**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**







**Form
      10-Q**




(Mark
      One)





x
            **QUARTERLY
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**For
                the quarterly period ended September 30, 2006 ̈
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**For
                the transition period from N/A to
                N/A





Commission
      File Number 000 - 25161








**MODTECH
      HOLDINGS, INC.**


**(Exact
      name of registrant as specified in its charter)**










**Delaware**
            **33
                - 0825386****(State
                or other jurisdiction of****incorporation
                or organization)**
            **(I.R.S.
                Employer****Identification
                No.)****2830
                Barrett Avenue, Perris, CA**
            **92571****(Address
                of principal executive office)**
            **(Zip
                Code)**





**(951)
      943-4014**


**(Registrant’s
      telephone number including area code)**







Indicate
      by check mark, whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.  Yes x No  ̈





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated filer. See definition of “accelerated
      filer” and “large accelerated file” in Rule 12b-2 of the Exchange
      Act. (Check one):





Large
      accelerated filer  ̈ Accelerated
      filer  ̈ Non-accelerated
      filer x





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





As
      of
      November 6, 2006 there were 20,018,855 of the Registrant’s Common Stock
      outstanding.






















**Modtech
      Holdings, Inc.**


**Index
      to Form 10-Q**







**Page
                #****PART
                I. **FINANCIAL
                INFORMATION****Item 1.
            Financial
                Statements (Unaudited)
            3Condensed
                Consolidated Balance SheetsAs
                of September 30, 2006 and December 31, 2005
            4Condensed
                Consolidated Statements of OperationsFor
                the Three and Nine Months Ended September 30, 2006 and
                2005
            5Condensed
                Consolidated Statements of Cash FlowsFor
                the Nine Months Ended September 30, 2006 and 2005
            6Notes
                to Unaudited Interim Condensed Consolidated Financial
                Statements
            7-15Item 2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            16-23Item 3.
            Quantitative
                and Qualitative Disclosures about Market Risk
            23Item 4.
            Controls
                and Procedures
            24-25**PART
                II. OTHER INFORMATION**Item 1.
            Legal
                Proceedings
            26Item
                1A.
            Risk
                Factors
            26Item 2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            26Item 3.
            Defaults
                upon Senior Securities
            26Item 4.
            Submission
                of Matters to a Vote of Security Holders
            26Item 5.
            Other
                Information
            26Item 6.
            Exhibits
            27-29Signatures
            
            30




2





**MODTECH
      HOLDINGS, INC.**





**FORM
      10-Q**





**FOR
      THE QUARTER ENDED SEPTEMBER 30, 2006**





**PART
      I. FINANCIAL INFORMATION**





**Item
      1. Financial Statements**





The
      condensed consolidated financial statements included herein have been prepared
      by Modtech Holdings, Inc. and subsidiaries (“Modtech”, “we”, “our”, or the
“Company”), without audit, pursuant to the rules and regulations of the
      Securities and Exchange Commission. Certain information normally included in
      consolidated financial statements prepared in accordance with accounting
      principles generally accepted in the United States of America has been omitted
      pursuant to such rules and regulations. However, we believe that the condensed
      consolidated financial statements, including the disclosures herein, are
      adequate to make the information presented not misleading. The results of
      operations for the three and nine months ended September 30, 2006 and 2005
      are
      not necessarily indicative of the results to be expected for the full fiscal
      years. The condensed consolidated financial statements should be read in
      conjunction with our consolidated financial statements and notes thereto
      included in our Annual Report on Form 10-K for the year ended December 31,
      2005,
      as filed with the Securities and Exchange Commission.






3




MODTECH
      HOLDINGS INC. AND SUBSIDIARIES


Condensed
      Consolidated Balance Sheets


(Unaudited)




**September
                    30,**
                
                **December
                    31,****2006**
                
                **2005**AssetsCurrent
                    assets:Cash
                    and cash equivalents
                
                $
                3,988,000
                
                $
                3,263,000Restricted
                    cash - current portion
                
                
                5,000,000
                
                
                11,452,000Contracts
                    receivable, less allowance for contract adjustments of $720,000
                    and$616,000
                    in 2006 and 2005, respectively
                
                
                29,629,000
                
                
                40,687,000Costs
                    and estimated earnings in excess of billings on contracts
                
                
                21,221,000
                
                
                16,050,000Inventories
                
                
                7,964,000
                
                
                12,047,000Prepaid
                    assets
                
                
                1,514,000
                
                
                960,000Income
                    tax receivable
                
                
                8,000
                
                
                6,000Other
                    current assets
                
                
                3,551,000
                
                
                1,373,000Total
                    current assets
                
                
                72,875,000
                
                
                85,838,000Property
                    and equipment, net
                
                
                14,482,000
                
                
                14,518,000Restricted
                    cash
                
                
                —
                
                
                5,000,000Goodwill
                
                
                71,903,000
                
                
                71,903,000Covenants
                    not to compete, net
                
                
                —
                
                
                4,000Debt
                    issuance costs, net
                
                
                1,859,000
                
                
                3,993,000Other
                    assets
                
                
                516,000
                
                
                577,000Total
                    assets
                
                $
                161,635,000
                
                $
                181,833,000Liabilities
                    and Shareholders’ EquityCurrent
                    liabilities:Accounts
                    payable
                
                $
                25,847,000
                
                $
                25,687,000Accrued
                    liabilities
                
                
                12,252,000
                
                
                28,498,000Billings
                    in excess of costs and estimated earnings on contracts
                
                
                2,972,000
                
                
                3,809,000Current
                    revolving credit line
                
                
                3,300,000
                
                
                4,819,000Current
                    maturities of long-term debt, net
                
                
                15,182,000
                
                
                19,831,000Total
                    current liabilities
                
                
                59,553,000
                
                
                82,644,000Long-term
                    debt, net, excluding current portion
                
                
                —
                
                
                14,628,000Total
                    liabilities
                
                
                59,553,000
                
                
                97,272,000Shareholders’
                    equity:Common
                    stock, $.01 par value. Authorized 55,000,000 shares; issued andoutstanding
                    19,018,855 and 17,062,219 in 2006 and 2005, respectively
                
                
                190,000
                
                
                170,000Additional
                    paid-in capital
                
                
                117,836,000
                
                
                96,640,000Accumulated
                    deficit
                
                
                (15,944,000
                )
                
                (12,249,000
                )Total
                    shareholders’ equity
                
                
                102,082,000
                
                
                84,561,000Total
                    liabilities and shareholders’ equity
                
                $
                161,635,000
                
                $
                181,833,000


*See
      notes to unaudited condensed consolidated financial
      statements.*




4




MODTECH
      HOLDINGS INC. AND SUBSIDIARIES


Condensed
      Consolidated Statements of Operations


(Unaudited)




**Three
                    Months Ended**
                
                **Nine
                    Months Ended****September
                    30,**
                
                **September
                    30,****2006**
                
                **2005**
                
                **2006**
                
                **2005**Net
                    sales
                
                $
                45,583,000
                
                $
                65,576,000
                
                $
                126,794,000
                
                $
                174,411,000Cost
                    of goods sold
                
                
                42,668,000
                
                
                60,805,000
                
                
                118,724,000
                
                
                161,237,000Gross
                    profit
                
                
                2,915,000
                
                
                4,771,000
                
                
                8,070,000
                
                
                13,174,000Selling,
                    general and administrative expenses
                
                
                3,672,000
                
                
                3,710,000
                
                
                10,526,000
                
                
                11,150,000Loss
                    (gain) on sale of property and equipment
                
                
                —
                
                
                5,000
                
                
                —
                
                
                (57,000
                )(Loss)
                    income from operations
                
                
                (757,000
                )
                
                1,056,000
                
                
                (2,456,000
                )
                
                2,081,000Other
                    (expense) income:Interest
                    expense
                
                
                (379,000
                )
                
                (1,704,000
                )
                
                (2,044,000
                )
                
                (5,557,000
                )Interest
                    income
                
                
                60,000
                
                
                44,000
                
                
                299,000
                
                
                47,000Gain
                    (loss) on warrant and embedded derivatives
                
                
                2,220,000
                
                
                (9,612,000
                )
                
                6,698,000
                
                
                (7,509,000
                )Amortization
                    of debt costs
                
                
                (146,000
                )
                
                (263,000
                )
                
                (2,657,000
                )
                
                (725,000
                )Accretion
                    of convertible debt discount
                
                
                (569,000
                )
                
                (268,000
                )
                
                (1,949,000
                )
                
                (793,000
                )Early
                    debt conversion fee
                
                
                —
                
                
                —
                
                
                (1,864,000
                )
                
                —Other
                    income, net
                
                
                74,000
                
                
                91,000
                
                
                278,000
                
                
                324,0001,260,000
                
                
                (11,712,000
                )
                
                (1,239,000
                )
                
                (14,213,000
                )Income
                    (loss) before income taxes
                
                
                503,000
                
                
                (10,656,000
                )
                
                (3,695,000
                )
                
                (12,132,000
                )Income
                    tax expense (benefit)
                
                
                —
                
                
                —
                
                
                —
                
                
                —Net
                    income (loss)
                
                $
                503,000
                
                $
                (10,656,000
                )
                $
                (3,695,000
                )
                $
                (12,132,000
                )Basic
                    earnings (loss) per common share
                
                $
                0.03
                
                $
                (0.66
                )
                $
                (0.20
                )
                $
                (0.80
                )Basic
                    weighted-average shares outstanding
                
                
                18,966,000
                
                
                16,146,000
                
                
                18,044,000
                
                
                15,218,000Diluted
                    earnings (loss) per common share
                
                $
                0.03
                
                $
                (0.66
                )
                $
                (0.20
                )
                $
                (0.80
                )Diluted
                    weighted-average shares outstanding
                
                
                19,432,000
                
                
                16,146,000
                
                
                18,044,000
                
                
                15,218,000


*See
      notes to unaudited condensed consolidated financial
      statements.*




5





MODTECH
      HOLDINGS INC. AND SUBSIDIARIES


Condensed
      Consolidated Statements of Cash Flows


(Unaudited)


**Nine
                  Months Ended September 30,****2006**
              
              **2005**Cash
                  flows from operating activities:Net
                  loss
              
              $
              (3,695,000
              )
              $
              (12,132,000
              )Adjustments
                  to reconcile net loss to net cash used in operating activities:Depreciation
                  and amortization
              
              
              1,905,000
              
              
              2,059,000Write-off
                  of debt issuance costs
              
              
              2,057,000
              
              
              —Gain
                  on sale of equipment
              
              
              —
              
              
              (57,000
              )Stock
                  compensation expense
              
              
              773,000
              
              
              —Non-cash
                  interest expense
              
              
              —
              
              
              900,000Gain
                  on derivative liability
              
              
              (6,698,000
              )
              
              7,509,000Accretion
                  on convertible debt discount
              
              
              1,948,000
              
              
              793,000Early
                  debt conversion fees settled with shares of common stock
              
              
              1,864,000
              
              
              —Decrease
                  (increase) in assets:Contracts
                  receivable
              
              
              11,058,000
              
              
              (5,929,000
              )Costs
                  and estimated earnings in excess of billings
              
              
              (5,171,000
              )
              
              (10,460,000
              )Inventories
              
              
              4,083,000
              
              
              756,000Income
                  tax receivable
              
              
              (2,000
              )
              
              4,956,000Other
                  current and non-current assets
              
              
              (2,670,000
              )
              
              188,000(Decrease)
                  increase in liabilities:Accounts
                  payable and accrued liabilities
              
              
              (5,080,000
              )
              
              3,240,000Billings
                  in excess of costs
              
              
              (837,000
              )
              
              603,000Net
                  cash used in operating activities
              
              
              (465,000
              )
              
              (7,574,000
              )Cash
                  flows from investing activities:Purchase
                  of property and equipment
              
              
              (1,266,000
              )
              
              (965,000
              )Proceeds
                  from sale of equipment
              
              
              —
              
              
              109,000Net
                  cash used in investing activities
              
              
              (1,266,000
              )
              
              (856,000
              )Cash
                  flows from financing activities:Net
                  principal payments under revolving credit line
              
              
              (1,519,000
              )
              
              (21,412,000
              )Principal
                  payments on long-term debt
              
              
              (12,895,000
              )
              
              (12,104,000
              )Proceeds
                  from issuance of long-term debt
              
              
              —
              
              
              27,898,000Decrease
                  (increase) in restricted cash
              
              
              11,452,000
              
              
              (7,396,000
              )Payment
                  of debt issuance costs
              
              
              (523,000
              )
              
              (2,313,000
              )Net
                  proceeds from issuance of common stock
              
              
              5,941,000
              
              
              15,460,000Net
                  cash provided by financing activities
              
              
              2,456,000
              
              
              133,000Net
                  increase (decrease) in cash and cash equivalents
              
              
              725,000
              
              
              (8,297,000
              )Cash
                  and cash equivalents at beginning of period
              
              
              3,263,000
              
              
              11,799,000Cash
                  and cash equivalents at end of period
              
              $
              3,988,000
              
              $
              3,502,000Non-cash
                  financing activity:Issuance
                  of common stock in connection with the conversion of debt
              
              $
              8,333,000
              
              $
              —




*See
      notes to unaudited condensed consolidated financial statements*




6








MODTECH
      HOLDINGS, INC.


Notes
      to
      Unaudited Interim Condensed Consolidated Financial Statements


September
      30, 2006





1)  Basis
      of
      Presentation





In
      the
      opinion of management, the condensed consolidated financial statements reflect
      all adjustments (which include only normal recurring adjustments) necessary
      to
      present fairly the financial position and results of operations as of and for
      the periods presented.





The
      results of operations for the three and nine months ended September 30, 2006
      and
      2005 are not necessarily indicative of the results to be expected for the full
      fiscal years.





2)  Inventories





Inventories
      consist of the following:




**September
                  30,**
              
              **December
                  31,****2006**
              
              **2005**Raw
                  materials
              
              $
              6,445,000
              
              $
              9,211,000Work-in-process
              
              
              1,229,000
              
              
              2,630,000Finished
                  goods
              
              
              290,000
              
              
              206,000$
              7,964,000
              
              $
              12,047,000




3)  Restricted
      Cash





Restricted
      cash as of September 30, 2006 consists of $5.0 million in cash collateral
      required under our 2005 $25.9 million Amended and Restated Senior
      Subordinated Secured Convertible Note (the “2005 Convertible Note”) and is
      included in current assets as the related 2005 Convertible Note is recorded
      as a
      current liability.





4)  Accrued
      Liabilities





Accrued
      liabilities consist of the following:




**September
                  30,**
              
              **December
                  31,****2006**
              
              **2005**Accrued
                  compensation
              
              $
              1,965,000
              
              $
              2,634,000Accrued
                  insurance expense
              
              
              3,460,000
              
              
              3,688,000Provision
                  for estimated losses on contracts
              
              
              141,000
              
              
              3,790,000Embedded
                  derivative liability
              
              
              1,387,000
              
              
              7,849,000Warrant
                  derivative liability
              
              
              1,648,000
              
              
              6,192,000Accrued
                  warranty
              
              
              1,027,000
              
              
              930,000Other
                  accrued liabilties
              
              
              2,624,000
              
              
              3,415,000$
              12,252,000
              
              $
              28,498,000




5)  Debt





Credit
      Facility





On
      March
      31, 2006, we entered into a Loan and Security Agreement (the “B of A Credit
      Facility”) with Bank of America, N.A., and completed an additional amendment to
      our 2005 Convertible Note. The B of A Credit Facility was funded and closed
      on
      April 4, 2006.





In
      connection with the B of A Credit Facility, we terminated our credit facility
      with Fortress Credit Corp. We paid off all amounts borrowed and due under the
      Fortress credit facility, which aggregated approximately $19.4 million,
      including approximately $0.3 million in accrued interest. There were no early
      termination penalties incurred by us in connection with the termination of
      the
      Fortress credit facility. Due to the replacement of the Fortress credit
      facility, approximately $2.1 million of unamortized debt issuance costs was
      written off and charged to expense for the quarter ended March 31,
      2006.





7


The
      B of
      A Credit Facility provides for revolving credit loans of up to a maximum
      principal amount of $25.0 million (the “Revolver Loans”) and a letter of
      credit subline in the maximum amount of $12.0 million. As of September 30,
      2006 $3.3 million is outstanding under the Revolver Loans and $7.2 million
      of
      the letter of credit subline is allocated for standby letters of credit. The
      Revolver Loans bear interest per annum, payable monthly, at a variable rate
      equal to Bank of America’s announced prime rate, plus up to 0.75%. Under certain
      circumstances, we may elect a LIBOR rate plus 2.0% to 3.0%, in which case,
      interest will be payable in one, two, three or nine month periods selected
      by
      us. The variable rates, plus an unused credit line fee of between 0.250% to
      0.375% per annum, will depend on our quarterly EBITDA (“Earnings Before Interest
      Taxes Depreciation and Amortization”) measured on a trailing 12 month
      basis.





The
      principal amount of the Revolver Loans is due and payable in full on March
      31,
      2009. The Revolver Loans may be prepaid from time to time without penalty or
      premium, but if the B of A Credit Facility is terminated during the first two
      years, there is a termination fee equal to $500,000 in the first year and
      $250,000 in the second year. The B of A Credit Facility is secured by
      substantially all of our assets.








In
      connection with the B of A Credit Facility, the 2005 Convertible Note was
      amended to bring its financial covenants in line with those in the B of A Credit
      Facility, extend each redemption date by 45 days, to August 31, 2006, August
      31,
      2007 and September 2, 2008, reduce one of the EBITDA measurement periods from
      12
      months to 6 months, and adjust the notice time periods for redemption. We also
      entered into a new Intercreditor Agreement with Bank of America and the holder
      of our 2005 Convertible Note that replaced the Intercreditor Agreement with
      Fortress Credit Corp. The replacement Intercreditor Agreement is on
      substantially the same terms as the original Intercreditor Agreement, but was
      modified to reflect the changes in the redemption provisions of the 2005
      Convertible Note.





Our
      financial performance for the nine month period ended September 30, 2006
      resulted in the violation of certain financial covenants within the B of A
      Credit Facility and the 2005 Convertible Note; therefore, the $15.2 million
      balance of the 2005 Convertible Note is classified as a current liability as
      of
      September 30, 2006.





As
      discussed in Note 10, subsequent to September 30, 2006, the B of A Credit
      Facility was terminated in connection with new financing arrangements completed
      on November 1, 2006.





2005
      Convertible Note





The
      2005
      Convertible Note bears interest at 7% per annum. Interest on the 2005
      Convertible Note is payable quarterly in cash and the principal amount is due
      on
      December 31, 2009.





On
      May 4,
      2006, the 2005 Convertible Note holder converted $5.7 million of the principal
      amount of the note into 728,900 shares of our common stock pursuant to an
      agreement to convert a total of $8.3 million of principal prior to the August
      31, 2006 redemption date set forth in the 2005 Convertible Note. The remaining
      $2.6 million of principal was converted into 336,743 shares of our common stock
      on July 13, 2006. As consideration for the early conversion, we issued the
      holder 189,189 additional shares of restricted common stock which was recorded
      as a $1.9 million early debt conversion fee for the quarter ended September
      30,
      2006.





Following
      the conversions of $5.7 million and $2.6 million of the principal amount of
      the 2005 Convertible Note on May 4, 2006 and July 18, 2006, respectively, the
      principal balance of the 2005 Convertible Note as of September 30, 2006 was
      $17.6 million with a discounted balance of $15.2 million.





The
      2005
      Convertible Note holder has the right to require us to redeem up to
      $9.2 million on August 31, 2007, and $8.3 million on September 2,
      2008.





The
      2005
      Convertible Note is secured by a first priority, perfected security interest
      in
      certain cash collateral placed in a restricted, segregated collateral account.
      As of September 30, 2006, the amount of cash collateral required to be
      maintained in this account is $5.0 million and is recorded as restricted
      cash on our condensed consolidated balance sheet as of September 30, 2006 (See
      Note 3). The cash collateral is not accessible for use by us until such time
      as
      it is released. The cash held in the cash collateral account will be reduced
      as
      certain financial milestones are met and can be used, in part, to fund
      redemptions that may be requested by the 2005 Convertible Note holder on the
      redemption dates described above, or upon an “event of default” as defined under
      the 2005 Convertible Note. The 2005 Convertible Note is also secured by a second
      priority security interest in our assets, subordinated only to the B of A Credit
      Facility.





8


As
      of
      September 30, 2006, the 2005 Convertible Note was convertible into 2,246,377
      shares of common stock and the warrants issued in connection with the 2005
      Convertible Note (the “2005 Convertible Note Warrants”) were exercisable for
      264,964 shares of common stock at a conversion and exercise price, respectively,
      of $7.82 per share. The conversion and exercise price and the number of shares
      to be acquired are subject to adjustment pursuant to customary anti-dilution
      provisions contained in the 2005 Convertible Note and 2005 Convertible Note
      Warrants. The 2005 Convertible Note and 2005 Convertible Note Warrants may
      be
      converted or exercised at any time or from time to time.





As
      discussed in Note 10, subsequent to September 30, 2006, the 2005 Convertible
      Note was terminated in connection with new financing arrangements completed
      on
      November 1, 2006.





Embedded
      Derivatives





There
      are
      certain embedded derivatives associated with the 2005 Convertible Note. An
      embedded derivative is a derivative instrument that is embedded within another
      contract, which under the 2005 Convertible Note (the host contract) includes
      the
      right to convert the 2005 Convertible Note by the holder, certain default
      redemption right premiums and a change of control premium (payable in cash
      if a
      fundamental change occurs). In accordance with Financial Accounting Standards
      Board (“FASB”) Statement No. 133, as amended, *Accounting
      for Derivative Instruments and Hedging Activities* ,
      these
      embedded derivatives are marked-to-market each reporting period, with a
      corresponding non-cash gain or loss charged to the current period. In connection
      with the May 4, 2006 and July 18, 2006 conversions of $5.7 million and
      $2.6 million, respectively, of the underlying 2005 Convertible Note, the
      relative fair value of the embedded derivative liability was reduced by
      $2.4 million and $0.4 million, respectively, and was reclassified to
      additional paid-in capital. We conducted a valuation of the remaining embedded
      derivatives as of September 30, 2006 using various valuation methods, which
      included Black-Scholes option pricing models. Due to the decrease in our stock
      price from $6.77 at June 30, 2006 to $5.56 at September 30, 2006, the valuation
      conducted as of September 30, 2006 resulted in a non-cash gain of
      $1.3 million for the three month period ended September 30, 2006, with a
      corresponding decrease in the embedded derivative liability, which is included
      as a component of accrued liabilities at September 30, 2006. As of September
      30,
      2006, the fair value of the embedded derivative liability is
      $1.4 million.








Release
      of $5.0 Million in Restricted Cash





In
      connection with the partial conversion of the 2005 Convertible Note, the holder
      agreed to cause the “Letter of Credit Amount” (as defined in the 2005
      Convertible Note) to be reduced by $5.0 million in accordance with the
      terms of the note as if we had achieved the performance standards set forth
      therein, as amended, by the August 31, 2006 date. This resulted in the release
      of $5.0 million of cash collateral to us on May 5, 2006.





6)  Warrants
      and warrant derivative liability





Between
      May 1, 2006 and May 12, 2006, outstanding warrants were exercised for a total
      of
      325,000 shares of common stock at an aggregate exercise price of
      $2.6 million.





Warrant
      activity for the nine months ended September 30, 2006, is summarized
      below:




**Weighted-****Average****Warrants**
              
              **Exercise
                  Price**Outstanding
                  warrants at beginning of period
              
              
              1,460,268
              
              $
              8.15Granted
                  (antidilution adjustment)
              
              
              37,830
              
              
              —Exercised
              
              
              (325,000
              )
              
              8.00Forfeited
              
              
              —
              
              
              —Outstanding
                  warrants at end of period
              
              
              1,173,098
              
              $
              7.93


The
      total
      intrinsic value of warrants exercised during the nine months ended September
      30,
      2006 totaled $0.6 million.





Emerging
      Issues Task Force (“EITF”) Issue No. 00-19, “Accounting for Derivative
      Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own
      Stock” (“EITF 00-19”) requires quarterly analysis of criteria which must be met
      in order to classify warrants issued in a company’s own stock as either equity
      or as a derivative liability. Evaluation of these criteria as of September
      30,
      2006 resulted in the determination that the outstanding warrants should continue
      to be classified as derivative liabilities.





9


In
      accordance with EITF 00-19, warrants which are determined to be classified
      as
      derivative liabilities are marked-to-market each reporting period, with a
      corresponding non-cash gain or loss charged to the current period. In connection
      with the May 2006 exercises of 325,000 warrants with proceeds of
      $2.6 million, the relative fair value of the derivative liability was
      reduced by $1.5 million, and was reclassified to additional paid-in
      capital. We valued the remaining warrant derivative liabilities as of September
      30, 2006 using a Black-Scholes option pricing model using the following
      assumptions: expected dividend yield of 0.0%, expected stock price volatility
      ranging from 42.8% to 43.4%, risk free interest rate ranging from of 4.46%
      to
      4.50% and a remaining contractual life ranging from 3.25 years to 3.83 years.
      Due primarily to the decrease in our stock price from $6.77 at June 30, 2006
      to
      $5.56 at September 30, 2006, the valuation conducted as of September 30, 2006
      resulted in a non-cash gain of $0.9 million for the three month periods
      ended September 30, 2006, with a corresponding decrease in the warrant
      derivative liability, which is included as a component of accrued liabilities
      at
      September 30, 2006. As of September 30, 2006, the total fair value of the
      warrant derivative liability is $1.7 million.





7)  Basic
      and
      Diluted Net Income (Loss) per Share




Basic
        net
        income (loss) per share is computed using the weighted average number of
        common
        shares outstanding during the period, excluding any unvested restricted stock
        that is subject to cancellation. Diluted net income (loss) per share is computed
        using the weighted average number of common shares and, if dilutive, potential
        common shares outstanding during the period. Potential common shares consist
        of
        unvested restricted stock (using the treasury stock method), the incremental
        common shares issuable upon the exercise of stock options and warrants (using
        the treasury stock method) and the conversion of the 2005 Convertible Note
        (using the if-converted method). For the three months ended September 30,
        2006
        and 2005, 1,873,232 and 2,827,135 options and warrants to purchase common
        stock,
        respectively, were excluded from the calculation, as they were anti-dilutive.
        For the nine months ended September 30, 2006 and 2005, approximately 1,950,273
        and 2,827,135 options and warrants to purchase common stock, respectively,
        were
        excluded from the calculation, as they were anti-dilutive. Excluded from
        diluted
        earnings (loss) per share as of September 30, 2006 and 2005 were 2,246,377
        and
        3,022,170 shares, respectively issuable upon conversion of the 2005 Convertible
        Note because the effect would be anti-dilutive. See Note 5 - “Debt” for
        additional information related to the 2005 Convertible Note.


The
      following table sets forth the computation of basic and diluted net income
      per
      share:




**Three
                  Months Ended**
              
              **Nine
                  Months Ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Basic
                  and diluted net income per share:Numerator:Net
                  income (loss)
              
              $
              503,000
              
              $
              (10,656,000
              )
              $
              (3,695,000
              )
              $
              (12,132,000
              )Denominator:Weighted
                    average common shares outstanding (denominator for basic
                    calculation)
              
              
              18,966,000
              
              
              16,146,000
              
              
              18,044,000
              
              
              15,218,000Shares
                  issuable through stock based compensation arrangements
              
              
              466,000
              
              
              —
              
              
              —
              
              
              —Denominator
                  for diluted calculation
              
              
              19,432,000
              
              
              16,146,000
              
              
              18,044,000
              
              
              15,218,000Basic
                  earnings (loss) per common share
              
              $
              0.03
              
              $
              (0.66
              )
              $
              (0.20
              )
              $
              (0.80
              )Diluted
                  earnings (loss) per common share
              
              $
              0.03
              
              $
              (0.66
              )
              $
              (0.20
              )
              $
              (0.80
              )




8)  Stock-Based
      Compensation





Our
      stock-based compensation consists of various stock option plans which grant
      stock options to employees, non-employee officers and directors, consultants,
      vendors, customers and others expected to provide significant services to the
      Company. Refer to Note 11 of our consolidated financial statements in our Annual
      Report on Form 10-K for the year ended December 31, 2005, for additional
      information related to these stock-based compensation plans.





Effective
      January 1, 2006, we adopted SFAS No. 123 (revised), “Share-Based Payment”
(“SFAS 123(R)”) utilizing the modified prospective approach permitted
      thereunder. Prior to the adoption of SFAS 123(R) we accounted for stock option
      grants in accordance with APB Opinion No. 25, “Accounting for Stock Issued
      to Employees” (the intrinsic value method). Under this method, compensation
      expense was recorded on the date of grant only if the current market price
      of
      the underlying stock exceeded the exercise price. The exercise price of previous
      stock options granted has not been less than the fair market value at the date
      of grant, and accordingly, prior to January 1, 2006, we have not previously
      recognized compensation expense related to stock option grants.





10


Under
      the
      modified prospective approach, SFAS 123(R) applies to new awards and to awards
      that were outstanding on January 1, 2006 that are subsequently modified,
      repurchased or cancelled. Under the modified prospective approach, compensation
      cost recognized in the nine months ended September 30, 2006 includes
      compensation cost for all share-based payments granted prior to, but not yet
      fully vested as of January 1, 2006, based on the grant-date fair value estimated
      in accordance with the original provisions of SFAS 123, and compensation cost
      for all share-based payments granted subsequent to January 1, 2006, based on
      the
      grant-date fair value estimated in accordance with the provisions of SFAS
      123(R). Prior periods were not restated to reflect the impact of adopting the
      new standard.





As
      a
      result of adopting SFAS 123(R) on January 1, 2006, our net loss and basic and
      diluted loss per share for the nine months ended September 30, 2006, were
      $513,000 and $0.03 higher, respectively, than if we had continued to account
      for
      stock-based compensation under APB opinion No. 25 for our stock option
      grants. For the three months ended September 30, 2006, our net income and basic
      and diluted income per share were $181,000 and $0.01 lower, respectively, than
      if we had continued to account for stock-based compensation under APB opinion
      No. 25 for our stock option grants.








We
      receive a tax deduction for certain stock option exercises during the period
      the
      options are exercised, generally for the excess of the price at which the
      options are sold over the exercise prices of the options. The tax benefit for
      the nine months ended September 30, 2006 was $155,000 and was recorded as a
      deferred tax asset with a full valuation allowance due to our continuing loss
      position. Prior to adoption of SFAS 123(R), we included these tax benefits
      resulting from the exercise of stock options as operating cash flows in our
      condensed consolidated statements of cash flows. In accordance with SFAS 123(R),
      future tax benefits arising from the exercise of stock options will be reported
      as financing cash flows rather than operating cash flows in our condensed
      consolidated statements of cash flows.





The
      following table illustrates the effect on operating results and per share
      information had we accounted for stock-based compensation in accordance with
      SFAS No. 148, “Accounting for Stock Based Compensation - Transition and
      Disclosure - an Amendment of SFAS No. 123,” for the three and nine months ended
      September 30, 2005:




**Three
                  Months**
              
              **Nine
                  Months****Ended**
              
              **Ended****September
                  30, 2005**
              
              **September
                  30, 2005**Net
                  income (loss)As
                  reported
              
              $
              (10,656,000
              )
              $
              (12,132,000
              )Deduct
                      stock-based compensation expense determined under fair-value
                      based method,
                      net of tax
              
              
              (108,000
              )
              
              (306,000
              )Pro
                  forma
              
              $
              (10,764,000
              )
              $
              (12,438,000
              )Basic
                  and diluted earnings (loss) per common shareAs
                  reported
              
              $
              (0.66
              )
              $
              (0.80
              )Pro
                  forma
              
              $
              (0.67
              )
              $
              (0.82
              )





There
      were no stock options granted during the three month period ended September
      30,
      2006. The per share weighted-average fair value of stock options granted during
      the three month period ended September 30, 2005 was $3.01. The per share
      weighted-average fair value of stock options granted during the nine months
      ended September 30, 2006 and 2005 were $4.79 and $3.11, respectively. We use
      the
      Black-Scholes option pricing model to estimate the fair value of stock-based
      awards, with the following weighted-average assumptions for the indicated
      periods:





**Three Months Ended**
              
              **Nine Months Ended****September
                  30,**
              
              **September
                  30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Expected
                  dividend yield
              
              
              —
              
              
              0
              %
              
              0
              %
              
              0
              %Average
                  risk-free interest rate
              
              
              —
              
              
              4.03
              %
              
              4.68
              %
              
              3.90
              %Expected
                  volatility
              
              
              —
              
              
              41.17
              %
              
              54.45
              %
              
              42.05
              %Expected
                  life of options (in years)
              
              
              —
              
              
              4.0
                  years
              
              
              6.59
                  years
              
              
              4.0
                  years





11




The
      assumptions above are based on multiple factors, including historical exercise
      patterns of employees in relatively homogeneous groups with respect to exercise
      and post-vesting employment termination behaviors, expected future exercising
      patterns for these same homogeneous groups and the implied volatility of our
      stock price.





At
      September 30, 2006, there was $4.2 million of unrecognized compensation
      cost related to share-based payments which is expected to be recognized over
      a
      weighted-average period of 2.4 years.





The
      following table represents stock option activity for the nine months ended
      September 30, 2006:




**Weighted-****Number
                  of**
              
              **Average****Shares**
              
              **Exercise
                  Price**Outstanding
                  options at beginning of period
              
              
              1,373,303
              
              $
              9.79Granted
              
              
              50,000
              
              
              8.17Exercised
              
              
              (376,804
              )
              
              8.95Forfeited
              
              
              (269,324
              )
              
              12.83Outstanding
                  options at end of period
              
              
              777,175
              
              $
              9.06Outstanding
                  exercisable at end of period
              
              
              513,881
              
              $
              9.46




Between
      April 17, 2006 and July 11, 2006, outstanding options were exercised for a
      total
      of 376,804 shares at an aggregate exercise price of
      $3.4 million.





The
      weighted average remaining contractual life for options outstanding and
      exercisable was 6.14 years and 5.19 years, respectively, as of September 30,
      2006. Shares available for future stock option grants were 1,274,948 at
      September 30, 2006. At September 30, 2006, the total intrinsic value of options
      outstanding was zero, and the aggregate intrinsic value of options exercisable
      was also zero.





The
      following table summarizes our nonvested stock option activity for the nine
      months ended September 30, 2006:




**Weighted-****Average****Number
                  of**
              
              **Grant-Date****Shares**
              
              **Fair
                  Value**Nonvested
                  stock options at beginning of period
              
              
              443,107
              
              $
              3.61Granted
              
              
              50,000
              
              
              4.79Vested
              
              
              (133,563
              )
              
              3.95Forfeited
              
              
              (96,250
              )
              
              3.41Nonvested
                  stock options at end of period
              
              
              263,294
              
              $
              3.74





On
      June
      13, 2006 the stockholders approved an amendment to the 2002 Stock Option Plan
      to
      provide for the granting of (i) restricted stock and/or restricted stock units,
      (ii) stock appreciation rights, and (iii) stock bonuses (the “Amended Plan”).
      The Amended Plan also sets for the business criteria for “performance-based
      compensation” that is subject to Section 162(m) of the Internal Revenue Code of
      1986, as amended, restricts the number of shares that may be granted to any
      one
      recipient in any one fiscal year to 100,000, and defines termination for cause
      (which was previously subject to definition in each stock option grant). On
      June
      13, 2006, 464,778 shares of restricted stock were granted to certain officers
      and members of the management team. All restricted stock granted to employees
      under the 2002 Stock Option Plan vest over a five year period with one-third
      vesting at the end of three, four and five years, respectively. As a result
      of
      this transaction, the $3.5 million intrinsic value of the restricted stock
      is
      required to be recognized as compensation expense ratably over the four year
      vesting period and therefore a charge of approximately $217,000 was recorded
      in
      the three month period ended September 30, 2006.




12




The
      restricted stock activity for the nine months ended September 30, 2006, is
      summarized below:




**Weighted-****Average****Number
                  of**
              
              **Grant-Date****Shares**
              
              **Fair
                  Value**Nonvested
                  shares at beginning of period
              
              
              —
              
              $
              —Granted
              
              
              464,778
              
              
              7.56Vested
              
              
              —
              
              
              —Canceled
              
              
              —
              
              
              —Nonvested
                  shares at end of period
              
              
              464,778
              
              $
              7.56





9)  Recent
      Accounting Pronouncements




*Uncertainty
      in Income Taxes*





In
      July
      2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in
      Income Taxes” (“FIN 48”). FIN 48 requires the use of a two-step approach for
      recognizing and measuring tax benefits taken or expected to be taken in a tax
      return and disclosures regarding uncertainties in income tax positions. We
      are
      required to adopt FIN 48 effective January 1, 2007. The cumulative effect of
      initially adopting FIN 48 will be recorded as an adjustment to opening retained
      earnings in the year of adoption and will be presented separately. Only tax
      positions that meet the more likely than not recognition threshold at the
      effective date may be recognized upon adoption of FIN 48. We are currently
      evaluating the impact this new standard; however, the standard is not expected
      to have a significant impact on our financial position, results of operation
      or
      cash flows.





*Leveraged
      Leases*





In
      July
      2006, the FASB issued Staff Position No. FAS 13-2, “Accounting for a Change or
      Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated
      by a Leveraged Lease Transaction” (“FSP 13-2”). FSP 13-2 requires that changes
      in the projected timing of income tax cash flows generated by a leveraged lease
      transaction be recognized as a gain or loss in the year in which change occurs.
      The pretax gain or loss is required to be included in the same line item in
      which the leveraged lease income is recognized, with the tax effect being
      included in the provision for income taxes. We are required to adopt FSP 13-2
      effective January 1, 2007. The cumulative effect of initially adopting this
      FSP
      will be recorded as an adjustment to opening retained earnings in the year
      of
      adoption and will be presented separately. FSP 13-2 is not expected to have
      any
      impact on our financial position, results of operation or cash
      flows.





*Fair
      Value Measurements*





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 does not require new fair
      value measurements but rather defines fair value, establishes a framework for
      measuring fair value and expands disclosure of fair value measurements. SFAS
      157
      is effective for fiscal years beginning after November 15, 2007 and interim
      periods within those fiscal years. We are currently assessing the impact of
      SFAS
      157 on our consolidated financial position and results of operations.





*Quantifying
      and Evaluating the Materiality of Unrecorded Misstatements*





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”).
      SAB 108 provides guidance on quantifying and evaluating the materiality of
      unrecorded misstatements. SAB 108 is effective for fiscal years ending after
      November 15, 2006, with earlier application encouraged for any interim period
      of
      the first fiscal year ending after November 15, 2006, filed after the
      publication of SAB 108 (September 13, 2006). We are currently assessing the
      impact of SAB 108, but we do not expect it to have a material impact on our
      consolidated financial position and results of operations unless prior period
      adjustments are discovered in the future.




13





10)  Subsequent
      Events





Conversion
      and Repurchase Agreement





Between
      October 31, 2006 and November 1, 2006, the holder of our 2005 Convertible Note
      converted $7,820,000 of the principal amount of the note into 1,000,000 shares
      of our common stock and we repurchased $9,746,666 of the outstanding
      principal amount of the 2005 Convertible Note for $8,000,000. In connection
      with
      this conversion and repurchase, the 2005 Convertible Note and the related Pledge
      and Security Agreement dated December 30, 2004 were terminated.





As
      part
      of the conversion and repurchase, we agreed to register the 189,189 shares
      of
      our common stock issued to the 2005 Convertible Note holder in connection with
      a
      partial conversion of the note on May 4, 2006. The registration will be pursuant
      to a separate Registration Rights Agreement between us and the 2005 Convertible
      Note holder which requires us to file a registration statement within 90 days
      following October 31, 2006.





Securities
      Transaction





On
      November 1, 2006, we issued and sold to Laurus Master Fund, Ltd. (“Laurus”) a
      Secured Convertible Term Note in the original principal amount of $5 million
      (the “2006 Convertible Note”), a Secured Term Note in the original principal
      amount of $13 million (the “2006 Nonconvertible Note”), a Common Stock Purchase
      Warrant exercisable for 1,540,697 shares of our common stock, at an average
      exercise price of $7.57 per share, and a second Common Stock Purchase Warrant
      exercisable for 581,395 shares of our common stock, at an average exercise
      price
      of $5.69 per share (collectively the “2006 Warrants”).





The
      2006 Notes





The
      2006
      Convertible Note and the 2006 Nonconvertible Note (the “2006 Notes”) bear
      interest at an adjustable rate equal to the prime rate as published in the
      Wall
      Street Journal, plus 2.5% and 3.75%, respectively (the “Contract Rates”). The
      2006 Notes’ interest rates will be adjusted with each adjustment in the prime
      rate. We have deposited $1,992,746 in a restricted account with North Fork
      Bank
      from which the first year’s interest on the 2006 Notes will be paid. The deposit
      is equivalent to one-year’s interest on both 2006 Notes at the current Contract
      Rates.





Payments
      of principal in the aggregate amount of $375,000 under both 2006 Notes, plus
      accrued interest, will commence February 28, 2007 and continue on the same
      day
      of each month until the final payment of principal and accrued interest under
      the 2006 Notes which is due October 31, 2009.





Laurus
      may, at its discretion, convert all or any portion of the 2006 Convertible
      Note
      into shares of our common stock at the following “Conversion Prices”: $5.96 per
      share for the first $1,666,668 of principal, $6.23 per share for the next
      $1,666,666 of principal, and $7.69 per share for the remaining $1,666,666 of
      principal. On any monthly payment date of principal and interest under the
      2006
      Convertible Note, Laurus must convert the monthly payment then due into shares
      of our common stock, in lieu of a cash payment by us, up to an amount that
      does
      not exceed 25% of the aggregate dollar trading volume of our common stock for
      the 22 trading days immediately preceding the monthly payment date, if the
      average closing price of our common stock for the five trading days immediately
      preceding the monthly payment date is 118% of the then current Conversion Price.
      The balance of the monthly payment then due, if any, must be paid by us in
      cash.





The
      2006
      Notes may be prepaid in whole, but not in part or separately, at any time by
      paying the Laurus 124% of the then aggregate outstanding principal balance
      and
      accrued interest.





The
      2006
      Notes are secured by substantially all of our assets.





Amounts
      owed under the 2006 Notes may be accelerated and are subject to default rate
      interest charges under various circumstances, including, but not limited to,
      the
      failure to make principal or interest payments when due under the Notes,
      breaches of certain covenants, representations, conditions and warranties set
      forth in the 2006 Notes and the purchase agreement pursuant to which they were
      issued, including, without limitation, the failure to maintain on a monthly
      basis at least $9 million in cash and eligible accounts receivable, the
      occurrence of certain insolvency or bankruptcy events affecting us, a change
      of
      control in the company, and certain judgments, liens and attachments in excess
      of permitted amounts.





14


The
      Purchase Agreement with Laurus, dated October 31, 2006, pursuant to which the
      2006 Note and 2006 Warrants were issued contains certain negative covenants,
      including, without limitation, restrictions on our ability to, among other
      things, pay dividends, incur debt, or change its business.





The
      2006 Warrants





The
      2006
      Warrants are exercisable at any time up to October 31, 2012. The exercise price
      of the 2006 Warrants and the number of shares issuable upon exercise of the
      2006
      Warrants will be adjusted in the event we issue a stock dividend, subdivide
      our
      shares or combine our shares.





Registration
      Rights Agreement





In
      connection with the sale and issuance of the 2006 Notes and 2006 Warrants,
      we
      entered into a Registration Rights Agreement with Laurus, dated October 31,
      2006, pursuant to which we agreed to prepare and file, within 90 days following
      the issuance of the 2006 Notes and 2006 Warrants, a registration statement
      with
      the Securities and Exchange Commission covering the resale of the common stock
      issuable upon conversion of the 2006 Convertible Note and exercise of the 2006
      Warrants. If the registration statement is not filed within 90 days or declared
      effective by the Securities and Exchange Commission within 180 days, we must
      pay
      the holder of the 2006 Notes a penalty of 1.0% of the principal amount of the
      notes for each 30 day period that the filing or effectiveness of the
      registration is delayed up to a maximum penalty of 10%. We can elect to pay
      up
      to 50% of the penalty amount in shares of our common stock.





Sale
      Leaseback Transaction





On
      November 1, 2006, we sold our manufacturing plant in Florida to NL Ventures
      V,
      L.P. for $4.5 million. Concurrently with the sale of the property, we entered
      into a Lease Agreement with the purchaser’s assignee, NL Ventures V Plant City,
      L.P., pursuant to which we leased back the property for an initial term of
      20
      years. We have the option to extend the lease term for two additional terms
      of
      five years each. The annual rent is $491,160 for the first year of the lease
      and
      increases at the rate of 3% per annum thereafter. We have posted a security
      deposit of $528,900 in connection with the lease.





Credit
      Facility Termination





In
      connection with the issuance of the 2006 Notes and 2006 Warrants, we terminated
      the B of A Credit Facility on November 1, 2006. We paid off all amounts borrowed
      and due under the B of A Credit Facility, which aggregated approximately $1.8
      million, including approximately $500,000 in early termination fees. Our
      Intercreditor Agreement with Amphora Limited and Bank of America, N.A. dated
      March 31, 2006, was also terminated.




15





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





**Cautionary
      Statement**





You
      should read the following discussion and analysis with our Unaudited Condensed
      Consolidated Financial Statements and related Notes thereto contained elsewhere
      in this report. We urge you to carefully review and consider the various
      disclosures made in this report and in our other reports filed with the
      Securities and Exchange Commission.








**Forward
      Looking Statements**





This
      quarterly report contains statements which, to the extent that they are not
      recitations of historical fact, constitute forward-looking statements within
      the
      meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934.
      The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,”
“plan,” “outlook,” “forecast,” “may,” “will,” “should,” “continue,” “predict”
and similar expressions are intended to identify forward-looking statements.
      Such forward-looking statements are intended to be subject to the safe harbor
      protection within the meaning of that term in Section 27A of the Securities
      Act
      of 1933 and Section 21E of the Securities Exchange Act of 1934. Future events
      and actual results could differ materially from those set forth in, contemplated
      by, or underlying the forward-looking statements. Statements in this report,
      including the Notes to the Consolidated Financial Statements and in the
“Management’s Discussion and Analysis of Financial Condition and Results of
      Operation,” describe factors, among others, that could contribute to or cause
      such differences. In addition, the accuracy of such forward looking statements
      may be impacted by a number of business risks and uncertainties that could
      cause
      actual results to differ materially from those projected or anticipated,
      including but not limited to: a continuing labor shortage in California; our
      current default under the terms of our B of A Credit Facility which could impact
      our liquidity in the future; the ability to adequately pass through to customers
      unanticipated future increases in raw material costs; an unanticipated change
      in
      the types of classrooms required by school districts; declines in available
      funding for modular classroom construction and other risks and uncertainties
      that are described elsewhere in this report and in our other filings with the
      Securities and Exchange Commission, including our reports on Form 10-K. Although
      we believe the expectations reflected in our forward-looking statements are
      based upon reasonable assumptions, there is no assurance that our expectations
      will be attained. The forward-looking statements are current only as of the
      date
      of this report. We do not undertake any obligation to update or revise publicly
      any forward-looking statements, even though our situation may change in the
      future. We qualify all of our forward-looking statements by these cautionary
      statements.





**USE
      OF ESTIMATES AND CRITICAL ACCOUNTING POLICIES**





Our
      condensed consolidated financial statements have been prepared in accordance
      with accounting principles generally accepted in the United States of America.
      As such, we are required to make estimates and assumptions that affect the
      reported amounts of assets and liabilities and disclosure of contingent
      liabilities at the balance sheet dates and the reported amounts of revenue
      and
      expense during the reporting periods. The estimates and assumptions are based
      on
      historical experience and on various other factors that we believe are
      reasonable under the circumstances, the results of which form the basis for
      making judgments about the carrying values of assets and liabilities that are
      not readily apparent from other sources. Actual results could significantly
      differ from such estimates. We believe that the following discussion addresses
      our most significant accounting policies, which aid in fully understanding
      and
      evaluating our reported financial results.





Allowances
      for Contract Adjustments





We
      maintain allowances for contract adjustments that result from the inability
      of
      our customers to make their required payments. Management bases its allowances
      on analysis of the aging of accounts receivable, by account, at the date of
      the
      financial statements, assessments of historical collection trends, and an
      evaluation of the impact of current economic conditions. If the financial
      condition of our customers were to deteriorate, resulting in an impairment
      of
      their ability to make payments, additional allowances may be
      required.





Accrual
      for Worker’s Compensation Reserve





Historically
      we have self-insured for workers compensation under a high deductible program.
      Management bases its accrual estimate on input from the insurance carrier which
      includes information regarding open and closed cases, historical costs
      associated with those claims, certain developed costs and an estimate of
      Incurred But Not Reported (“IBNR”) claims. Actual claims often vary to some
      extent from our estimates. This variability may result in actual costs being
      either above or below the estimates recorded on our consolidated financial
      statements. Beginning in July 2006, we became fully insured with no deductible
      for any new workers compensation claims arising after the date of the new
      policy.




16





Revenue
      Recognition on Construction Contracts





Contracts
      are recognized using the percentage-of-completion method of accounting and,
      therefore, take into account the costs, estimated earnings and revenue to date
      on contracts not yet completed. Revenue recognized is that percentage of the
      total contract price that cost expended to date bears to anticipated final
      total
      cost, based on current estimates of costs to complete. The
      percentage-of-completion methodology generally results in the recognition of
      reasonably consistent profit margins over the life of a contract. Cumulative
      revenues recognized may be less or greater than cumulative costs and profits
      billed at any point in time during a contract’s term. The resulting difference
      is recognized as unbilled or deferred revenue.





Any
      estimation process, including that used in preparing contract accounting models,
      involves inherent risk. We reduce the inherent risk relating to revenue and
      cost
      estimates in percentage-of-completion models through corporate policy, approval
      and monitoring processes. Risks relating to project delivery, productivity
      and
      other factors are considered in the estimation process. Our estimates of
      revenues and costs on construction contracts change periodically in the normal
      course of business due to factors such as productivity and modifications of
      contractual arrangements. Such changes are reflected in the results of
      operations as a change in accounting estimate in the period the revisions are
      determined. Provisions for estimated losses are made in the period in which
      the
      loss first becomes apparent.








Valuation
      of the Embedded and Warrant Derivatives





The
      valuation of our embedded derivatives associated with our $25.9 million
      convertible subordinated promissory note, and our warrant derivatives,
      associated principally with the 1,023,000 warrant shares issued in connection
      with our $11.6 million private equity placement on August 5, 2005, are
      determined primarily by the Black-Scholes option pricing model. An embedded
      derivative is a derivative instrument that is embedded within another contract,
      which under the convertible note (the host contract) includes the right to
      convert the note by the holder, certain default redemption right premiums and
      a
      change of control premium (payable in cash if a fundamental change occurs).
      In
      accordance with FASB Statement No. 133, as amended, *Accounting
      for Derivative Instruments and Hedging Activities* , these
      embedded derivatives are marked-to-market each reporting period, with a
      corresponding non-cash gain or loss charged to the current period. A warrant
      derivative liability is determined in accordance with Emerging Issues Task
      Force
      (“EITF”) Issue No. 00-19, “Accounting for Derivative Financial Instruments
      Indexed to, and Potentially Settled in, a Company’s Own Stock” (“EITF 00-19”).
      Based on EITF 00-19, warrants which are determined to be classified as
      derivative liabilities are marked-to-market each reporting period, with a
      corresponding non-cash gain or loss charged to the current period. The practical
      effect of this has been that when our stock price increases so does our
      derivative liability, resulting in a non-cash loss charge that reduces our
      earnings and earnings per share. When our stock price declines, we record a
      non-cash gain, increasing our earnings and earnings per share.





To
      determine the fair value of our embedded derivatives, management evaluates
      assumptions regarding the probability of certain future events. Other factors
      used to determine fair value include our period end stock price, historical
      stock volatility, risk free interest rate and derivative term. The fair value
      recorded for the derivative liability varies from period to period. This
      variability may result in the actual derivative liability for a period either
      above or below the estimates recorded on our consolidated financial statements,
      resulting in significant fluctuations in other income (expense) because of
      the
      corresponding non-cash gain or loss recorded.




Recent
      Accounting Pronouncements




*Uncertainty
      in Income Taxes*





In
      July
      2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in
      Income Taxes” (“FIN 48”). FIN 48 requires the use of a two-step approach for
      recognizing and measuring tax benefits taken or expected to be taken in a tax
      return and disclosures regarding uncertainties in income tax positions. We
      are
      required to adopt FIN 48 effective January 1, 2007. The cumulative effect of
      initially adopting FIN 48 will be recorded as an adjustment to opening retained
      earnings in the year of adoption and will be presented separately. Only tax
      positions that meet the more likely than not recognition threshold at the
      effective date may be recognized upon adoption of FIN 48. We are currently
      evaluating the impact this new standard; however, the standard is not expected
      to have a significant impact on our financial position, results of operation
      or
      cash flows.




17




*Leveraged
      Leases*





In
      July
      2006, the FASB issued Staff Position No. FAS 13-2, “Accounting for a Change or
      Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated
      by a Leveraged Lease Transaction” (“FSP 13-2”). FSP 13-2 requires that changes
      in the projected timing of income tax cash flows generated by a leveraged lease
      transaction be recognized as a gain or loss in the year in which change occurs.
      The pretax gain or loss is required to be included in the same line item in
      which the leveraged lease income is recognized, with the tax effect being
      included in the provision for income taxes. We are required to adopt FSP 13-2
      effective January 1, 2007. The cumulative effect of initially adopting this
      FSP
      will be recorded as an adjustment to opening retained earnings in the year
      of
      adoption and will be presented separately. FSP 13-2 is not expected to have
      any
      impact on our financial position, results of operation or cash
      flows.





*Fair
      Value Measurements*





In
      September 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 does not require new fair
      value measurements but rather defines fair value, establishes a framework for
      measuring fair value and expands disclosure of fair value measurements. SFAS
      157
      is effective for fiscal years beginning after November 15, 2007 and interim
      periods within those fiscal years. We are currently assessing the impact of
      SFAS
      157 on our consolidated financial position and results of operations.





*Quantifying
      and Evaluating the Materiality of Unrecorded Misstatements*





In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”).
      SAB 108 provides guidance on quantifying and evaluating the materiality of
      unrecorded misstatements. SAB 108 is effective for fiscal years ending after
      November 15, 2006, with earlier application encouraged for any interim period
      of
      the first fiscal year ending after November 15, 2006, filed after the
      publication of SAB 108 (September 13, 2006). We are currently assessing the
      impact of SAB 108, but we doe not expect it to have a material impact on our
      consolidated financial position and results of operations unless prior period
      adjustments are discovered in the future.





**Company
      Overview**





Modtech
      manufactures and sells modular relocatable classrooms and commercial and light
      industrial modular buildings. We are a leading provider of modular classrooms
      in
      the State of California and a significant provider of commercial and light
      industrial modular buildings in California, Nevada, Arizona, New Mexico, Utah,
      Colorado, Texas, Florida and other neighboring states.





In
      California and Florida, we market and sell our modular classrooms to school
      districts. Virtually all of our classroom sales are dependent upon public
      funding. Such funding is sourced in multiple ways which are strongly influenced
      by educational policies that are subject to political concerns.





The
      modular re-locatable classroom industry is highly competitive with the market
      divided among a number of privately-owned companies whose share of the market
      is
      smaller than ours. The nonresidential modular building industry is highly
      competitive and fragmented. It is composed primarily of regionally based private
      companies, each with a single manufacturing facility.





**Results
      of Current Operations - Overview**





Revenues
      were $45.6 million and $126.8 million for the three and nine months ended
      September 30, 2006, respectively, down 30.5% and 27.3%, respectively, from
      the
      corresponding periods of the prior year. The decline was due in part to a return
      to normal production levels in Florida in 2006 following unusually strong sales
      in the state for the first half of 2005. The unusually strong Florida sales
      in
      the first half of the prior year were due to classroom rebuilding projects
      following hurricane activity in late 2004. The decline in revenue in 2006 was
      also caused by slower-than-expected education sales in Florida, project delays
      in California and very sluggish sales in Texas for the three months ended
      September 30, 2006.





As
      a
      result of smaller projects and a resulting quicker project turnover in
      2006 **,** our
      backlog of sales orders has declined from $127.5 million at October 31, 2005
      to
      $72.6 million at October 31, 2006. We do not expect our backlog to return
      to the historically high level we experienced during late 2004 and the first
      half of 2005.




18


**Results
      of Operations**





The
      following table sets forth certain items in the Condensed Consolidated
      Statements of Operations as a percent of net sales.




**Percent of Net Sales**
              
              **Percent of Net Sales****Three Months Ended
                  September 30,**
              
              **Nine Months Ended
                  September 30,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Net
                  sales
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %Cost
                  of goods sold
              
              
              93.6
              
              
              92.7
              
              
              93.6
              
              
              92.4Gross
                  profit
              
              
              6.4
              
              
              7.3
              
              
              6.4
              
              
              7.6Selling,
                  general and administrative expenses
              
              
              8.1
              
              
              5.7
              
              
              8.3
              
              
              6.4Gain
                  on sale of property and equipment
              
              
              —
              
              
              0.0
              
              
              —
              
              
              (0.0
              )(Loss)
                  income from operations
              
              
              (1.7
              )
              
              1.6
              
              
              (1.9
              )
              
              1.2Other
                  (expense) income:Interest
                  expense
              
              
              (0.8
              )
              
              (2.6
              )
              
              (1.6
              )
              
              (3.2
              )Interest
                  income
              
              
              0.1
              
              
              0.1
              
              
              0.2
              
              
              0.0Gain
                  (loss) on warrant and embedded derivatives
              
              
              4.9
              
              
              (14.7
              )
              
              5.3
              
              
              (4.3
              )Amortization
                  of debt costs
              
              
              (0.3
              )
              
              (0.4
              )
              
              (2.1
              )
              
              (0.4
              )Accretion
                  on convertible debt discount
              
              
              (1.2
              )
              
              (0.4
              )
              
              (1.5
              )
              
              (0.5
              )Early
                  debt conversion fee
              
              
              —
              
              
              —
              
              
              (1.5
              )
              
              —Other
                  income, net
              
              
              0.2
              
              
              0.1
              
              
              0.2
              
              
              0.2Income
                  (loss) before income taxes
              
              
              1.1
              
              
              (16.2
              )
              
              (2.9
              )
              
              (7.0
              )Income
                  tax expense (benefit)
              
              
              —
              
              
              —
              
              
              —
              
              
              —Net
                  income (loss)
              
              
              1.1
              %
              
              (16.2
              )%
              
              (2.9
              )%
              
              (7.0
              )%





Revenue





Revenues
      were $45.6 million for the quarter ended September 30, 2006, down 30.5%
      from the record revenues of $65.6 million in the prior year period. Arizona
      and Texas sales for the quarter totaled $8.7 million for a combined shortfall
      of
      $4.6 million when compared to the same quarter last year. Florida revenue
      for the three months ended September 30, 2006 was $11.0 million, down
      $5.4 million or 33.0% from the corresponding quarter of the prior year. The
      decrease in Florida was due to lower classroom sales. California revenue of
      $25.9 million for the quarter ended September 30, 2006 was
      $10.0 million or 27.9% less than the corresponding quarter the prior year.
      The decrease in California was primarily due to project delays in the education
      market.





For
      the
      nine month ended September 30, 2006, revenues were $126.8 million, down
      27.3% from the record revenues of $174.4 million in the corresponding prior
      year period. Arizona and Texas sales for the nine months had a combined
      shortfall of $9.7 million when compared to the corresponding period of last
      year. Florida revenue for the nine months ended September 30, 2006 was
      $28.2 million, down $14.2 million or 33.5% from the corresponding
      period of the prior year. The decrease in Florida was due to a return to prior
      levels of sales in the region as the first half of 2005 revenues were bolstered
      by a major classroom projects stemming from the hurricanes in the fall of 2004.
      California revenue of $74.4 million for the nine months ended
      September 30, 2006 was down $23.7 million, or 24.1%, from the
      corresponding period of the prior year. The decrease in California was primarily
      due to project delays in the education market, lower production volumes in
      part
      due to factory inefficiencies and periodic labor shortages in California. In
      addition, in the prior year periods more of our California revenue was
      attributable to fieldwork on large school projects. In the current year period
      we were more reliant on revenue generated from the shipment of factory-built
      units for both schools and commercial customers.





It
      is
      believed that the demise of the piggyback contracting system in California
      has
      had an adverse affect on the sales volume in recent quarters. Prior to January
      27, 2006 many school districts in California utilized “piggy-back” contracts
      which allowed them to order buildings off of contracts bid and entered into
      by
      builders, including Modtech, with other school districts. Since January 27,
      2006, these piggyback contracts are no longer allowed. As a result, more public
      bids will have to occur for the same volume of work. Because the public bidding
      process is a lengthy one, it is our belief that this change has delayed some
      anticipated work into the fourth quarter 2006 and the first quarter of 2007.
      In
      the long-term, we expect the demand for our products and services will not
      be
      significantly impacted by the change in the piggyback contracting
      system.




Our
      gross
      profit margin has declined year over year for the quarter and nine months ended
      September 30, 2006. As a percent of sales, gross profit declined from 7.3%
      of
      sales for the quarter ended September 30, 2005 to 6.4% of sales for the quarter
      ended September 30, 2006. For the nine month period ended September 30, 2006,
      our gross profit margin declined to 6.4% from 7.6% in the corresponding prior
      year period. Our gross profit margin declined as revenues declined more than
      expected and we were not able to reduce fixed and certain variable costs as
      quickly as revenues declined. In addition, the prior year margins benefited
      from
      volume efficiencies related to record results in the three and nine months
      ended
      September 30, 2005.





19


As
      of
      October 31, 2006, the backlog of sales orders was approximately
      $72.6 million, down from approximately $127.5 million at
      October 31, 2005. Backlog that is expected to be converted to sales during
      the remainder of the current fiscal year is approximately $20.0 million.
      The backlog by region as of October 31, 2006 was as follows:
      California—$69.0 million; Arizona—$1.5 million;
      Texas—$0.3 million; and Florida—$1.8 million. This compares to the
      backlog by region as of October 31, 2005 was as follows:
      California—$108.9 million; Arizona—$5.0 million;
      Texas—$5.1 million; and Florida—$8.5 million.





The
      change in the piggyback contracting system, quicker project turnover and
      generally smaller projects are the primary reasons for the decline in backlog.
      We do not expect our backlog to return to the very high levels we experienced
      in
      late 2004 and early 2005. The rate of booking new contracts varies month to
      month, and customer changes in delivery schedules occur. For these reasons,
      among others, our backlog as of any particular date may not be representative
      of
      actual sales for any succeeding period.





Selling,
      General and Administrative Expense





Selling,
      general and administrative (“SG&A”) expenses were approximately flat for the
      quarter and down $0.6 million or 5.6% for the nine months ended September 30,
      2006 compared to the corresponding periods of the prior year. The decrease
      in
      SG&A was primarily attributable to reduced legal, accounting and
      professional services as well as reduced sales commissions that resulted from
      lower sales. SG&A expenses for the quarter and nine months ended September
      30, 2006 include $397,000 and $773,000, respectively, in stock compensation
      expense as a result of the implementation of SFAS 123(R). This expense was
      reported in the past on a pro forma basis pursuant to the predecessor to SFAS
      123(R), SFAS 123. As a result of the lower sales during 2006, selling, general,
      and administrative expenses increased as a percentage of net sales from 5.7%
      to
      8.1% for the three months ended September 30, 2005 and 2006, respectively,
      and
      from 6.4% to 8.3% for the three months ended September 30, 2005 and 2006,
      respectively. In the third quarter management has taken actions to reduce
      SG&A costs, primarily by a reduction of staffing in order to achieve
      profitability at current revenue levels.





Other
      income (expense)





Interest
      expense decreased for the three and nine months ended September 30, 2006, by
      $1.3 million and $3.5 million, respectively when compared to the
      corresponding periods in 2005. The decrease is attributable to lower debt when
      compared to the prior year.





We
      recognized a non-cash gain of $2.2 million and $6.7 million related to the
      embedded derivatives associated with the 2005 Convertible Note and outstanding
      warrants in the three and nine months ended September 30, 2006,
      respectively.





Accretion
      of the convertible debt discount for the three months ended September 30, 2006
      was $0.6 million, which included a $0.4 million incremental non-cash charge
      related to the discount on the $2.6 million conversion of a portion of the
      2005 Convertible Note in July 2006.





In
      the
      quarter ended June 30, 2006, we recognized a non-cash early debt conversion
      fee
      of $1.9 million for the fair value of 189,189 restricted shares issued to
      the note holder as consideration for the early conversion of a portion of the
      2005 Convertible Notes.





Due
      to
      the replacement of the credit facility with Fortress Credit Corp., approximately
      $2.1 million of unamortized debt issue costs were written off and charged to
      interest expense for the quarter ended March 31, 2006.





Based
      upon our cumulative loss position for the nine months ended September 30, 2006,
      we continue to provide a valuation allowance on our deferred tax assets
      including deferred tax assets related to our net operating loss carryforward,
      which completely offsets the initial tax benefit calculation. The non-cash
      gains
      and losses from embedded derivatives are excluded from taxable income or
      loss.





Net
      Income (Loss)





The
      net
      income of $0.5 million for the three months ended September 30, 2006 and
      the net loss of $3.7 million for the nine months ended September 30, 2005
      compare to a net loss of $10.7 million and a net loss of $12.1 million for
      the same periods, respectively, from the prior year. The changes in the periods
      compared are a direct result of the factors discussed above.




20





**Inflation**





We
      are
      subject to the effects of changing prices. During the nine months ended
      September 30, 2006, there was no significant inflationary impact. While the
      cost
      outlook for commodities used in our products, in particular steel, dimensional
      lumber and plywood products is not certain, management believes it can manage
      these inflationary pressures with sales price adjustments as allowed by our
      contracts and by actively monitoring material costs and supply chain and
      inventory management.





**Liquidity
      and Capital Resources**





We
      have
      funded our operations and capital expenditures mostly with cash generated
      internally by operations and borrowings under various credit facilities as
      well
      as cash received from exercised options and warrants. At September 30, 2006
      we
      had $4.0 million in unrestricted cash and an additional $5.0 million
      in restricted cash. The restricted cash is held as collateral for our 2005
      Amended and Restated Senior Subordinated Secured Convertible Note (the “2005
      Convertible Note”). During the nine months ended September 30, 2006 our
      operations used $0.5 million cash. During the second and third quarters of
      2006 we received an aggregate of $17.4 million from the exercise of
      outstanding options and warrants and the release of restricted
      cash.





On
      April
      4, 2006, we paid off all amounts borrowed and due under our credit facility
      with
      Fortress Credit Corp., which aggregated approximately $19.4 million,
      including approximately $0.3 million in accrued interest, and replaced the
      facility with a facility with Bank of America, N.A. (the “B of A Credit
      Facility”). There were no early termination penalties incurred by us in
      connection with the termination of the Fortress credit facility.





The
      B of
      A Credit Facility provides for revolving credit loans of up to a maximum
      principal amount of $25,000,000 (the “Revolver Loans”) and a letter of credit
      subline in the maximum amount of $12,000,000. The Revolver Loans bear interest
      per annum, payable monthly, at a variable rate equal to Bank of America’s
      announced prime rate, plus up to 0.75%. The principal amount of the Revolver
      Loans is due and payable in full on March 31, 2009. The Revolver Loans may
      be
      prepaid from time to time without penalty or premium, but if the B of A Credit
      Facility is terminated during the first two years, there is a termination fee
      equal to $500,000 in the first year and $250,000 in the second year. The B
      of A
      Credit Facility is secured by substantially all of our assets.





Our
      financial performance for the nine month period ended September 30, 2006
      resulted in the violation of certain financial covenants within the B of A
      Credit Facility and the 2005 Convertible Note; therefore, the $15.2 million
      balance of the 2005 Convertible Note is classified as a current liability as
      of
      September 30, 2006.





On
      May 4,
      2006, the 2005 Convertible Note holder converted $5.7 million of the principal
      amount of the 2005 Convertible Note into 728,900 shares of our common stock
      pursuant to an agreement to convert a total of $8.3 million of principal prior
      to the August 31, 2006 redemption date set forth in the 2005 Convertible Note.
      The remaining $2.6 million of principal was converted into 336,743 shares of
      our
      common stock on July 13, 2006. As consideration for the early conversion, we
      issued the holder 189,189 additional shares of restricted common stock which
      was
      recorded as a $1.9 million early debt conversion fee for the quarter ended
      September 30, 2006.





In
      connection with the partial conversion of the 2005 Convertible Note, the holder
      agreed to cause the “Letter of Credit Amount” (as defined in the 2005
      Convertible Note) to be reduced by $5.0 million in accordance with the
      terms of the 2005 Convertible Note as if we had achieved the performance
      standards set forth in the 2005 Convertible Note, as amended, by the August
      31,
      2006 date. This resulted in the release of $5.0 million of cash collateral
      to us on May 5, 2006. In connection with the change to the B of A Credit
      Facility restricted cash was reduced by $6.5 million, which was held as cash
      collateral for the letter of credit subfacility under our prior revolving credit
      loan.





Between
      May 1, 2006 and May 12, 2006, outstanding warrants were exercised for a total
      of
      325,000 shares of common stock at an aggregate exercise price of
      $2.6 million.





Between
      April 17, 2006 and July 11, 2006, outstanding options were exercised for a
      total
      of 376,804 shares at an aggregate exercise price of
      $3.4 million.




21




Subsequent
      to September 30, 2006, the following transactions impacted our liquidity and
      capital structure:





Conversion
      and Repurchase Agreement





Between
      October 31, 2006 and November 1, 2006, the holder of our 2005 Convertible Note
      converted $7,820,000 of the principal amount of the note into 1,000,000 shares
      of our common stock and we repurchased $9,746,666 of the outstanding
      principal amount of the 2005 Convertible Note for $8,000,000. In connection
      with
      this conversion and repurchase, the 2005 Convertible Note and the related Pledge
      and Security Agreement dated December 30, 2004 were terminated.





As
      part
      of the conversion and repurchase, we agreed to register the 189,189 shares
      of
      our common stock issued to the 2005 Convertible Note holder in connection with
      a
      partial conversion of the note on May 4, 2006. The registration will be pursuant
      to a separate Registration Rights Agreement between us and the 2005 Convertible
      Note holder which requires us to file a registration statement within 90 days
      following October 31, 2006.





Securities
      Transaction





On
      November 1, 2006, we issued and sold to Laurus Master Fund, Ltd. (“Laurus”) a
      Secured Convertible Term Note in the original principal amount of $5 million
      (the “2006 Convertible Note”), a Secured Term Note in the original principal
      amount of $13 million (the “2006 Nonconvertible Note”), a Common Stock Purchase
      Warrant exercisable for 1,540,697 shares of our common stock, at an average
      exercise price of $7.57 per share, and a second Common Stock Purchase Warrant
      exercisable for 581,395 shares of our common stock, at an average exercise
      price
      of $5.69 per share (collectively the “2006 Warrants”).





The
      2006 Notes





The
      2006
      Convertible Note and the 2006 Nonconvertible Note (the “2006 Notes”) bear
      interest at an adjustable rate equal to the prime rate as published in the
      Wall
      Street Journal, plus 2.5% and 3.75%, respectively (the “Contract Rates”). The
      2006 Notes’ interest rates will be adjusted with each adjustment in the prime
      rate. We have deposited $1,992,746 in a restricted account with North Fork
      Bank
      from which the first year’s interest on the 2006 Notes will be paid. The deposit
      is equivalent to one-year’s interest on both 2006 Notes at the current Contract
      Rates.





Payments
      of principal in the aggregate amount of $375,000 under both 2006 Notes, plus
      accrued interest, will commence February 28, 2007 and continue on the same
      day
      of each month until the final payment of principal and accrued interest under
      the 2006 Notes which is due October 31, 2009.





Laurus
      may, at its discretion, convert all or any portion of the 2006 Convertible
      Note
      into shares of our common stock at the following “Conversion Prices”: $5.96 per
      share for the first $1,666,668 of principal, $6.23 per share for the next
      $1,666,666 of principal, and $7.69 per share for the remaining $1,666,666 of
      principal. On any monthly payment date of principal and interest under the
      2006
      Convertible Note, Laurus must convert the monthly payment then due into shares
      of our common stock, in lieu of a cash payment by us, up to an amount that
      does
      not exceed 25% of the aggregate dollar trading volume of our common stock for
      the 22 trading days immediately preceding the monthly payment date, if the
      average closing price of our common stock for the five trading days immediately
      preceding the monthly payment date is 118% of the then current Conversion Price.
      The balance of the monthly payment then due, if any, must be paid by us in
      cash.





The
      2006
      Notes may be prepaid in whole, but not in part or separately, at any time by
      paying the Laurus 124% of the then aggregate outstanding principal balance
      and
      accrued interest.





The
      2006
      Notes are secured by substantially all of our assets.





Amounts
      owed under the 2006 Notes may be accelerated and are subject to default rate
      interest charges under various circumstances, including, but not limited to,
      the
      failure to make principal or interest payments when due under the Notes,
      breaches of certain covenants, representations, conditions and warranties set
      forth in the 2006 Notes and the purchase agreement pursuant to which they were
      issued, including, without limitation, the failure to maintain on a monthly
      basis at least $9 million in cash and eligible accounts receivable, the
      occurrence of certain insolvency or bankruptcy events affecting us, a change
      of
      control in the company, and certain judgments, liens and attachments in excess
      of permitted amounts.





22




The
      Purchase Agreement with Laurus, dated October 31, 2006, pursuant to which the
      2006 Note and 2006 Warrants were issued contains certain negative covenants,
      including, without limitation, restrictions on our ability to, among other
      things, pay dividends, incur debt, or change its business.





The
      2006 Warrants





The
      2006
      Warrants are exercisable at any time up to October 31, 2012. The exercise price
      of the 2006 Warrants and the number of shares issuable upon exercise of the
      2006
      Warrants will be adjusted in the event we issue a stock dividend, subdivide
      our
      shares or combine our shares.





Registration
      Rights Agreement





In
      connection with the sale and issuance of the 2006 Notes and 2006 Warrants,
      we
      entered into a Registration Rights Agreement with Laurus, dated October 31,
      2006, pursuant to which we agreed to prepare and file, within 90 days following
      the issuance of the 2006 Notes and 2006 Warrants, a registration statement
      with
      the Securities and Exchange Commission covering the resale of the common stock
      issuable upon conversion of the 2006 Convertible Note and exercise of the 2006
      Warrants. If the registration statement is not filed within 90 days or declared
      effective by the Securities and Exchange Commission within 180 days, we must
      pay
      the holder of the 2006 Notes a penalty of 1.0% of the principal amount of the
      notes for each 30 day period that the filing or effectiveness of the
      registration is delayed up to a maximum penalty of 10%. We can elect to pay
      up
      to 50% of the penalty amount in shares of our common stock.





Sale
      Leaseback Transaction





On
      November 1, 2006, we sold our manufacturing plant in Florida to NL Ventures
      V,
      L.P. for $4.5 million. Concurrently with the sale of the property, we entered
      into a Lease Agreement with the purchaser’s assignee, NL Ventures V Plant City,
      L.P., pursuant to which we leased back the property for an initial term of
      20
      years. We have the option to extend the lease term for two additional terms
      of
      five years each. The annual rent is $491,160 for the first year of the lease
      and
      increases at the rate of 3% per annum thereafter. We have posted a security
      deposit of $528,900 in connection with the lease.





Credit
      Facility Termination





In
      connection with the issuance of the 2006 Notes and 2006 Warrants, we terminated
      the B of A Credit Facility on November 1, 2006. We paid off all amounts borrowed
      and due under the B of A Credit Facility, which aggregated approximately $1.8
      million, including approximately $500,000 in early termination fees. Our
      Intercreditor Agreement with Amphora Limited and Bank of America, N.A. dated
      March 31, 2006, was also terminated.





In
      the
      third quarter management has took actions to reduce overhead and SG&A costs,
      primarily by a reduction of staffing in order to achieve profitability at
      current revenue levels. Management believes that existing capital, anticipated
      cash flow from operations, and current credit facilities will be sufficient
      to
      meet operating needs and capital expenditures for the foreseeable future.





**Item
      3. Quantitative And Qualitative Disclosures About Market
      Risk**





Market
      risk refers to the risk that a change in the level of one or more market factors
      such as interest rates, foreign currency exchange rates, or equity prices will
      result in losses for a certain financial instrument of group of instruments.
      We
      do not hold any instruments that are subject to such risks, but we are exposed
      to the risk of increased interest rates on our credit facility the risk of
      loss
      on credit extended to our customers, and risk of fluctuations in the fair value
      of our derivative liabilities on certain instruments.





INTEREST
      RATE RISK





We
      are
      exposed to the risk of fluctuation in interest rates. During the nine months
      ended September 30, 2006, we did not use interest rate swaps or other types
      of
      interest-related derivative financial instruments. The carrying value of the
      B
      of A Credit Facility approximates fair value as the interest rate is variable
      and resets frequently. Indebtedness under the B of A Credit Facility bears
      interest at a variable rate of up to 0.75% per annum plus Bank of America’s
      announced prime rate. Interest is payable monthly. The 2006 Convertible Note
      and
      the 2006 Nonconvertible Note with Laurus bear interest at adjustable rates
      equal
      to the prime rate as published in the Wall Street Journal, plus 2.5% and 3.75%,
      respectively. The debt outstanding under these notes for the balance of 2006
      will be $18.0 million. Therefore, a one-percentage point increase in
      interest rates would result in an increase in interest expense of approximately
      $180,000 per annum.





23





CREDIT
      RISK





Our
      credit terms generally are “net 30” for dealer accounts and defined by contracts
      which vary for direct sales. We actively monitor this risk through a variety
      of
      control procedures involving senior management. Historically, credit losses
      have
      been less than 0.5% of sales and within our expectations.





DERIVATIVE
      LIABILITY RISK





We
      are
      exposed to the risk of fair value derivative liability fluctuations in the
      equity instruments we have issued, which include the 2005 Convertible Note
      and
      outstanding warrants. The fair value of these derivative liabilities is
      primarily determined by fluctuations in our stock price. As our stock price
      increases or decreases, the fair value of these derivative liabilities increase
      or decrease, resulting in a corresponding current period loss or gain to be
      recognized. Based on the balance on our 2005 Convertible Note, number of
      outstanding warrants, market interest rates and historical volatility of our
      stock price as of September 30, 2006, a $1 increase or decrease in our
      stock price results in a non-cash derivative loss or gain of approximately
      $1.1 million. During the quarter ended September 30, 2006, we experienced a
      $2.2 million non-cash gain on warrant and embedded derivatives.





**Item
      4. Controls And Procedures**




**a.**
            **Evaluation
                of Disclosure Controls and
                Procedures**




We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed in the reports that we file under the
      Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded,
      processed, summarized and reported within the time periods specified in the
      Securities and Exchange Commission’s rules and forms, and that such information
      is accumulated and communicated to management, including our Chief Executive
      Officer and Chief Financial Officer, as appropriate, to allow timely decisions
      regarding required disclosure. Our management, with the participation of the
      Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness
      of our disclosure controls and procedures (as such terms are defined in Rules
      13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2006 and
      concluded that our disclosure controls and procedures were not effective as
      of
      September 30, 2006, because certain material weaknesses in our internal controls
      over financial reporting described in Management’s Report On Internal Control
      Over Financial Reporting in Item 9A of our Annual Report on Form 10-K for the
      year ended December 31, 2005 (the “2005 10-K Report”), had not been remediated
      as of September 30, 2006.





The
      material weaknesses reported in our 2005 10-K Report that had not been
      remediated as of September 30, 2006 were as follows:




1.
              During
                  the quarter ending December 31, 2005, there were multiple changes
                  in
                  personnel and an overall understaffing of the finance function.
                  Insufficient staff, at times, did not allow for timely completion
                  of
                  certain tasks, including analysis and review required for full
                  compliance
                  with internal controls. As a result, we identified the following
                  issues as
                  of December 31, 2005:




·
            A
                control failure occurred involving processing of accrual of open
                invoices
                and valuation of work-in-process inventory, resulting in misstatements
                to
                accrued liabilities, cost of sales and
                revenue.




·
            Our
                controls associated with accounting for our long-term contracts were
                not
                operating effectively. As a consequence, an error was identified
                relating
                to the accounting for a contract amount and one concerning the
                classification of a contract, resulting in misstatements to revenue
                and
                cost of sales.




2.
                The
                      specific control deficiencies in information technology noted
                      as of
                      December 31, 2005, were as
                      follows:


·
            We
                did not have a sufficiently comprehensive review of segregation of
                duties
                regarding access rights when employees changed positions.




·
            System
                limitations allow unrestricted access rights to certain applications.




·
            Removal
                of access rights for terminated employees was not always done on
                a timely
                basis. Although no security breaches occurred, the potential for
                such
                breaches exists.




·
            Inadequate
                monitoring of server backups allowed one location to not be properly
                backed up over one weekend.




24


**b.**
              **Changes
                  in Internal Control over Financial
                  Reporting**




In
      order
      to remediate the material weaknesses described in the 2005 10-K Report, we
      hired
      a Director of Internal Control and SOX during the first quarter of 2006. This
      position, however, is currently vacant and we are actively seeking a
      replacement. We made the following changes during the fiscal quarter ended
      September 30, 2006 in our internal control over financial
      reporting:




·
            We
                further integrated a new general ledger accounting package, Great
                Plains,
                in the current quarter to improve our internal control efforts.




·
            Through
                our continued use of an outside Information Technology consultant
                we
                completed assessment and began remediation at our control deficiencies
                in
                information technology





In
      light
      of the material weaknesses that remain as of September 30, 2006, we performed
      additional analysis and other post-closing procedures to ensure the Consolidated
      Financial Statements are prepared in accordance with generally accepted
      accounting principles. Accordingly, management believes that the financial
      statements included in this report fairly present in all material respects
      our
      financial condition, results of operations and cash flows for the periods
      presented.





Other
      than the remediation measures described above, there have been no changes in
      our
      internal control over financial reporting that occurred during the quarter
      ended
      September 30, 2006, that have materially affected, or are reasonably likely
      to
      materially affect, our internal control over financial reporting.


**c.**
                **Remediation
                    Plan for Material Weaknesses in Internal Control over Financial
                    Reporting**


Our
      plan
      to remediate those material weaknesses remaining as of September 30, 2006 is
      as
      follows:




·
            We
                continue to search for additional staff for our Internal Control
                department and operational finance teams. The searches are underway
                and
                the positions will be filled as soon as qualified candidates are
                identified.




·
            We
                are currently evaluating all finance personnel to ensure that appropriate
                skills and training are maintained in all critical positions.




·
            We
                are currently in the process of remediating the deficiencies noted
                in
                Information Technology controls with the aid of an outside Information
                Technology consultant in connection with the implementation of our
                new
                general ledger accounting package, Great Plains.




25





PART
      II.
      OTHER INFORMATION





**Item
      1. Legal Proceedings**





None





**Item
      1A. Risk Factors**





There
      have been no material changes from the risk factors disclosed in our most
      recently file report on Form 10-K  other
      than the risk factor described in Item 3 below:





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





None
      in
      the reporting period.





**Item
      3. Defaults upon Senior Securities**





Our
      financial performance for the nine month period ended September 30, 2006
      resulted in the violation of certain financial covenants within the B of A
      Credit Facility and the 2005 Convertible Note. As a result, the
      $15.2 million balance of the 2005 Convertible Note is classified as a
      current liability.





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





None





**Item
      5. Other Information**





None




26


**Item
      6. Exhibits**




**Exhibit****Number**
              **Name
                  of Exhibit**3.1
              Certificate
                  of Incorporation of the Company.3.2(1)
              Bylaws
                  of the Company.10.1(2)
              Company’s
                  1994 Stock Option Plan.10.2(2)
              Company’s
                  1996 Stock Option Plan.10.3(2)
              Company’s
                  1999 Stock Option Plan.10.4(2)
              Company’s
                  2002 Stock Option Plan.10.5(3)
              Employment
                  Agreement between the Company and Dennis L. Shogren.10.6(3.1)
              Employment
                  Agreement between the Company and Ronald Savona.10.7(2)
              Separation
                  Agreement between the Company and Evan M. Gruber.10.8(2)
              Separation
                  Agreement between the Company and Michael G. Rhodes.10.9(2)
              Employment
                  Agreement between the Company and David M. Buckley10.10(4)
              Lease
                  between the Company and Pacific Continental Modular Enterprises,
                  relating
                  to the Barrett property in Perris, California10.11(4)
              Lease
                  between the Company and BMG, relating to the property in Lathrop,
                  California10.12(5)
              Conversion
                  and Repurchase Agreement, dated October 31, 200610.13(6)
              Securities
                  Purchase Agreement, dated December 31, 200410.14(6)
              Senior
                  Subordinated Secured Convertible Note, dated December 31,
                  200410.15(6)
              Warrant
                  to Purchase Common Stock issued December 31, 200410.16(6)
              Registration
                  Rights Agreement, dated December 31, 200410.17(6)
              Pledge
                  and Security Agreement, dated December 31, 200410.18(6)
              Intercreditor
                  Agreement, dated December 31, 200410.19(6)
              Amendment
                  and Forbearance Agreement among the Company, Wells Fargo Bank,
                  N.A., Union
                  Bank of California, N.A. and Comerica Bank California, dated December
                  29,
                  2004.10.20(7)
              Financing
                  Agreement between the Company and Fortress Credit Corp. as administrative
                  agent, dated February 25, 2005.10.21(8)
              Amendment
                  Number 1 to Industrial Real Estate Lease between Modtech Holdings,
                  Inc.
                  and BMG2 Enterprises, dated July 29, 200510.22(8)
              Sublease
                  between Modtech Holdings, Inc. and Boise Building Solutions Distribution,
                  L.L.C., dated July 29, 2005
  27
  **Exhibit****Number**
              **Name
                  of Exhibit**10.23(9)
              Securities
                  Purchase Agreement with Peninsula Fund, L.P. and others, dated
                  August 5,
                  200510.24(9)
              First
                  Amendment and Waiver of Financing Agreement between Fortress and
                  Modtech
                  Holdings, Inc., dated August 5, 200510.25(9)
              First
                  Amendment and Restated Registration Rights Agreement, dated August
                  5,
                  200510.26(9)
              Amended
                  and Restated Senior Subordinated Secured Convertible Note, dated
                  August 5,
                  200510.27(9)
              Consent,
                  Waiver, Amendment and Exchange Agreement, dated August 5, 2005
                  (“Waiver”)10.28(9)
              Form
                  of Voting Agreement executed pursuant to Waiver10.29(9)
              Form
                  of Lock Up Letter executed pursuant to the Securities Purchase
                  Agreement,
                  dated August 5, 200510.30(9)
              Form
                  of Warrant issued pursuant to the Securities Purchase Agreement,
                  dated
                  August 5, 200510.31(9)
              Warrant
                  for 8,276 shares of common stock, dated August 5, 200510.32(10)
              Second
                  Amendment of Financing Agreement between Fortress and Modtech Holdings,
                  Inc., dated September 19, 200510.32(11)
              Third
                  Amendment of Financing Agreement between Fortress and Modtech Holdings,
                  Inc., dated December 22, 200510.33(12)
              Intercreditor
                  Agreement with Bank of America, N.A., dated, March 31,
                  200610.34(12)
              Loan
                  and Security Agreement with Bank of America, N.A., dated March
                  31,
                  200610.35(12)
              Amendment
                  Agreement, dated March 31, 200610.36(13)
              Amendment
                  to 2002 Stock Option Plan, dated June 13, 200610.37(15)
              Exchange
                  of Senior Subordinated Secured Convertible Notes, dated May 3,
                  200610.38
              Securities
                  Purchase Agreement with Laurus Master Fund, Ltd. (and attached
                  exhibits),
                  dated October 21, 200610.39
              Intellectual
                  Property Security Agreement, dated October 31, 200610.40
              Master
                  Security Agreement with Laurus Master Fund, Ltd., dated October
                  31,
                  200610.41
              Registration
                  Rights Agreement with Laurus Master Fund, Ltd., dated October 31,
                  200610.42
              Sale
                  and Purchase Agreement and Joint Escrow Instructions with NL Ventures
                  V,
                  L.P. dated November 1, 200610.43
              Lease
                  Agreement with NL Ventures V Plant City, L.P. dated November 1,
                  200610.44(14)
              Registration
                  Rights Agreement with Amphora Limited, dated October 31,
                  200631.1
              Certification
                  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 200231.2
              Certification
                  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 200232.1
              Certification
                  of Chief Executive Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  200232.2
              Certification
                  of Chief Financial Officer pursuant to 18 U.S.C. Section 1350,
                  as adopted
                  pursuant to Section 906 of the Sarbanes-Oxley Act of
                  2002




28





(1)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 10-K filed with the
                Commission on March 15, 2004 (Commission File No.
                000-25161).




(2)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 10-Q filed with the
                Commission on November 12, 2004 (Commission File No.
                000-25161).





(3)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on September 22, 2006 (Commission File No.
                000-25161).




(3.1)
              Incorporated
                    by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                    Commission on February 13, 2006 (Commission File No.
                    000-25161).


(4)
            Incorporated
                by reference to Modtech, Inc.’s Registration Statement on Form S-1 filed
                with the Commission on June 6, 1990 (Commission File No.
                033-35239).





(5)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on November 1, 2002 (Commission File No.
                000-25161).





(6)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on January 3, 2005 (Commission File No.
                000-25161).





(7)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on March 2, 2005 (Commission File No.
                000-25161).





(8)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 10-Q/A filed with the
                Commission on October 17, 2005 (Commission File No.
                000-25161).





(9)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on August 9, 2005 (Commission File No.
                000-25161).





(10)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on September 23, 2005 (Commission File No.
                000-25161).





(11)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on December 29, 2005 (Commission File No.
                000-25161).





(12)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 10-K filed with the
                Commission on April 4, 2006 (Commission File No.
                000-25161).





(13)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Definitive Proxy Statement filed
                with the Commission on May 5, 2006 (Commission File No.
                000-25161)





(14)
            Incorporated
                by reference to Modtech Holdings, Inc.’s Form 8-K filed with the
                Commission on November 1, 2006 (Commission File No.
                000-25161).


(15)
              Incorporated
                  by reference to Modtech Holdings, Inc.’s Form 10-Q filed with the
                  Commission on August 14, 2006 (Commission File No.
                  000-25161).


29





**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.




MODTECH
                HOLDINGS, INC.Date:
                November 14, 2006
            by:
            /s/ KENNETH
              S. CRAGUN**Kenneth
                S. Cragun**
              **Chief
                Financial Officer****and
                Chief Accounting Officer**


by:
              /s/ DENNIS
                L.
                SHOGREN**Dennis
                    L. Shogren**
                  **President
                    and Chief Executive Officer**




30