UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q


             [X] QUARTERLY  REPORT  PURSUANT TO SECTION 13 OR 15(D) OF THE
                 SECURITIES EXCHANGE ACT OF 1934

                For the quarterly period ended September 30, 2006

                                       OR

             [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                For the transition period from to ______________


                         Commission File Number 0-29798


                              COMPUDYNE CORPORATION
             (Exact name of registrant as specified in its charter)

           Nevada                                   23-1408659
--------------------------------                -------------------
(State or other jurisdiction of                  (I.R.S. Employer
incorporation or organization)                   Identification No.)

              2530 Riva Road, Suite 201, Annapolis, Maryland 21401
                    (Address of principal executive offices)

       Registrant's telephone number, including area code: (410) 224-4415


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  filer in Rule 12b-2 of the  Exchange  Act.  (Check
one):

   Large accelerated filer [_] Accelerated filer [_] Non-accelerated filer [X]

Indicate by checkmark  whether the  registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act)

                                 Yes [_] NO [X]

As of November 09, 2006, a total of 8,430,294  shares of Common Stock,  $.75 par
value, were outstanding.

                                        1
<PAGE>



                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                                      INDEX




                                                                        Page No.
Part I.  Financial Information

   Item 1.  Financial Statements - Unaudited

      Consolidated Balance Sheets - September 30, 2006
      and December 31, 2005                                               3

      Consolidated Statements of Operations -
      Three Months and Nine Months Ended September 30, 2006 and 2005      4

      Consolidated Statement of Changes in Shareholders' Equity -
      Nine Months Ended September 30, 2006                                5

      Consolidated Statements of Cash Flows -
      Nine Months Ended September 30, 2006 and 2005                       6

      Notes to Consolidated Financial Statements                       7-17

    Item 2.  Management's Discussion and Analysis of
      Financial Condition and Results of Operations                   18-33

    Item 3.  Quantitative and Qualitative Disclosures
      About Market Risk                                                  34

    Item 4.  Controls and Procedures                                     35

Part II.  Other Information                                              36

      Signature                                                          37


                                        2

<PAGE>



                          ITEM 1. FINANCIAL STATEMENTS

                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                                   (unaudited)

<TABLE>
<CAPTION>
                                                                          September 30,  December 31,
                                                                               2006         2005
                                                                            ---------    ---------
                                     ASSETS
                                                                            (dollars in thousands)
Current Assets
<S>                                                                         <C>          <C>
        Cash and cash equivalents                                           $   3,042    $   6,938
        Marketable securities                                                  11,891       11,429
        Accounts receivable, net                                               30,131       39,625
        Contract costs in excess of billings                                   11,039       13,764
        Inventories                                                             6,056        6,195
        Prepaid expenses and other                                              2,818        2,809
                                                                            ---------    ---------
           Total Current Assets                                                64,977       80,760

Cash equivalents pledged                                                        5,479         --
Property, plant and equipment, net                                             10,723        9,962
Goodwill                                                                       27,519       26,846
Other intangible assets, net                                                    8,596        8,221
Other                                                                           2,036          903
                                                                            ---------    ---------
           Total Assets                                                     $ 119,330    $ 126,692
                                                                            =========    =========

                                     LIABILITIES AND SHAREHOLDERS' EQUITY

Current Liabilities
        Accounts payable and accrued liabilities                            $  14,220    $  23,030
        Billings in excess of contract costs incurred                          11,491       13,847
        Deferred revenue                                                        8,213        8,094
        Current portion of notes payable                                          440          440
                                                                            ---------    ---------
           Total Current Liabilities                                           34,364       45,411

Notes payable                                                                   2,685        3,125
Convertible subordinated notes payable, net                                    39,445       39,305
Deferred tax liabilities                                                        2,060        2,060
Other                                                                             385          369
                                                                            ---------    ---------
           Total Liabilities                                                   78,939       90,270
                                                                            ---------    ---------

Commitments and Contingencies

Shareholders' Equity
        Preferred stock, 2,000,000 shares authorized and unissued                --           --
        Common stock, par value $.75 per share:  50,000,000 shares
         authorized at September 30, 2006 and December 31, 2005;
         9,258,801 and 8,950,356 shares issued at September 30,
         2006 and December 31, 2005, respectively                               6,944        6,712
        Additional paid-in-capital                                             46,988       44,388
        Accumulated deficit                                                    (7,524)      (8,963)
        Accumulated other comprehensive (loss)                                   (341)         (39)
        Treasury stock, at cost; 831,777 shares at September 30, 2006
         and December 31, 2005                                                 (5,676)      (5,676)
                                                                            ---------    ---------
           Total Shareholders' Equity                                          40,391       36,422
                                                                            ---------    ---------
           Total Liabilities and Shareholders' Equity                       $ 119,330    $ 126,692
                                                                            =========    =========
</TABLE>

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

                                        3
<PAGE>

                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (unaudited)


<TABLE>
<CAPTION>
                                                           Three Months Ended                    Nine Months Ended
                                                              September 30,                        September 30,
                                                          2006              2005               2006              2005
                                                        --------          --------          ---------          ---------
                                                                     (in thousands, except per share data)
Revenues:
<S>                                                     <C>               <C>               <C>                <C>
  Contract revenues earned                              $ 19,354          $ 21,749          $  60,847          $  64,070
  Maintenance revenues                                     5,608             4,615             17,020             14,265
  Other revenues                                           9,734             7,135             35,693             22,574
                                                        --------          --------          ---------          ---------
     Total revenues                                       34,696            33,499            113,560            100,909

Cost of sales                                             22,878            25,561             77,097             70,161
                                                        --------          --------          ---------          ---------
Gross profit                                              11,818             7,938             36,463             30,748

Selling, general & administrative expenses                 9,175            10,592             28,253             30,914
Research and development                                   1,769             2,565              5,470              6,918
                                                        --------          --------          ---------          ---------
Income (loss) from operations                                874            (5,219)             2,740             (7,084)
                                                        --------          --------          ---------          ---------
Other expense (income)
  Interest expense                                           822               748              2,479              2,301
  Interest income                                           (269)             (187)              (837)              (625)
  Other income                                               (14)               (3)              (172)               (25)
                                                        --------          --------          ---------          ---------
     Total other expense                                     539               558              1,470              1,651
                                                        --------          --------          ---------          ---------
Income (loss) before taxes on income                         335            (5,777)             1,270             (8,735)
Income tax expense (benefit)                                   8              (500)              (169)              (500)
                                                        --------          --------          ---------          ---------
Net income (loss)                                       $    327          $ (5,277)         $   1,439          $  (8,235)
                                                        ========          ========          =========          =========
Income (loss) per share:
Basic income (loss) per common share                    $    .04          $   (.65)         $     .18          $   (1.01)
                                                        ========          ========          =========          =========
Weighted average number of common
shares outstanding                                         8,355             8,116              8,198              8,132
                                                        ========          ========          =========          =========
Diluted income (loss) per common share                  $    .04          $   (.65)         $     .18          $   (1.01)
                                                        ========          ========          =========          =========
Weighted average number of common
shares and equivalents                                     8,378             8,116              8,233              8,132
                                                        ========          ========          =========          =========
</TABLE>

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

                                        4
<PAGE>

                     COMPUDYNE CORPORATION AND SUBSIDIARIES
            CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
                                   (unaudited)
                                 (in thousands)
<TABLE>
<CAPTION>
                                                                                 Accumulated
                                                    Additional                      Other
                                  Common Stock        Paid-in     Accumulated   Comprehensive    Treasury Stock
                                Shares   Amount       Capital       Deficit     Income (Loss)    Shares    Amount    Total
                                -----------------   ----------    -----------   -------------    ----------------   --------
<S>                             <C>      <C>         <C>          <C>             <C>           <C>   <C>         <C>
Balance at January 1, 2006        8,950    $6,712      $44,388      $(8,963)        $  (39)       832   $ (5,676)   $36,422
Common stock issued in              308       231        1,630                                                        1,861
connection with acquisition
Stock options exercised               1         1            3                                                            4
Stock-based compensation                                   967                                                          967
                              ---------- ---------- ------------ -------------- -------------- -------- ---------- ---------
  Subtotal                        9,259     6,944       46,988       (8,963)           (39)       832     (5,676)    39,254
Comprehensive income:
  Net income                                                          1,439                                           1,439
Other comprehensive
 loss, net of tax:
Unrealized loss on
available for
 sale marketable securities                                                           (302)                            (302)
                                                                                                                   ---------
Comprehensive income                                                                                                  1,137
                              ---------- ---------- ------------ -------------- -------------- -------- ---------- ---------
Balance at September 30, 2006     9,259    $6,944      $46,988      $(7,524)       $  (341)       832   $ (5,676)   $40,391
                              ========== ========== ============ ============== ============== ======== ========== =========
</TABLE>




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

                                        5
<PAGE>



                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (unaudited)


<TABLE>
<CAPTION>
                                                                           Nine Months Ended September 30,
                                                                                  2006       2005
                                                                               --------    --------
                                                                                  (in thousands)
Cash flows from operating activities:
<S>                                                                            <C>         <C>
   Net income (loss)                                                           $  1,439    $ (8,235)

Adjustments  to reconcile  net income  (loss) to net cash  provided by (used in)
 operations:
   Depreciation and amortization                                                  2,339       2,596
   Amortization of debt discount and financing fees                                 246         140
   Accretion of premium on marketable securities, net                                (1)        (10)
   Stock-based compensation expense                                                 967          --
   Unrealized gain on interest rate swap                                             --          21

Changes in assets and liabilities:
   Accounts receivable                                                            9,580       2,396
   Contract costs in excess of billings                                           2,725       1,703
   Inventories                                                                      270        (573)
   Prepaid expenses and other current assets                                        (25)      1,553
   Other assets                                                                  (1,237)         (3)
   Accounts payable and accrued liabilities                                      (8,849)     (3,928)
   Billings in excess of contract costs incurred                                 (2,356)     (1,398)
   Deferred revenue                                                                 119       1,143
   Other liabilities                                                               (119)        (98)
                                                                               --------    --------
Net cash flows provided by (used in) operating activities                         5,098      (4,693)
                                                                               --------    --------
Cash flows from investing activities:
   Purchase of marketable securities                                             (6,938)     (7,722)
   Redemption of marketable securities                                            6,193      19,288
   Additions to property, plant and equipment                                    (1,400)       (843)
   Cash acquired from acquisition                                                    --         363
   Net payment for acquisition                                                     (934)        (66)
                                                                               --------    --------
Net cash flows (used in) provided by investing activities                        (3,079)     11,020
                                                                               --------    --------
Cash flows from financing activities:
   Stock options exercised                                                            4          25
   Purchase of treasury shares                                                       --        (690)
   Restricted cash                                                               (5,479)       (121)
   Repayment of notes payable                                                      (440)       (440)
                                                                               --------    --------
Net cash used in financing activities                                            (5,915)     (1,226)
                                                                               --------    --------
Net change in cash and cash equivalents                                          (3,896)      5,101
Cash and cash equivalents at beginning of period                                  6,938       5,198
                                                                               --------    --------
Cash and cash equivalents at end of period                                     $  3,042    $ 10,299
                                                                               ========    ========
</TABLE>



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

                                        6
<PAGE>



                     COMPUDYNE CORPORATION AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)


1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation:
The  accompanying  unaudited  consolidated  financial  statements  of  CompuDyne
Corporation and its subsidiaries  (the "Company") have been prepared pursuant to
the rules  and  regulations  of the  Securities  and  Exchange  Commission.  The
consolidated  balance  sheet as of December  31, 2005 has been  derived from the
Company's December 31, 2005 audited financial  statements.  Certain  information
and note disclosures  included in the annual financial  statements,  prepared in
accordance with accounting principles generally accepted in the United States of
America, have been condensed or omitted pursuant to those rules and regulations,
although the Company  believes that the  disclosures  made in this Form 10-Q are
adequate to make the information presented not misleading.

In the opinion of the Company, the accompanying unaudited consolidated financial
statements reflect all necessary adjustments and reclassifications (all of which
are  of a  normal,  recurring  nature,  unless  otherwise  disclosed)  that  are
necessary for the fair  presentation of the periods  presented.  It is suggested
that these consolidated  unaudited  financial  statements be read in conjunction
with the consolidated financial statements and the notes thereto included in the
Company's  annual report filed with the  Securities  and Exchange  Commission on
Form 10-K for the year ended December 31, 2005.  Operating results for the three
and nine month  periods ended  September  30, 2006 and 2005 are not  necessarily
indicative of operating results for the entire fiscal year.

COMPREHENSIVE INCOME (LOSS)
The following table shows the components of comprehensive  income (loss), net of
income  taxes,  for the nine  months  ended  September  30,  2006 and  2005,  in
thousands:
<TABLE>
<CAPTION>

                                                                         For the Nine Months
                                                                         Ended September 30,
                                                                           2006       2005
                                                                        --------    ---------
<S>                                                                     <C>         <C>
          Net income (loss)                                             $ 1,439     $  (8,235)
          Unrealized loss on available-for-sale securities                 (302)          (90)
                                                                        --------    ---------
          Comprehensive income (loss)                                   $ 1,137     $  (8,325)
                                                                        ========    =========
</TABLE>

STOCK-BASED COMPENSATION
In December  2004,  the FASB issued SFAS No. 123R  (revised  2004)  "Share-Based
Payment."  This statement  replaces SFAS No. 123,  "Accounting  for  Stock-Based
Compensation,"  and supersedes  Accounting  Principles Board ("APB") Opinion No.
25, "Accounting for Stock Issued to Employees." This statement requires that the
cost resulting from all  share-based  payment  transactions be recognized in the
financial  statements.  Pro forma  disclosure is no longer an alternative.  This
statement  establishes fair value as the measurement objective in accounting for
share-based   payment   arrangements  and  requires  all  entities  to  apply  a
fair-value-based  measurement  method  in  accounting  for  share-based  payment
transactions  with  employees.  This statement uses the terms  compensation  and
payment in their broadest senses to refer to the consideration paid for goods or
services, regardless of whether the supplier is an employee.

The Company  adopted SFAS No. 123R effective  January 1, 2006 and is recognizing
the cost of stock-based  compensation,  consisting of stock  options,  using the
modified  prospective  application  method  whereby  the cost of new  awards and
awards modified,  repurchased or cancelled after January 1, 2006 and the portion
of awards  for which  the  requisite  service  has not been  rendered  (unvested
awards) that are outstanding as of January 1, 2006, as the requisite  service is
rendered on or after the effective  date,  January 1, 2006.  This standard has a
material impact on our financial statements.

INCOME TAXES
The Company follows  Statement of Financial  Accounting  Standards  ("SFAS") No.
109,  "Accounting  for Income Taxes." Under SFAS 109,  deferred income taxes are
recognized for the future tax  consequences of differences  between tax bases of
assets and liabilities and financial  reporting amounts,  based upon enacted tax
laws and statutory tax rates  applicable to the periods in which the differences
are  expected  to affect  taxable  income.  The Company has decided to provide a
valuation  allowance  against its deferred tax assets, as it has determined that
due to the Company's accumulated deficit resulting from recent prior year losses
there is  uncertainty as to whether it is more likely than not that these assets
will be realized.

OTHER RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No 157 "Fair Value  Measurements".  This
Statement  defines fair value,  establishes a framework for measuring fair value
in generally accepted  accounting  principles  (GAAP),  and expands  disclosures
about fair value measurements. The adoption of this new accounting pronouncement
will not have an impact on our financial position or results of operation.

                                       7
<PAGE>

In September  2006,  the FASB issued SFAS No. 158,  "Employers'  Accounting  for
Defined Benefit Pension and Other  Postretirement  Plans -- an amendment of FASB
Statements No. 87, 88, 106 and 132(R)." This  statement  would require a company
to (a)  recognize in its  statement of financial  position an asset for a plan's
overfunded status or a liability for a plan's underfunded  status, (b) measure a
plan's assets and its obligations that determine its funded status as of the end
of the employer's fiscal year, and (c) recognize changes in the funded status of
a defined  postretirement  plan in the year in which the changes occur (reported
in  comprehensive  income).  The requirement to recognize the funded status of a
benefit plan and the disclosure  requirements are effective as of the end of the
fiscal year ending after December 15, 2006. The  requirement to measure the plan
assets and benefit  obligations as of the date of the employer's fiscal year-end
statement  of  financial  position is  effective  for fiscal  years ending after
December 15, 2008.  The adoption of this new accounting  pronouncement  will not
have an impact on our financial  position or results of  operation.  The Company
does not have any such plans.

In June 2006,  the FASB  issued  Interpretation  48 ("FIN 48"),  Accounting  for
Uncertainty  in Income  Taxes,  an  interpretation  of FASB  Statement  No. 109,
Accounting for Income Taxes.  FIN 48 clarifies the accounting for uncertainty in
income taxes  recognized in an enterprise's  financial  statements in accordance
with FASB  Statement  No. 109.  FIN 48  describes a  recognition  threshold  and
measurement  attribute for financial statement  recognition and measurement of a
tax  position  taken or expected  to be taken in a tax return and also  provides
guidance on de-recognition,  classification,  interest and penalties, accounting
in interim  periods,  disclosure and  transition.  The guidance is effective for
fiscal years beginning after December 15, 2006, which we intend to adopt for our
fiscal year ending December 31, 2007. We have not yet determined the impact from
adoption  of this new  accounting  pronouncement  on our  financial  position or
results of operation.

In  May  2005,  the  FASB  issued  SFAS  154,   "Accounting  Changes  and  Error
Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting  Changes"
and SFAS 3, "Reporting  Accounting  Changes in Interim  Financial  Statements-An
Amendment of APB Opinion No. 28." SFAS 154 provides  guidance on the  accounting
for and reporting of accounting  changes and error  corrections.  It establishes
retrospective  application,  or the latest  practicable  date,  as the  required
method for  reporting a change in  accounting  principle  and the reporting of a
correction  of an  error.  SFAS 154 is  effective  for  accounting  changes  and
corrections  of errors made in fiscal years  beginning  after December 15, 2005.
The  adoption  of SFAS  154 did not  have a  material  impact  on our  financial
position, results of operations or cash flows.

Reclassifications - Certain prior year amounts have been reclassified to conform
with the current year's presentation.  The effect of these  reclassifications is
not material to the condensed consolidated financial statements.

2. EARNINGS PER SHARE

Earnings per share are presented in accordance with SFAS No. 128,  "Earnings Per
Share." This Statement  requires dual presentation of basic and diluted earnings
per share on the face of the statement of  operations.  Basic earnings per share
is computed using the weighted average number of shares  outstanding  during the
period and excludes any dilutive  effects of options,  warrants,  or convertible
securities.  Diluted  earnings per share is computed using the weighted  average
number of common and  common  stock  equivalent  shares  outstanding  during the
period;  common stock  equivalent  shares are excluded from the  computation  if
their effect is antidilutive.

Stock options and warrants to purchase  1,584,936  and 1,456,133  shares for the
three month periods ended  September 30, 2006 and 2005,  respectively,  were not
dilutive  and,  therefore,  were not  included  in the  computation  of  diluted
earnings per common  share.  Additionally,  the 2,897,768  shares  issuable upon
conversion of the 6.25% Convertible Subordinated Notes due January 15, 2011 (the
"2011 Notes") are excluded for the three month periods ended  September 30, 2006
and 2005 as the effect is antidilutive.

Stock options and warrants to purchase  1,454,236  and 1,456,133  shares for the
nine month periods ended  September  30, 2006 and 2005,  respectively,  were not
dilutive  and,  therefore,  were not  included  in the  computation  of  diluted
earnings per common  share.  Additionally,  the 2,897,768  shares  issuable upon
conversion of the 6.25% Convertible Subordinated Notes due January 15, 2011 (the
"2011 Notes") are excluded for the nine month  periods ended  September 30, 2006
and 2005 as the effect is antidilutive.


                                       8
<PAGE>




The  computations of the Company's  basic and diluted  earnings per common share
amounts were as follows:

<TABLE>
<CAPTION>
                                                          Three Months Ended              Nine Months Ended
                                                             September 30,                  September 30,
                                                       ------------------------          ---------------------
                                                         2006         2005                 2006         2005
                                                       -------      --------             --------     --------
                                                                  (in thousands, except per share data)
<S>                                                    <C>          <C>                  <C>          <C>
Net income (loss)                                      $   327      $ (5,277)            $  1,439     $ (8,235)
                                                       =======      ========             ========     ========
Weighted average common shares outstanding               8,355         8,116                8,198        8,132
Effect of dilutive stock options and warrants               23             -                   35            -
                                                       -------      --------             --------     --------
Diluted weighted average number of common shares
outstanding                                              8,378         8,116                8,233        8,132
                                                       =======      ========             ========     ========
Net income (loss) per common share
Basic                                                  $   .04      $  (.65)             $    .18     $  (1.01)
Diluted                                                $   .04      $  (.65)             $    .18     $  (1.01)
</TABLE>

In March 2004, the Emerging Issues Task Force ("EITF") reached a final
consensus on Issue 03-6,  "Participating  Securities  and the  Two-Class  Method
under FASB Statement No. 128, Earnings Per Share" ("Issue 03-6"), effective June
30,  2004.  Issue  03-6  requires  the use of the  two-class  method to  compute
earnings per share for companies that have issued  securities  other than common
stock that  contractually  entitle the holder to  participate  in dividends  and
earnings  of the  Company  ("participation  rights")  when,  and if, it declares
dividends on its common stock.

The 2011 Notes contain contingent participation rights. The participation rights
are contingent  upon the ability,  based on the  undistributed  earnings for the
period, of the Company to declare and distribute dividends per share equal to or
in  excess  of the per share  fair  value of the  Company's  common  stock.  The
contingency  was not met for the three or nine month periods ended September 30,
2006 and September 30, 2005.  Accordingly,  no undistributed  earnings have been
allocated to the 2011 Notes.  The 2011 Notes provide that "if the portion of the
cash so  distributed  applicable  to one  share of  Common  Stock is equal to or
greater  than the  Current  Market  Price on the  Record  Date [of the  dividend
declared],  in lieu of the  foregoing  adjustment  [to  the  conversion  price],
adequate provision shall be made so that each Noteholder shall have the right to
receive upon  conversion  the amount of cash such holder would have received had
such holder  converted  each Note on the Record  Date."  Under EITF  03-06,  the
assessment  as to whether the  contingency  criteria  have been met must be made
each  reporting  period.  This  determination  is  made  without  regard  to the
participation  rights of the convertible  notes. Under the consensus reached for
Issue 3 of EITF 03-06,  the criteria  could be met even if the dividend were not
declared. The consensus also permits consideration of avoiding allocation to the
participating  securities  in certain  events.  At each  reporting  period,  the
Company assesses whether the contingency criteria have been met and consequently
if undistributed earnings should be allocated to participating securities.

3. STOCK-BASED COMPENSATION

Effective  January 1, 2006, we adopted SFAS No. 123(R),  "Share-Based  Payment."
This  statement  requires  us to  expense  the fair  value of grants of  various
stock-based  compensation  programs  over the vesting  period of the awards.  We
elected to adopt the "Modified Prospective  Application" transition method which
does not require the  restatement  of previously  issued  financial  statements.
Compensation expense is measured and recognized beginning in 2006 as follows:

AWARDS GRANTED AFTER DECEMBER 31, 2005 - Awards are measured at their fair value
at date of grant.  The  resulting  compensation  expense  is  recognized  in the
consolidated  statement of  operations  ratably  over the vesting  period of the
award.

AWARDS  GRANTED  PRIOR TO DECEMBER 31, 2005 - Awards were measured at their fair
value at the date of original grant.  Compensation  expense  associated with the
unvested  portion  of these  options at  January  1, 2006 is  recognized  in the
consolidated statement of operations ratably over the remaining vesting period.

For all  grants  issued  after  December  31,  2005  the  amount  of  recognized
compensation  expense is adjusted based upon an estimated  forfeiture rate which
is derived from historical data.



                                       9
<PAGE>

The following table shows total stock-based compensation expense included in the
Consolidated Statement of Operations:

<TABLE>
<CAPTION>
                                                     For the Three Months      For the Nine Months
                                                     Ended September 30,       Ended September 30,
                                                     -------------------      -------------------
                                                            2006                     2006
                                                          ---------                  ---------
                                                                       (in thousands)
<S>                                                          <C>                      <C>
       Cost of sales                                      $       8                $      47
       Selling, general and administrative                      359                      852
       Research and development                                  22                       68
                                                          ---------                ---------
       Effect on net income                               $     389                $     967
                                                          =========                =========
</TABLE>

No similar expense was charged against income in the prior periods as we had
elected to apply the provisions of APB No. 25 to those periods as permitted by
SFAS No. 123.

SFAS No.  123(R) also requires that the tax benefit from the exercise of options
be  reflected  in the  statement  of cash flows as a cash inflow from  financing
activities.  Prior to the adoption of SFAS No.  123(R),  these tax benefits were
reflected  as a cash  inflow  from  operations.  Because we elected to adopt the
"Modified Prospective  Application" transition method, the prior year statements
of cash flows have not been  restated.  The tax  benefit  from the  exercise  of
options was $0 for each of the three and nine months  ended  September  30, 2006
and September 30, 2005.

Stock Option Plans

2005 Stock Incentive Compensation Plan for Employees.  Stock options are granted
with an  exercise  price  equal to the market  price of the stock at the date of
grant.  Substantially  all of the options granted are exercisable  pursuant to a
five-year vesting  schedule.  The fair value of these options is estimated using
the Black-Scholes  option pricing model which incorporates the assumptions noted
in  the  table  below.   Expected  volatilities  are  based  on  the  historical
performance of our stock. We also use historical data to estimate the timing and
amount of option  exercises  and  forfeitures  within the valuation  model.  The
expected  term of the options is derived  from the output of the option  pricing
model and  represents  the period of time that  options  are  expected to remain
unexercised. The risk-free interest rate for periods within the contractual life
of the option is based on the U.S.  Treasury  bond rate in effect at the time of
grant.

2005 Stock Option Plan for  Non-Employee  Directors.  Stock  options are granted
with an  exercise  price  equal to the market  price of the stock at the date of
grant.  Substantially  all of the options granted are exercisable  pursuant to a
three-year vesting schedule.  The fair value of these options is estimated using
the Black-Scholes  option pricing model which incorporates the assumptions noted
in  the  table  below.   Expected  volatilities  are  based  on  the  historical
performance of our stock. We also use historical data to estimate the timing and
amount of option  exercises  and  forfeitures  within the valuation  model.  The
expected  term of the options is derived  from the output of the option  pricing
model and  represents  the period of time that  options  are  expected to remain
unexercised. The risk-free interest rate for periods within the contractual life
of the option is based on the U.S.  Treasury  bond rate in effect at the time of
grant.

The 1996 Stock  Incentive  Plan for Employees and the 1996 Stock Option Plan for
Non-Employee  Directors,  collectively referred to as the "Prior Plans," expired
in accordance with their terms and no further stock options may be granted under
these plans.

The fair values of grants in the stated period were computed using the following
range of assumptions for our various stock option plans:

<TABLE>
<CAPTION>
                                        For the Three             For the Nine
                                        Months Ended              Months Ended
                                     Septemer 30, 2006         September 30, 2006
                                     --------------------     -----------------------
<S>                                          <C>                      <C>
Risk-free interest rates                     5.0%                     4.9%
Dividend yield                                 -                        -
Expected volatility                         76.9%                    77.8%
Expected lives                               6.5 years                6.2 years
Annual forfeiture rate                       4.4%                     4.4%
</TABLE>

                                       10

<PAGE>




The  following  is a summary of all option  activity  for the nine months  ended
September 30, 2006:

<TABLE>
<CAPTION>
                                                              Weighted-
                                                               Average            Aggregate
                                               Number of       Exercise       Intrinsic Value at
                                                Shares          Price        September 30, 2006
                                              ------------   -----------     ------------------
<S>                                           <C>           <C>               <C>
Outstanding at December 31, 2005                1,453,358       $8.7550
Granted                                           444,000       $6.7987
Exercised                                             825       $4.3100
Forfeited                                          99,200       $7.1295
Expired                                           115,397       $9.8840
                                              ------------   -----------     ------------------
Outstanding at September 30, 2006               1,681,936       $8.2592           $178,813
                                              ============   ===========     ==================
Exercisable at September 30, 2006                 855,936       $9.3913           $146,218
                                              ============   ===========     ==================
</TABLE>

A summary of our stock options outstanding at September 30, 2006 follows:

<TABLE>
<CAPTION>
                                                 Options outstanding                  Options  exercisable
                                            --------------------------------    -------------------------------
                                              Weighted-         Weighted-                           Weighted-
                                              Average           Average                             Average
                                              Remaining         Exercise                            Exercise
 Range of Exercise Price        Shares        Life (yrs)        Price              Shares           Price
 -----------------------      -----------     ----------        ---------       -------------      ------------
<S>                           <C>              <C>             <C>                  <C>            <C>
     $  1.690 - $  6.235       202,000          6.69            $  5.3548            66,000         $   4.0246
     $  6.250 - $  6.855       189,136          7.57            $  6.7018            20,736         $   6.6823
     $  6.860 - $  6.950       246,800          9.42            $  6.9248             6,800         $   6.8750
     $  7.000 - $  7.640       260,500          4.56            $  7.4243            82,500         $   7.4188
     $  7.719 - $  8.195       175,000          5.28            $  8.0597           151,400         $   8.0650
     $  8.215 - $  9.190       168,200          6.34            $  8.6426           113,200         $   8.6349
     $  9.410 - $ 10.420       173,800          6.46            $ 10.1272           148,800         $  10.0940
     $ 11.165 - $ 12.210       173,000          5.27            $ 11.6267           173,000         $  11.6267
     $ 13.290 - $ 16.330        92,500          5.60            $ 13.4794            92,500         $  13.4794
     $ 16.630 - $ 16.630         1,000          4.99            $ 16.6300             1,000         $  16.6300
                             ------------    ----------         ---------       -------------      ------------
     $  1.690 - $ 16.630     1,681,936          6.45            $  8.2592           855,936         $   9.3913
                             ============                                       =============
</TABLE>

In the first three quarters of 2006, the weighted-average grant-date fair value
of an option granted was $4.83. The total intrinsic value, the difference
between the exercise price and the market price on the date of exercise, of all
options exercised during the period was approximately $1,600. Total unrecognized
compensation expense from stock options was $2.7 million excluding estimated
forfeitures, which is expected to be recognized over a weighted-average period
of 3.0 years as follows, in thousands:

<TABLE>
<CAPTION>
                                                                 Compensation Expense
                                                                 Excluding Estimated
                                      Year                           Forfeitures
                                      ----                       --------------------
<S>                                                                   <C>
                                      2006 (remaining)                 $   186
                                      2007                                 925
                                      2008                                 682
                                      2009                                 487
                                      2010                                 341
                                      2011                                  78
                                                                       --------
                                          Total                        $ 2,699
                                                                       ========
</TABLE>


                                       11
<PAGE>




For the three and nine months ended September 30, 2005, we applied the intrinsic
value based method of  accounting  for stock  options  prescribed by APB No. 25.
Accordingly,  no  compensation  expense was  recognized  for these stock options
since all options granted had an exercise price equal to the market value of the
underlying stock on the grant date. If compensation  expense had been recognized
based on the  estimate  of the fair value of each option  granted in  accordance
with the  provisions  of SFAS No. 123 as amended by SFAS No. 148, our results of
operations  would  have been  reduced  to the  following  pro forma  amounts  as
follows, in thousands:

<TABLE>
<CAPTION>
                                                                            Three Months Ended      Nine Months Ended
                                                                            September 30, 2005     September 30, 2005
                                                                            ------------------     ------------------
<S>                                                                           <C>                    <C>
                          Net loss as reported                                $    (5,277)           $    (8,235)
                          Deduct:  pro forma stock based employee
                             compensation expense, net of tax                        (481)                (1,428)
                                                                              -----------            ------------
                          Pro forma net loss                                  $    (5,758)           $    (9,663)
                                                                              ===========            ===========

                          Earnings per common share:
                              Basic - as reported                                $  (0.65)              $  (1.01)
                              Basic - pro forma                                  $  (0.71)              $  (1.19)

                              Diluted - as reported                              $  (0.65)              $  (1.01)
                              Diluted - pro forma                                $  (0.71)              $  (1.19)
</TABLE>





Pro forma compensation expense recognized under SFAS No. 123 does not consider
potential forfeitures.

4. INVESTMENTS IN MARKETABLE SECURITIES

The  Company's  marketable  securities  are  categorized  as  available-for-sale
securities,  as defined by SFAS No. 115,  "Accounting for Certain Investments in
Debt and Equity  Securities." At September 30, 2006 and December 31, 2005 all of
the  Company's   investments  in  marketable   securities   were  classified  as
available-for-sale,  and as a result,  were  reported at fair value.  Unrealized
gains and losses are reported as a component of accumulated other  comprehensive
income/(loss) in shareholders'  equity.  The cost for marketable  securities was
determined using the specific  identification  method and adjusted for accretion
of discounts or  amortization of premiums from the date of purchase to maturity.
The accretion and amortization is included in interest  income.  The fair values
of  marketable  securities  are  estimated  based on the quoted market price for
these securities.

Marketable securities are summarized, in thousands, as follows:

<TABLE>
<CAPTION>
                                                    September 30,                                  December 31,
                                                        2006                                           2005
                                      -----------------------------------------   -----------------------------------------
                                                  Gross Unrealized      Fair                Gross Unrealized       Fair
                                        Cost      Gains     Losses      Value      Cost      Gains     Losses      Value
                                      --------    -----     ------      -----     -------   -------   -------    ----------
<S>                                   <C>           <C>      <C>       <C>        <C>        <C>      <C>        <C>

Collateralized mortgage
 obligations (CMO's) consisting
 of securities issued by
 Fannie Mae and Freddie Mac           $ 12,240      $ -      $  349    $11,891    $11,494    $   -    $  65      $11,429
</TABLE>




The cost and estimated fair value of current marketable  securities at September
30, 2006, by contractual  maturity,  are shown below.  Expected  maturities will
differ from  contractual  maturities  because the issuers of the securities have
the right to repay obligations without prepayment penalties. It is the Company's
policy to classify  available-for-sale  securities that are available for use in
current operations as a current asset.

<TABLE>
<CAPTION>
                                                                          Estimated
(in thousands)                                          Cost              Fair Value
                                                       --------             --------
<S>                                                    <C>                  <C>
Due after one year and beyond                          $ 12,240             $ 11,891
                                                       --------             --------
Total debt securities                                  $ 12,240             $ 11,891
                                                       ========             ========
</TABLE>



                                       12
<PAGE>

5. INVENTORIES

Inventories consist of the following, in thousands:

<TABLE>
<CAPTION>
                                                           September 30,      December 31,
                                                               2006              2005
                                                           -------------      ------------
<S>                                                          <C>               <C>
Raw materials                                                $ 3,267           $ 3,984
Work in progress                                               3,406             3,342
Finished goods                                                   397               240
                                                           -------------      ------------
Total inventories                                              7,070             7,566
Reserve for excess and obsolete inventory                     (1,014)           (1,371)
                                                           -------------      ------------
Inventories, net                                             $ 6,056           $ 6,195
                                                           =============      ============
</TABLE>

6. GOODWILL

The Company  reviews the carrying value of goodwill  annually  during the fourth
quarter of the year or whenever events or changes in circumstances indicate that
the carrying  value may not be  recoverable,  utilizing a  discounted  cash flow
model.  Changes  in  estimates  of future  cash  flows  caused by items  such as
unforeseen  events or changes in market  conditions could negatively  affect the
reporting  unit's  fair value and result in an  impairment  charge.  The Company
cannot predict the occurrence of events that might adversely affect the reported
value of goodwill of approximately $27.5 million at September 30, 2006.

Goodwill, by segment, consists of the following, in thousands:


<TABLE>
<CAPTION>
                                                           Integrated        Public
                                            Attack         Electronic        Safety &
                                          Protection         Systems         Justice           Total
                                          ----------         -------          -------           -----
<S>                                       <C>                <C>           <C>              <C>
December 31, 2005                            $  728             $   -         $ 26,118         $ 26,846
Addition from 2006 acquisition                    -               673               -               673
                                             ------             -----         --------         --------
September 30, 2006                           $  728             $ 673         $ 26,118         $ 27,519
                                             ======             =====         ========         ========
</TABLE>


7. INTANGIBLE ASSETS

Intangible  assets include the trade name,  customer  relationships  and backlog
from the acquisition of Tiburon,  Inc. in 2002. Other intangibles  include trade
names,  Department  of State  Certifications,  Underwriters  Laboratories,  Inc.
listings,  and patents  related to the  acquisition of Norment in 1998 and other
recent  acquisitions.  With  the  exception  of  the  trade  names,  which  have
indefinite   lives,  the  intangible   assets  are  being  amortized  using  the
straight-line method.

Intangible assets consist of the following, in thousands:

<TABLE>
<CAPTION>
<S>                                         <C>                 <C>            <C>
                                             September 30,      December 31,    Amortizable
                                                 2006               2005          Lives
                                             -------------      ------------   -------------
      Cost                                                                      (in years)
        Trade names                             $  6,132          $  5,632      Indefinite
        Customer relationships                     2,500             2,500          14
        Other                                      1,330             1,255         1-20
                                                --------          --------
                                                   9,962             9,387
      Accumulated amortization
        Customer relationships                      (789)             (655)
        Other                                       (577)             (511)
                                                --------          --------
                                                  (1,366)           (1,166)
                                                --------          --------
      Net cost                                  $  8,596           $ 8,221
                                                ========          ========
</TABLE>

                                       13
<PAGE>


Amortization  expense for the Company's intangible assets for the three and nine
month  periods  ended  September  30, 2006 was $66  thousand  and $196  thousand
respectively. The following schedule lists the expected amortization expense for
each of the next five years ending December 31, in thousands:


                      Year
                      2006 (remaining)           $    70
                      2007                           274
                      2008                           261
                      2009                           258
                      2010                           239
                      Thereafter                   1,362
                                                 -------
                      Total                      $ 2,464
                                                 =======

8. NOTES PAYABLE AND LINE OF CREDIT

<TABLE>
<CAPTION>

                                                                                   September 30,     December 31,
                                                                                       2006              2005
                                                                                   -------------     ------------
<S>                                                                                <C>               <C>
                                                                                           (in thousands)
Industrial  revenue bond,  interest payable monthly at a variable rate of 3.14 %
to 4.19 %  (3.95  % at  September  30,  2006)  principal  payable  in  quarterly
installments of $35,000. The bond is fully collateralized by a $1.1 million letter
of credit and a bond guarantee agreement.                                           $  1,120          $  1,260

Industrial  revenue bond,  interest payable monthly at a variable rate of 3.07 %
to  4.11  %  (3.89  %  at  September  30,  2006)  principal  payable  in  annual
installments  of  $300,000  until  2013  when  the  annual  installments  become
$100,000. The bond is fully collateralized by a $2.0 million letter of credit
and a bond guarantee agreement.                                                        2,005             2,305

6.25%  Convertible  Subordinated  Notes due  January  15,  2011.  The notes bear
interest  at  a  rate  of  6.25%  per  annum,  payable  semi-annually,  and  are
convertible  into  shares of common  stock at a  conversion  price of $13.89 per
share. These notes are subordinated to all other liabilities of the Company.          40,250            40,250
                                                                                    --------          --------
Total notes payable                                                                   43,375            43,815
Less convertible subordinated notes discount                                             805               945
                                                                                    --------          --------
Subtotal                                                                              42,570            42,870
Less amount due within one year                                                          440               440
                                                                                    --------          --------
                                                                                    $ 42,130          $ 42,430
                                                                                    ========          ========
</TABLE>

Maturities of notes payable are as follows, in thousands:

                            Year Ending December 31,               Amount
                            ------------------------         -------------
                            2006 (remaining)                 $           -
                            2007                                       440
                            2008                                       440
                            2009                                       440
                            2010                                       440
                            Thereafter                              41,615
                                                             -------------
                                                             $      43,375
                                                             =============


                                       14
<PAGE>




On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million
principal  amount of the 2011 Notes.  The 2011 Notes bear  interest at a rate of
6.25% per annum,  payable  semi-annually,  and are  convertible  into  shares of
common stock at a conversion price of $13.89 per share,  subject to adjustments.
The 2011 Notes are  subordinated  to all other  liabilities of the Company.  The
September 30, 2006 carrying value is listed below, in thousands.

                            Face value                          $  40,250
                            Underwriters discounts, net               805
                                                                ---------
                                                                $  39,445
                                                                =========

The 2011 Notes can be converted into the Company's common stock at the option of
the holder at any time at a  conversion  price of $13.89  per share,  subject to
adjustments for stock splits, stock dividends, the issuance of certain rights or
warrants to the existing  holders of the Company's common stock and common stock
cash dividends in excess of a stated threshold.

The 2011 Notes are  redeemable  at the option of the Company  after  January 15,
2009, at a premium of two percent of the face value plus accrued interest unless
a change in control event,  as defined in the indenture  dated as of January 15,
2004 between the Company and U.S. Bank,  relating to the 2011 Notes,  occurs. If
such an event does occur, the Company may redeem the 2011 Notes at a premium, in
whole but not in part,  to face.  If a change in  control  event  occurs and the
Company  does not elect to redeem the 2011  Notes,  the  holders can require the
Company to repurchase the 2011 Notes at face value plus accrued interest.

The debt issuance  costs for the 2011 Notes are recorded as  non-current  assets
and are amortized on a straight-line  basis to interest expense over the term of
the 2011 Notes. In addition,  underwriters'  discounts  totaled $1.3 million and
are amortized on a straight-line  basis to interest expense over the term of the
2011 Notes. There is no material difference between the straight-line  method of
amortization and the effective  interest method with respect to the amortization
of the  underwriters'  discounts  and debt  issuance  costs  on the 2011  Notes.
Interest  expense recorded for the total of the deferred debt issuance costs and
underwriters'  discounts on the 2011 Notes totaled $63 thousand and $63 thousand
for the three month periods ended September 30, 2006 and 2005, respectively, and
$189 thousand and $189  thousand for the nine month periods ended  September 30,
2006 and 2005, respectively.

On December 19, 2005, the Company and its bank entered into a Second Amended and
Restated  Revolving  Credit and Security  Agreement (the "Second Restated Credit
Agreement").  The Second  Restated  Credit  Agreement  amended and  restated the
Company's Amended and Restated Credit Agreement dated March 31, 2004.

In connection with the execution of the Second Restated  Credit  Agreement,  the
Company  provided  the bank  with  collateral  that  includes  all  receivables,
equipment,  general intangibles,  inventory,  investment property, real property
and a  security  interest  in  subsidiary  stock.  The  Second  Restated  Credit
Agreement allows the Company to obtain revolving  advances in a principal amount
of up to $20 million. Revolving advances are limited by a borrowing base formula
based upon the value of the Company's  receivables,  inventories,  fixed assets,
real  property  and  issued and  outstanding  letters  of  credit.  The  maximum
aggregate  face  amount of letters of credit  that may be drawn under the Second
Restated Credit  Agreement is $18 million.  The Second Restated Credit Agreement
matures on December 18, 2008.

Revolving advances under the Second Restated Credit Agreement bear interest,  at
the  election of the Company,  at a variable  rate equal to the  alternate  base
rate, a prime interest based rate, or the Eurodollar  rate plus two and one half
percent.  For letters of credit, the Company pays an amount equal to the average
daily face amount of each outstanding letter of credit multiplied by two and one
half  percent  per annum,  and a fronting  fee of one quarter of one percent per
annum, together with other administrative fees and charges. The Company paid its
bank a closing  fee of $50  thousand in  connection  with the  execution  of the
Second Restated Credit  Agreement.  The Company is also required to pay the bank
an unused fee equal to  three-eighths  of one percent per annum of the amount by
which $20 million  exceeds the average  daily  unpaid  balance of the  revolving
advances and undrawn amount of any outstanding  letters of credit.  In addition,
the Company is required to pay a collateral  monitoring fee equal to $1 thousand
per month and a collateral evaluation fee as required.

The Second Restated Credit Agreement  contains various  affirmative and negative
covenants including financial covenants.  The Company is required to maintain an
unrestricted  undrawn  borrowing  base  availability  of at  least  $5  million.
Commencing  with the fiscal quarter ended June 30, 2006, the Company is required
to  maintain  a fixed  charge  coverage  ratio  of at  least  1.1 to  1.0.  This
requirement was met at September 30, 2006.

On July 14, 2006,  the Company and its banks  entered into a First  Amendment to
Second  Amended and Restated  Revolving  Credit  Security  Agreement (the "First
Amendment").  The First Amendment amended the Credit Agreement to (i) modify the
borrowing base, (ii) permit any Borrower to guaranty certain indebtedness of any
other  Borrower,  (iii)  increase  the  maximum  limit of  rental  payments  for
non-capitalized  leases  from $3  million to $4 million  per fiscal  year,  (iv)
permit the  Company to  repurchase  or redeem  certain  of the  Company's  6.25%
Convertible  Subordinated  Notes due  January  15,  2011 and (v)  consent  to an
acquisition by a newly formed indirect  subsidiary of the Company pursuant to an
asset purchase transaction.



                                       15
<PAGE>

9. PRODUCT WARRANTIES

Included in accounts  payable and accrued  liabilities  are  estimated  expenses
related  to  warranties  made at the  time  products  are sold or  services  are
rendered.  These accruals are established  using  historical  information on the
nature,  frequency,  and average cost of warranty  claims.  The Company warrants
numerous  products,  the terms of which vary  widely.  In  general,  the Company
warrants its products against defect and specific  non-performance.  The changes
in the product  warranty  liability  are displayed in the  following  table,  in
thousands:

              Beginning balance at January 1, 2006               $ 388
              Plus:  accruals for product warranties               369
              Less:  warranty charges/claims                      (240)
                                                                 -----
              Ending balance at September 30, 2006               $ 517
                                                                 =====


10. OPERATING SEGMENT INFORMATION


The following is the operating segment information for the three months ended
September 30, 2006 and 2005, in thousands:

<TABLE>
<CAPTION>

                                                 Revenues                     Gross Profit               Pre-tax income(loss)
                                           ----------------------        ----------------------        ----------------------
                                              2006         2005            2006          2005             2006        2005
                                           ---------    ---------        --------     ---------        ---------    ---------
<S>                                        <C>          <C>              <C>          <C>              <C>            <C>
Institutional Security Systems             $  11,091    $  15,548        $  1,780     $   2,343        $    (360)     $ (170)
Attack Protection                              8,822        5,892           3,279           341            1,456      (1,800)
Integrated Electronic Systems                 4 ,117        2,898           1,009           473              377         172
Public Safety and Justice                     10,666        9,161           5,750         4,781             (644)     (3,188)
CompuDyne Corporate                                -            -               -             -             (494)       (791)
                                           ---------    ---------        --------     ---------        ---------    ---------
                                           $  34,696    $  33,499        $ 11,818     $   7,938        $     335    $ (5,777)
                                           =========    =========        ========     =========        =========    =========
</TABLE>

The following is the operating segment information for the nine months ended
September 30, 2006 and 2005, in thousands:

<TABLE>
<CAPTION>
                                                 Revenues                      Gross Profit              Pre-tax income(loss)
                                           ----------------------        ----------------------        ----------------------
                                              2006         2005            2006          2005             2006        2005
                                           ---------    ---------        --------     ---------        ---------    ---------
<S>                                        <C>          <C>              <C>          <C>              <C>          <C>
Institutional Security Systems             $  37,666    $  43,008        $  5,806     $   7,491        $    (610)   $    528
Attack Protection                             31,839       18,855          10,430         4,089            4,209      (2,141)
Integrated Electronic Systems                 10,687        6,805           2,009         1,095              722         180
Public Safety and Justice                     33,368       32,241          18,218        18,073           (1,166)     (3,270)
CompuDyne Corporate                                -            -               -             -           (1,885)     (4,032)
                                           ---------    ---------        --------     ---------        ---------    ---------
                                           $ 113,560    $ 100,909        $ 36,463     $  30,748        $   1,270    $ (8,735)
                                           =========    =========        ========     =========        =========    =========
</TABLE>

11.      CONTINGENCIES

LEGAL  MATTERS.  The Company is party to certain legal actions and inquiries for
environmental  and other matters  resulting  from the normal course of business.
Some of the  businesses,  especially  Institutional  Security  Systems,  involve
working as a subcontractor to a prime contractor.  From time to time the Company
makes claims against the prime contractor,  or the prime contractor makes claims
against the Company.  At any point in time the Company is engaged in a number of
claim  disputes  with prime  contractors,  some of which may have a  significant
negative outcome.  Although the total amount of potential liability with respect
to  these  matters  can not be  ascertained  given  the  nature  of the  related
allegations,  the Company presently  believes that any resulting  liability will
not  have a  material  effect  on its  financial  position,  results  of  future
operations or cash flows.

In addition to claims with prime  contractors,  the Company may also make claims
against customers and customers may make claims against the Company.

During  the third  quarter  of 2006 we  received  a letter  from a client of our
Public Safety and Justice  segment  indicating  their intent to terminate  their
contract  with us for cause.  The letter  alleges that we failed to complete the
project under the terms of the agreement and the applications implemented failed
to meet the functionality requirements of the agreement. The customer is seeking
a refund of approximately $400 thousand previously paid by them. Costs in excess
of billings of approximately  $627 thousand related to this project remain as an
asset on our books and  records as of  September  30,  2006.  Public  Safety and
Justice  disagrees  with the client's  views and is  attempting  to complete the
substantially  completed client installation.  While the ultimate outcome cannot
be predicted,  the Company intends to vigorously pursue this matter.  Therefore,
the Company is unable to currently  estimate the loss, if any,  associated  with
this matter and no accrual related thereto has been recorded.



                                       16
<PAGE>

The Company has learned  that the National  Association  of  Securities  Dealers
("NASD") and other regulatory bodies are seeking sanctions against purchasers of
the  Company's  common  stock in its 2001 PIPE  transaction.  In  addition,  the
Company has learned that the placement agent for this  transaction is also being
investigated  by the SEC,  NASD and other  regulatory  bodies.  The  Company  is
investigating these matters,  and has filed lawsuits against certain purchasers.
The Company is currently attempting to resolve these matters.

The Company  has been named in  lawsuits  involving  asbestos  related  personal
injury and death claims in which CompuDyne  Corporation,  individually and as an
alleged successor, is a defendant.  The Company has been named as a defendant in
cases  related  to  claims  for  asbestos  exposure  allegedly  due to  asbestos
contained in certain of its predecessor's  products. The Company has advised its
insurers  of each of these  cases,  and the  insurers  are  providing  a defense
pursuant to agreement with the Company,  subject to reservation of rights by the
insurers.  The insurers have advised that claims in such litigation for punitive
damages,  exemplary  damages,  malicious  and  willful and wanton  behavior  and
intentional  conduct are not covered.  One of the carriers has given notice that
asbestos  related  claims  are  excluded  from  certain of these  policies.  The
insurers have additional coverage defenses,  which are reserved,  including that
claims may fall outside of a particular  policy  period of coverage.  Litigation
costs  to date  have  not  been  significant  and the  Company  has not paid any
settlements from its own funds.

The Company  cannot  ascertain  the total  amount of  potential  liability  with
respect to these legal  matters,  but does not believe  that any such  potential
liability  should  have a  material  effect on its  financial  position,  future
operations or future cash flows.

The Company,  as a government  contractor,  is from time to time subject to U.S.
Government  investigations  relating to its operations.  Government  contractors
that are found to have  violated  the  False  Claims  Act,  or are  indicted  or
convicted for  violations of other  federal  laws, or are  considered  not to be
responsible   contractors,   may  be  suspended  or  debarred  from   government
contracting  for some  period of time.  Such  convictions  could also  result in
fines.  Suspension  or  debarment  could have a material  adverse  effect on the
Company. No such violations or conditions of debarment exist at this time.

In connection  with the  acquisition  of the assets of Signami,  LLC made by the
Company in July 2006, the Company issued certain shares to the sellers for which
it  guaranteed  for a 2 year  period  that  upon sale of these  securities,  the
Company would guarantee a price of $7.50 per share for these shares. This period
is extended for members  precluded  from  selling  their shares due to statutory
reasons.  Included  in other long term  liabilities  at  September  30,  2006 is
approximately $135 thousand representing the fair value of the liability.


                                       17
<PAGE>



                 ITEM 2. COMPUDYNE CORPORATION AND SUBSIDIARIES
                     MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS

INTRODUCTION

OVERVIEW OF COMPUDYNE CORPORATION

CompuDyne  Corporation was  reincorporated in Nevada in 1996. We were originally
incorporated in 1952. We believe that we are a leading  provider of products and
services to the public security markets.  We operate in four distinct  segments:
Institutional  Security Systems ("ISS");  Attack Protection  ("AP");  Integrated
Electronic Systems ("IES"); and Public Safety and Justice ("PS&J").

The  Institutional  Security  Systems  segment is  headquartered  in Montgomery,
Alabama and operates under the trade name Norment  Security  Group  ("Norment").
This segment provides physical and electronic  security products and services to
the corrections  industry  (prisons and jails) and to the courthouse,  municipal
and commercial markets. ISS typically serves as a subcontractor, responsible for
their portion of the installation work on larger projects. Installations involve
hard-line   (steel  security  doors,   frames,   locking   devices,   etc.)  and
sophisticated  electronic  security systems,  including  software,  electronics,
touch-screens,  closed  circuit TV,  perimeter  alarm devices and other security
monitoring controls.  ISS also developed a product called MaxWall.  MaxWall is a
modular  steel,   concrete  filled   prefabricated  jail  cell.  It  allows  for
construction  projects to use  considerably  less space and can save the project
owner   significant   amounts  of  money.   ISS  provides  field  level  design,
installation and maintenance of both physical and electronic security products.

Included in the  Institutional  Security  Systems  segment is the TrenTech  line
which  manufactures  and  integrates   electronic  security  systems.   TrenTech
integrates  generally  available products and software as well as developing its
own  proprietary  systems.  TrenTech has developed a  sophisticated  proprietary
video badging system,  with  approximately 250 systems installed at more than 70
facilities, most of which are military installations.

The Institutional  Security Systems segment also manufactures a complete line of
locks and locking  devices  under the brand name  Airteq.  Airteq is an industry
leader  in  pneumatic  and  electro-mechanical   locking  devices  used  in  the
corrections industry.

The Attack Protection  segment is one of the country's largest  manufacturers of
bullet,  blast and attack resistant windows and doors designed for high security
applications such as embassies, courthouses, Federal buildings, banks, corporate
headquarters  and other  facilities  that insist on having the highest  level of
protection  currently  available.  We believe that we are a premier  provider of
Underwriters  Laboratory  ballistic standard UL-752 Level 8 security windows and
doors,  the highest rating level of commercial  ballistic  security  windows and
doors.  Our attack  resistant  windows and doors are integrated and structurally
secure  products with  specifically  designed  frames and  encasements  that are
integral  parts of the structure in which they are installed.  Existing  product
installations  number in the  thousands  and range from the  Middle  East to the
White House. AP is a significant  supplier of bullet and blast resistant windows
and doors to United  States  embassies  throughout  the world.  AP usually works
under contracts from prime contractors who have direct contracts with the United
States  Department of State,  the segment's  largest  client.  Other  commercial
applications  include guard booths,  tollbooths,  cash drawers and other similar
items.  Additionally,  this segment  designs and installs  both fixed and pop-up
bollards and wedge barrier security systems.

The Attack  Protection  segment also  manufactures a  sophisticated  fiber optic
sensor system,  known as Fiber SenSys, used to detect physical  intrusion.  This
application is designed to protect large perimeters  including such applications
as Federal  facilities,  military  deployments  and bases,  oil fields,  airport
tarmacs,  public utilities,  nuclear reactors and water systems. In addition, it
has been  installed  to protect  the  perimeters  of private  estates  and other
similar properties.

The  Integrated  Electronic  Systems  segment  consists of  CompuDyne-Integrated
Electronics  Division,  LLC and the newly-formed  Signami DCS, LLC. Its customer
base  includes  the  military,   governmental  agencies,  and  state  and  local
governmental  units. IES provides turnkey system  integration of public security
and safety  systems.  This  segment  specializes  in a wide range of  customized
access control and badging,  intrusion  detection,  surveillance and assessment,
communications,  command and control,  fire and life safety,  and asset tracking
systems.  IES provides  central  station  oversight  and control of multiple and
separate  facilities  as well as security  and public  life  safety  systems and
equipment.  This segment also designs and  manufactures  advanced digital signal
processing products used in reconnaissance of foreign telecommunications signals
designed for the United States  Government and its foreign allies. In July 2006,
the Company  acquired  the assets and  certain  liabilities  of Signami,  LLC, a
producer of software and hardware  systems for signals  intelligence  gathering.
Together with the Data Control Systems  ("DCS")  division of IES, a new business
will go to market under the name Signami DCS.

                                       18
<PAGE>

The Public Safety and Justice segment consists of Tiburon, Inc., CorrLogic, LLC,
Xanalys  Corporation  ("Xanalys"),  and the acquired assets of 90 Degrees,  Inc.
("90 Degrees") and Copperfire Software Solutions,  Inc.  ("Copperfire").  PS&J's
software  systems  are used in a wide  range of  applications  within the public
safety and criminal  justice sectors of governmental  units,  including  police,
fire and emergency medical services computer-aided dispatch systems, and police,
fire, jail,  prosecution,  probation,  court records and  institutional  medical
software   management   systems.   We  also   specialize  in  the   development,
implementation  and support of complex,  integrated inmate  management  software
systems  that  improve the  efficiency  and  accuracy of  correctional  facility
operations.

During the second half of 2004,  we expanded our  offerings in the Public Safety
and Justice  segment by acquiring  the assets of 90 Degrees and  Copperfire.  90
Degrees  provides a  web-based  fire  records  management  system.  90  Degrees'
enterprise-wide  records management  solutions assist fire and Emergency Medical
Service agencies in managing  responses to emergency  situations.  We anticipate
that 90 Degrees' open web-based  technology  product  offerings will advance our
current fire and rescue product offerings. Copperfire provides customized report
writing and forms generation  software  designed  specifically for public safety
and justice  agencies.  The  software  automates  an agency's  current  business
practices,  turning hard copy forms into digital  images,  to create a paperless
report writing  system.  Xanalys was acquired  during the third quarter of 2005.
Xanalys provides a suite of investigative management and analysis solutions that
enable investigators to collect, analyze and share information to solve cases.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

Certain  statements  made  in  this  Form  10-Q  with  regard  to the  Company's
expectations as to future revenues,  expenses,  financial  position and industry
conditions, the Company's ability to secure new contracts, the ability to secure
payment and performance bonds, its goals for future  operations,  implementation
of  business  strategy  and  other  future  events  constitute  "forward-looking
statements" within the meaning of the federal securities laws. When used in this
Form 10-Q, words such as "anticipate," "believe," "estimate," "expect," "intend"
and  similar  expressions  identify  forward-looking  statements.  Although  the
Company makes such  statements  based on current  information and assumptions it
believes to be  reasonable,  there can be no assurance  that actual results will
not differ  materially from those  expressed or implied by such  forward-looking
statements.  Actual results could differ  materially from those  contemplated by
the  forward-looking  statements  as a  result  of  certain  important  factors,
including but not limited to, capital  spending  patterns of the security market
and the demand for the  Company's  products,  competitive  factors  and  pricing
pressures, changes in legislation and regulatory requirements, government budget
problems,  the Company's ability to secure new contracts,  the ability to remain
in  compliance  with  its  bank  covenants,  delays  in  government  procurement
processes,  inability to obtain bid, payment and performance bonds on various of
the Company's  projects,  technological  change or difficulties,  the ability to
refinance debt when it becomes due, product development risks, commercialization
difficulties,  adverse results in litigation,  the level of product returns, the
amount  of  remedial  work  needed to be  performed,  costs of  compliance  with
Sarbanes-Oxley  requirements  and the impact of the  failure to comply with such
requirements,  risks associated with internal control  weaknesses  identified in
complying with Section 404 of  Sarbanes-Oxley,  the Company's ability to realize
anticipated  cost savings,  the Company's  ability to simplify its structure and
modify its strategic objectives, and general economic conditions. Risks inherent
in the Company's  business and with respect to future  uncertainties are further
described in our other filings with the Securities and Exchange Commission.

MANAGEMENT OUTLOOK

We continue to find  ourselves in very  challenging  times.  We have three major
areas of focus:


o    The first is increasing the amount of our backlog.
o    The second is migrating to a business model with a more predictable revenue
     stream.
o    The third is to improve our cost structure (including evaluating our
     strategy to determine if we would benefit from focusing on fewer segments),
     quality, and customer and employee satisfaction.



                                       19
<PAGE>



Our backlog is a key indicator of what our future  revenues will look like.  Our
backlog  peaked at December 31, 2002,  at which time it exceeded  $204  million.
Backlog was approximately  $121.7 million at September 30, 2006, as shown in the
following table:

<TABLE>
<CAPTION>
                              Institutional                          Integrated       Public
                                 Security           Attack           Electronic      Saftey and          Backlog
(in thousands)                   Systems           Protection        Systems          Justice            Total
------------------------------------------------------------------------------------------------------------------
<S>                         <C>               <C>               <C>              <C>               <C>
December 31, 2002                $ 99,527          $ 18,478          $11,440          $ 74,867          $204,312
December 31, 2003                $ 57,258          $ 10,043          $ 8,326          $ 63,727          $139,354
December 31, 2004                $ 49,324          $ 20,803          $ 8,299          $ 48,434          $126,860
March 31, 2005                   $ 42,700          $ 20,139          $ 8,395          $ 44,488          $115,722
June 30, 2005                    $ 56,492          $ 19,466          $ 9,105          $ 46,045          $131,108
September 30, 2005               $ 52,557          $ 16,210          $ 8,146          $ 58,270          $135,183
December 31, 2005                $ 58,128          $ 28,802          $ 7,503          $ 53,705          $148,138
March 31, 2006                   $ 57,030          $ 20,961          $ 6,590          $ 43,874          $128,455
June 30, 2006                    $ 51,173          $ 13,593          $ 7,393          $ 39,351          $111,510
September 30, 2006               $ 65,489          $  7,991          $ 8,137          $ 40,088          $121,705
</TABLE>


During the fourth  quarter of 2005 the Attack  Protection  segment was awarded a
significant  contract to provide its products to a large  embassy  project.  The
execution of this contract is  substantially  complete as of September 30, 2006.
Since  the  award  of this  contract,  the  Norshield  component  of the  Attack
Protection  segment has had  limited  success in winning  new  contracts  due to
competitive  factors which has resulted in a significant  decline in the backlog
of this  segment.  We are  actively  pursuing  non-embassy  work in an effort to
generate awards  incremental to our embassy work. The overall decline in backlog
year to date in 2006  could  lead to a  potential  decline  in future  quarterly
revenues.

Historically,  approximately  93% of our revenues  were  generated  from sources
where the ultimate client is a federal,  state or local government unit.  During
the last few  years,  due to the  general  economic  slowdown,  state  and local
budgets, which we are dependent on for approximately 69% of our revenue sources,
have  come  under  intense  pressure.  Most  states  were  running  in a deficit
situation, as were many local governments. This caused many of them to delay and
in some cases cancel  certain  infrastructure  projects until such time as their
economic  fortunes rebound.  In recent months,  tax revenues have been improving
resulting  in  increased  activity  preparatory  to the  issuance  of  bids  and
ultimately  the awarding of new  projects.  In addition,  we have  increased our
sales and  marketing  efforts  with a specific  objective  of  marketing  to the
commercial  sector  which  inherently   offers  faster  project   implementation
schedules.

Our second area of focus is the  reengineering  of our business model so that it
contains  a  greater  percentage  of  recurring  revenue.  As  indicated  in the
following table,  approximately  15% of our revenue during the first nine months
of 2006 was generated  from recurring  revenue  sources  (primarily  maintenance
revenues),  and the majority of these revenues occurred in our Public Safety and
Justice  segment.  We define  one-time  revenue as revenue derived from discrete
projects,  from which we do not expect to generate  incremental revenue upon the
completion  of the project.  We define  recurring  revenue as sources of revenue
from which we  anticipate  receiving  revenue in the current,  as well as future
periods, for example annual renewable maintenance contracts.

<TABLE>
<CAPTION>
                                                               Nine Months  Ended September 30, 2006
                                                ------------------------------------------------------------------------
          (in thousands)                        One-time Revenue    %          Recurring Revenue     %          Total
                                                ----------------  -----        -----------------   ----      -----------
<S>                                                <C>            <C>             <C>               <C>       <C>
Institutional Security Systems                     $ 34,053       30.0            $  3,613          3.2       $   37,666
Attack Protection                                    31,839       28.0                   -            -           31,839
Integrated Electronic Systems                        10,687        9.4                   -            -           10,687
Public Safety and Justice                            19,962       17.6              13,406         11.8           33,368
                                                   --------       ----            --------         ----       ----------
     Total                                         $ 96,541       85.0            $ 17,019         15.0       $  113,560
                                                   ========       ====            ========         ====       ==========
</TABLE>



Since the majority of our revenues are one-time revenues and are  non-recurring,
we must reinvent our book of business on a continual  basis.  This makes it very
difficult  for us to project  our future  revenue  stream and thus makes it very
difficult for us to project our earnings as well as our business  outlook.  Over
the next five  years,  we hope to modify  our  business  model to rely less upon
one-time sources of revenue and more on recurring sources of revenue.

Our third focus area is to improve our cost structure,  quality,  and client and
employee satisfaction.  Our Institutional Security Systems and Attack Protection
business  segments  are  undergoing   significant   organizational  and  expense
restructuring,  including a partial consolidation of regional office efforts and
an increased focus on centralized  performance of the most complicated  security
projects. This initiative began by ensuring our organization is properly aligned
with our  clients'  needs.  Many  changes  have  been made and  initial  results
indicate  that  our  cost,  our  quality,  our  clients  and our  employees  are
responding  favorably to the changes implemented thus far. We have much room for
improvement as we move toward a more client-oriented  organization. In addition,
our Public Safety and Justice  segment has and is continuing to undergo  expense
restructuring including right sizing its organization in light of its relatively
low level of backlog.  The Attack Protection segment also has a very low backlog
level which will necessitate us to reevaluate and reduce our expense  structure.
In addition,  in light of the  escalating  selling,  general and  administrative
costs  associated with the current  heightened  regulatory  environment,  we are
evaluating our structure and strategy to determine if a less  decentralized,  or
other  organizational  structure  would  result in lower  selling,  general  and
administrative costs and we are evaluating our strategy to determine if we would
benefit from focusing on fewer segments.

                                       20
<PAGE>

We believe that if we address and implement  successfully  the above three areas
of focus, we will significantly enhance our future growth opportunities and will
provide for more predictable financial results.

On May 2, 2005, we filed a Form 8-K disclosing  that we failed to timely file an
amendment to our Annual Report on Form 10-K for the year ended December 31, 2004
to provide  management's  report on internal control over financial reporting as
of December 31, 2004 and the related report of our independent registered public
accounting  firm on  management's  assessment of the  effectiveness  of internal
control  over  financial  reporting  (together,  the "404  Report")  required by
Section 404 of the Sarbanes-Oxley Act of 2002.

On May 4, 2005, we received a notice from the Listing Qualifications  Department
of The Nasdaq  Stock  Market  stating that due to our failure to timely file the
404 Report, we were no longer in compliance with the requirements of Marketplace
Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports
required to be filed with the  Securities  and Exchange  Commission on or before
the date they are required to be filed with the SEC.

On June 27, 2005,  the Company filed its Form 10-K/A with the SEC containing the
404 Report.  On June 30, 2005, the Nasdaq Listing  Qualifications  Panel advised
CompuDyne  that  CompuDyne had remedied its filing  delinquency  and was in full
compliance with Nasdaq Market Place Rules.

On December 21, 2005 the Securities and Exchange  Commission  issued Release No.
33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For
Filing Periodic Reports" (the "Release").  The Release revised the definition of
"accelerated filer" to make it simpler for accelerated filers whose public float
falls below the $50 million threshold on the measurement date of June 30 to exit
accelerated  filer status.  Under the new rules,  an accelerated  filer that has
voting and non-voting  equity held by non-affiliates of less than $50 million at
the end of its second  fiscal  quarter is  permitted to exit  accelerated  filer
status at the end of that year and to file its  annual  report for that year and
subsequent periodic reports on a non-accelerated basis. Accelerated filer status
affects an issuer's  deadlines for filing its periodic  reports with the SEC and
complying  with the  requirements  of Section 404 of the  Sarbanes-Oxley  Act of
2002. A  non-accelerated  filer must begin to comply with the  internal  control
over financial  reporting  requirements  including the  attestation  report of a
registered  public  accounting firm for its first fiscal year ending on or after
December 15, 2007.

The aggregate worldwide market value of CompuDyne  Corporation's  equity held by
non-affiliates as of June 30, 2005, the last business day of CompuDyne's  second
fiscal quarter, was less than $50 million. As a result, as of December 31, 2005,
CompuDyne exited accelerated filer status.

Prior  to  the  issuance  of  the  Release,   CompuDyne  was  classified  as  an
"accelerated  filer" and was required to comply with the requirements of Section
404 of the Sarbanes-Oxley Act of 2002. In light of the Release,  CompuDyne, as a
non-accelerated  filer as of December 31, 2005,  was not required to comply with
Section 404 for the year ended December 31, 2005. The Company's worldwide market
value  held by  non-affiliates  on June 30,  2006 was less than $50  million  so
CompuDyne will also not be classified as an accelerated filer for the year ended
December 31, 2006.

RESULTS OF OPERATIONS

THREE MONTHS ENDED SEPTEMBER 30, 2006 and 2005

Revenues.  The Company had revenues of $34.7  million and $33.5  million for the
three months ended  September  30, 2006 and  September  30, 2005,  respectively,
representing  an increase  of $1.2  million or 3.6%.  As  discussed  below,  the
increase  occurred  primarily  due to higher  revenues  in our AP,  IES and PS&J
segments, offset in part by a decrease in revenues from our ISS segment.

                                       21
<PAGE>

Revenues from the Institutional  Security Systems segment were $11.1 million for
the three months ended September 30, 2006, a decrease from $15.5 million for the
three months ended  September 30, 2005,  representing a decrease of $4.5 million
or 28.7%. The  Institutional  Security Systems segment is largely a construction
driven business.  Much of its revenue is obtained by working on new and retrofit
construction  projects  in the  corrections  industry,  as opposed to sources of
recurring revenue.  As such, the decrease in revenue experienced by this segment
is largely  attributable  to our  working on fewer  projects  than we did in the
previous year. Although backlog increased significantly during the third quarter
of 2006,  it was not at a  significantly  high  enough  level  prior  thereto to
maintain  its revenue  levels.  Backlog was $65.5  million and $52.6  million at
September 30, 2006 and September 30, 2005, respectively. The years 2003 and 2004
were  slow  bidding  periods  for the  Company.  Although  the  gross  amount of
construction  spending in the corrections area remained  relatively flat between
2003  and  2004,  the  types  of  projects  that the  Company  solicits,  namely
large-scale medium to maximum security installations,  declined significantly in
2003 and 2004.  This  situation was further  compounded by the general state and
local  governmental  budget  deficits which caused these  governmental  units to
rethink and delay many of their pending  corrections  projects.  Since 2005, ISS
has seen  heightened  bidding  activity,  particularly  in the  market  space it
serves, namely large-scale medium to maximum security prisons.

Revenues  from the Attack  Protection  segment  were $8.8  million for the three
months  ended  September  30, 2006,  an increase  from $5.9 million for the same
period of 2005  representing  an increase of $2.9  million or 49.7%.  During the
fourth  quarter  of 2005 and  during  2006  the  factory  utilization  increased
significantly.  This segment is composed of two chief product offerings,  namely
Norshield,  which  encompasses  bullet and blast resistant windows and doors and
ancillary  products,  and Fiber SenSys,  which encompasses fiber optic intrusion
detection  systems.  For the three months ended September 30, 2006 the Norshield
line  experienced  a 16.0%  increase in revenues as compared to the three months
ended  September  30, 2005,  whereas the Fiber SenSys line  experienced a 250.8%
increase in revenues for the comparable  period. The increase in revenue of $0.8
million in the Norshield line is a direct result of the execution on an award of
a major contract won in the fourth  quarter of 2005.  Execution on this contract
began immediately upon award. Fiber SenSys' revenue increase of $2.1 million was
the result of a significant customer order of $1.2 million in the quarter. Fiber
SenSys' revenues were depressed during the third quarter of 2005 while they were
waiting for the  completion of the Air Force's  tests on our new products.  This
testing was  completed  by the third  quarter of 2006.  During  2003,  Norshield
furnished  bids to supply its  products for eight new embassy  projects.  At the
time,  this was the largest number of embassy  projects bid in a single calendar
year for this  segment.  We were awarded four of these embassy  projects,  for a
total  Norshield  contract  value of $7.0 million,  and lost the remaining  four
embassy project bids to competitors.  During 2004, we bid on fifteen new embassy
projects.  The Company was awarded seven of these  embassy  projects for a total
contract  value  of  $9.9  million,  and  lost  eight  embassy  project  bids to
competitors.  In 2005,  we bid on seventeen  embassy  projects.  The Company was
awarded  five of these  projects,  for a total of $20.4  million,  and lost four
projects  and one  bulk  bid  embassy  project  comprising  eight  embassies  to
competitors.  In 2006, seven embassy projects are planned, six of which have not
been  awarded yet. To date we have lost one of these 2006  projects.  We believe
that this increased level of new embassy construction will continue for the next
several years.  In addition,  to augment our embassy program and to generate new
backlog, Norshield has been actively pursuing non-embassy work.

Revenues  from  Integrated  Electronic  Systems  were $4.1 million for the three
months  ended  September  30, 2006,  an increase  from $2.9 million for the same
period of 2005,  representing  an increase of $1.2  million or 42.1%.  The first
three  quarters  of 2005  were a  difficult  time for IES,  with a  downturn  in
revenues  and  gross  profit   ensuing  from:  (i)  a  delay  in  a  large-scale
installation contract pending the government's completion of a building to house
the  system's  Command  and  Control  Center;  (ii) a  reduction  in an  ongoing
governmental  integration  program,  resulting  from the Department of Defense's
base relocation and closure (BRAC) program;  (iii) delays in several significant
awards,  because  funding  had been  redirected  to the war  efforts in Iraq and
Afghanistan;  and (iv) a delay in the start-up of a 5-year, $25 million security
contract  with the  Bureau of  Engraving  &  Printing  ("BEP"),  due to an award
protest by the predecessor  contractor.  IES is currently  performing work under
the BEP  contract  although  the protest  remains  unresolved.  During the third
quarter of 2006 IES acquired  the assets of a signals  intercept  business.  The
combination of sales from this new business,  plus segment revenues returning to
a more normal level resulted in the revenue increase.

Revenues from the Public Safety and Justice segment were $10.7 million for
the three months ended September 30, 2006, an increase from $9.2 million for the
same  period  of 2005  representing  an  increase  of  $1.5  million  or  16.4%.
Commencing  in 2005 our Public  Safety and Justice  segment  embarked on a major
overhaul  of its  suite of  existing  software  products  to a  ".net"  software
platform from its current software platform. We refer to this effort as Nextgen.
It is beginning to appear that as a result of this undertaking, some existing as
well as potential clients are deferring their decision to upgrade or procure new
Public  Safety  software  until our new  products  are  complete.  While we have
attempted  to  diminish  the impact on our  results of  operations  by  shifting
personnel from research and  development to revenue  generating  projects,  this
transition  has had and we expect  will  continue  to have a negative  effect on
backlog and the related operating  results.  It should be noted that although we
made three acquisitions in this segment, two in 2004 (90 Degrees and Copperfire)
and one in August 2005 (Xanalys), these acquisitions had little impact on Public
Safety and Justice's revenues due to their relatively small size.

                                       22
<PAGE>

Expenses.  Cost of goods  sold of  $22.9  million  for the  three  months  ended
September 30, 2006 were down $2.7 million or 10.5% from $25.6 million during the
same period of 2005.  The  increase in sales as compared to the decrease in cost
of goods sold resulted in an increased gross profit  percentage of 34.1% for the
three months ended September 30, 2006, as compared to 23.7% for the three months
ended September 30, 2005.

Cost of goods sold in the Institutional Security Systems segment of $9.3 million
for the three  months ended  September  30, 2006 were down $3.9 million or 29.5%
from $13.2 million during the same period of 2005. This percentage  decrease was
greater than the related sales  decrease of this segment of 28.7 %, resulting in
a slight  increase in the gross  profit  percentage  to 16.0% from 15.1% for the
three months ended September 30, 2005. The minimal  increase in the gross profit
percentage  is largely  due to the mix of  projects  and a  concerted  effort to
reduce costs.

Cost of goods sold in the Attack  Protection  segment  of $5.5  million  for the
three months ended September 30, 2006 remained unchanged from the same period in
2005. However,  because of the 49.7% sales increase experienced by this segment,
the gross profit percentage  increased by 31.4% to 37.2% during the three months
ended  September  30, 2006 as compared  to 5.8%  during the three  months  ended
September 30, 2005.  The reason for the increase in the gross profit  percentage
during the third  quarter of 2006 as compared  to the third  quarter of 2005 was
due to increased  utilization  in the third  quarter of 2006 of our Fiber Sensys
facility  which  inherently   produces  high  margin  items,  and  the  sale  of
significantly higher margin items such as our bullet and blast resistant windows
and doors, magnified by its increase in sales.

Cost of goods sold in the Integrated  Electronic Systems segment of $3.1 million
for the three months ended  September 30, 2006  increased  $0.7 million or 28.2%
from $2.4 million  during the same period of 2005.  This  increase was less then
the  related  sales  increase  of this  segment of 42.1%,  resulting  in an 8.2%
increase in the gross profit  percentage to 24.5% from 16.3% in the three months
ended  September  30,  2005.  During  the third  quarter of 2006,  this  segment
acquired  the  assets of  Signami,  LLC.  Products  sold by this  portion of the
Integrated  Electronic  Systems  segment are higher  margin items which  largely
contributed to the overall increase in gross profit and the related gross profit
percentage.

Cost of goods sold in the Public Safety and Justice  segment of $4.9 million for
the three months ended September 30, 2006 was up $0.5 million or 12.2% from $4.4
million during 2005.  This increase,  coupled with the related sales increase of
this  segment  of  16.4%,  resulted  in a  1.7%  increase  in the  gross  profit
percentage  to 53.9% from 52.2% in the period ended  September  30,  2005.  This
increase  in gross  profit  percentage  was  largely  due to the mix of projects
worked on by this segment  during the third quarter of 2006. All of the contract
revenues of this segment are derived from discrete projects.

Selling,  general and  administrative  expenses  were $9.2 million for the three
months ended  September 30, 2006, a decrease of $1.4 million or 13.4% from $10.6
million for the same period of 2005.  Much of this  decrease is related to costs
incurred by the Company  during 2005 related to  compliance  with Section 404 of
the Sarbanes-Oxley  Act ("SOX").  The Company exited accelerated filer status as
of  December  31, 2005 and is  currently  not  subject to full  compliance  with
Section 404 of SOX until December 31, 2007.

In conjunction  with the  acquisition  of the assets of Signami,  90 Degrees and
Copperfire  and the  stock  of  Xanalys  and in  compliance  with  Statement  of
Financial  Accounting  Standards No. 141 (SFAS 141) Business  Combinations,  the
Company  determined  the fair  value of the  following  identifiable  assets and
assigned the indicated lives for the purposes of amortization and depreciation.

<TABLE>
<CAPTION>
                                            September 30, 2006   September 30, 2005     Life
                                              (in thousands)       (in thousands)    (in years)
                                              --------------       --------------    ----------
<S>                                              <C>                <C>                   <C>
     Software                                    $ 3,934            $ 2,800               5
     Non Compete Agreements                          205                120             3-5
     Other                                            60                  -              15
                                            -------------------- ------------------
                                                 $ 4,199            $ 2,920
                                            ==================== ==================
</TABLE>

The  amortization  of  the  above  assets  resulted  in  the  Company  recording
amortization  expense related to these assets of $210 thousand and $134 thousand
for the three months ended September 30, 2006 and 2005,  respectively,  which is
included in operating expenses.

                                       23
<PAGE>

Research and  development  expenses were $1.8 million for the three months ended
September  30,  2006,  a decrease of $0.8 million or 31.0% from $2.6 million for
the same period of 2005.  Being a  technology-driven  enterprise,  the Company's
Public Safety and Justice segment  continually updates and enhances its software
offerings, thus incurring significant research and development costs.

During  September of each year,  Tiburon hosts its annual users group conference
which is attended by approximately 400 client personnel. During 2005, to be in a
position to  adequately  demonstrate  the segment's  new Nextgen  products,  the
Company diverted  significant  resources to its research  development  effort to
advance the  demonstrability of its updated product  offerings.  This effort was
not required in 2006 thus resulting in the decrease in research and  development
expenditures  during the third  quarter of 2006 as compared to the third quarter
of 2005.

Pre-Tax  Income.  The Company had pre-tax  income of $335 thousand for the three
months ended  September  30, 2006 compared to a pre-tax loss of $5.8 million for
the three months ended  September  30, 2005.  As discussed  below,  the increase
occurred  primarily due to improved results in our Attack  Protection and Public
Safety and Justice segments.

Pre-tax loss from the  Institutional  Security Systems segment was $360 thousand
for the three months ended  September 30, 2006, an increase from a $170 thousand
pre-tax loss for the three months ended  September  30, 2005.  This  increase in
pre-tax  loss was  largely  a result of this  segment's  sales  decline,  offset
partially by continued cost cutting measures taken by this segment in 2006.

Pre-tax income from the Attack Protection segment was $1.5 million for the three
months ended  September 30, 2006, an increase from the $1.8 million pre-tax loss
for the three months ended  September  30, 2005.  This  significant  increase in
pre-tax income for this segment is attributable  to the significant  increase in
this segment's revenues, amplified by the fact that products with higher margins
were sold during 2006 as compared to 2005.

Pre-tax income from the Integrated  Electronic Systems segment was $377 thousand
for the three months ended  September  30, 2006,  an increase from $172 thousand
for the three months ended  September 30, 2005.  This increase in pre-tax income
is a result  of the  increased  revenue  generated  by this  segment  in 2006 as
compared  to  2005,  which  includes  revenues  from the new  signals  intercept
business acquired by Integrated  Electronic  Systems during the third quarter of
2006, which contributed revenues with higher margins to this segment.

Pre-tax loss from the Public  Safety and Justice  segment was $643  thousand for
the three months ended September 30, 2006, an improvement  from the $3.2 million
pre-tax loss for the three months ended  September 30, 2005. The  improvement in
this  segment's  pre-tax loss is largely a result of a significant  reduction in
costs including headcount by this segment in its effort to improve upon its 2005
losses.  The third  quarter  results of this segment are always  impacted by the
users group meeting held during September of each year. Significant expenditures
are incurred in holding our annual users group meeting.

Pre-tax loss at the Corporate level was $494 thousand for the three months ended
September  30, 2006 as compared to a pre-tax loss of $791 thousand for the three
months ended  September 30, 2005.  During the third quarter of 2005, the Company
incurred  costs to comply with Section 404 of the Sarbanes  Oxley Act, which the
Company was not required to incur in 2006.

Interest  expense was $0.8 million for the three months ended September 30, 2006
and $0.7 for the three months ended  September  30, 2005.  The  following  table
compares the weighted  average of the Company's three months ended September 30,
2006 and 2005 interest bearing borrowings, which includes bank letters of credit
fees for the industrial revenue bonds, and the related rates charged thereon:

<TABLE>
<CAPTION>
                                                 Monthly Weighted                 Monthly Weighted
                                                  Average - 2006                   Average - 2005
                                               Amount                             Amount
                                           (in thousands)       Rate          (in thousands)     Rate
                                           --------------       ----          --------------     ----
<S>                                            <C>              <C>              <C>             <C>
Industrial revenue bonds                       $  3,172         6.6%             $ 3,612         3.6%
Subordinated borrowings                        $ 40,250         6.3%             $40,250         6.3%
Swap hedge agreement                           $      -           -              $   676         1.4%
</TABLE>

The Company also incurred letter of credit fees, in addition to those related to
the  industrial  revenue  bonds,  of $39  thousand and $7 thousand for the three
months ended September 30, 2006 and 2005, respectively.

                                       24
<PAGE>


In addition the Company recorded the following  non-cash  interest  expense,  in
thousands:

                     Amortization and write-off
                       of deferred financing charges       $ 82       $ 67


Taxes on Income.  The  effective  tax rate was 2.4% for the three  months  ended
September  30,  2006 and the  effective  tax rate was 8.7% for the three  months
ended September 30, 2005. The Company  decided to provide a valuation  allowance
against its deferred tax assets,  as it has determined that due to the Company's
accumulated deficit resulting from recent prior year losses there is uncertainty
as to whether it is more likely than not that the assets will be  realized.  The
Company had net operating loss carryforwards for financial  accounting  purposes
of $8.9 million at September 30, 2006.

Net Income (Loss). The Company reported net income of $0.3 million for the three
months  ended  September  30, 2006 and a net loss of $5.3  million for the three
months  ended  September  30, 2005.  Diluted  income per share was $0.04 for the
three months ended  September  30, 2006 and a loss of $0.65 for the three months
ended  September  30,  2005.  The  weighted  average  number  of  common  shares
outstanding and equivalents used in computing earnings per share was 8.4 million
and 8.1 million for the three month periods  ended  September 30, 2006 and 2005,
respectively.

NINE MONTHS ENDED SEPTEMBER 30, 2006 and 2005

Revenues.  The Company had revenues of $113.6 million and $100.9 million for the
nine months ended  September  30, 2006 and  September  30,  2005,  respectively,
representing  an increase of $12.7  million or 12.5%.  As discussed  below,  the
increase  occurred  primarily  due to higher  revenues  in our AP,  IES and PS&J
segments, offset in part by a decrease in revenues from our ISS segment.

Revenues from the Institutional  Security Systems segment were $37.7 million for
the nine months ended  September 30, 2006, a decrease from $43.0 million for the
nine months ended September 30, 2005, representing a decrease of $5.3 million or
12.4%.  The  Institutional  Security  Systems  segment is largely a construction
driven business.  Much of its revenue is obtained by working on new and retrofit
construction  projects  in the  corrections  industry,  as opposed to sources of
recurring revenue.  As such, the decrease in revenue experienced by this segment
is largely  attributable  to our  working on fewer  projects  than we did in the
previous  year and the delay in the  start of some  projects.  Although  backlog
increased  significantly  during  the  third  quarter  of 2006,  it was not at a
significantly  high enough level prior  thereto to maintain its revenue  levels.
Backlog was $65.5  million and $52.6 million at September 30, 2006 and September
30, 2005, respectively.  Several of ISS' recently won awards were delayed and/or
not yet  available  to be  worked on by us.  The  years  2003 and 2004 were slow
bidding  periods for the  Company.  Although  the gross  amount of  construction
spending in the corrections area remained relatively flat between 2003 and 2004,
the types of projects that the Company solicits,  namely  large-scale  medium to
maximum security  installations,  declined  significantly in 2003 and 2004. This
situation was further  compounded  by the general  state and local  governmental
budget deficits which caused these  governmental units to rethink and delay many
of their  pending  corrections  projects.  Since 2005,  ISS has seen  heightened
bidding activity, particularly in the market space it serves, namely large-scale
medium to maximum security prisons.

Revenues from the Attack Protection segment were $31.8 million for the nine
months ended  September  30, 2006,  an increase  from $18.9 million for the same
period of 2005,  representing an increase of $13.0 million or 68.9%.  During the
fourth  quarter of 2005 and 2006 factory  utilization  increased  significantly.
This segment is composed of two chief product offerings, namely Norshield, which
encompasses bullet and blast resistant windows and doors and ancillary products,
and Fiber SenSys, which encompasses fiber optic intrusion detection systems. For
the nine months ended September 30, 2006 the Norshield line  experienced a 99.4%
increase in revenues as compared to the nine months  ended  September  30, 2005,
whereas the Fiber SenSys line  experienced  a 7.4%  decrease in revenues for the
comparable  period.  The increase in revenue of $13.4  million in the  Norshield
line is a direct result of the execution on an award of a major  contract won in
the fourth quarter of 2005.  Execution on this contract began  immediately  upon
award.  Fiber  SenSys'  revenue  decline is a result of the  rollout of its next
generation product,  which until its testing was completed and accepted,  at the
end of the second quarter of 2006,  negatively  impacted revenues.  During 2003,
Norshield  furnished bids to supply its products for eight new embassy projects.
At the time,  this was the largest  number of embassy  projects  bid in a single
calendar year for this segment.  We were awarded four of these embassy projects,
for a total  Norshield  contract  value of $7.0 million,  and lost the remaining
four embassy  project bids to  competitors.  During 2004,  we bid on fifteen new
embassy  projects.  We were awarded seven of these embassy  projects for a total
contract  value  of  $9.9  million,  and  lost  eight  embassy  project  bids to
competitors.  In 2005,  we bid on seventeen  embassy  projects.  The Company was
awarded  five of these  projects,  for a total of $20.4  million,  and lost four
projects  and one  bulk  bid  embassy  project  comprising  eight  embassies  to
competitors.  In 2006, seven embassy projects are planned, six of which have not
been  awarded yet. To date we have lost one of these 2006  projects.  We believe
that this increased level of new embassy construction will continue for the next
several years.


                                       25
<PAGE>

Revenues  from  Integrated  Electronic  Systems were $10.7  million for the nine
months  ended  September  30, 2006,  an increase  from $6.8 million for the same
period of 2005,  representing  an increase of $3.9  million or 57.0%.  The first
half of 2005 was a difficult time for IES, with a downturn in revenues and gross
profit, ensuing from: (i) a delay in a large-scale installation contract pending
the  government's  completion  of a building to house the  system's  Command and
Control Center; (ii) a reduction in an ongoing governmental integration program,
resulting from the  Department of Defense's  base  relocation and closure (BRAC)
program;  (iii) delays in several significant  awards,  because funding had been
redirected to the war efforts in Iraq and  Afghanistan;  and (iv) a delay in the
start-up of a 5-year, $25 million security contract with the Bureau of Engraving
& Printing ("BEP"), due to an award protest by the predecessor  contractor.  IES
is currently performing work under the BEP contract although the protest remains
unresolved.  During the first nine months of 2006 IES saw its revenues return to
a more normal level.

Revenues from the Public  Safety and Justice  segment were $33.4 million for the
nine months ended  September  30, 2006,  an increase  from $32.2 million for the
same period of 2005,  representing an increase of $1.1 million or 3.5%. PS&J has
been  experiencing  lower backlogs and has increased its focus on developing its
next generation products. Beginning in the fourth quarter of 2005 and continuing
through  the  first  nine  months of 2006,  PS&J  redeployed  a  portion  of its
technical  staff,  typically  deployed in the research and development  area, to
work on projects and thus increase quarterly  revenues.  It should be noted that
although we made three acquisitions in this segment, two in 2004 (90 Degrees and
Copperfire)  and one in August 2005  (Xanalys),  these  acquisitions  had little
impact on Public Safety and  Justice's  revenues due to their  relatively  small
size.

Expenses.  Cost of  goods  sold of  $77.1  million  for the  nine  months  ended
September  30, 2006 were up $6.9 million or 9.9% from $70.2  million  during the
same period of 2005. The larger percentage  increase in sales as compared to the
percentage  increase in cost of goods sold resulted in an increased gross profit
percentage of 32.1% for the nine months ended September 30, 2006, as compared to
30.5% for the nine months ended September 30, 2005.

Cost of  goods  sold in the  Institutional  Security  Systems  segment  of $31.9
million for the nine months ended  September  30, 2006 were down $3.7 million or
10.3%,  from $35.5 million during the same period of 2005. This decrease coupled
with the related  sales  decrease of this  segment of 12.4%,  resulted in a 2.0%
decrease in the gross profit  percentage to 15.4% from 17.4% for the nine months
ended September 30, 2005. The decrease in the gross profit percentage is largely
a result of ISS' fixed costs now being absorbed by a smaller revenue base during
the first nine months of 2006.  In addition,  during the first  quarter of 2005,
one of  this  segment's  customers  terminated  its  contract  for  convenience,
resulting in the recognition of $1.3 million in gross margin.

Cost of goods sold in the Attack  Protection  segment of $21.4  million  for the
nine months ended  September 30, 2006 increased $6.6 million or 45.0% from $14.8
million during the same period of 2005.  This increase was less than the related
68.9%  sales  increase,  resulting  in an 11.1%  increase  in the  gross  profit
percentage to 32.8% from 21.7% during the nine months ended  September 30, 2005.
The principal reason for the increase in the gross profit  percentage during the
first nine months of 2006,  as compared to the first nine months of 2005,  was a
shift in product mix and a  significant  increase in facility  utilization  as a
result of the significant increase in sales of this segment.

Cost of goods sold in the Integrated  Electronic Systems segment of $8.7 million
for the nine months ended  September  30, 2006  increased  $3.0 million or 52.0%
from $5.7 million  during the same period of 2005.  This increase was consistent
with the related  sales  increase of this segment of 57.0%,  resulting in a 2.7%
increase in the gross profit  percentage  to 18.8% from 16.1% in the nine months
ended  September  30, 2005.  Substantially  all of the projects  awarded in this
segment are discrete projects.

Cost of goods sold in the Public Safety and Justice segment of $15.1 million for
the nine months ended  September 30, 2006 was up $1.0 million or 6.9% from $14.2
million  during 2005.  This increase was greater than the related sales increase
of this  segment  of 3.5%,  resulting  in a 1.5%  decrease  in the gross  profit
percentage  to 54.6% from 56.1% in the nine month  period  ended  September  30,
2005.

Selling,  general and  administrative  expenses  were $28.3 million for the nine
months ended  September  30, 2006, a decrease of $2.7 million or 8.6% from $30.9
million for the same period of 2005.  Much of this  decrease is related to costs
incurred by the Company  during 2005 related to  compliance  with Section 404 of
SOX. The Company exited  accelerated filer status as of December 31, 2005 and is
currently not subject to full  compliance with Section 404 of SOX until December
31,  2007.  In  addition,  AP's  selling,  general and  administrative  expenses
increased  by $0.4 million or 5.5% during the nine months  ended  September  30,
2006 as compared to the nine months ended  September 30, 2005. This increase was
largely the result of  increased  legal costs  associated  with  ongoing  claims
resolutions  in actions  both as  plaintiff  and  defendant,  and for  increased
selling and training  costs as the segment is trying to expand its presence into
new marketplaces.

                                       26
<PAGE>

In conjunction  with the  acquisition  of the assets of Signami,  90 Degrees and
Copperfire  and the  stock  of  Xanalys  and in  compliance  with  Statement  of
Financial  Accounting  Standards No. 141 (SFAS 141) Business  Combinations,  the
Company  determined  the fair  value of the  following  identifiable  assets and
assigned the indicated lives for the purposes of amortization and depreciation.

<TABLE>
<CAPTION>
                                            September 30, 2006   September 30, 2005    Life
                                              (in thousands)      (in thousands)    (in years)
                                              --------------      --------------    ----------
<S>                                              <C>                <C>                  <C>
     Software                                    $ 3,934            $ 2,800              5
     Non Compete Agreements                          205                120            3-5
     Other                                            60                  -             15
                                              -----------        -----------
                                                 $ 4,199            $ 2,920
                                              ===========        ===========
</TABLE>

The  amortization  of  the  above  assets  resulted  in  the  Company  recording
amortization  expense related to these assets of $622 thousand and $402 thousand
for the nine months ended  September 30, 2006 and 2005,  respectively,  which is
included in operating expenses.

Research and  development  expenses  were $5.5 million for the nine months ended
September  30,  2006,  a decrease of $1.4 million or 20.9% from $6.9 million for
the nine months ended September 30, 2005. Being a technology-driven  enterprise,
the Company's Public Safety and Justice segment continually updates and enhances
its software  offerings,  thus incurring  significant  research and  development
costs.  During  September  of each year,  Tiburon  hosts its annual  users group
conference which is attended by approximately 400 client personnel. During 2005,
to  be in a  position  to  adequately  demonstrate  the  segment's  new  Nextgen
products, the Company diverted significant resources to its research development
effort to advance the  demonstrability  of its updated product  offerings.  This
effort was not  required in 2006 thus  resulting in the decrease in research and
development  expenditures  during the third  quarter of 2006 as  compared to the
third quarter of 2005.

Pre-Tax  Income.  The Company had  pre-tax  income of $1.3  million for the nine
months ended  September  30, 2006 compared to a pre-tax loss of $8.6 million for
the nine months ended  September  30, 2005.  As  discussed  below,  the increase
occurred  primarily due to improved results in our Attack  Protection and Public
Safety and Justice segments and improved Corporate results.

Pre-tax loss from the  Institutional  Security Systems segment was $610 thousand
for the nine months ended  September 30, 2006, a decrease from a pre-tax  income
of $524 thousand for the nine months ended September 30, 2005. This decrease was
largely a result of this segment's sales decline.

Pre-tax income from the Attack Protection  segment was $4.2 million for the nine
months ended  September 30, 2006, an improvement  from the $2.1 million  pre-tax
loss for the nine months ended September 30, 2005. This significant  increase in
pre-tax income for this segment is attributable  to the significant  increase in
this segment's revenues, amplified by the fact that products with higher margins
were sold during 2006 as compared to 2005.

Pre-tax income from the Integrated  Electronic Systems segment was $722 thousand
for the nine months ended  September  30, 2006, an increase from a $180 thousand
pre-tax  income for the nine months ended  September 30, 2005.  This increase in
pre-tax income is a result of the increased revenue generated by this segment in
2006 as compared to 2005, which includes revenues from the new signals intercept
business acquired by Integrated  Electronic  Systems during the third quarter of
2006, which contributed revenues with higher margins to this segment.

Pre-tax loss from the Public Safety and Justice segment was $1.2 million for the
nine months ended September 30, 2006, an improvement from a $3.3 million pre-tax
loss for the nine months ended  September  30,  2005.  The  improvement  in this
segment's  pre-tax loss is largely a result of a significant  reduction in costs
including  headcount  by this  segment in its  effort to  improve  upon its 2005
losses.

Pre-tax loss at the  Corporate  level was $1.9 million for the nine months ended
September  30, 2006 as compared to a pre-tax  loss of $4.0  million for the nine
months ended  September  30, 2005.  During the same period in 2005,  the Company
incurred  costs to comply with Section 404 of the Sarbanes  Oxley Act, which the
Company was not required to incur in 2006.

                                       27
<PAGE>

Interest  expense was $2.5  million and $2.3  million for the nine months  ended
September  30, 2006 and September 30, 2005,  respectively.  The following  table
compares the weighted  average of the Company's nine months ended  September 30,
2006 and 2005 interest bearing borrowings, which includes bank letters of credit
fees for the industrial revenue bonds, and the related rates charged thereon:

<TABLE>
<CAPTION>
                                                      Monthly Weighted                   Monthly Weighted
                                                       Average - 2006                     Average - 2005
                                                     Amount                             Amount
                                                 (in thousands)     Rate            (in thousands)     Rate
                                                 --------------     ----            --------------     ----
<S>                                                  <C>            <C>               <C>               <C>
      Industrial revenue bonds                       $  3,384       6.3%              $  3,774          3.5%
      Subordinated borrowings                        $ 40,250       6.3%              $ 40,250          6.3%
      Swap hedge agreement                           $      -         -               $  1,353          1.9%
</TABLE>

The Company also incurred letter of credit fees, in addition to those related to
the  industrial  revenue  bonds,  of $141 thousand and $14 thousand for the nine
month periods ended September 30, 2006 and 2005, respectively.

In addition the Company recorded the following  non-cash  interest  expense,  in
thousands:

      Amortization and write-off
        of deferred financing charges                   $  246       $ 201


Other income  benefited  during the first nine months of 2006 by receipt of $161
thousand in a legal settlement by the Attack Protection segment.

Taxes on  Income.  The  effective  tax rate was a benefit  of 13.3% for the nine
months ended September 30, 2006 and the effective tax rate was a benefit of 5.7%
for the nine  months  ended  September  30,  2005.  The tax benefit for the nine
months  ended  September  30,  2006 is  primarily  a  result  of  $200  thousand
previously  recorded as a reserve for uncertain tax positions which is no longer
needed,  partially  offset by state tax  expenses.  The  Company  has decided to
provide a  valuation  allowance  against  its  deferred  tax  assets,  as it has
determined that due to the Company's  accumulated  deficit resulting from recent
prior year losses there is  uncertainty as to whether it is more likely than not
the assets will be realized.  The Company had net operating  loss  carryforwards
for financial accounting purposes of $8.9 million at September 30, 2006.

Net Income (Loss).  The Company reported net income of $1.4 million for the nine
months  ended  September  30,  2006 and a net loss of $8.2  million for the nine
months ended September 30, 2005. Diluted income per share was $0.18 for the nine
months  ended  September  30, 2006 and a loss of $1.01 for the nine months ended
September 30, 2005. The weighted average number of common shares outstanding and
equivalents used in computing earnings per share was 8.2 million and 8.1 million
for the nine month periods ended September 30, 2006 and 2005, respectively.

LIQUIDITY AND CAPITAL RESOURCES

The  Company  funds  its  operations  through  cash  flows  generated  from  its
operations,  bank and public  financings,  and the sale of its common stock. The
Company's  liquidity  requirements  arise  from  cash  necessary  to  carry  its
inventories and billed and unbilled receivables,  for capital  expenditures,  to
repurchase  shares of its common stock under its share repurchase  program,  for
payments of principal and interest on  outstanding  indebtedness,  and to retire
its 2011 Notes. The ultimate clients of the Company are primarily federal, state
and local  governmental  units.  In the event the funding of these  governmental
units is reduced for any reason,  including budgetary reductions due to economic
conditions, there is a risk that the demand for the Company's goods and services
would decrease which would reduce the availability of funds to the Company.

As of  September  30,  2006,  the Company had working  capital of $30.6  million
compared with $35.3 million as of December 31, 2005.

Net cash  provided by  operating  activities  was $5.1  million  during the nine
months ended September 30, 2006 versus $4.7 million used in operating activities
during the nine months ended  September 30, 2005. The largest  component of cash
provided by operating  activities was a decrease in accounts  receivable of $9.6
million,  which was  partially  offset by a decrease  in  accounts  payable  and
accrued liabilities of $8.8 million.

                                       28
<PAGE>

Net cash used in investing activities was $3.1 million for the nine months ended
September  30, 2006  compared to net cash  provided of $11.0 million in the nine
months ended  September 30, 2005.  In the nine months ended  September 30, 2006,
the net of marketable  securities  bought and redeemed was a decrease of cash of
$0.7 million.  In the nine months ended September 30, 2005 the net redemption of
marketable securities was $11.6 million.

Net cash used in  financing  activities  amounted  to $5.9  million for the nine
months  ended  September  30,  2006  compared  with net cash  used in  financing
activities of $1.2 million in the nine months ended September 30, 2005.

The Company enters into purchase  obligations to procure equipment and services,
including  subcontractor   contracts,  in  the  performance  of  the  day-to-day
operations of its business.  Substantially  all of these obligations are covered
by our  existing  backlog  and the  revenues  generated  by these  backlogs  are
expected to be sufficient to meet any payment  obligations  resulting from these
purchase commitments.

On January 22, 2004, the Company  completed the offering of the 2011 Notes.  The
offering was for $40.25 million principal  amount.  The 2011 Notes bear interest
at the rate of 6.25% per annum, payable semi-annually,  and are convertible into
shares of common stock at a conversion  price of $13.89 per share.  The proceeds
from the  2011  Notes  were  used to repay  substantially  all of the  Company's
outstanding bank borrowings.

On December 19, 2005, the Company and its bank entered into a Second Amended and
Restated  Revolving  Credit and Security  Agreement (the "Second Restated Credit
Agreement").  The Second  Restated  Credit  Agreement  amended and  restated the
Company's Amended and Restated Credit Agreement dated March 31, 2004.

In connection with the execution of the Second Restated  Credit  Agreement,  the
Company  provided  the bank  with  collateral  that  includes  all  receivables,
equipment, general intangibles,  inventories, investment property, real property
and a  security  interest  in  subsidiary  stock.  The  Second  Restated  Credit
Agreement allows the Company to obtain revolving  advances in a principle amount
of up to $20 million. Revolving advances are limited by a borrowing base formula
based upon the value of the Company's  receivables,  inventories,  fixed assets,
real  property,  and issued and  outstanding  letters  of  credit.  The  maximum
aggregate  face  amount of letters of credit  that may be drawn under the Second
Restated Credit Agreement is limited to $18 million.  The Second Restated Credit
Agreement matures on December 18, 2008.

Revolving advances under the Second Restated Credit Agreement bear interest,  at
the  election of the Company,  at a variable  rate equal to the  alternate  base
rate, a prime interest based rate, or the Eurodollar  rate plus two and one half
percent.  For letters of credit, the Company pays an amount equal to the average
daily face amount of each outstanding letter of credit multiplied by two and one
half  percent  per annum,  and a fronting  fee of one quarter of one percent per
annum, together with other administrative fees and charges. The Company paid its
bank a closing  fee of $50  thousand in  connection  with the  execution  of the
Second Restated Credit  Agreement.  The Company is also required to pay the bank
an unused fee equal to  three-eighths  of one percent per annum of the amount by
which $20 million  exceeds the average  daily  unpaid  balance of the  revolving
advances and undrawn amount of any outstanding  letters of credit.  In addition,
the Company is required to pay a collateral  monitoring fee equal to $1 thousand
per month and a collateral evaluation fee as required.

The Second Restated Credit Agreement  contains various  affirmative and negative
covenants including financial covenants.  The Company is required to maintain an
unrestricted  undrawn  borrowing  base  availability  of at  least  $5  million.
Commencing  with the fiscal quarter ended June 30, 2006, the Company is required
to  maintain  a fixed  charge  coverage  ratio  of at  least  1.1 to 1.0.  These
requirements were met at September 30, 2006.

On July 14, 2006,  the Company and its banks  entered into a First  Amendment to
Second  Amended and Restated  Revolving  Credit  Security  Agreement (the "First
Amendment").  The First Amendment amended the Credit Agreement to (i) modify the
borrowing base, (ii) permit any Borrower to guaranty certain indebtedness of any
other  Borrower,  (iii)  increase  the  maximum  limit of  rental  payments  for
non-capitalized  leases  from $3  million to $4 million  per fiscal  year,  (iv)
permit the  Company to  repurchase  or redeem  certain  of the  Company's  6.25%
Convertible  Subordinated  Notes due  January  15,  2011 and (v)  consent  to an
acquisition by a newly formed indirect  subsidiary of the Company pursuant to an
asset purchase transaction.

The  Company's  total  outstanding  borrowings at September 30, 2006 amounted to
approximately  $43.4  million,  less  broker's  discounts  in the amount of $0.8
million.  The 2011 Notes accounted for $39.4 million, net of broker's discounts,
of  these  borrowings.  The  remaining  amount  of $3.1  million  resulted  from
borrowings  at variable  rates and  consisted of two  industrial  revenue  bonds
outstanding  in the  amounts  of $1.1  million  and $2.0  million.  The  average
interest  rate charged to the Company at September  30, 2006 for its  industrial
revenue  bonds  was  3.9%.  The  variable  interest  rate for  these  borrowings
fluctuated between 3.1% and 4.2% during the nine months ended September 30, 2006
based on weekly market conditions.  These bonds are fully collateralized by bank
letters of credit issued under the Company's bank agreement.  The Company's bank
considers  letters of credit as  outstanding  borrowings  when  considering  the
amount of availability the Company has remaining under its line of credit.

                                       29
<PAGE>

Other than the Company's  letters of credit,  which  amounted to $3.2 million at
September  30,  2006,  the  Company  has no other  material  off  balance  sheet
liabilities.

At September 30, 2006 the Company had $16.8 million of unused availability under
the Second Restated Credit Agreement,  subject to the availability of collateral
under its line of credit.

The Company  anticipates  that cash generated from  operations and its currently
available  cash will enable the Company to meet its liquidity,  working  capital
and capital  expenditure  requirements  during the next 12 months.  The Company,
however,  may require  additional  financing  to meet its  long-term  liquidity,
working  capital and capital  expenditure  requirements.  If such  financing  is
required,  there are no assurances  that it will be available,  or if available,
that it can be obtained on terms  favorable to the  Company.  From time to time,
the Company may be party to one or more non-binding  letters of intent regarding
material  acquisitions,  which,  if  consummated,  may be paid for with  cash or
through the issuance of a significant  number of shares of the Company's  common
stock.

The Company was  profitable  for the nine months ended  September 30, 2006.  The
Company did,  however,  record  significant  losses in fiscal 2004 and 2005.  We
recognize  that  sustaining  profitability  is a  critical  objective  which the
Company must attain.  The Company continues to have a significant amount of cash
and marketable  securities on its balance sheet at September 30, 2006,  however,
the Company must sustain its  profitability  prior to depleting its current cash
and marketable securities.

On May 2, 2005, we filed a Form 8-K disclosing  that we failed to timely file an
amendment to our Annual Report on Form 10-K for the year ended December 31, 2004
to provide  management's  report on internal control over financial reporting as
of December 31, 2004 and the related report of our independent registered public
accounting  firm on  management's  assessment of the  effectiveness  of internal
control  over  financial  reporting  (together,  the "404  Report")  required by
Section 404 of the  Sarbanes-Oxley  Act of 2002.  On May 3, 2005,  the Company's
bank  confirmed in writing that there will not be any event of default under the
various credit agreements, by virtue of the Company's failure to file its report
required by Section 404 of Sarbanes-Oxley in a timely manner.

On May 4, 2005, we received a notice from the Listing Qualifications  Department
of The Nasdaq  Stock  Market  stating that due to our failure to timely file the
404 Report, we were no longer in compliance with the requirements of Marketplace
Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports
required to be filed with the  Securities  and Exchange  Commission on or before
the date they are required to be filed with the SEC.

On June 27, 2005,  the Company filed its Form 10-K/A with the SEC containing the
404 Report.  On June 30, 2005, the Nasdaq Listing  Qualifications  Panel advised
CompuDyne  that  CompuDyne had remedied its filing  delinquency  and was in full
compliance with Nasdaq Market Place Rules.

Another  consequence of not filing the 404 Report timely as noted above includes
our  inability to use a shorter form  registration  document for one year in the
event we were to engage in an offering of our securities. This could have had an
adverse impact on our ability to raise capital and the cost of raising  capital.
This consequence lapsed on June 27, 2006.

Additional Considerations

BID BONDS AND PAYMENT AND PERFORMANCE BONDS
Historically,  certain of the Company's projects have required bid bonds at time
of proposal submission and payment and/or performance bonds upon contract award.
The  majority  of these  bonds  have been  needed in the ISS and PS&J  segments.
Recently,  approximately  75% of ISS' work has come from jobs where  payment and
performance  bonds  are  required  and for  PS&J,  19% of its work has  required
payment and performance  bonds.  The Company's losses in 2004 and 2005 have made
it more  challenging  for the  Company to attain the  bonding  needed to procure
certain of its projects.  As of September 30, 2006,  the Company was required to
provide  collateral for certain of its bonded  projects which it did by pledging
cash as collateral in the amount of approximately $5.5 million. In the event the
Company  is  unable  to  obtain  bonds,  or  if  the  terms,  namely  additional
collateral,  of the bonds are not within the financial means of the Company, the
amount of work the Company is able to contract for will be negatively impacted.


                                       30
<PAGE>


COST CONTAINMENT
Due to current economic  conditions,  the Company's losses in 2004 and 2005, and
in light of a very strong competitive  environment,  the Company recognizes that
its  ability to  increase  the  prices it charges  its  clients is  limited.  In
addition,  in light of significant  selling,  general and  administrative  costs
associated with the current heightened regulatory environment, we are evaluating
our strategy to determine if a revised  strategy  would result in lower selling,
general  and  administrative  costs.  As a  result,  in  order  to  enhance  our
profitability, the Company will continue to seek ways to reduce its costs.

TOTAL BACKLOG
CompuDyne's backlog amounted to $121.7 million at September 30, 2006. This was a
decrease  of 17.0%  from the  Company's  December  31,  2005  backlog  of $148.1
million.  The break down of the Company's  backlog by segment is as follows,  in
thousands:

<TABLE>
<CAPTION>
                                                               September 30,      December 31,
                                                                    2006              2005
                                                               -------------       ----------
<S>                                                               <C>               <C>
                     Institutional Security Systems               $  65,489         $ 58,128
                     Attack Protection                                7,991           28,802
                     Integrated Electronic Systems                    8,137            7,503
                     Public Safety and Justice                       40,088           53,705
                                                               -------------       ----------
                              Total                               $ 121,705         $148,138
                                                               =============       ===========
</TABLE>

The decline in backlog  during the first three  quarters of 2006 could lead to a
potential decline in future quarterly revenues.

Included in the backlog of the ISS, AP and PS&J  segments at September  30, 2006
is $21.2  million,  $1.1 million and $3.3  million,  respectively,  representing
awards  received by the segment for which the clients  have not yet entered into
signed  contracts.  These awards are expected to result in signed contracts over
the next twelve months.

CORPORATE REORGANIZATION
As part of the Company's  efforts to better  manage its costs,  during the first
quarter of 2005 the Company  implemented a corporate  reorganization  whereby it
converted several corporate entities into LLCs (Limited Liability Corporations).
This activity was designed to improve the Company's tax reporting  structure and
should  help  better  manage the  Company's  state  income tax  obligations.  In
conjunction  with this  reorganization,  our  Federal  Security  Systems  group,
formerly   known   as   Quanta   Systems    Corporation,    was   re-formed   as
CompuDyne-Integrated Electronics Division, LLC. In addition, CorrLogic, Inc. was
converted  to  CorrLogic,  LLC and Fiber  SenSys,  Inc.  was  converted to Fiber
SenSys,  LLC.  The  impact  of this  reorganization  is not  expected  to have a
material  effect on  operations.  In addition,  in light of escalating  selling,
general  and  administrative   costs  associated  with  the  current  heightened
regulatory environment,  we are evaluating our structure to determine if another
organizational   structure   would   result  in  lower   selling,   general  and
administrative costs.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
A complete description of the Company's significant  accounting policies appears
in the  Company's  Annual  Report on Form 10-K for the year ended  December  31,
2005.

Percentage of Completion  Accounting and Revenue Recognition.  A majority of the
Company's  revenues  are  derived  from  long-term  contracts  where  revenue is
recognized  under  the  percentage  of  completion  method  of  accounting.  The
Company's  software related  contracts utilize labor hours incurred to date on a
project, divided by the total expected project hours to determine the completion
percentage.  The Company's construction contracts utilize costs incurred to date
on a project,  divided by the total  expected  project  costs to  determine  the
completion percentage.  Both of these methods require considerable judgment and,
as such, the estimates  derived at any point in time could differ  significantly
from actual  results.  These  estimates  affect  many of the  balance  sheet and
statement  of  operations  accounts  including  net sales,  cost of goods  sold,
accounts receivable, contract costs in excess of billings and billings in excess
of contract  costs  incurred.  Revenues from these  contracts are  classified as
contract revenues earned on the statement of operations.

Change orders are modifications of an original contract that effectively  change
the  provisions  of the  contract  without  adding new  provisions.  They may be
initiated by either us as the contactor, or by the customer, and include changes
in  specifications  or  design,  method or manner  of  performance,  facilities,
equipment, materials, site, and period for completion of the work.

Change orders approved by the customer and us regarding both scope and price are
reflected  as an  adjustment  to the  revenue and costs of the  contract.  Costs
attributable  to  unpriced  change  orders  are  treated  as costs  of  contract
performance  in the period in which the costs are incurred if it is not probable
that the costs will be recovered through a change in the contract price. When it
is probable  that the costs will be  recovered  through a change in the contract
price,  the costs are  deferred  until the parties  have agreed on the change in
contract price. Change orders that are in dispute or are unapproved in regard to
both scope and price, are evaluated as claims.

                                       31
<PAGE>

Revenues for support and  maintenance  contracts  are  deferred  and  recognized
ratably over the life of the contract.  Revenues for these items are  classified
as maintenance revenues on the statement of operations.

Sales of products  unrelated to contract  revenue are recognized as revenue when
all of the following  criteria are met:  persuasive  evidence of an  arrangement
exists; delivery has occurred or services have been rendered; the seller's price
to the buyer is fixed or determinable; and collectibility is reasonably assured.
Revenues for these items are  classified  as other  revenues on the statement of
operations.

Provisions for estimated  losses on uncompleted  contracts are recognized in the
period such losses are determined.

Inventories  are  stated at the  lower of cost or  market,  using the  First-in,
First-out  (FIFO) method.  Costs  included in inventories  consist of materials,
labor,  and  manufacturing  overhead,  which are  related  to the  purchase  and
production of inventories.

Warranty  reserves are  estimated  and recorded at the time products are sold or
services are rendered.  They are established using historical information on the
nature,  frequency  and average cost of warranty  claims.  The Company  warrants
numerous  products,  the terms of which vary  widely.  In  general,  the Company
warrants its products against defect and specific non-performance.

Accounts  receivable are expected to be substantially  collected within one year
except  for a  portion  of the  receivables  recorded  as  retainage.  Retainage
expected to be collected in over one year is reflected as a current  asset as it
will be collected within the operating cycle under the related contract.

Tax valuation  allowances are  established  when the Company  believes it is not
"more  likely than not" that the Company will be able to receive tax benefits in
the future. The federal income tax benefit recorded in the first quarter of 2006
is primarily the result of the reduction of a liability maintained for uncertain
tax positions which was no longer required.

Goodwill and Intangible Assets.
The Company  reviews the carrying  value of goodwill and  intangible  assets not
subject to  amortization  annually during the fourth quarter of the year or when
events or changes in  circumstances  indicate that the carrying value may not be
recoverable,  utilizing a  discounted  cash flow model.  Changes in estimates of
future cash flows caused by items such as unforeseen events or changes in market
conditions could negatively affect the Company's reporting units' fair value and
result in an impairment  charge.  The carrying  value of goodwill and intangible
assets not subject to amortization totaled  approximately $27.5 million and $6.1
million,  respectively,  and intangible  assets subject to amortization  totaled
approximately  $2.5  million,  net, at September  30, 2006.  The Company  cannot
predict the occurrence of events that might adversely affect these values.

Stock Compensation Policy.
Effective  January 1, 2006, we adopted SFAS No. 123(R),  "Share-Based  Payment."
This  statement  requires  us to  expense  the fair  value of grants of  various
stock-based  compensation  programs  over the vesting  period of the awards.  We
elected to adopt the "Modified Prospective  Application" transition method which
does not require the  restatement  of previously  issued  financial  statements.
Compensation expense is measured and recognized beginning in 2006 as follows:

AWARDS GRANTED AFTER DECEMBER 31, 2005 - Awards are measured at their fair value
at date of grant.  The  resulting  compensation  expense  is  recognized  in the
consolidated  statement of  operations  ratably  over the vesting  period of the
award.

AWARDS  GRANTED  PRIOR TO DECEMBER 31, 2005 - Awards were measured at their fair
value at the date of original grant.  Compensation  expense  associated with the
unvested  portion  of these  options at  January  1, 2006 is  recognized  in the
consolidated statement of operations ratably over the remaining vesting period.

For all  grants  issued  after  December  31,  2005  the  amount  of  recognized
compensation  expense is adjusted based upon an estimated  forfeiture rate which
is derived from historical data.

ECONOMIC  CONDITIONS  AND THE AFTER EFFECT OF THE SEPTEMBER  11, 2001  TERRORIST
ATTACKS Much of the work CompuDyne  performs is for state and local governmental
units.  These entities were severely impacted by recent economic  conditions and
the resulting  contraction of the tax bases of these  governmental  units.  This
caused these  governmental  units to carefully  evaluate their budgets and defer
expenses and projects where possible.  Much of the work of the Company's  Public
Safety and Justice and  Institutional  Security  Systems  segments is contracted
with these state and local governmental units. As a result,  these segments have
seen delays in new work  available  to be bid and worked on. In  addition,  even
work that had been  contracted  for was sometimes  deferred by the customer into
the future. In recent months, it appears the state and local government revenues
have been improving, resulting in increased activity preparatory to the issuance
of requests for new bids and ultimately, the Company expects the awarding of new
projects.  It  appears  to us that we are in the  early  stages  of an  economic
recovery as it relates to the segments of the marketplace we serve.

                                       32
<PAGE>

After the  occurrence of the tragic  events of the September 11, 2001  terrorist
attacks,  there was a general perception that our Integrated  Electronic Systems
and Attack Protection  segments would see a significant  increase in order flow.
To the  contrary,  in the  months  subsequent  to the  terrorist  attacks  these
segments saw a slowing in new work opportunities as the various federal agencies
and other  customers  that are the usual source of their  business  slowed their
procurement  processes waiting for definitive  direction as to how to proceed in
the post September 11 world.  Now further  complicated by the military action in
Afghanistan  and Iraq,  the Company's  clients are  reevaluating  priorities and
budgets and are funding only their most  pressing  demands while also making key
decisions as to which projects can be deferred.

As a result of the above  factors,  during  the last few years the  Company  has
experienced a more  challenging  marketplace  than it  experienced  in the years
prior to September 11, 2001.

MARKET RISK
On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million
principal  amount of the 2011 Notes. The 2011 Notes bear interest at the rate of
6.25% per annum,  payable  semi-annually,  and are  convertible  into  shares of
common  stock at a  conversion  price of $13.89 per share.  The  Company  used a
portion of the proceeds of this note offering to pay down outstanding borrowings
under its variable rate bank notes. Subsequent to the pay-down of its bank notes
the only variable rate borrowing remaining  outstanding at September 30, 2006 is
approximately  $3.1 million of industrial  revenue  bonds.  Since this borrowing
bears  interest  at  variable  rates,  in  the  event  interest  rates  increase
dramatically  the increase in interest  expense to the Company could be material
to the results of operations of the Company.

RECENT ACCOUNTING PRONOUNCEMENTS
In September 2006, the FASB issued SFAS No 157 "Fair Value  Measurements".  This
Statement  defines fair value,  establishes a framework for measuring fair value
in generally accepted  accounting  principles  (GAAP),  and expands  disclosures
about fair value measurements. The adoption of this new accounting pronouncement
will not have an impact on our financial position or results of operation.

In September  2006,  the FASB issued SFAS No. 158,  "Employers'  Accounting  for
Defined Benefit Pension and Other  Postretirement  Plans -- an amendment of FASB
Statements No. 87, 88, 106 and 132(R)." This  statement  would require a company
to (a)  recognize in its  statement of financial  position an asset for a plan's
overfunded status or a liability for a plan's  underfunded  status (b) measure a
plan's assets and its obligations that determine its funded status as of the end
of the employer's fiscal year, and (c) recognize changes in the funded status of
a defined  postretirement  plan in the year in which the changes occur (reported
in  comprehensive  income).  The requirement to recognize the funded status of a
benefit plan and the disclosure  requirements are effective as of the end of the
fiscal year ending after December 15, 2006. The  requirement to measure the plan
assets and benefit  obligations as of the date of the employer's fiscal year-end
statement  of  financial  position is  effective  for fiscal  years ending after
December 15, 2008.  The adoption of this new accounting  pronouncement  will not
have an impact on our financial  position or results of  operation.  The Company
does not have any such plans.

In June 2006,  the FASB  issued  Interpretation  48 ("FIN 48"),  Accounting  for
Uncertainty  in Income  Taxes,  an  interpretation  of FASB  Statement  No. 109,
Accounting for Income Taxes.  FIN 48 clarifies the accounting for uncertainty in
income taxes  recognized in an enterprise's  financial  statements in accordance
with FASB  Statement  No. 109.  FIN 48  describes a  recognition  threshold  and
measurement  attribute for financial statement  recognition and measurement of a
tax  position  taken or expected  to be taken in a tax return and also  provides
guidance on de-recognition,  classification,  interest and penalties, accounting
in interim  periods,  disclosure and  transition.  The guidance is effective for
fiscal years beginning after December 15, 2006, which we intend to adopt for our
fiscal year ending December 31, 2007. We have not yet determined the impact from
adoption  of this new  accounting  pronouncement  on our  financial  position or
results of operation.

In  May  2005,  the  FASB  issued  SFAS  154,   "Accounting  Changes  and  Error
Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting  Changes"
and SFAS 3, "Reporting  Accounting  Changes in Interim  Financial  Statements-An
Amendment of APB Opinion No. 28." SFAS 154 provides  guidance on the  accounting
for and reporting of accounting  changes and error  corrections.  It establishes
retrospective  application,  or the latest  practicable  date,  as the  required
method for  reporting a change in  accounting  principle  and the reporting of a
correction  of an  error.  SFAS 154 is  effective  for  accounting  changes  and
corrections  of errors made in fiscal years  beginning  after December 15, 2005.
The  adoption  of SFAS  154 did not  have a  material  impact  on our  financial
position, results of operations or cash flows.

                                       33
<PAGE>

       ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk
CompuDyne  has fixed and variable rate notes  payable.  These  on-balance  sheet
financial instruments expose the Company to interest rate risk, with the primary
interest  rate  exposure  resulting  from  changes  in the bond  market  used to
determine the interest rate  applicable  to the  borrowings  under the Company's
industrial revenue bond borrowings.

The following information  summarizes our sensitivity to market risks associated
with fluctuations in interest rates as of September 30, 2006. To the extent that
the Company's  financial  instruments  expose the Company to interest rate risk,
they are presented in the table below.  The table presents  principal cash flows
and related  interest  rates by year of maturity of the Company's  notes payable
with variable rates of interest in effect at September 30, 2006.

On January 22,  2004,  the  Company  completed  an  offering  of $40.25  million
principal  amount of 6.25%  Convertible  Subordinated  Notes due on January  15,
2011.  The 2011  Notes  bear  interest  at a rate of 6.25%  per  annum,  payable
semi-annually,  and are convertible  into shares of common stock at a conversion
price of $13.89 per share.  The  Company  used a portion of the  proceeds of the
2011  Notes to pay down its  variable  bank notes  payable.  The pay down of its
variable borrowings reduced the Company's interest rate risk.

          Financial Instruments by Expected Maturity Date

<TABLE>
<CAPTION>
               Notes Payable             Variable                             Fixed
               Year Ending               Rate ($)      Average Variable       Rate ($)       Average Fixed
               December 31            (in thousands)    Interest Rate       (in thousands)   Interest Rate
              ----------------        -------------    --------------       -------------    -------------
<S>                                       <C>              <C>              <C>
              2006 (remaining)            $     -             3.91%            $     -              -
              2007                            440             3.91%                  -              -
              2008                            440             3.91%                  -              -
              2009                            440             3.91%                  -              -
              2010                            440             3.91%                  -              -
              Thereafter                    1,365             3.91%              40,250           6.25%
                                      -----------                          ----- ------
              Total                       $ 3,125             3.91%            $ 40,250           6.25%
              Fair Value                  $ 3,125             3.91%            $ 33,709          11.98%
</TABLE>


                                       34
<PAGE>

ITEM 4. CONTROLS AND PROCEDURES

CHANGES IN ACCELERATED FILER STATUS

On December 21, 2005 the Securities and Exchange  Commission  issued Release No.
33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For
Filing  Periodic  Reports"  (the  "Release").  Included  in the  Release  was an
amendment to revise the definition of the term "accelerated  filer" to permit an
accelerated  filer that has an  aggregate  worldwide  market value of voting and
non-voting  common equity held by  non-affiliates of less than $50 million as of
the last business day of its second  fiscal  quarter to exit  accelerated  filer
status at the end of the fiscal year in which the  company's  equity falls below
$50 million as of the last business day of its second fiscal quarter and to file
its  annual  report  for  that  year  and  subsequent   periodic  reports  on  a
non-accelerated basis.

The aggregate worldwide market value of CompuDyne  Corporation's  equity held by
non-affiliates as of June 30, 2005, the last business day of CompuDyne's  second
fiscal quarter, was less than $50 million. As a result, as of December 31, 2005,
CompuDyne exited accelerated filer status.

Prior to the Release, CompuDyne was classified as an "accelerated filer" and was
required to comply with the  requirements  of Section 404 of the  Sarbanes-Oxley
Act of 2002. The Company's worldwide market value held by non-affiliates on June
30, 2006 was less than $50 million so  CompuDyne  will not be  classified  as an
accelerated filer for the year ended December 31, 2006.

DISCLOSURE CONTROLS AND PROCEDURES

As required by Rule 13a-15 under the Securities Exchange Act of 1934, as amended
(the "Exchange Act"), the Company  conducted an evaluation under the supervision
and with the  participation  of the  Company's  management,  including the Chief
Executive Officer and the Chief Financial  Officer,  of the effectiveness of the
Company's disclosure controls and procedures as of the end of the period covered
by this report.  Based on that evaluation,  the Chief Executive  Officer and the
Chief Financial  Officer  concluded that the disclosure  controls and procedures
are  effective  in ensuring  that all  information  required to be  disclosed in
reports  that the Company  files or submits  under the Exchange Act is recorded,
processed,  summarized  and reported  within the time  periods  specified in the
Securities  and Exchange  Commission  rules and forms.  There was no significant
change in the Company's internal control over financial  reporting that occurred
during the Company's most recent fiscal quarter that has materially affected, or
is reasonably likely to materially  affect,  the Company's internal control over
financial reporting.



                                       35
<PAGE>




PART II - OTHER INFORMATION

Item 6:  Exhibits.

Exhibits -

31.1 Certification by Mr. Martin Roenigk, Chief Executive Officer pursuant to
     Rule 13a-14(a), filed herewith.

31.2 Certification by Mr. Geoffrey F. Feidelberg, Chief Financial Officer
     pursuant to Rule 13a-14(a), filed herewith.

32.1 Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002, 18
     U.S.C. Section 1350, for Mr. Martin Roenigk, Chief Executive Officer, filed
     herewith.

32.2 Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002, 18
     U.S.C. Section 1350, for Mr. Geoffrey F. Feidelberg, Chief Financial
     Officer, filed herewith.



                                       36
<PAGE>




SIGNATURE

  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.

                                         COMPUDYNE CORPORATION



Date:  November 14, 2006                 /s/ Martin Roenigk
                                         ------------------
                                           Martin Roenigk
                                         Chief Executive Officer


                                         /s/ Geoffrey F. Feidelberg
                                         --------------------------
                                         Geoffrey F. Feidelberg
                                         Chief Financial Officer

                                       37