenses                                                       |       | (1,492,376                                                          | )          | (2,712,009 | ) |
| Deferred revenue                                                                            |       | (828,119                                                            | )          | 125,000 |   |
| Deferred rent                                                                               |       | 20,701                                                              |       | 220,895 |   |
| Net cash provided by (used in) operating activities                                         |       | 7,447,945                                                           |       | (5,038,138 | ) |
|                                                                                        |       |                                                                |       |   |   |
| Cash flows from  investing activities                                                       |       |                                                                |       |   |   |
| Proceeds from sale of fixed assets                                                          |       | 35,000                                                              |       | 7,465 |   |
| Capital expenditures                                                                        |       | (5,431,493                                                          | )          | (4,983,922 | ) |
| Acquisition of businesses                                                                   |       | (6,120,010                                                          | )          | (825,326 | ) |
| Cash held in escrow from acquisition of businesses  inclusive of interest earned            |       | (603,247                                                            | )          | — |   |
| Net cash used in investing activities                                                       |       | (12,119,750                                                         | )          | (5,801,783 | ) |
|                                                                                        |       |                                                                |       |   |   |
| Cash flows from  financing activities                                                       |       |                                                                |       |   |   |
| Proceeds from revolving credit facility                                                     |       | 7,400,000                                                           |       | 17,550,000 |   |
| Repayments of revolving credit facility                                                     |       | (7,400,000                                                          | )          | (7,500,000 | ) |
| Repayments of loans payable                                                                 |       | —                                                              |       | (75,166 | ) |
| Repayments of capital lease obligations                                                     |       | (147,214                                                            | )          | (65,871 | ) |
| Repayment of term loan                                                                      |       | (70,200,501                                                         | )          | (2,250,000 | ) |
| Deferred charges related to the issuance of debt                                            |       | (124,158                                                            | )          | — |   |
| Proceeds from issuance of common stock upon initial  public offering                        |       | 146,625,000                                                         |       | — |   |
| Underwriting commisssions and offering expenses                                             |       | (14,795,756                                                         | )          |   |   |
| Redemption of convertible preferred stock                                                   |       | (52,764,950                                                         | )          |   |   |
| Proceeds from the exercise of stock options                                                 |       | 26,000                                                              |       | 8,466 |   |
| Distributions to stockholders                                                               |       | —                                                              |       | (4,000,000 | ) |
| Net cash provided by financing activities                                                   |       | 8,618,421                                                           |       | 3,667,429 |   |
|                                                                                        |       |                                                                |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                        |       | 3,946,616                                                           |       | (7,172,492 | ) |
|                                                                                        |       |                                                                |       |   |   |
| Cash and cash  equivalents at the beginning of the period                                   |       | 7,208,875                                                           |       | 12,450,147 |   |
|                                                                                        |       |                                                                |       |   |   |
| Cash and cash  equivalents at the end of the period                                         |       | $                                                                   | 11,155,491 |   | $ | 5,277,655 |   |

 

The accompanying notes are an integral part ofthese statements.

4

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**CLAYTON HOLDINGS, INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (continued)**

**(unaudited)**

 
| ** **                                           | ** ** | **For the six months ended June 30:** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                                            | ** ** | **2005** | ** ** |
|                                                 |       |                                                                |       |   |   |
| Supplementary  disclosures of cash flow information: |       |                                                                |       |   |   |
| Cash paid during the period for                      |       |                                                                |       |   |   |
|                                                 |       |                                                                |       |   |   |
| Income taxes                                         |       | $                                                                   | 661,418    |   | $ | 3,255,264 |   |
|                                                 |       |                                                                |       |   |   |
| Interest                                             |       | $                                                                   | 4,209,919  |   | $ | 2,819,637 |   |
|                                                 |       |                                                                |       |   |   |
| Other noncash  investing and financing activities:   |       |                                                                |       |   |   |
| Assets acquired under capital lease                  |       | $                                                                   | 581,244    |   | $ | 187,050 |   |
| Liabilities  assumed from acquisitions               |       | $                                                                   | 1,013,143  |   | $ | 401,664 |   |

 

The accompanying notes are an integral part ofthese statements.

5

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

**(unaudited)**

**Note1—Organization, Description of Business and Basis of Presentation**

 

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.Each holding company was controlled by TA Associates (“TA”) prior to thecombination. In accordance with accounting principles generally accepted in theUnited States of America (“US GAAP”), assets transferred between entities undercommon control are accounted for at historical cost similar to a pooling ofinterests, and the financial statements of previously separate companies forperiods they were under common control are restated on a combined basis. TheCompany’s consolidated financial statements include the results of GRP and TMHCbeginning from the date of acquisition of a controlling interest by TA, whichwere August 2, 2004 and May 24, 2004, respectively.

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 otherdebt instruments. The Company’s services include transaction management, whichconsists of due diligence, conduit support, professional staffing, complianceproducts and services as well as credit risk management and securitiessurveillance, and special servicing. The Company uses proprietary technologyand processes to provide these services across the lifecycle of a loan, fromloan origination, aggregation and securities issuance to the surveillance andadministration of loans and securities. The Company provides a majority of itsservices to participants in the non-agency segment of the mortgage-backedsecurities, or MBS, market and the non-conforming mortgage 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 with US GAAPhave been 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’sregistration statement on Form S-1 (File No. 333-129526) declaredeffective by the Securities and Exchange Commission on March 23, 2006,which includes audited financial statements for the year endedDecember 31, 2005. Results for the interim periods are not necessarilyindicative 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 all outstandingshares of redeemable preferred stock, which were issued upon the conversion ofthe Company’s 

6

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convertible preferredstock. The Company used the remaining approximately $1,600,000 for generalcorporate purposes. After giving effect to this offering, the Company had20,516,306 shares of common stock outstanding.

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.

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

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

***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 accountingpolicies require the application of significant judgment by management in theselection of appropriate assumptions for determining these estimates. By theirnature, these judgments are subject to an inherent degree of uncertainty;therefore, the Company cannot give assurance that actual results will notdiffer significantly from estimated results. Management bases these judgmentson the Company’s historical experience, management’s forecasts and otheravailable information, as appropriate. The most significant estimates reflectedin the financial statements include deferred tax assets and liabilities, incometax accruals, valuation allowance for accounts receivable, unbilledreceivables, asset impairments, the valuation of stock options and thevaluation of intangible assets and assessments of their useful lives, andrelated party transactions. Actual results could differ from estimated amounts.The Company also makes estimates in determining other ordinary accruals.

***Segment Reporting***

The Company’s activities are considered to be in asingle industry segment for financial reporting purposes. The Company providesservices that support the purchase and sale of, and investment in, mortgageloans and related securities across the mortgage loan lifecycle. Revenues fromthe Company’s various products and services are affected by the same factors,primarily the origination of non-conforming mortgage loans and the issuance ofnon-agency mortgage-backed securities.

***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. As a result of the Company’s IPO (see Note 1) onMarch 29, 2006, the Company repaid $70,000,000 of principal on its$150,000,000 term loan and wrote off a proportionate share of the unamortizeddeferred financing costs associated with the term loan. A loss onextinguishment of $746,002 reflecting this write off was reflected in the statementof income for the six months ended June 30, 2006. Unamortized deferredfinancing costs at June 30, 2006 and December 31, 2005 were $1,544,767 and

7

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$2,354,099,respectively, and are included on the accompanying consolidated balance sheetsin other assets, net.

***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 and pass-through expenses arerecorded as work is performed and expenses are incurred. Revenues also includeexpenses billed to clients, which includes travel and other out-of-pocketexpenses, and other reimbursable expenses. Based on aggregate volume of alltravel expenses incurred for both corporate purposes and client serviceactivities, the Company is eligible to receive certain retroactive volume discountsfrom several of its travel providers. Such amounts are accrued as earned, arenetted against travel and related expenses and historically have not beenmaterial.  For the three months endedJune 30, 2006 and 2005, pass-through expenses included in revenues were$6,753,221 and $7,114,991, respectively.   For the six months ended June 30, 2006 and 2005, pass-through expensesincluded in revenues were $13,879,787 and $14,469,059, 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.

***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. 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 annual reportingperiods beginning on or after June 15, 2005. The Company previouslyadopted 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 SFASNo. 123(R) does not have a material impact on its financial statements.

According to the provisions of the incentive stockoption agreements between the Company and its employees, the vesting term forcertain options outstanding as of the date of the IPO accelerated by either oneyear or twenty percent, varying in accordance with the terms of the employee’sspecific incentive stock option agreement. In addition, 130,208 of performancebased options became immediately vested. Therefore, on March 29, 2006, theCompany recognized $611,696 of additional compensation expense from thisaccelerated vesting.

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

At June 30, 2006, 17.2% and 14.1% of the Company’sbilled and unbilled receivables were related to its two largest clients,respectively. At December 31, 2005, 30.1% and 25.5% of the Company’sbilled and unbilled receivables were related to its two largest clients,respectively.

8

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For the three months ended June 30, 2006 and 2005,revenue from the Company’s large three clients accounted for an aggregate of33.2% and 38.6% of total revenue, respectively. Revenue from two clientsexceeded 10% of revenue for the three months ended June 30, 2006 and revenuefrom three clients exceeded 10% of revenue for the three months ended June 30,2005.

For the six months ended June 30, 2006 and 2005,revenue from the Company’s largest three clients accounted for an aggregate of33.2% and 36.8% of total revenue, respectively. Revenue from two clientsexceeded 10% of revenue for the six months ended June 30, 2006 and revenue fromthree clients exceeded 10% of revenue for the six months ended June 30, 2005.

***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. The Company’s convertiblepreferred stock is deemed to be a common stock equivalent and included in thecomputation of basic earnings per share because it receives dividends at a ratethat results in a per share amount that is equivalent to the per share amountpaid on common stock. Diluted earnings per share gives effect to dilutive options,warrants and other potential common stock outstanding during the period.  At June 30, 2006, outstanding options topurchase 28,000 and 130,000 common shares had exercise prices in excess of theaverage market price of common shares for the three and six month periods endedJune 30, 2006, respectively.  At June 30,2005, outstanding options to purchase 520,833 common shares had exercise pricesin excess of the average market price of common shares for the three and sixmonth periods ended June 30, 2005.  These options were not included in the computation of diluted earningsper share for the respective periods because the effect would be antidilutive.

The following table presents a reconciliation of thenumerators and denominators of basic and diluted net income per share for thethree and six months ended June 30, 2006 and 2005:

 
|                                                             | ** ** | **For the three months ended** | ** ** | **For the three months ended** | ** ** |
|-------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                  | ** ** | **June 30, 2006**                        | ** ** | **June 30, 2005**                        | ** ** |
| ** **                                                  | ** ** | **Basic**                                          | ** ** | **Diluted**                                        | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Net income                                                  |       | $                                                  | 2,351,458  |                                               | $          | 2,351,458 |   | $ | 1,088,385 |   | $ | 1,088,385 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Weighted average  number of common shares outstanding       |       | 20,522,449                                         |       | 20,522,449                                         |       | 11,887,403 |   | 11,887,403 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Dilutive effect  of stock options                           |       |                                               |       | 999,657                                            |       |   |   | 401,670 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Total weighted  average number of common shares outstanding |       | 20,522,449                                         |       | 21,522,106                                         |       | 11,887,403 |   | 12,289,073 |   |
|                                                        |       |                                               |       |                                               |       |   |   |   |   |
| Earnings per share                                          |       | $                                                  | 0.11       |                                               | $          | 0.11 |   | $ | 0.09 |   | $ | 0.09 |   |

 
|                                                             | ** ** | **For the six months ended** | ** ** | **For the six months ended** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                  | ** ** | **June 30, 2006**                      | ** ** | **June 30, 2005**                      | ** ** |
| ** **                                                  | ** ** | **Basic**                                        | ** ** | **Diluted**                                      | ** ** | **Basic** | ** ** | **Diluted** | ** ** |
|                                                        |       |                                             |       |                                             |       |   |   |   |   |
| Net income                                                  |       | $                                                | 1,274,299  |                                             | $          | 1,274,299 |   | $ | 2,979,048 |   | $ | 2,979,048 |   |
|                                                        |       |                                             |       |                                             |       |   |   |   |   |
| Weighted average  number of common shares outstanding       |       | 16,373,676                                       |       | 16,373,676                                       |       | 11,887,045 |   | 11,887,045 |   |
| Dilutive effect  of stock options                           |       |                                             |       | 929,028                                          |       |   |   | 379,798 |   |
|                                                        |       |                                             |       |                                             |       |   |   |   |   |
| Total weighted  average number of common shares outstanding |       | 16,373,676                                       |       | 17,302,704                                       |       | 11,887,045 |   | 12,266,843 |   |
|                                                        |       |                                             |       |                                             |       |   |   |   |   |
| Earnings per share                                          |       | $                                                | 0.08       |                                             | $          | 0.07 |   | $ | 0.25 |   | $ | 0.24 |   |

 

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***Adoption of New Accounting Pronouncements***

 

In July 2006, the FASB issued FASB Interpretation (“FIN”)No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASBStatement 109.”  FIN 48 prescribes acomprehensive model for recognizing, measuring, presenting and disclosing inthe financial statements tax positions taken or expected to be taken on a taxreturn including a decision whether to file or not to file in a particularjurisdiction.  FIN 48 is effective forfiscal years beginning after December 15, 2006. If there are changes in net assets as a result of application of FIN 48these will be accounted for as an adjustment to retained earnings.  The Company is currently assessing the impactof FIN 48 on its consolidated financial position and results of operations.

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**Note 3—Business Acquisitions**

***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 currently d/b/a Clayton Lender Solutions,  Inc.) for an estimated aggregate purchaseprice of $6,120,010, pending a final closing balance sheet. The asset purchaseagreement provided for a 60-day period subsequent to the closing date toprovide a closing balance sheet which will be used to determine final fairmarket values. The agreement also established two escrow accounts aggregating$600,000 which are reflected in the accompanying condensed consolidated balancesheet, including accumulated interest, at June 30, 2006 as cash held in escrow.Of this amount, $350,000 of this escrow is held against any claims the Companymay have for indemnification or a working capital shortfall uponpreparation of the final closing balance sheet. The 60-day period to reachagreement on the final closing balance sheet was extended so that the Companycan better evaluate the fair value of assets acquired. The remaining $250,000of the escrow will be retained by the Company if the Company is not able toexecute a new services agreement with a primary Clayton Lender Solutions,  Inc. client before August 3, 2007. InJuly, 2006, an additional escrow account in the amount of $392,842 was establishedby the former principal owners of M R Network I, Ltd.  This amount will be retained by the Companyif the Company is not able to collect certain accounts receivable balancesincluded in the assets acquired by the Company. This acquisition has not been presented on a pro forma basis because itis not deemed to be material.

Pendingthe final agreement as to the closing balance sheet the purchase price waspreliminarily allocated as follows:
| Accounts receivable                           |   | $          | 789,024   |   |
|-----------------------------------------------|--------|------------|-----------|--------|
| Prepaid expenses                              |   | 15,417     |      |
| Property and  equipment                       |   | 949,555    |      |
|                                          |   |       |      |
| Goodwill                                      |   | 4,508,171  |      |
| Intangible  assets - customer relationships   |   | 771,000    |      |
| Intangible  assets - noncompetition agreement |   | 74,000     |      |
| Deposit                                       |   | 25,986     |      |
| Liabilities  assumed                          |   | (1,013,143 | )         |
|                                          |   | $          | 6,120,010 |   |

 

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

At June 30, 2006 and December 31, 2005, 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 June 30, 2006and December 31, 2005, the cash balances exceeded $100,000 by $32,607,422and $13,447,318, respectively, including restricted cash.

At June 30, 2006 and December 31, 2005, theCompany maintained restricted cash balances of $26,201,042 and $4,966,839,respectively. This balance represented funds received in connection withcertain loan servicing functions the Company performs for a customer. Suchfunds are received throughout the month and remitted to the customer on amonthly basis. The balance on hand is included in servicer escrow liability inthe accompanying condensed consolidated balance sheets.

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

Property and equipment consists of the following:
|                                                 | ** ** | **June 30,  2006** | ** ** | **December 31,   2005** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------------------|------------|
|                                            |       |                    |       |                              |       |
| Computer and  office equipment                  |       | $                       | 8,883,337  |                              | $          | 6,526,737 |   |
| Software                                        |       | 16,080,937              |       | 8,100,020                         |       |
| Furniture and  fixtures                         |       | 3,269,560               |       | 2,926,452                         |       |
| Leasehold  improvements                         |       | 1,651,676               |       | 1,391,952                         |       |
| Website                                         |       | 280,317                 |       | 280,317                           |       |
| Automobiles                                     |       | 112,336                 |       | 171,395                           |       |
|                                            |       | 30,278,163              |       | 19,396,873                        |       |
| Less accumulated  depreciation and amortization |       | 9,590,961               |       | 6,117,862                         |       |
|                                            |       | 20,687,202              |       | 13,279,011                        |       |
| Software under  development                     |       | 559,809                 |       | 4,896,706                         |       |
|                                            |       | $                       | 21,247,011 |                              | $          | 18,175,717 |   |

 

Included in software at June 30, 2006 andDecember 31, 2005, is $9,622,153 and $3,189,915, 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 June 30, 2006 and 2005depreciation and amortization expense charged to operations was $1,960,929 and$1,080,833, respectively. For the six months ended June 30, 2006 and 2005depreciation and amortization expense charged to operations was $3,499,256 and$1,950,622, respectively.

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

As of June 30, 2006 and December 31, 2005,intangible assets not subject to amortization consist of goodwill of $74,351,639and $69,843,468, respectively, and trade names and trademarks of $15,504,917and $15,504,338, respectively.

At June 30, 2006, the Company’s intangible assets withidentifiable useful lives, which continue to be amortized, consist of thefollowing:
| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer  relationships             |       |                            |       |                          |       |       |       |
| Transaction management and advisory |       | $                               | 36,400,000 |                          | $          | 3,875,926  |       | $ | 32,524,074 |   |
| Staffing services                   |       | 4,300,000                       |       | 824,167                       |       | 3,475,833  |       |
| Portfolio management                |       | 11,485,600                      |       | 2,429,375                     |       | 9,056,225  |       |
| Client backlog                      |       | 2,146,200                       |       | 903,480                       |       | 1,242,720  |       |
| Technology                          |       | 26,842,900                      |       | 10,404,296                    |       | 16,438,604 |       |
| Noncompetition  agreements          |       | 3,568,950                       |       | 1,384,753                     |       | 2,184,197  |       |
| Patent                              |       | 20,451                          |       | 4,850                         |       | 15,601     |       |
|                                |       | $                               | 84,764,101 |                          | $          | 19,826,847 |       | $ | 64,937,254 |   |

 

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At December 31, 2005, the Company’s intangibleassets with identifiable useful lives, which continue to be amortized, consistof the following: 
| ** **                          | ** ** | **Gross carrying  amount** | ** ** | **Accumulated  amortization** | ** ** | **Net**    | ** ** |
|-------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|------------|------------|
| Customer  relationships             |       |                            |       |                          |       |       |       |
| Transaction management and advisory |       | $                               | 36,400,000 |                          | $          | 2,864,815  |       | $ | 33,535,185 |   |
| Staffing services                   |       | 4,300,000                       |       | 609,167                       |       | 3,690,833  |       |
| Portfolio management                |       | 10,714,600                      |       | 1,776,817                     |       | 8,937,783  |       |
| Client backlog                      |       | 2,146,200                       |       | 688,861                       |       | 1,457,339  |       |
| Technology                          |       | 26,842,900                      |       | 7,720,006                     |       | 19,122,894 |       |
| Noncompetition  agreements          |       | 3,494,950                       |       | 1,022,292                     |       | 2,472,658  |       |
| Patent                              |       | 20,204                          |       | 1,460                         |       | 18,744     |       |
|                                |       | $                               | 83,918,854 |                          | $          | 14,683,418 |       | $ | 69,235,436 |   |

 

Amortization expense for the three months ended June30, 2006 and 2005 was $2,601,577 and $2,546,661, respectively.  Amortization expense for the six months endedJune 30, 2006 and 2005 was $5,143,429 and $5,093,661, respectively.

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

Long-term debt and capital lease obligations consistof the following: 
|                                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Term loans                              |       | $                       | 79,799,499 |                        | $          | 150,000,000 |   |
|                                    |       |                    |       |                        |       |
| Capital lease  obligations              |       | 875,383                 |       | 416,583                     |       |
|                                    |       |                    |       |                        |       |
| Total long-term debt                    |       | 80,674,882              |       | 150,416,583                 |       |
| Less current  portion                   |       | 1,086,944               |       | 1,639,411                   |       |
|                                    |       |                    |       |                        |       |
| Long-term debt,  net of current portion |       | $                       | 79,587,938 |                        | $          | 148,777,172 |   |

 

***Credit Agreement***

On December 8, 2005 the Company entered into acredit agreement (the “Credit Agreement”) with a financial institution. TheCredit Agreement, provided the Company with a $150,000,000 term loan, all ofwhich was funded at closing, and a $40,000,000 revolving credit facility, noneof which was funded at closing. Subject to the agreement of the lenders toincrease their commitments, the Company had the option to borrow up to anadditional $10,000,000 under the revolving credit facility, for an aggregaterevolving credit facility of $50,000,000. On January 11, 2006 andApril 28, 2006, the Company exercised its option and amended the CreditAgreement to increase the revolving credit facility by $5,000,000 on each date,such that the Company had an aggregate revolving credit facility of $50,000,000as of April 28, 2006. The Credit Agreement expires on December 8,2011.

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After the Company’s initial public offering wascompleted on March 29, 2006 the Company repaid $70,000,000 of the$150,000,000 outstanding term loan balance without incurring any prepaymentpenalty. In addition, $7,400,000 which was outstanding under the revolvingcredit facility was repaid. The first $375,000 of the $70,000,000 term loanpayment was applied against the principal payment due on March 31, 2006and future principal repayments were recalculated pro rata based on theremaining balance. Therefore, scheduled quarterly payments of the term loanthrough December 31, 2010 were reduced from $375,000 to $200,501 with theremaining balance of $76,190,476 payable in four quarterly installments of$19,047,619 in 2011. As a result of the repayment of the term loan the Companywrote off a proportionate share of deferred financing costs associated with theterm loan (see Note 2) and reflected a loss on extinguishment of $746,002 inthe condensed consolidated statement of income for the six months ended June30, 2006.

The Credit Agreement is collateralized bysubstantially all of the assets of the Company. The agreement containscovenants which, among other matters, require the Company to maintain certainlevels of interest coverage ratio, fixed charge ratio and total leverage ratio.Such covenants commenced effectiveness on March 31, 2006. The Company isin compliance with these covenants. 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. TheCredit Agreement also contains provisions for an increased rate of interestduring periods of default.

Loans under the Credit Agreement bear interest at theapplicable London interbank offer rate (“LIBOR”) plus 3.00% or Prime rate plus2.0%, 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.

At June 30, 2006 and December 31, 2005, therevolving credit facility had no outstanding balance and there was anoutstanding balance of $79,799,499 and $150,000,000, respectively, under theterm loan with an interest rate of 8.13% and 9.25%, respectively.

***Interest Rate Cap***

In September 2004, CSI purchased an interest ratecap agreement to reduce the potential impact that interest rate increases couldhave on its floating-rate debt interest expense. The terms of the interest ratecap provide that the Company would receive quarterly payments equal to thenotional amount multiplied by the difference by which LIBOR exceeds 5%. Theinitial notional amount was $20,000,000 and declines during the term of theagreement, which expires on September 30, 2006. As of June 30, 2006 andDecember 31, 2005, the notional amounts were $15,312,500 and $16,937,500,respectively. The interest rate cap does not qualify for hedge accounting underSFAS No. 133, as amended. The initial premium of $29,900 was recorded asan asset on the date of purchase. Subsequent declines in the fair value of thisderivative are recorded as interest expense in the accompanying condensedconsolidated statements of income. For the three and six months ended June 30,2005, the Company recorded $0 and $7,860, respectively, of interest expense toreflect a decline in the fair value of this asset during the respectiveperiods.  In January 2006, the Companyrecorded interest expense of $1,915 to reduce the book value of this asset tozero.

***Capitalized Lease Obligations***

At June 30, 2006, the Company leased $1,048,828 ofequipment under agreements accounted for as capital leases with accumulateddepreciation of $170,918. The obligations for the equipment required theCompany to make monthly payments through March 2011, with implicitinterest rates from 7.06% to 19.06%.

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At December 31, 2005, the Company leased $467,584of equipment under agreements accounted for as capital leases with accumulateddepreciation of $51,597. The obligations for the equipment required the Companyto make monthly payments through August 2010, with implicit interest ratesfrom 7.06% to 19.06%.

**Note 8—Preferred Stock**

As of December 31, 2005 the Company had 8,825,241shares designated as Series A Redeemable Preferred Stock, par value $0.01per share, and 27,837,046 shares designated as Series B RedeemablePreferred Stock, par value $0.01 per share, none of which were outstanding. Asof December 31, 2005, the Company had 8,825,241 shares designated asSeries A Convertible Preferred Stock, par value $0.01 per share, and24,185,493 shares designated as Series B Convertible Preferred Stock, parvalue $0.01 per share, all of which were outstanding. As of December 31,2005, the Series A and Series B convertible preferred stock werecarried on the consolidated balance sheet at their liquidation preference of$12,258,319 and $43,866,683, respectively.

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—Commitments and Contingencies**

***Operating Leases***

The Company leases its office facilities and certainequipment under noncancelable operating lease arrangements expiring on variousdates through 2013. Such leases include fixed or minimum payments plus, in somecases, scheduled base rent increases over the term of the lease and additionalrents based on the Consumer Price Index. Certain leases provide for monthlypayments of real estate taxes, insurance and other operating expensesapplicable to the property.

For the three months ended June 30, 2006 and 2005,rent expense was approximately $984,572 and $700,047, respectively. For the sixmonths ended June 30, 2006 and 2005, rent expense was approximately $1,895,204and $1,393,387, 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 10—Common Stock**

At December 31, 2005, the Company had60,000,000 shares of common stock authorized, of which 3,281,607 wereissued and outstanding.

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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 deductingthe underwriting discount and approximately $4,500,000 of offeringexpenses. After giving effect to this offering and the conversion transactionsdescribed above, the Company had 20,516,306 shares of common stockoutstanding as of March 29, 2006.

On March 29, 2006,in connection with the Company’s initial public offering, the Fourth Amendedand Restated Certificate of Incorporation, which was adopted by thestockholders prior to the initial public offering, was filed with the State ofDelaware. The Company’s Certificate of Incorporation was amended to change theauthorized capital stock of the Company from an aggregate of 160,000,000shares, consisting of (a) 69,673,021 shares of preferred stock, par value$0.01 per share, consisting of Series A Convertible Preferred Stock,Series B Convertible Preferred Stock, Series A Redeemable PreferredStock and Series B Redeemable Preferred Stock, (b) 80,326,979 sharesof common stock, consisting of common stock and Class B common stock, and(c) 10,000,000 shares of undesignated preferred stock to a total of160,000,000 shares of capital stock consisting of (i) 150,000,000 sharesof common stock, par value $0.01 per share, and (ii) 10,000,000 shares ofundesignated preferred 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.

At June 30, 2006, the Company had 150,000,000 sharesof common stock authorized, of which 20,526,849 were issued and outstanding.

**Note 11- 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 provides due diligence andstaffing services to this entity and revenues aggregated $177,137 and $579,768for the three and six month periods ended June 30,  2005, respectively.  The Company received no revenues from thiscompany in 2006.

CFIS has contracts to perform Credit RiskManagement services for portfolios managed by a stockholder. Revenues generatedfrom the contracts for the six months ended June 30, 2006 and 2005 wereapproximately $313,723 and $292,399, respectively, and for the three monthsended June 30, 2006 and 

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2005were approximately $163,926 and $154,612, respectively, and were included inservice fee revenue in the condensed consolidated statements of income.Accounts receivable from this party at June 30, 2006 and December 31,2005, were $34,759 and $74,555, respectively.

Until December 8, 2005, the Company hadsubordinated note and subordinated convertible note purchase agreements withcertain stockholders of the Company. For the six months ended June 30, 2005interest expense on these notes was $1,800,000. There was no interest expenseon these notes in the six months ended June 30, 2006.

**Note 12—Stock Options**

The Company’s 2005 Stock Option and Grant Plan (“2005Option Plan”) permitted the Company to make grants of incentive stock options,non-qualified stock options, restricted stock awards and unrestricted stockawards to officers, employees, directors, consultants and other key persons.Stock options granted under the 2005 Option Plan have a maximum term of tenyears from the date of grant and incentive stock options have an exercise priceof no less than the fair market value of the common stock on the date of grant.In connection with the adoption of the Company’s 2006 Option Plan, which isdiscussed below, the board of directors determined not to grant any furtherawards under the 2005 Option Plan.

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.  The options generally vest over a period offour years, with 25% of each grant vesting after one year and the remainingshares vesting monthly over the following three years.  As of June 30, 2006, 140,000 awards had beengranted under the 2006 Option Plan.  TheCompany issues new shares upon the exercise of stock options.

Changes in options outstanding during the six monthsended June 30, 2006 are as follows:
|                                                                                        | ** ** | **Number of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------|------------|---------------------------------------|------------|
| Options  outstanding, December 31, 2005                                           |       | 1,460,656                  |       | $                                     | 4.52       |   |
|                                                                                   |       |                       |       |                                  |       |
| Granted                                                                                |       | 140,000                    |       | 14.92                                 |       |
| Exercised                                                                              |       | 10,543                     |       | 2.47                                  |       |
| Forfeited                                                                              |       | 12,019                     |       | 3.51                                  |       |
|                                                                                   |       |                       |       |                                  |       |
| Options  outstanding, June 30, 2006                                                    |       | 1,578,094                  |       | $                                     | 5.46       |   |
|                                                                                   |       |                       |       |                                  |       |
| Weighted average  fair value of options granted for the six months ended June 30, 2006 |       |                       |       | $                                     | 5.87       |   |
| Options available for  future grant at June 30, 2006                                   |       |                       |       | 1,674,130                             |       |

 

Theintrinsic value of options exercised in the six months ended June 30, 2006 wasapproximately $130,000.

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Changes in unvested options outstanding during the sixmonths ended June 30, 2006 are as follows:
| ** **                                       | ** ** | ** **         | ** ** | **Weighted**                                                                                                      | ** ** |
|--------------------------------------------------|------------|--------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Number of** | ** ** | **Average Exercise**                                                                                         | ** ** |
| ** **                                       | ** ** | **Shares**         | ** ** | **Price**                                                                                                         | ** ** |
|                                             |       |               |       |                                                                                                              |       |
| Unvested options  outstanding, December 31, 2005 |       | 1,209,592          |       | $                                                                                                                 | 4.77       |   |
|                                             |       |               |       |                                                                                                              |       |
| Granted                                          |       | 139,001            |       |                  14.91            |       |
| Vested                                           |       | 641,630            |       |                    4.74 |       |
| Cancelled or Forfeited                           |       | 12,019             |       |                    3.51 |       |
|                                             |       |               |       |                                                                                                              |       |
| Unvested options outstanding, June 30, 2006      |       | 694,944            |       | $                                                                                                                 | 6.85       |   |

 

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Thefollowing table summarizes information about stock options outstanding at June30, 2006:
| **June 30, 2006** | ** ** |
|-----------------------------|------------|
| ** **                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
| ** **                  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | ** ** | ** ** | **Remaining** | ** ** | **Intrinsic** | ** ** | ** ** | ** ** | **Average** | ** ** | **Intrinsic** | ** ** |
| **Exercise**                | ** ** | **Number** | ** ** | **Contractual** | ** ** | **Value as of** | ** ** | **Number** | ** ** | **Exercise** | ** ** | **Value as of** | ** ** |
| **Price**                   | ** ** | **Outstanding** | ** ** | **Life (yrs.)** | ** ** | **June 30, 2006** | ** ** | **Exercisable** | ** ** | **Price** | ** ** | **June 30, 2006** | ** ** |
| $                           | 0.98       |   | 407,858 |   | 8.41 |   | $ | 4,924,657 |   | 264,602 |   | $ | 0.98 |   | $ | 3,194,921 |   |
| 4.00                        |       | 62,500 |   | 7.90 |   | 565,625 |   | 55,338 |   | 4.00 |   | 500,809 |   |
| 4.13                        |       | 86,914 |   | 8.50 |   | 775,447 |   | 61,863 |   | 4.13 |   | 551,942 |   |
| 6.00                        |       | 520,833 |   | 8.82 |   | 3,671,873 |   | 341,796 |   | 6.00 |   | 2,409,662 |   |
| 6.36                        |       | 110,019 |   | 9.07 |   | 736,027 |   | 49,174 |   | 6.36 |   | 328,974 |   |
| 6.80                        |       | 249,970 |   | 9.25 |   | 1,562,313 |   | 109,128 |   | 6.80 |   | 682,050 |   |
| 13.05                       |       | 10,000 |   | 10.00 |   | — |   | — |   | 13.05 |   | — |   |
| 14.05                       |       | 102,000 |   | 9.92 |   | — |   | — |   | 14.05 |   | — |   |
| 17.00                       |       | 15,500 |   | 9.73 |   | — |   | 1,249 |   | 17.00 |   | — |   |
| 20.40                       |       | 5,000 |   | 9.74 |   | — |   | — |   | 20.40 |   | — |   |
| 21.38                       |       | 7,500 |   | 9.76 |   | — |   | — |   | 21.38 |   | — |   |
|                        |       |   |   |   |   |   |   |   |   |   |   |   |   |
|                        |       | 1,578,094 |   | 8.84 |   | $ | 12,235,942 |   | 883,150 |   | $ | 4.37 |   | $ | 7,668,358 |   |
|                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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 SFASNo. 123(R) does not have a material impact on its 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 Companyutilizes the Black-Scholes option valuation method to calculate the fair marketvalue of the options using assumptions in effect on the date of the grant, asfollows:
| ** **                | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------|------------|---------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| Expected life  (in years) |       | 6.5–7.5                                      |       | 6.25 |   |
| Risk-free  interest rate  |       | 4.7–5.1                                      | %          | 3.9 - 4.2 | % |
| Volatility                |       | 25                                                | %          | 25 | % |
| Dividend                  |       | 0                                                 | %          | 0 | % |

 

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For the three monthsended June 30, 2006 and 2005 the Company recognized expenses related to thestock option grants summarized above over the vesting period of such options ofapproximately $132,000 and $50,000, respectively. For the six months ended June30, 2006 and 2005 the Company recognized expenses related to the stock optiongrants summarized above over the vesting period of such options ofapproximately $854,000 and $78,000, respectively.  In addition, the Company will recognizeapproximately $1,562,000 of expense related to these grants over the remainingvesting period of such options.  Thisexpense is expected to be recognized over a weighted-average period of 2.87years.

 

**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 onForm 10-Q and in our Quarterly Report on Form 10-Q for the three monthperiod ended March 31, 2006. Accordingly, you should not rely upon forwardlooking statements as predictions of future events. We cannot assure you thatthe events and circumstances reflected in the forward looking statements willbe achieved or occur, and actual results could differ materially from thoseprojected in the forward looking statements. The forward looking statementsmade in this Quarterly Report on Form 10-Q relate only to events as of thedate on which the statements are made. We undertake no obligation to update anyforward looking statement to reflect events or circumstances after the date onwhich the statement is made or to reflect the occurrence of unanticipatedevents.*

**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 securities and otherdebt instruments. Our services include transaction management, which consistsof due diligence, mortgage processing services for buyers of mortgage loans(conduit support services), professional staffing, and compliance products andservices, as well as monitoring of mortgage-backed securities (credit riskmanagement and surveillance), and specialized loan servicing services (specialservicing). We provide a majority of our services to participants in thenon-agency mortgage-backed securities, or MBS, market and the non-conformingmortgage loan market. We believe that several trends support the demand for ourservices, 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 loan performance data; and

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·                  buyerspurchasing smaller pools of loans from a larger number of sellers, increasingthe need for our conduit 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 may be lower in2006 than in 2005. We expect the non-agency MBS securitization andnon-conforming mortgage loan origination markets to continue growing over thelong term, although the rate of growth may be slower than in recent years.We believe there is an increasing demand for and the availability of new loanproducts, increased home ownership driven in part by first-timehomeowners, minorities and immigrants, and increased liquidity in thenon-agency MBS market. We face a number of risks in our industry and the marketfor our services is highly competitive. Our business is driven in part bythe MBS market, the mortgage lending industry and the housing market, eachof which is highly sensitive to trends in the general economy, includinginterest rates, perceived and actual economic conditions, taxation policies,availability of credit, employment levels and wage and salary levels. Adversechanges in any of these trends, or a decline in the sale of both new andexisting homes or in home values, could lessen the demand for mortgage loans,which could result over time in a reduced demand for our services and diminishour revenue. A material reduction in the number of loans available forsecuritization may cause our clients to engage us for fewer services,which could have an adverse effect on our business and results of operations.Moreover, the majority of our business is generated through our largest 20clients. The loss of one or more of these clients could adversely affect ourbusiness and results of operations. Lastly, we are dependent on our independentloan review specialists to perform our services. Our business could sufferif we are unable to recruit and retain additional qualified independent loanreview 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 First Madison, and CFIS,formerly The Murrayhill Company, or Murrayhill. Prior to the combination, eachholding company was controlled by TA Associates. In accordance with US GAAPrelating to companies under common control prior to their combination, thefinancial statements of the previously separate companies under common controlare restated on a combined basis from the dates of their respectiveacquisitions by the controlling entity. Accordingly, for accounting purposes,the date of our inception was May 24, 2004, the date that TA Associatesacquired CFIS, the first of the combined entities that were brought undercommon control.

**Critical Accounting Policies**

*Basis ofPresentation*

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 registration statement onForm S-1 (File No. 333-129526) declared effective by the Securitiesand Exchange Commission on March 23, 2006, which includes auditedfinancial statements for the year ended December 31, 2005. Results for theinterim periods are not necessarily indicative of results for the 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 

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accompanyingnotes. Some of our accounting policies require the application of significantjudgment by management in the selection of appropriate assumptions fordetermining these estimates. By their nature, these judgments are subject to aninherent degree of uncertainty; therefore, we cannot assure you that actualresults will not differ significantly from estimated results. We base these judgmentson our historical experience, management’s forecasts and other availableinformation, as appropriate.

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

*RevenueRecognition*

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.

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 unbilledreceivables in the Company’s condensed 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. 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 annual reportingperiods beginning on or after June 15, 2005. We previously adopted thefair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” for all awards granted to employees. OnJanuary 1, 2006 we adopted SFAS No. 123(R) and it does not have amaterial impact on our financial statements.

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, werecognized $611,696 of additional compensation expense from this acceleratedvesting.

Options to purchase 140,000 shares were granted in thesix months ended June 30, 2006 with an average exercise price of $14.92 pershare.

*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. Our convertible 

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preferred stock is deemed to be a common stockequivalent and included in the computation of basic earnings per share because itreceives dividends at a rate that results in a per share amount that isequivalent to the per share amount paid on common stock. Diluted earnings pershare gives effect to dilutive options, warrants and other potential commonstock outstanding during the period.   AtJune 30, 2006, outstanding options to purchase 28,000 and 130,000 common shareshad exercise prices in excess of the average market price of common shares forthe three and six month periods ended June 30, 2006, respectively.  At June 30, 2005, outstanding options topurchase 520,833 common shares had exercise prices in excess of the averagemarket price of common shares for the three and six month periods ended June30, 2005.   These options were not includedin the computation of diluted earnings per share for the respective periodsbecause the effect would be antidilutive.

*Valuation ofLong-lived Assets Excluding 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. 

*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 the "Clayton" and other names that we use. The valueof the non-competition agreements are an appraisal of potential lost revenuesthat would arise 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 the Company and its independentappraisal expert. Identifiable intangible assets with finite lives areamortized under the straight-line method over their applicable estimated usefullives. 

The Company adopted SFAS No. 142 "Goodwill andOther Intangible Assets" ("SFAS No. 142"), which provides, amongother things, that goodwill and intangibles with indefinite lives are no longeramortized but are reviewed for impairment at least annually (beginning with thefirst anniversary of the acquisition date). Annual impairment tests wereconducted for Clayton Services and CFIS in 2006 and there was no impairment togoodwill or intangibles with indefinite lives of either entity. 

**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 arrangements, we bill our clients for each file reviewed with traveland other reimbursable expenses passed through separately or included in the perfile rate. Revenues consisting of billed fees and pass-through expenses, whichinclude travel and other reimbursable expenses, are recorded as work isperformed and expenses are incurred. Revenues recognized, but not yet billed toclients, have been recorded as unbilled receivables in our condensedconsolidated balance sheets. For the three and six months ended June 30, 2006,transaction management revenue accounted for 79.5 % 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. For the three and six months ended June 30, 2006,surveillance and special servicing services revenue accounted for 20.5% oftotal revenue.

For the three months ended June 30, 2006 and 2005,revenue from our largest three clients accounted for an aggregate of 33.2% and38.6% of total revenue, respectively. Revenue from two clients exceeded 10% ofrevenue for the three months ended June 30, 2006 and revenue from three clientsexceeded 10% of revenue for the three months ended June 30, 2005.

For the six months ended June 30, 2006 and 2005,revenue from our largest three clients accounted for an aggregate of 33.2% and36.8% of total revenue, respectively. Revenue from two clients exceeded 10% ofrevenue for the six months ended June 30, 2006 and revenue from three clientsexceeded 10% of revenue for the six months ended June 30, 2005.

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**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 Company-related benefits 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.

*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 andexecutive 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.

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*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 those intangibleassets. In accordance with SFAS No. 142, *Goodwilland Other Intangible Assets* (SFAS No. 142), goodwill is notamortized, but is subject to annual impairment testing which is discussed ingreater 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.  The first step of our annual test is tocompare the fair value of our shares to the carrying value of our net assets ofthe reporting unit. If we determine that our carrying value exceeds our fairvalue, we would conduct a second step to the goodwill impairment test. Thesecond step compares the implied fair value of the goodwill (determined as theexcess fair value over the fair value assigned to our other assets andliabilities) to the carrying amount of goodwill. When the carrying amount ofgoodwill exceeds the implied fair value of goodwill, an impairment loss isrecognized.

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 circumstancesindicate that 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.

**Net Interest Expense**

Net interest expense consists of interest paid on ourdebt net of interest received on our cash balances. Interest expense for thesix months ended June 30, 2006 primarily consisted of interest on our$150,000,000 term loan, amortization of debt issuance costs related to the termloan and interest on our revolving line of credit. Interest expense for the sixmonths ended June 30, 2005 primarily consisted of interest on our prior termloan, which had a balance of $37,750,000 at the start of the period, andinterest on 12% subordinated and 12% senior subordinated notes issued to TAAssociates and our other noteholders in connection with the acquisitions ofClayton Services and CFIS, respectively, by TA Associates. The combined balanceof the 12% senior subordinated and 12% subordinated notes at the start of theperiod was $29,486,478. The remaining balances of the prior term loan, the 12%subordinated notes and the 12% senior subordinated notes were repaid with theproceeds from our $150,000,000 term loan on December 8, 2005.

**Loss from Extinguishment of Debt**

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 repayment of $70,000,000 on our term loan, we wrote-off aportion of the debt issuance costs on the term loan and recognized a loss fromextinguishment of debt of $746,002.

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**Results of Operations**

***Comparison of Three Month Periods EndedJune 30, 2006 and 2005***

**Revenue**

Our revenue was $61.8 million for the threemonths ended June 30, 2006, an increase of $12.5 million or 25.4%,compared to revenue of $49.3 million for the three months ended June 30,2005*.*The increase was primarilydue to an increase in volume in our conduit support services, staffing servicesand special servicing businesses, as well as growth in our surveillanceservices due in part to an increased joint sales effort following thecombination of CFIS and Clayton. Revenue for the three months ended June 30,2006 included $1.9 million from Clayton Lender Solutions, Inc., (formerly d/b/aas Mortgage Resource Network), following the Company’s acquisition ofsubstantially all of the assets of that business in February 2006. Due togrowth in our non-loan related services, our total revenues per loan increased25.6%.  The total number of loans serviceddecreased by 0.1%.

***Cost of Services***

Our cost of services was $41.1 million for the threemonths ended June 30, 2006, an increase of $9.5 million or 29.8%, compared tocost of services of $31.6 million for the three months ended June 30,2005. This increase was attributable to the specific factors discussed below.

*Compensation Expense.*Compensationexpense was $31.3 million for the three months ended June 30, 2006, anincrease of $7.8 million or 33.2%, compared to compensation expense of$23.5 million for the three months ended June 30, 2005***.**** *The increase was primarily due tothe growth in our conduit services, staffing services, special servicing andconsulting businesses, as well as the acquisition of Clayton Lender Solutions,Inc.  Compensation expense in our duediligence business also increased, as increased fixed expenses due toinvestments in product development and management infrastructure offset reducedvariable expenses per loan.

*Travel and Related Expenses.*Traveland related expenses were $6.8 million for the three months ended June 30,2006, a decrease of $0.3 million or 5.1%, compared to travel and relatedexpenses of $7.1 million for the three months ended June 30, 2005.  Travel expenses per loan decreased by 5.0% asreduced travel expenses per loan in our core due diligence business werepartially offset by increases in travel in our non-loan related staffingservices business.   Travel expenses perloan in our core due diligence business decreased due to reduced expenses perloan in our field business and an increase in the percentage of loans servicedin our central underwriting facility.

*Other Direct Costs.*Otherdirect costs were $3.0 million for the three months ended June 30, 2006,an increase of $1.9 million or 188.7%, compared to other direct costs of$1.1 million for the three months ended June 30, 2005. The increase wasprimarily due to an increase in third-party appraisal fees due to an increasein appraisal revenue in our due diligence business.

***Operating Expenses***

Operating expenses were $15.2 million for the threemonths ended June 30, 2006, an increase of $1.4 million or 10.3%, compared tooperating expenses of $13.8 million for the three months ended June 30,2005. This increase was attributable to the specific factors discussed below.

*Salaries and Benefits.*Salariesand benefits were $5.7 million for the three months ended June 30, 2006, anincrease of $0.5 million or 8.2%, compared to salaries and benefits of$5.2 million for the three 

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monthsended June 30, 2005.  This increase wasprimarily due to the costs of additional administrative, finance, humanresources, technology and executive personnel which were added in preparationfor becoming a public company and following the acquisition of Clayton LenderSolutions, Inc.

*Other Selling, General andAdministrative Expenses.*Other selling, general andadministrative expenses were $5.0 million for the three months ended June 30,2006, an increase of $0.1 million or 1.1%, as compared to selling, general andadministrative expenses of $4.9 million for the three months ended June30, 2005*. ** ***This increase was due togeneral increases in occupancy, corporate governance, insurance, recruiting,non-reimbursable travel and telecommunications costs relating to growth in ourbusiness, the acquisition of Clayton Lender Solutions, Inc. and becoming apublic company.  These increases werelargely offset by reduced consulting expenses and professional fees.

*Depreciation and Amortization.*Depreciationand amortization was $2.0 million for the three months ended June 30, 2006, anincrease of $0.9 million or 81.4%, compared to depreciation and amortization of$1.1 million for the three months ended June 30, 2005*.*This increase was primarily due todepreciation recorded on additional property and equipment and softwaredeveloped for internal use. These additions were made to enhance our corporateinfrastructure and technology platform in support of the growth inbusiness operations and in preparation for becoming a public company.

*Amortization of Intangibles.*Amortizationof intangibles was $2.6 million for the three months ended June 30, 2006, anincrease of $0.1 million or 2.2%, compared to amortization of intangibles of$2.5 million for the three months ended June 30, 2005.

***Interest Expense, net***

Interest expense, net was $1.7 million for the threemonths ended June 30, 2006, a decrease of $0.3 million or 16.6%, compared tointerest expense, net of $2.0 million for the three months ended June 30,2005*.*This decrease was due todecreased borrowings under our credit facilities due to the repayment of $70.0million owed under our senior term loan following our initial public offeringin March 2006. *See “—Liquidity and CapitalResources.”*

***Comparison of Six Month Periods Ended June30, 2006 and 2005***

**Revenue**

Our revenue was $117.0 million for the six monthsended June 30, 2006, an increase of $19.8 million or 20.4%, compared torevenue of $97.2 million for the six months ended June 30, 2005*.*The increase was primarily due to anincrease in volume in our conduit support services, staffing services andspecial servicing businesses as well as growth in our surveillance services duein part to an increased joint sales effort following the combination ofCFIS and Clayton. Revenue for the six months ended June 30, 2006 included $3.2million from Clayton Lender Solutions, Inc., following the Company’sacquisition of substantially all of the assets of that business inFebruary 2006. Due to growth in our non-loan related services, our totalrevenues per loan increased 29.5%. This increase offset a 7.0% decrease in thenumber of loans serviced during the six months ended June 30, 2006 as comparedto the six months ended June 30, 2005. Revenues per loan in our core due diligence business decreased slightlyduring the period due to an increase in the percentage of loans serviced in ourcentral underwriting facility.

***Cost of Services***

Our cost of services was $80.0 million for the sixmonths ended June 30, 2006, an increase of $16.3 million or 25.6%, compared tocost of services of $63.7 million for the six months ended June 30, 2005.This increase was attributable to the specific factors discussed below.

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*Compensation Expense.*Compensationexpense was $60.7 million for the six months ended June 30, 2006, an increaseof $13.9 million or 29.7%, compared to compensation expense of$46.8 million for the six months ended June 30, 2005*.*The increase was primarily due to thegrowth in our conduit services, staffing services, special servicing andconsulting businesses, as well as the acquisition of Clayton Lender Solutions,Inc.  Compensation expense in our coredue diligence business also increased, as a result of increased fixed expensesdue to investments in product development and management infrastructure andslightly higher variable compensation expense per loan due to a slight decreasein productivity and higher average contractor wages.

*Travel and Related Expenses.*Traveland related expenses were $13.9 million for the six months ended June 30, 2006,a decrease of $0.6 million or 4.1%, compared to travel and related expenses of$14.5 million for the six months ended June 30, 2005. The decrease wasprimarily due to a 7.0% reduction in the number of loans serviced. Travelexpenses per loan increased by 3.1%, as increased travel expense in ournon-loan related staffing services business offset reduced travel expenses perloan in our core due diligence business. Travel expenses per loan in our core due diligence business declined dueto an increase in the percentage of loans serviced in our central underwritingfacility.

*Other Direct Costs.*Otherdirect costs were $5.4 million for the six months ended June 30, 2006, anincrease of $3.0 million or 127.6%, compared to other direct costs of$2.4 million for the six months ended June 30, 2005. The increase wasprimarily due to an increase in third-party appraisal fees due to an increasein appraisal revenue in our due diligence business.

***Operating Expenses***

Operating expenses were $29.6 million for the sixmonths ended June 30, 2006, an increase of $4.9 million or 19.6%, compared tooperating expenses of $24.7 million for the six months ended June 30,2005. This increase was attributable to the specific factors discussed below.

*Salaries and Benefits.*Salariesand benefits were $11.0 million for the six months ended June 30, 2006, anincrease of $1.7 million or 18.8%, compared to salaries and benefits of$9.3 million for the six months ended June 30, 2005. Salaries and benefitsexpense for the six months ended June 30, 2006 included $0.5 million of expenserelated to the acceleration of vesting of certain stock options as a result ofthe Company’s initial public offering in March 2006. The remainingincrease was primarily due to the costs of additional administrative, finance,human resources, technology and executive personnel which were added inpreparation for becoming a public company and following the acquisition of ClaytonLender Solutions, Inc.

*Other Selling, General andAdministrative Expenses.*Other selling, general andadministrative expenses were $9.9 million for the six months ended June 30,2006, an increase of $1.5 million or 17.9%, compared to selling, general andadministrative expenses of $8.4 million for the six months ended June 30,2005*.**** ** ***This increase was due togeneral increases in occupancy, corporate governance, insurance, recruiting,non-reimbursable travel, advertising and promotion and telecommunications costsrelating to growth in our business, the acquisition of Clayton LenderSolutions, Inc. and becoming a public company. These increases were partially offset by reduced consulting expenses andprofessional fees.

*Depreciation and Amortization.*Depreciationand amortization was $3.5 million for the six months ended June 30, 2006, anincrease of $1.5 million or 79.4%, compared to depreciation and amortization of$2.0 million for the six months ended June 30, 2005*.*This increase was primarily due to depreciationrecorded on additional property and equipment and software developed forinternal use. These additions were made to enhance our corporate infrastructureand technology platform in support of the growth in business operationsand in preparation for becoming a public company.

*Amortization of Intangibles.*Amortizationof intangibles was $5.1 million for the six month periods ended June 30, 2006and 2005.

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***Interest Expense, net***

Interest expense, net was $4.7 million for the sixmonths ended June 30, 2006, an increase of $0.9 million or 24.0%, compared tointerest expense, net of $3.8 million for the six months ended June 30,2005*.*This increase was due toincreased borrowings outstanding under our credit facilities during the firstthree months of the year prior to our initial public offering. *See “—Liquidity and Capital Resources.”*

***Loss from Extinguishment of Debt***

For the six months ended June 30, 2006, we recognizeda loss from extinguishment of debt of $0.7 million due to the write-off of debtissuance costs as a result of a $70.0 million prepayment on our term loanfollowing our initial public offering. *See “—Liquidityand Capital Resources.”*

**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 at least through 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

OnMarch 1, 2006, we consummated a 1-for-4 reverse stock split of our commonstock 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.

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

·                  redeem $52.8million of 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.

On February 3, 2006, we acquired substantiallyall of the assets and assumed certain liabilities of Clayton LenderSolutions,  Inc. (formerly known asMortgage Resource Network) for an aggregate purchase price and fees aggregatingapproximately $6.1 million.  Workingcapital was used to fund the acquisition of such assets and assumedliabilities. Clayton Lender Solutions, Inc. is engaged in the business of providing outsourced mortgageprocessing and fulfillment services to the mortgage industry, includingmortgage brokers, lenders and securitizers.

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Our operating activities provided cash of $7.4 millionin the six months ended June 30, 2006 and used cash of $5.0 million in the sixmonths ended June 30, 2005. Cash provided from and used in operations isgenerated primarily from net income and the timing of accounts receivablecollections and disbursements of accounts payable. Cash provided by operationsfor the six months ended June 30, 2006 was generated from net income of $1.3million plus $10.4 million of non cash charges, partially offset by $4.3million from a net increase in current assets, primarily due to anincrease in accounts receivable and unbilled receivables and a decrease inprepaid income taxes and deferred revenue. Cash used in operations for the sixmonths ended June 30, 2005 resulted from $3.0 million of net income plus$7.6 million of non cash charges and was negatively impacted by a net increasein operating assets of $15.6 million primarily from an increase in the balanceof accounts receivable****as a resultof an increase in the amount of time receivables remained outstanding. Webelieve cash flow from operations will be sufficient to finance our currentoperations for the next twelve months.

Our investing activities used cash of $12.1 millionand $5.8 million in the six months ended June 30, 2006 and 2005, respectively.Cash used in investing activities in the six months ended June 30, 2006primarily consisted of the Clayton Lender Solutions,  Inc. acquisition and increased capitalexpenditures. Cash used in investing activities in the six months ended June30, 2005 primarily consisted of capital expenditures and the acquisition ofNYSIS, Inc.

Our financing activities provided cash of $8.6 millionand $3.7 million in the six months ended June 30, 2006 and 2005, respectively.The principal sources of cash from financing activities in the six months endedJune 30, 2006 were the proceeds from the initial public offering describedabove and, to a lesser extent, borrowings under our revolving credit agreement.This was partially offset by the redemption of preferred stock and repaymentsof outstanding debt under our credit facility described above. The principalsources of cash from financing activities in the six months ended June 30, 2005were borrowings under our prior revolving credit agreement, partially offset byloan repayments and distributions to shareholders.

Cash paid for interest expense was $4.2 million and$2.8 million in each of the six months ended June 30, 2006 and 2005,respectively. In the six months ended June 30, 2006, the majority of interestexpense was paid on borrowings outstanding under our term loan. In the sixmonths ended June 30, 2005, the majority of interest expense was paid onborrowings outstanding under our subordinated notes, senior subordinated notes,prior revolving line of credit and prior term loan.

***Credit Agreement***

On December 8, 2005, we entered into a$190.0 million senior credit facility. The credit facility provided for a$150.0 million term loan, and a revolving credit facility of$40.0 million. The credit facility also provided us with an option,subject to the consent of the lenders, to increase the revolving creditfacility by $10.0 million to an aggregate of $50.0 million. We exercised theoption to increase our revolving credit facility on January 11, 2006 andApril 28, 2006, and amended our credit facility to increase the revolvingloan facility by $5.0 million on each date, for an aggregate revolvingcredit facility of $50.0 million as of April 28, 2006. Following ourinitial public offering in March 2006, we repaid $70.0 million outstandingunder the term loan and repaid $7.4 million outstanding under the revolvingcredit facility.

The credit agreement terminates on December 8,2011. Principal repayments on the term loan of $200,500 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 levels of interest coverageratio, fixed charge ratio and total leverage ratio. As of June 30, 2006,we were in compliance with all debt covenants. In addition, the credit agreementplaces limitations 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. Thecredit agreement also contains provisions for an increased interest rate duringperiods of default. We do not believe that these covenants will affect ourability to operate our business.

Loans under the credit agreement bear interest at theapplicable LIBOR rate plus 3.0% or Prime Rate plus 2.0%, at our option. Inaddition, we are required to repay a commitment fee of 0.5% based on thecalculation of the excess of the revolving credit loan commitment over theoutstanding balance as defined.

At June 30, 2006, there was an outstanding balance of$79.8 million under the term loan and no outstanding balance under therevolving credit facility.

***Interest Rate Cap***

In September 2004, we purchased an interest ratecap agreement to reduce the potential impact that interest rate increases couldhave on our floating-rate debt interest expense. In January 2006, the Companyrecorded interest expense of $1,915 to reduce the book value of this asset tozero. At June 30, 2006, the notional amount of the interest rate cap agreementwas $15.3 million. The terms of the interest rate cap agreement, whichexpires on September 30, 2006, provide that we would receive quarterlypayments equal to the notional amount multiplied by the difference by whichLIBOR exceeds 5%. The initial premium of $29,900 was recorded as an asset onthe date of purchase. Subsequent declines in the fair value of this derivativewere recorded as interest expense.

***Contractual Obligations***

The following table describes our cash commitments, inthousands, to settle contractual obligations as of June 30, 2006.
| ** **                    | ** ** | **Total** | ** ** | **Less  than  1 year** | ** ** | **1-3 years** | ** ** | **4-5 years** | ** ** | **More than  5 years** | ** ** |
|-------------------------------|------------|-----------|------------|-----------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|
| Term loans and  loans payable |       | $         | 79,799     |                        | $          | 401                |       | $                  | 2,406      |                             | $          | 76,992 |   | $ | — |   |
| Capital lease  obligations    |       | 1,028     |       | 180                         |       | 733                |       | 115                |       | —                           |       |
| Operating lease  obligations  |       | 9,773     |       | 1,413                       |       | 6,772              |       | 1,113              |       | 475                              |       |
|                          |       |      |       |                        |       |               |       |               |       |                             |       |
| Total                         |       | $         | 90,600     |                        | $          | 1,994              |       | $                  | 9,911      |                             | $          | 78,220 |   | $ | 475 |   |

 

**Off-Balance-Sheet Arrangements**

As of June 30, 2006, 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 six months ended June 30, 2006, there wereno material changes in our market risk exposure. For a discussion of our marketrisk associated with interest rate risk and equity price risk as ofDecember 31, 2005, see Risk Factors and Management’s Discussion andAnalysis of Financial Condition and Results of Operations contained inour registration statement on Form S-1 (File No. 333-129526),declared effective by the Securities and Exchange Commission on March 23,2006, which includes audited financial statements for the year endedDecember 31, 2005.

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**Item 4.****  Controlsand Procedures**

** **

***Evaluation of Disclosure Controls andProcedures***

In connection with the preparation and review of ourQuarterly Report on Form 10-Q for the three month period ended March 31, 2006,our independent registered public accounting firm identified adjustments to ourfinancial statements as part of their quarterly review procedures.  Theseadjustments were made prior to the issuance of our financial statements for thethree months ended March 31, 2006. After considering the preparation and reviewprocess for those financial statements, our chief executive officer and chieffinancial officer concluded that certain control deficiencies existed in ourinternal control over financial reporting as of such date, which, as discussedbelow, constituted a material weakness.  Our management, with theparticipation of our chief executive officer and chief financial officer, andafter consideration of the implementation of our remediation plan, as discussedbelow, and in consultation with our Audit Committee and our independentregistered public accounting firm, evaluated the effectiveness of our disclosurecontrols and procedures as of June 30, 2006.  The term “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSEC’s rules and forms.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by a company in the reports that it files or submitsunder the Exchange Act is accumulated and communicated to the company’smanagement, including its principal executive and principal financial officers,as appropriate to allow timely decisions regarding required disclosure.Management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving theirobjectives and management necessarily applies its judgment in evaluating thecost-benefit relationship of possible controls and procedures. We havetaken actions to remediate the material weakness identified during the priorquarter and will continue to further implement our remediation plan.  We believe the actions taken to date havebeen effective in mitigating the material weakness identified.  Nevertheless, because the new disclosurecontrols and procedures implemented as part of the remediation plan have notbeen in place for a sufficient length of time, our chief executive officer andchief financial officer concluded that our disclosure controls and procedureswere not effective at the reasonable assurance level as of June 30, 2006.

Notwithstanding the material weakness described below,management believes the condensed consolidated financial statements included inthis Quarterly Report on Form 10-Q fairly present in all material respects ourfinancial condition, results of operations and cash flows at and for theperiods presented in accordance with accounting principles generally acceptedin the United States of America (“US GAAP”).

*Material Weakness in Internal Control over FinancialReporting*

A “material weakness” is a control deficiency, orcombination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.

As of June 30, 2006, we did not have a sufficientcomplement of personnel with an appropriate level of accounting knowledge,experience and training in the application of US GAAP to support our financialaccounting and reporting requirements. As a result, we did not maintaineffective controls over the application of our accounting policies related tothe timing of expense recognition sufficient to ensure such charges andexpenses were accounted for in accordance with US GAAP.  If leftunremediated, these control deficiencies could potentially result inmisstatement of significant accounts and disclosures that could result in amaterial misstatement to our interim or annual consolidated financialstatements that would not be prevented or detected.  Accordingly,management has determined that these control deficiencies constituted amaterial weakness in internal control over financial reporting.

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*Management’s Remediation Initiatives*

We are in the process of remediating the materialweakness in our internal control over financial reporting described above. We have completed or expect to complete the following actions:

·                                          Wehave recently added several professionals possessing significant accounting andcontrol expertise. These individuals have been included in the preparation andreview of our periodic financial statements and evaluate transactions andaccounting treatments that may give rise to additional research and controlconsiderations.

 

·                                          Subsequentto June 30, 2006, an individual with significant public company financialreporting experience accepted a position of employment to supplement ourfinance and accounting staff.

 

·                                          Wehave drafted critical accounting policies and implemented procedures to ensurethat account reconciliations and amounts recorded in our books and records aresubstantiated by detailed and contemporaneous documentary support. Thesepolicies and procedures include strengthened reconciliation procedures,approvals and supervisory review controls.

 

·                                          Wehave engaged the services of external advisors, as necessary, in relation tosignificant accounting matters.

 

·                                          Weare training certain key personnel with responsibilities for financial and taxreporting in order to improve the quality, communication and review processesand procedures over these functions.

 

·                                          Wecontinue to assess the performance and skills of the accounting and financeorganization in order to evaluate competencies and responsibilities and takecorrective actions as necessary.

 

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

No change in our internal control over financialreporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)occurred during the three months ended June 30, 2006, other than the remedialactions described above that were undertaken to address the material weaknessin our internal control over financial reporting, that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

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**Part II— OTHER INFORMATION**

**Item 1.****  LegalProceedings**

Not applicable.

**Item 1A. Risk Factors**

Not applicable.

**Item 2. Unregistered Sales ofEquity Securities and Use of Proceeds**

(a)                                  Notapplicable.

(b)                                 OnMarch 23, 2006, our registration statement on Form S-1 (RegistrationNo. 333-129526) was declared effective for our initial public offering,pursuant to which we offered and sold 8,625,000 shares of common stock andreceived net proceeds of approximately $131.8 million.  We used approximately $130.2 million of theseproceeds to pay down indebtedness and to redeem all outstanding shares of ourredeemable preferred stock, which were issued upon the conversion of ourconvertible preferred stock in conjunction with the closing of our initialpublic offering.  As of March 31, 2006,we retained approximately $1.6 million of these net proceeds, all of which wereused during the three month period ended June 30, 2006 for general corporatepurposes.

(c)                                  Notapplicable.

**Item 3.****  DefaultsUpon Senior Securities**

Not applicable.

**Item 4.  Submission ofMatters to a Vote of Security Holders**

Not applicable.

**Item 5.  OtherInformation**

Not applicable.

**Item 6.  Exhibits**

The exhibits listed in the Exhibit Indeximmediately preceding the exhibits are filed as part of this QuarterlyReport on Form 10-Q and such Exhibit Index is incorporated herein byreference.

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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:  August 14, 2006 | By:                             | /s/ Frederick C. Herbst |   |
|                        |                            | Frederick C. Herbst |
|                        | * *                        | *Chief Financial Officer* |
|                        |                            | (Duly Authorized Officer and Principal Financial  Officer) |

 

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**EXHIBIT INDEX**

Listed and indexed below are all Exhibits filed aspart of this report.
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1             |       | Employment Agreement, dated May 1, 2006, by and  between Clayton Holdings, Inc. and David Keith Johnson (filed as Exhibit 10.1  to the Current Report on Form 8-K filed on May 5, 2006 and incorporated  herein by reference). |
|             |       |                                                                                                                                                                                                                           |
| 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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