Table of Contents

** **

 

** **

**UNITEDSTATES**

**SECURITIESAND 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  June 30, 2008.**                                                                                                                                                                                                           |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                        |
| **or**     | ** ** | ** **                                                                                                                                                                                                                                                        |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                        |
| **o**      | ** ** | **Transition Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                           |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                        |
| ** ** | ** ** | **For the transition period from                      to                  .** |

 

**CommissionFile Number: 000-51639**

 

**ArgyleSecurity, Inc.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                      | ** ** | **20-3101079**                          |
|-------------------------------------------------------------------|------------|-----------------------------------------|
| (State or Other  Jurisdiction of   Incorporation or Organization) |       | (I.R.S. Employer    Identification No.) |

 

**200Concord Plaza Suite 700 San Antonio, TX 78216**

(Address ofPrincipal Executive Offices including Zip Code)

 

**(210)828-1700**

(Registrant’sTelephone Number, Including Area Code)

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theExchange Act during the preceding 12 months (or for such shorter period thatthe registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes  x  No o

 

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

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company. See definitions of “large accelerated filer,” “acceleratedfiler,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.(Check one):

 
| Large accelerated filer o                      |   | Accelerated filer o         |
|------------------------------------------------|--------|----------------------------------|
|                                           |   |                             |
| Non-accelerated filer o                        |   | Smaller reporting company x |
| (Do not check if a  smaller reporting company) |   |                             |

 

There were 5,964,342, shares of the Registrant’scommon stock issued and outstanding as of August 14, 2008.

 

 

 

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Table ofContents

 

**ArgyleSecurity, Inc. Index to Form 10-Q**

 
| **Part I.**  | **Financial Information**                                                                            | 1          |
|-------------------|------------------------------------------------------------------------------------------------------|------------|
|              |                                                                                                 |       |
|              | Item 1.  Financial Statements                                                                        | 1          |
|              |                                                                                                 |       |
|              | Consolidated Balance  Sheets                                                                         | 1          |
|              |                                                                                                 |       |
|              | Consolidated  Statements of Operations                                                               | 2          |
|              |                                                                                                 |       |
|              | Consolidated  Statement of Stockholders’ Equity                                                 | 4          |
|              |                                                                                                 |       |
|              | Consolidated  Statement of Cash Flows                                                                | 5          |
|              |                                                                                                 |       |
|              | Notes to  Unaudited Consolidated Financial Statements                                                | 6          |
|              |                                                                                                 |       |
|              | Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations | 32         |
|              |                                                                                                 |       |
|              | Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                  | 55         |
|              |                                                                                                 |       |
|              | Item 4T. Controls  and Procedures                                                                    | 55         |
|              |                                                                                                 |       |
| **Part II.** | **Other Information**                                                                                | ** ** |
|              |                                                                                                 |       |
|              | Item 1. Legal Proceedings                                                                            | 56         |
|              |                                                                                                 |       |
|              | Item  1A. Risk Factors                                                                               | 56         |
|              |                                                                                                 |       |
|              | Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds                                 | 57         |
|              |                                                                                                 |       |
|              | Item 3.  Defaults Upon Senior Securities                                                             | 57         |
|              |                                                                                                 |       |
|              | Item 4.  Submission of Matters to a Vote of Security Holders                                         | 57         |
|              |                                                                                                 |       |
|              | Item 5. Other Information                                                                            | 57         |
|              |                                                                                                 |       |
|              | Item  6. Exhibits                                                                                    | 58         |
|              |                                                                                                 |       |
| SIGNATURES        |                                                                                                 |

 

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Table ofContents

 

**PART I- FINANCIAL INFORMATION**

 

**ITEM 1 - CONSOLIDATED FINANCIALSTATEMENTS (UNAUDITED)**

 

**ARGYLESECURITY, INC.**

**CONSOLIDATEDBALANCE SHEET**S

 

(in thousands except sharedata)

 
| ** **                                                                                                                                                                                           | ** ** | **June 30,** | ** ** | ** **            | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **2008**          | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                                                           | ** ** | **(Unaudited)**   | ** ** | **2007**              | ** ** |
| **Assets**                                                                                                                                                                                           |       |              |       |                  |       |
| Current assets:                                                                                                                                                                                      |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                            |       | $                 | 13,838     |                  | $          | 3,556 |   |
| Restricted cash                                                                                                                                                                                      |       | 2,505             |       | —                |       |
| Receivables:                                                                                                                                                                                         |       |              |       |                  |       |
| Contract – net of allowance for doubtful accounts of $1,316 and $975  at June 30, 2008 and December 31, 2007, respectively                                                            |       | 29,502            |       | 14,459                |       |
| Contract receivables – related party                                                                                                                                                            |       | 10,844            |       | 10,887                |       |
| Other receivables – related party                                                                                                                                                               |       | 34                |       | 42                    |       |
| Costs and estimated earnings in excess of billings on incomplete  contracts                                                                                                                          |       | 6,754             |       | 7,665                 |       |
| Intangible assets                                                                                                                                                                                    |       | 2,346             |       | 2,959                 |       |
| Refundable income taxes                                                                                                                                                                              |       | 491               |       | 561                   |       |
| Other current assets                                                                                                                                                                                 |       | 1,705             |       | 378                   |       |
| Deferred income taxes, net                                                                                                                                                                           |       | 165               |       | —                |       |
| Total current assets                                                                                                                                                                                 |       | 68,184            |       | 40,507                |       |
| Property and equipment, net                                                                                                                                                                          |       | 8,722             |       | 5,227                 |       |
| Goodwill                                                                                                                                                                                             |       | 24,850            |       | 19,937                |       |
| Intangible assets                                                                                                                                                                                    |       | 17,358            |       | 15,146                |       |
| Deposits, deferred transaction costs, and other assets                                                                                                                                               |       | 403               |       | 331                   |       |
| Total other assets                                                                                                                                                                                   |       | 51,333            |       | 40,641                |       |
| Total assets                                                                                                                                                                                         |       | $                 | 119,517    |                  | $          | 81,148 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                        |       |              |       |                  |       |
| Current liabilities:                                                                                                                                                                                 |       |              |       |                  |       |
| Accounts payable and accrued liabilities                                                                                                                                                             |       | $                 | 16,641     |                  | $          | 14,318 |   |
| Accounts payable – related party                                                                                                                                                                |       | 97                |       | 40                    |       |
| Billings in excess of costs and estimated earnings on incomplete  contracts                                                                                                                          |       | 10,273            |       | 5,733                 |       |
| Interest payable to stockholders                                                                                                                                                                     |       | 48                |       | 40                    |       |
| Current portion of capitalized lease obligations                                                                                                                                                     |       | 212               |       | 97                    |       |
| Current portion of long-term debt                                                                                                                                                                    |       | 2,400             |       | 81                    |       |
| Deferred income taxes                                                                                                                                                                                |       | —            |       | 211                   |       |
| Total current liabilities                                                                                                                                                                            |       | 29,671            |       | 20,520                |       |
| Long-Term Liabilities:                                                                                                                                                                               |       |              |       |                  |       |
| Deferred income taxes                                                                                                                                                                                |       | 5,467             |       | 6,095                 |       |
| Long-term debt – less current portion                                                                                                                                                           |       | 31,750            |       | 15,965                |       |
| Deferred rent and other long term liabilities                                                                                                                                                        |       | 151               |       | —                |       |
| Long-term capitalized lease obligations - less current portion                                                                                                                                       |       | 3,458             |       | 1,904                 |       |
| Total long-term liabilities                                                                                                                                                                          |       | 40,826            |       | 23,964                |       |
| Total liabilities                                                                                                                                                                                    |       | 70,497            |       | 44,484                |       |
| Stockholders’ Equity                                                                                                                                                                            |       |              |       |                  |       |
| Preferred stock of Argyle Security, Inc. - $.0001 par value; 1,000,000  shares authorized; 18,750 shares issued and outstanding                                                                 |       | —            |       | —                |       |
| Common stock of Argyle Security, Inc. - $.0001 par value; 89,000,000  shares authorized; shares issued and outstanding 5,964,342 at June 30,  2008 and 5,879,342 at December 31, 2007 |       | 1                 |       | 1                     |       |
| Additional paid in capital                                                                                                                                                                           |       | 50,475            |       | 36,279                |       |
| Accumulated earnings (deficit)                                                                                                                                                                       |       | (1,456            | )          | 384                   |       |
| Total stockholders’ equity                                                                                                                                                                      |       | 49,020            |       | 36,664                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                      |       | $                 | 119,517    |                  | $          | 81,148 |   |

 

See notes to unauditedconsolidated financial statements

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

**(unaudited)**

 

(in thousands exceptshare data)

 
| ** **                                                                                                         | ** ** | ** **                       | ** ** | ** **             | ** ** | **Predecessor (ISI)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------|------------|
| ** **                                                                                                         | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
| ** **                                                                                                         | ** ** | **June 30,**                | ** ** | **June 30,**      | ** ** | **June 30,**          | ** ** |
| ** **                                                                                                         | ** ** | **2008**                         | ** ** | **2007**               | ** ** | **2007**                   | ** ** |
| Revenues:                                                                                                          |       |                             |       |                   |       |                       |       |
| Contract revenues                                                                                                  |       | $                                | 24,711     |                   | $          | —                     |       | $ | 8,441 |   |
| Contract revenues - related party                                                                                  |       | 5,282                            |       | —                 |       | 7,365                      |       |
| Service and other revenues                                                                                         |       | 6,513                            |       | —                 |       | 1,980                      |       |
| Total revenues                                                                                                     |       | 36,506                           |       | —                 |       | 17,786                     |       |
| Cost of revenues:                                                                                                  |       |                             |       |                   |       |                       |       |
| Contract costs                                                                                                     |       | 24,424                           |       | —                 |       | 12,037                     |       |
| Service and other costs, including $1,276 of amortization of  intangibles in 2008                                  |       | 6,018                            |       | —                 |       | 1,320                      |       |
| Total cost of revenues                                                                                             |       | 30,442                           |       | —                 |       | 13,357                     |       |
| Gross profit                                                                                                       |       | 6,064                            |       | —                 |       | 4,429                      |       |
| Operating expenses:                                                                                                |       |                             |       |                   |       |                       |       |
| Salaries and related expenses, including $191 in stock-based  compensation in 2008                                 |       | 3,410                            |       | 230                    |       | 1,320                      |       |
| Consulting fees and outside services                                                                               |       | 637                              |       | —                 |       | 176                        |       |
| Depreciation                                                                                                       |       | 598                              |       | —                 |       | 226                        |       |
| Other general and administrative expenses                                                                          |       | 1,671                            |       | —                 |       | 1,230                      |       |
| Amortization of intangible assets                                                                                  |       | 427                              |       | —                 |       | —                     |       |
| Total operating expenses                                                                                           |       | 6,743                            |       | 230                    |       | 2,952                      |       |
| Operating income (loss)                                                                                            |       | (679                             | )          | (230                   | )          | 1,477                      |       |
| Other income (expense):                                                                                            |       |                             |       |                   |       |                       |       |
| Interest income                                                                                                    |       | 52                               |       | 387                    |       | —                     |       |
| Interest expense                                                                                                   |       | (854                             | )          | (82                    | )          | (1,892                     | )          |
| Total other income (expense)                                                                                       |       | (802                             | )          | 305                    |       | (1,892                     | )          |
| Income (loss) before provision for income taxes                                                                    |       | (1,481                           | )          | 75                     |       | (415                       | )          |
| Provision (benefit) for income taxes                                                                               |       | (461                             | )          | 25                     |       | 204                        |       |
| Net income (loss)                                                                                                  |       | (1,020                           | )          | 50                     |       | (619                       | )          |
| Deferred interest, net of taxes, subject to possible redemption                                                    |       | —                           |       | 51                     |       |                       |       |
| Dividends on convertible preferred stockholders                                                                    |       | 86                               |       | —                 |       |                       |       |
| Net income (loss) allocable to holders of non-redeemable common stock                                              |       | $                                | (1,106     | )                      | $          | (1                         | )          |   |   |
|                                                                                                               |       |                             |       |                   |       |                       |       |
| Weighted-average number of shares of common stock outstanding  exclusive of shares subject to possible redemption: |       |                             |       |                   |       |                       |       |
| Basic                                                                                                              |       | 5,799,342                        |       | 4,781,307              |       |                       |       |
| Diluted                                                                                                            |       | 5,799,342                        |       | 4,781,307              |       |                       |       |
|                                                                                                               |       |                             |       |                   |       |                       |       |
| Net income (loss) per share allocable to holders of non-redeemable  common stock:                                  |       |                             |       |                   |       |                       |       |
| Basic                                                                                                              |       | $                                | (0.19      | )                      | $          | (0.00                      | )          |   |   |
| Diluted                                                                                                            |       | $                                | (0.19      | )                      | $          | (0.00                      | )          |   |   |
|                                                                                                                    |            |                                  |            |                        |            |                            |            |  |  |  |

 

See notes to unauditedconsolidated financial statements

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

**(unaudited)**

 

(in thousands exceptshare data)

 
| ** **                                                                                                         | ** ** | ** **                     | ** ** | ** **                     | ** ** | **Predecessor (ISI)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|----------------------------|------------|
| ** **                                                                                                         | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
| ** **                                                                                                         | ** ** | **June 30,**              | ** ** | **June 30,**              | ** ** | **June 30,**          | ** ** |
| ** **                                                                                                         | ** ** | **2008**                       | ** ** | **2007**                       | ** ** | **2007**                   | ** ** |
| Revenues:                                                                                                          |       |                           |       |                           |       |                       |       |
| Contract revenues                                                                                                  |       | $                              | 49,899     |                           | $          | —                     |       | $ | 17,782 |   |
| Contract revenues - related party                                                                                  |       | 12,225                         |       | —                         |       | 13,166                     |       |
| Service and other revenues                                                                                         |       | 11,979                         |       | —                         |       | 5,691                      |       |
| Total revenues                                                                                                     |       | 74,103                         |       | —                         |       | 36,639                     |       |
| Cost of revenues:                                                                                                  |       |                           |       |                           |       |                       |       |
| Contract costs                                                                                                     |       | 50,094                         |       | —                         |       | 24,094                     |       |
| Service and other costs, including $2,529 of amortization of  intangibles in 2008                                  |       | 11,540                         |       | —                         |       | 4,360                      |       |
| Total cost of revenues                                                                                             |       | 61,634                         |       | —                         |       | 28,454                     |       |
| Gross profit                                                                                                       |       | 12,469                         |       | —                         |       | 8,185                      |       |
| Operating expenses:                                                                                                |       |                           |       |                           |       |                       |       |
| Salaries and related expenses, including $749 in stock-based  compensation in 2008                                 |       | 6,779                          |       | 520                            |       | 2,782                      |       |
| Consulting fees and outside services                                                                               |       | 1,583                          |       | —                         |       | 268                        |       |
| Depreciation                                                                                                       |       | 1,057                          |       | —                         |       | 467                        |       |
| Other general and administrative expenses                                                                          |       | 3,259                          |       | —                         |       | 1,990                      |       |
| Amortization of intangible assets                                                                                  |       | 847                            |       | —                         |       | —                     |       |
| Total operating expenses                                                                                           |       | 13,525                         |       | 520                            |       | 5,507                      |       |
| Operating income (loss)                                                                                            |       | (1,056                         | )          | (520                           | )          | 2,678                      |       |
| Other income (expense):                                                                                            |       |                           |       |                           |       |                       |       |
| Interest income                                                                                                    |       | 78                             |       | 771                            |       | 4                          |       |
| Interest expense                                                                                                   |       | (1,653                         | )          | (97                            | )          | (2,877                     | )          |
| Total other income (expense)                                                                                       |       | (1,575                         | )          | 674                            |       | (2,873                     | )          |
| Income (loss) before provision for income taxes                                                                    |       | (2,631                         | )          | 154                            |       | (195                       | )          |
| Provision (benefit) for income taxes                                                                               |       | (877                           | )          | 53                             |       | 301                        |       |
| Net income (loss)                                                                                                  |       | (1,754                         | )          | 101                            |       | (496                       | )          |
| Deferred interest, net of taxes, subject to possible redemption                                                    |       | —                         |       | 101                            |       |                       |       |
| Dividends on convertible preferred stockholders                                                                    |       | 86                             |       | —                         |       |                       |       |
| Net income (loss) allocable to holders of non-redeemable common stock                                              |       | $                              | (1,840     | )                              | $          | —                     |       |   |   |
|                                                                                                               |       |                           |       |                           |       |                       |       |
| Weighted-average number of shares of common stock outstanding  exclusive of shares subject to possible redemption: |       |                           |       |                           |       |                       |       |
| Basic                                                                                                              |       | 5,795,221                      |       | 4,781,307                      |       |                       |       |
| Diluted                                                                                                            |       | 5,795,221                      |       | 4,781,307                      |       |                       |       |
| Net income (loss) per share allocable to holders of non-redeemable  common stock:                                  |       |                           |       |                           |       |                       |       |
| Basic                                                                                                              |       | $                              | (0.32      | )                              | $          | —                     |       |   |   |
| Diluted                                                                                                            |       | $                              | (0.32      | )                              | $          | —                     |       |   |   |
|                                                                                                                    |            |                                |            |                                |            |                            |            |  |  |  |

 

See notes to unauditedconsolidated financial statements

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATEDSTATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**DECEMBER31, 2007 THROUGH JUNE 30, 2008**

**(unaudited)**

 

(in thousands except pershare data)

 
| ** **                            | ** ** | ** **            | ** ** | ** **               | ** ** | ** **       | ** ** | **Additional**      | ** ** | **Accumulated**        | ** ** | **Total**     | ** ** |
|---------------------------------------|------------|-----------------------|------------|--------------------------|------------|------------------|------------|---------------------|------------|------------------------|------------|---------------|------------|
| ** **                            | ** ** | **Common Stock** | ** ** | **Preferred Stock** | ** ** | **Paid in** | ** ** | **Earnings /** | ** ** | **Stockholders’** | ** ** |
| ** **                            | ** ** | **Shares**            | ** ** | **Amount**               | ** ** | **Shares**       | ** ** | **Amount**          | ** ** | **Capital**            | ** ** | **(Deficit)** | ** ** | **Equity** | ** ** |
| **Balance at December 31, 2007** | ** ** | **5,879,342**         | ** ** | **$**                    | **1**      | ** **       | **—** | ** **          | **$**      | **—**             | ** ** | **$**         | **36,279** | ** ** | **$** | **384** | ** ** | **$** | **36,664** | ** ** |
| Stock-based compensation              |       | 85,000                |       | —                   |       | —           |       | —              |       | 749                    |       | —        |       | 749 |   |
| Issuance of preferred stock           |       | —                |       | —                   |       | 18,750           |       | 0                   |       | 13,523                 |       | —        |       | 13,523 |   |
| Dividends on preferred stock          |       | —                |       | —                   |       | —           |       | —              |       | —                 |       | (86           | )          | (86 | ) |
| Common stock registration costs       |       | —                |       | —                   |       | —           |       | —              |       | (76                    | )          | —        |       | (76 | ) |
| Net income (loss)                     |       | —                |       | —                   |       | —           |       | —              |       | —                 |       | (1,754        | )          | (1,754 | ) |
| **Balance at June 30, 2008**     | ** ** | **5,964,342**         | ** ** | **$**                    | **1**      | ** **       | **18,750** | ** **          | **$**      | **0**                  | ** ** | **$**         | **50,475** | ** ** | **$** | **(1,456** | **)** | **$** | **49,020** | ** ** |

 

See notes to unauditedconsolidated financial statements

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

**(unaudited)**

 

(in thousands)

 
| ** **                                                                                         | ** ** | ** **                     | ** ** | ** **                     | ** ** | **Predecessor (ISI)** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|----------------------------|------------|
| ** **                                                                                         | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
| ** **                                                                                         | ** ** | **June 30,**              | ** ** | **June 30,**              | ** ** | **June 30,**          | ** ** |
| ** **                                                                                         | ** ** | **2008**                       | ** ** | **2007**                       | ** ** | **2007**                   | ** ** |
| **Cash flows from operating activities:**                                                          |       |                           |       |                           |       |                       |       |
| Net income (loss)                                                                                  |       | $                              | (1,754     | )                              | $          | 101                        |       | $ | (496 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities |       |                           |       |                           |       |                       |       |
| Stock-based compensation                                                                           |       | 749                            |       | —                         |       | —                     |       |
| Amortization                                                                                       |       | 3,376                          |       | 65                             |       | 175                        |       |
| Depreciation                                                                                       |       | 1,114                          |       | 1                              |       | 292                        |       |
| Accrued interest on deferred underwriting costs                                                    |       | —                         |       | 30                             |       | —                     |       |
| Interest earned on assets held in trust                                                            |       | —                         |       | (768                           | )          | —                     |       |
| Tax payments relapsed from the trust                                                               |       | —                         |       | 149                            |       | —                     |       |
| Decrease (increase) in contract receivables                                                        |       | (10,210                        | )          | —                         |       | (681                       | )          |
| Decrease (increase) in related party contract receivables                                          |       | 43                             |       | —                         |       | (1,486                     | )          |
| Decrease (increase) in related party receivables                                                   |       | 9                              |       | —                         |       | (408                       | )          |
| Decrease (increase) in costs and estimated earnings in excess of  billings                         |       | 1,687                          |       | —                         |       | (732                       | )          |
| Decrease (increase) in other assets                                                                |       | (76                            | )          | (44                            | )          | 256                        |       |
| Increase (decrease) in accounts payable and accrued expenses                                       |       | (660                           | )          | (80                            | )          | (824                       | )          |
| Increase (decrease) in other long-term liabilities                                                 |       | 64                             |       | —                         |       | 1,014                      |       |
| Increase (decrease) in deferred income taxes                                                       |       | (963                           | )          | —                         |       | (96                        | )          |
| Increase (decrease) in billings in excess of costs and estimated  earnings                         |       | 4,022                          |       | (96                            | )          | 1,160                      |       |
| **Net cash used in operating activities**                                                          | ** ** | **$**                          | **(2,599** | **)**                          | **$**      | **(642**                   | **)**      | **$** | **(1,826** | **)** |
|                                                                                               |       |                           |       |                           |       |                       |       |
| **Cash flows from investing activities:**                                                          |       |                           |       |                           |       |                       |       |
| Purchase of investments held in trust                                                              |       | —                         |       | (141,256                       | )          | —                     |       |
| Maturity of investments held in trust                                                              |       | —                         |       | 141,256                        |       | —                     |       |
| Acquisitions, net of cash acquired                                                                 |       | (5,264                         | )          | —                         |       | —                     |       |
| Purchase of property and equipment                                                                 |       | (1,679                         | )          | —                         |       | (929                       | )          |
| Transaction costs                                                                                  |       | (329                           | )          | (271                           | )          | —                     |       |
| Increase / (decrease) in other assets                                                              |       | —                         |       | (16                            | )          | 173                        |       |
| **Net cash used in investing activities**                                                          | ** ** | **$**                          | **(7,272** | **)**                          | **$**      | **(287**                   | **)**      | **$** | **(756** | **)** |
|                                                                                               |       |                           |       |                           |       |                       |       |
| **Cash flows from financing activities:**                                                          |       |                           |       |                           |       |                       |       |
| Issuance of preferred stock                                                                        |       | 15,000                         |       | —                         |       | —                     |       |
| Offering and financing costs                                                                       |       | (1,452                         | )          | (7                             | )          | —                     |       |
| Restricted cash                                                                                    |       | (2,505                         | )          | —                         |       | —                     |       |
| Payments on borrowings                                                                             |       | (23,097                        | )          | —                         |       | (311                       | )          |
| Proceeds from borrowings                                                                           |       | 27,271                         |       | —                         |       | 2,076                      |       |
| Proceeds from notes payable                                                                        |       | 5,000                          |       | —                         |       | 260                        |       |
| Proceeds from warrants to stockholders                                                             |       | —                         |       | 300                            |       | —                     |       |
| Payments on capital lease obligations                                                              |       | (64                            | )          | —                         |       | (50                        | )          |
| **Net cash provided by increase (used in)  financing activities**                                  | ** ** | **$**                          | **20,153** | ** **                     | **$**      | **293**                    | ** ** | **$** | **1,975** | ** ** |
|                                                                                               |       |                           |       |                           |       |                       |       |
| **Net increase (decrease) in cash and cash  equivalents**                                          | ** ** | **$**                          | **10,282** | ** **                     | **$**      | **(636**                   | **)**      | **$** | **(607** | **)** |
| Cash and cash equivalents at beginning of year                                                     | ** ** | **3,556**                      | ** ** | **694**                        | ** ** | **359**                    | ** ** |
| **Cash and cash equivalents at end of year**                                                       | ** ** | **$**                          | **13,838** | ** **                     | **$**      | **58**                     | ** ** | **$** | **(248** | **)** |

 

See notes to unauditedconsolidated financial statements

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 1 — Basis ofPresentation**

 

Argyle Security, Inc. is the parent company whoseprimary business operations are conducted under the name Argyle Security USA(which consists of the business of our wholly-owned subsidiary ISI SecurityGroup, Inc. and all of its operating subsidiaries). We refer to ArgyleSecurity USA as “AUSA” in this document and where the context indicates, to thehistorical business of ISI Security Group, Inc. as ISI.

 

Argyle Security, Inc. (formerly Argyle SecurityAcquisition Corporation) (the “Company”, “we”, “us”, “our”, or “Argyle”) wasincorporated in Delaware in June 2005 as a blank check company formed toacquire, through merger, capital stock exchange, asset acquisition, or othersimilar business combination, a business in the security industry. On July 31,2007, Argyle consummated its initial acquisition through the acquisition of100% of the outstanding capital stock of ISI Detention Contracting Group, Inc.(“ISI”) and its subsidiaries. Prior to the acquisition of ISI, Argyle had nooperations and was considered a developmental stage enterprise. ISI is deemedto be a “predecessor” to the Company.  As a result, the statements of operations and statements of cash flowsof ISI for three months ended June 30, 2007 are presented for comparativepurposes only. The results of operations and cash flows on a consolidated basissubsequent to the acquisition of ISI are not comparative to the predecessor ISIresults of operations and cash flows because the basis for the acquired assetsand liabilities of ISI have been adjusted to fair value pursuant to Statementof Financial Accounting Standards (“SFAS”) No. 141, *Business Combinations*.

 

In February 2008, we reorganized our businessunder the name of Argyle Security USA, or AUSA, through which we providephysical security solutions to commercial, governmental, and correctionalcustomers.  Argyle Security USA has tworeporting segments, Argyle Corrections and Argyle Commercial Security.

 

Argyle Corrections consists of all of our businessesin the corrections sector including ISI, Metroplex Control Systems (“MCS”) aswell as Com-Tec Security LLC (“Com-Tec”) and Peterson Detention, Inc. (“PDI”).  Com-Tec and PDI were acquired in January 2008.  This segment includes:

 

·ISI (also referred to historically as ISI-Detention) designs, engineers,supplies, installs, and maintains a full array of detention systems andequipment, targeting correctional facilities throughout the United States;

 

·Metroplex Control Systems (also referred to historically as MCS-Detention)designs, engineers, supplies, installs and maintains complex, customizedsecurity, access control, video and electronic security control systemsolutions at correctional and government facilities;

 

·PDI is a full-service, turnkey solutions provider that manufactures highsecurity metal barriers, high security observation window systems, detentionfurniture and accessories; and

 

·Com-Tec is an industry leader in the custom design and manufacture ofelectronic security and communications systems.

 

Argyle Commercial Security focuses on the commercialsecurity sector and provides turnkey, electronic security systems to thecommercial market. Currently, MCS Commercial Fire & Security is theonly member of this group and is referred to historically as MCS-Commercial.

 

AUSA is a detention and commercial equipmentcontractor that specializes in turnkey installations, including design,engineering, supply, and installation of various detention equipment forcorrectional facilities and institutions. The work is performed underfixed-price contracts. The projects are located in various cities in the UnitedStates. The length of the contracts varies but is typically less than twoyears. AUSA also provides turnkey installations covering the full spectrum ofelectronic security and low voltage systems, including fire alarm, accesscontrol, closed circuit television, intercom, sound/paging, and other customdesigned systems.

 

On January 1, 2008, MCFSA, Ltd. (MCFSA), all ofthe partnership interests of which are directly or indirectly wholly owned byAUSA, acquired substantially all of the business assets and liabilities of FireQuest Inc. (“Fire Quest”). Fire Quest is engaged in the business of alarmsystem sales and service.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 1 — Basis of Presentation(continued)**

 

On January 4, 2008, AUSA acquired substantiallyall of the business assets and liabilities of PDI.  PDI is a full-service, turnkey solutionsprovider that manufactures high security metal barriers, high securityobservation window systems, detention furniture and accessories.

 

On January 31, 2008, ISI Controls, Ltd. (“ISI-Controls”),a wholly owned subsidiary of AUSA, which in turn is a wholly owned subsidiaryof the Company, closed a transaction, pursuant to which ISI-Controls acquired100% of the outstanding units of Com-Tec, resulting in Com-Tec becoming awholly owned subsidiary of ISI-Controls. Com-Tec is engaged in the business ofcustom design, manufacture and installation of electronic security andcommunication systems.

 

The unaudited consolidated financial statements ofArgyle as of June 30, 2008 and for the three and six months ended June 30,2008 and 2007 include the accounts of the Company and all wholly-ownedsubsidiaries. All significant intercompany transactions and balances have beeneliminated in consolidation.  In theopinion of management, all normal recurring adjustments considered necessaryfor a fair presentation have been included. Operating results for the interim periods presented are not necessarilyindicative of the results to be expected for a full fiscal year.

 

*Pro Forma Results of Operations*

 

The accompanying unaudited consolidated statements ofoperations only reflect the operating results of companies acquired followingthe date of acquisition and do not reflect the operating results prior to theacquisitions. Following are pro forma unaudited results of operations for theCompany for the three and six months ended June 30, 2008 and 2007 assumingthe Fire Quest, PDI and Com-Tec acquisitions occurred on January 1, 2008and 2007, respectively.

 

The Company derived the unaudited pro forma results ofoperations from (i) the unaudited consolidated financial statements of ISIfrom January 1, 2007 to June 30, 2007, (ii) the unauditedconsolidated financial statements of Com-Tec for the one month ended January 31,2008 and the three and six months ended June 30, 2007, (iii) theunaudited financial statements of PDI for the three and six months ended June 30,2007, (iv) the unaudited financial statements of Fire Quest for the threeand six months ended June 30, 2007 and (v) the unaudited consolidatedfinancial statements of the Company for the three and six months ended June 30,2008 and 2007. The unaudited pro forma results of operations are notnecessarily indicative of results of operations that may have actually occurredhad the acquisitions taken place on the dates noted, or the future financialposition or operating results of the Company. The pro forma adjustments arebased upon available information and assumptions that the Company believes arereasonable. The pro forma adjustments include adjustments for interest expenseand increased depreciation and amortization expense as a result of theapplication of the purchase method of accounting based on the fair values ofthe tangible and intangible assets.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 1 — Basis ofPresentation (continued)**

 

**Pro Forma Consolidated Statements of Operations**

**(unaudited)**

 

(inthousands, except share data)

 
| ** **                                                                                                                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                                                                                | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                                                                                 |       |                             |       |                           |       |   |   |   |   |
| Contract revenues                                                                                                                         |       | $                                | 24,711     |                           | $          | 10,730 |   | $ | 51,617 |   | $ | 22,536 |   |
| Contract revenues - related party                                                                                                         |       | 5,282                            |       | 7,365                          |       | 12,225 |   | 13,166 |   |
| Service and other revenues                                                                                                                |       | 6,513                            |       | 3,836                          |       | 11,979 |   | 9,402 |   |
| Total revenues                                                                                                                            |       | 36,506                           |       | 21,931                         |       | 75,821 |   | 45,104 |   |
| Cost of revenues:                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Contract costs                                                                                                                            |       | 24,424                           |       | 13,465                         |       | 51,464 |   | 27,278 |   |
| Service and other costs, including amortization of intangibles  ($1,276 for three months 2008 and $2,565 for 6 months 2008, respectively) |       | 6,018                            |       | 3,885                          |       | 11,577 |   | 9,506 |   |
| Total cost of revenues                                                                                                                    |       | 30,442                           |       | 17,350                         |       | 63,041 |   | 36,784 |   |
| Gross profit                                                                                                                              |       | 6,064                            |       | 4,581                          |       | 12,780 |   | 8,320 |   |
| Operating expenses:                                                                                                                       |       |                             |       |                           |       |   |   |   |   |
| Salaries and related expense, including stock-based compensation of  $191 and $749 for the three and six months 2008, respectively.       |       | 3,410                            |       | 2,294                          |       | 6,987 |   | 4,783 |   |
| Consulting fees and outside services                                                                                                      |       | 637                              |       | 311                            |       | 1,586 |   | 606 |   |
| Depreciation                                                                                                                              |       | 598                              |       | 289                            |       | 1,060 |   | 591 |   |
| Other general and administrative expenses                                                                                                 |       | 1,671                            |       | 1,581                          |       | 3,340 |   | 2,746 |   |
| Amortization of intangible assets                                                                                                         |       | 427                              |       | 426                            |       | 868 |   | 868 |   |
| Total operating expenses                                                                                                                  |       | 6,743                            |       | 4,901                          |       | 13,841 |   | 9,594 |   |
| Operating loss                                                                                                                            |       | (679                             | )          | (320                           | )          | (1,061 | ) | (1,274 | ) |
| Other income (expense):                                                                                                                   |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                                                                                           |       | 52                               |       | 51                             |       | 78 |   | 111 |   |
| Interest expense                                                                                                                          |       | (854                             | )          | (916                           | )          | (1,698 | ) | (1,757 | ) |
| Total other income (expense)                                                                                                              |       | (802                             | )          | (865                           | )          | (1,620 | ) | (1,646 | ) |
| Income (loss) before provision for income taxes                                                                                           |       | (1,481                           | )          | (1,185                         | )          | (2,681 | ) | (2,920 | ) |
| Provision (benefit) for income taxes                                                                                                      |       | (461                             | )          | (254                           | )          | (912 | ) | (978 | ) |
| Net income (loss)                                                                                                                         |       | $                                | (1,020     | )                              | $          | (931 | ) | $ | (1,769 | ) | $ | (1,942 | ) |
| Deferred interest, net of taxes, subject to possible redemption                                                                           |       | —                           |       | —                         |       | — |   | — |   |
| Dividends on convertible preferred stockholders                                                                                           |       | 86                               |       | —                         |       | 86 |   | — |   |
| Net income (loss) allocable to holders of non-redeemable common stock                                                                     |       | $                                | (1,106     | )                              | $          | (931 | ) | $ | (1,855 | ) | $ | (1,942 | ) |
|                                                                                                                                      |       |                             |       |                           |       |   |   |   |   |
| Weighted-average number of shares of common stock outstanding  exclusive of shares subject to possible redemption:                        |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                                                                     |       | 5,799,342                        |       | 5,799,342                      |       | 5,795,221 |   | 5,799,342 |   |
| Diluted                                                                                                                                   |       | 5,799,342                        |       | 5,799,342                      |       | 5,795,221 |   | 5,799,342 |   |
| Net income (loss) per share allocable to holders of non-redeemable  common stock:                                                         |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                                                                     |       | $                                | (0.19      | )                              | $          | (0.16 | ) | $ | (0.32 | ) | $ | (0.33 | ) |
| Diluted                                                                                                                                   |       | $                                | (0.19      | )                              | $          | (0.16 | ) | $ | (0.32 | ) | $ | (0.33 | ) |

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 2 — Background,Formation, and Summary of Significant Accounting Policies**

 

Argyle completed a private placement (the “PrivatePlacement”) in January 2006 and received net proceeds of approximately$0.9 million. Also in January 2006, the registration statement for Argyle’sinitial public offering (the “Public Offering”) was declared effective, and thenet proceeds from the sale of Argyle’s units, after deducting certain offeringexpenses of approximately $2.4 million, including underwriting discounts of approximately$1.8 million, were approximately $28.2 million. Approximately $27.3 million ofthe proceeds from the Public Offering and the Private Placement were placed ina trust account for Argyle’s benefit. Except for $0.6 million in interest thatwas earned on the funds contained in the trust account and that was released toArgyle to be used as working capital, and the amounts released to Argyle forthe payment of taxes, Argyle was not able to access the amounts held in thetrust until it consummated a business combination. The amounts held outside ofthe trust account were used by Argyle to provide for business, legal, andaccounting due diligence on prospective acquisitions and continuing general andadministrative expenses. Prior to releasing the funds held in trust, the trustaccount contained $1.4 million reserved for the compensation of Argyle’sunderwriters in its Public Offering which was paid to them upon completion ofthe business combination. All amounts held in trust were released on July 31,2007 to fund the ISI acquisition.

 

On March 14, 2007, the underwriters from thePublic Offering agreed to forfeit any and all rights or claims to a pro-rataportion of the deferred underwriting costs and associated interest with respectto any shares of common stock redeemed in connection with any acquisition (seeNote 16). In connection with the Public Offering and the Private Placement,Argyle’s officers and directors placed all the shares owned by them before thePrivate Placement and the Public Offering into an escrow account. Except incertain circumstances, the shares held in escrow may not be released prior to January 24,2009.

 

As part of the ISI merger, stockholders holding211,965 of the aggregate number of shares sold in the Public Offering electedto redeem such shares (see Note 14). The per share redemption price was equalto $7.80 per share including interest earned thereon in the trust account, lesstaxes payable, $0.6 million of interest income which was released from thetrust account in September 2006 to fund our working capital, and amountsowed to the underwriter for the Private Placement (approximately $45,000 plusinterest). Approximately $1.7 million was paid to redemptive shareholders in August of2007.

 

***Cash and CashEquivalents***

 

The Company considers all highly liquid investmentswith original maturities of three months or less to be cash equivalents, andthe carrying amounts approximate fair value.

 

***Restricted Cash***

 

Represents deposits required by the Company’scommercial bank letter of credit.

 

***ContractsReceivable***

 

Contracts receivable are recorded at the invoicedamount and do not bear interest. The allowance for doubtful accounts isestablished as losses are estimated to have occurred through a provision forbad debts charged to earnings. Losses are charged against the allowance whenmanagement believes the uncollectibility of a receivable is confirmed.Subsequent recoveries, if any, are credited to the allowance. The allowance fordoubtful accounts is evaluated on a regular basis by management and is based onhistorical experience and specifically identified questionable receivables. Theevaluation is inherently subjective as it requires estimates that aresusceptible to significant revision as more information becomes available.

 

***Revenue Recognition***

 

A majority of the Company’s revenues are performedunder fixed-price construction contacts. Revenues under fixed-price contracts are recognized under thepercentage-of-completion methodology. *** ***Service revenues are recognizedwhen the services have been delivered to and accepted by the customer. Otherrevenues consists of product sales and are recognized upon shipment, or laterif required by shipping terms, provided title is transferred, prices are fixedand collection is deemed probable.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 2 — Background,Formation, and Summary of Significant Accounting Policies (continued)**

 

***ConstructionContracts***

 

Construction contracts are those as defined in theAmerican Institute of Certified Public Accountants’ Statement of Position 81-1(SOP 81-1), *Accounting for Performance ofConstruction-Type and Certain Production-Type Contracts*.

 

Most of the Company’s contracts extend over a periodof 12 to 16 months, which is the period the Company considers to be itsoperating cycle. Such contracts generally provide that the customers acceptcompletion of progress to date and compensate the Company for services renderedmeasured in terms of units installed, hours expended, or some other measure ofprogress. Revenues from construction contracts are recognized on the percentage-of-completionmethod in accordance with SOP 81-1. The Company recognizes revenue on signedcontracts and change orders. The Company generally recognizes revenue onunsigned change orders where it has written notices to proceed from thecustomer and where collection is deemed probable. Percentage-of-completion forconstruction contracts is measured principally by the percentage of costsincurred and accrued to date for each contract to the estimated total costs foreach contract at completion. The Company generally considers contracts to besubstantially complete upon departure from the work site and acceptance by thecustomer. Contract costs include all direct material, labor, subcontract,equipment costs, related payroll taxes and insurance costs, and any otherindirect costs related to contract performance. Changes in job performance, jobconditions, estimated contract costs, profitability, and final contractsettlements may result in revisions to costs and income and the effects ofthese revisions are recognized in the period in which the revisions aredetermined. Provisions for total estimated losses on incomplete contracts aremade in the period in which such losses are determined.

 

Pre-contract costs are costs that are incurred for aspecific anticipated contract and that will result in no future benefits unlessthe contract is obtained. Such costs are expensed as incurred.

 

The balances billed but not paid by customers pursuantto retainage provisions in construction contracts will be due upon completionof the contracts and acceptance by the customer. Based on the Company’sexperience with similar contracts in recent years, the retention balance ateach balance sheet date will be collected within the subsequent fiscal year.

 

The current asset, “costs and estimated earnings inexcess of billings on incomplete contracts,” represents revenues recognized inexcess of amounts billed which management believes will be billed and collectedwithin the subsequent year. The current liability, “billings in excess of costsand estimated earnings on incomplete contracts,” represents billings in excessof revenues recognized.

 

***Service Sales***

 

Service sale revenue are recognized when the serviceshave been delivered to and accepted by the customer.  These are generally short-term projects whichare evidenced by signed service agreements or customer work orders or purchaseorders.  These sales agreements/customerorders generally provide for billing to customers based on time at quotedhourly or project rates plus costs of materials and supplies furnished by theCompany.

 

***Inventory***

 

Inventory is valued at the lower of cost or market andconsists primarily of finished goods. Costs of finished goods are determinedusing the average cost method for all segments of AUSA. Inventory that wasacquired from ISI has been stated at fair value at July 31, 2007; allsubsequent purchases are recorded based on cost. The $1.0 million of inventorythat was acquired from the Fire Quest, Com-Tec, and PDI acquisitions have beenstated at fair value at the date of acquisition (see Note 3).  At June 30, 2008 and December 31,2007, the Company’s inventory balance was $1.5 million and $138,000,respectively, which is included in other current assets on the consolidatedbalance sheet.

 

***Property and Equipment***

 

Property and equipment is stated at cost lessaccumulated depreciation, except for the plant and equipment acquired in theISI acquisition which has been recorded at fair value at July 31, 2007;all subsequent purchases are recorded based on cost. The $1.2 million ofproperty and equipment from the Fire Quest, Com-Tec, and PDI acquisitions havebeen stated at fair value at the date of acquisition (see Note 3).  Depreciation is calculated on the straight-linemethod.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 2 — Background,Formation, and Summary of Significant Accounting Policies (continued)**

 

The Company reviews the carrying value of property andequipment for impairment whenever events and circumstances indicate thecarrying value of the asset may not be recoverable from the estimated futurecash flows expected to result from its use and eventual disposition. In caseswhere undiscounted expected future cash flows are less than the carrying value,an impairment loss is recognized equal to an amount by which the carrying valueexceeds the fair value of assets. The factors considered by management inperforming this assessment include current operating results, trends, andprospects, and the effects of obsolescence, demand, competition, and othereconomic factors.

 

***Assets Held UnderCapital Leases***

 

Assets held under capital leases are recorded at thelower of the net present value of the minimum lease payments or the fair valueof the asset at the inception of the lease. Amortization expense is computedusing the straight-line method over the shorter of the estimated useful life ofthe asset or the lease term. Assets held under capital leases that wereacquired from ISI have been stated at fair value as of July 31, 2007.

 

***Goodwill and OtherIntangible Assets***

 

Goodwill represents the excess of consideration paidover the fair value of net assets acquired in the business combination inaccordance with SFAS No. 142, *Goodwilland Other Intangible Assets*. Goodwill and other indefinite-livedintangibles (trade name) are not amortized but are tested at least annually forimpairment. The Company must recognize an impairment loss if, and to the extentthat, goodwill exceeds fair value. The Company will perform impairment testingon an annual basis for each acquisition unless impairment indicators exist thatwould require immediate testing.

 

The Company has two primary reporting units(Corrections and Commercial) that provide different services and products.Accordingly, goodwill was allocated to each. Management believes that the relationship between allocation of identifiedtangible and intangible assets to be in similar proportion to how goodwill isto be allocated among its reporting units. Accordingly, each reporting divisionwas allocated its share of goodwill based upon its percentage of purchase priceallocation related to identified tangible and intangible assets.

 

Intangible assets that have finite useful lives areamortized over their useful lives which range from 96 to 120 months forcustomer relationships, 12 to 16 months for backlog, 36 months for software and24 to 36 months for non-competes.

 

A summary of the activity in goodwill by segment is asfollows (in thousands):

 
| ** **                     | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-----------------|------------|----------------|------------|-----------|------------|
| Balance December 31, 2007 |       | $               | 13,275     |           | $          | 6,662     |       | $ | 19,937 |   |
| ISI Adjustments                |       | 92              |       | (20            | )          | 72        |       |
| Com-Tec Acquisition            |       | 2,691           |       | —         |       | 2,691     |       |
| Peterson Acquisition           |       | 1,421           |       | —         |       | 1,421     |       |
| Fire Quest Acquisition         |       | —          |       | 729            |       | 729       |       |
| Balance June 30, 2008     |       | $               | 17,479     |           | $          | 7,371     |       | $ | 24,850 |   |

 

During the six months ended June 30, 2008, theCompany increased goodwill from the ISI acquisition by $72,000 as a result of$17,000 of additional transaction costs ($4,000 accounting fees, $9,000 ininsurance costs and $4,000 in legal fees), a $12,000 write-down of stale checksoutstanding (decrease in cash), a $29,000 reduction in refundable taxes(current tax asset) and a $14,000 adjustment to intangible assets.

 

During the three months ended June 30, 2008, theCompany increased goodwill from the Com-Tec acquisition by $312,000 as a resultof $42,000 of additional transaction costs and a $270,000 adjustment tointangible assets due to a change in the valuation inputs associated with thediscount rate applied to the cash flows associated with those intangibleassets.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 2 — Background,Formation, and Summary of Significant Accounting Policies (continued)**

 

During the three months ended June 30, 2008, theCompany increased goodwill from the PDI acquisition by $197,000 as a result of$67,000 of additional transaction costs, a $110,000 adjustment to intangible assets due to a change in thevaluation inputs associated with the discount rate applied to the cash flowsassociated with those intangible assets and a $20,000 increase in currentliabilities for the PDI Promissory Note derivative (see Note 8).

 

During the three months ended June 30, 2008, theCompany had no change to goodwill from the acquisition of Fire Quest.

 

***Software Costs***

 

Software costs represent internally-developed softwarethat is proprietary to the Company and assists in its operations. According toStatement of Position 98-1, *Accounting forthe Costs of Computer Software Developed or Obtained for Internal Use*,the costs of computer software developed or obtained for internal use are to beamortized on a straight-line basis unless another systematic and rational basisis more representative of the software’s use. Management does not believe thereis another more rational basis and therefore the assets are amortized on thestraight-line basis over a 36-month period.

 

***Self Insurance***

 

AUSA and Com-Tec are self-insured to certain limitsunder its group health and dental plans. On an annual basis, the Company estimates its health insurance cost, forits self insured employee base at AUSA, based upon expected health insuranceclaims for the current year. The insurance company which provides both the stoploss and total aggregate insurance coverages also provides the average orexpected and maximum claims for each class. The average and maximum claims arebased on the Company’s demographics and prior claim history. The Company usesthe average claims history for the trailing twelve months as its basis foraccruing health care cost.

 

***Warranty Reserve***

 

One of the Company’s subsidiaries warrants itsproducts against defects in design, materials and workmanship generally forperiods ranging from one to two years.  Aprovision for estimated future costs relating to warranty expense is recordedwhen products are sold.  Managementestimates the provision based primarily on historical warranty claimexperience.  As of June 30, 2008,the warranty reserve was $175,000 and included in accounts payable and accruedexpenses on the unaudited consolidated balance sheet.

 

***Fair Value ofFinancial Instruments***

 

The recorded values of financial instruments,including contracts receivable, other assets, and accounts payable, approximatefair value due to their short maturity. The carrying value of the revolvingline of credit approximates fair value due to its variable interest rate. Therecorded value of the long-term debt approximates fair value based on borrowingrates currently available to the Company for financing arrangements withsimilar terms and average maturities.

 

***Income Taxes***

 

The Company accounts for income taxes in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 109, *Accounting for Income Taxes*. Deferredincome taxes are recorded pursuant to FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes, aninterpretation of FASB No. 109* (FIN 48) and are based onenacted statutory rates to reflect the tax consequences in future years of thedifferences between the tax bases of assets and liabilities and their financialreporting amounts. Deferred tax assets which will generate future tax benefitsare recognized to the extent that realization of such benefits through futuretaxable earnings or alternative tax strategies in the foreseeable short-termfuture is more likely than not. A valuation allowance is established whennecessary to reduce deferred tax assets to the amount expected to be realized.

 

***Reclassifications***

 

Prior year balances have been reclassified to conformto current year presentation.  The balance sheet includes areclassification of website development costs that was in other assets toPP&E.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 2 — Background,Formation, and Summary of Significant Accounting Policies (continued)**

 

***Recently IssuedAccounting Pronouncements***

 

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*. SFAS No. 157defines fair value, establishes a framework for measuring fair value andexpands disclosures about fair value measurements but does not change existingguidance as to whether or not an instrument is carried at fair value.  In February 2008,the FASB released a FASB Staff Position, which delayed the effective date ofSFAS No. 157 for all nonfinancial assets and liabilities, except those thatare recognized or disclosed at fair value in the condensed consolidatedfinancial statements on a recurring basis. SFAS No. 157 was firsteffective for the Company on January 1, 2008. The impact of the adoptionof SFAS No. 157 on our financial assets and liabilities, which areprincipally comprised of cash equivalents, did not have a significant impact ontheir fair value measurements or require expanded disclosures.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andLiabilities*. SFAS No. 159 permits all entities to choose toelect to measure eligible financial instruments at fair value. SFAS No. 159applies to fiscal years beginning after November 15, 2007, with earlyadoption permitted for an entity that has also elected to apply the provisionsof SFAS No. 157. The Company elected not to adopt the fair value optionfor valuation of those assets and liabilities which are eligible, therefore,there is no impact on our financial position or results of operations.

 

In December 2007, the FASB issued SFAS No. 141(R),*Business Combinations—a replacement of FASBStatement No. 141*, which significantly changes the principlesand requirements for how the acquirer of a business recognizes and measures inits financial statements the identifiable assets acquired, the liabilitiesassumed, and any non-controlling interest in the acquiree. The statement alsoprovides guidance for recognizing and measuring the goodwill acquired in thebusiness combination and determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. This statement is effective prospectively, exceptfor certain retrospective adjustments to deferred tax balances, for fiscalyears beginning after December 15, 2008. We are currently evaluating theimpact that SFAS No. 141(R) will have on our accounting foracquisitions prior to the effective date of the first fiscal year beginningafter December 31, 2008.

 

In December 2007, the FASB issued SFAS No. 160,*Non-controlling Interests in ConsolidatedFinancial Statements — an amendment of ARB No. 51*. SFAS 160requires non-controlling interests held by parties other than the parent insubsidiaries be clearly identified, labeled, and presented in the consolidatedstatement of financial position within equity, but separate from the parent’sequity. SFAS No. 160 is effective for fiscal years beginning after December 15,2008. We are currently evaluating the impact SFAS No. 160 will have on ourfinancial position and results of operations.

 

In May 2008, the FASB issued FSP No. APB14-1, *Accounting for Convertible DebtInstruments That May Be Settled in Cash upon Conversion (Including PartialCash Settlement)* (“APB 14-1”). APB 14-1 requires the issuer ofcertain convertible debt instruments that may be settled in cash (or otherassets) on conversion to separately account for the liability (debt) and equity(conversion option) components of the instrument in a manner that reflects the issuer’snonconvertible debt borrowing rate. APB 14-1, which is applied retrospectively,is effective for the Company beginning January 1, 2009. The Company iscurrently evaluating the potential impact of APB 14-1 on its consolidatedfinancial statements.

 

In June 2008, the Financial Accounting StandardsBoard (“FASB”) issued FASB Staff Position (“FSP”) No. EITF 03-6-1, *Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities* (“EITF03-6-1”). EITF 03-6-1 addresses whether instruments granted in share-basedpayment transactions are participating securities prior to vesting and,therefore, need to be included in the earnings allocation under the two-classmethod of calculating earnings per share. EITF 03-6-1, which is appliedretrospectively, is effective for the Company beginning January 1, 2009.The Company is currently evaluating the potential impact of EITF 03-6-1 on itsconsolidated financial statements.

 

***Use of Estimates***

 

The preparation of financial statements in conformitywith U.S. GAAP requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities at the date of thefinancial statements. Actual results could differ from those estimates.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 2 — Background,Formation, and Summary of Significant Accounting Policies (continued)**

 

***Contingencies***

 

Certain conditions may exist as of the date of theconsolidated balance sheet, which may result in a loss to the Company but whichwill only be resolved when one or more future events occur or fail to occur.The Company’s management and its legal counsel assess such contingentliabilities, and such assessment inherently involves an exercise of judgment.In assessing loss contingencies related to legal proceedings that are pendingagainst the Company or its subsidiaries or unasserted claims that may result insuch proceedings, the Company’s legal counsel evaluates the perceived merits ofany legal proceedings or unasserted claims, as well as the perceived merits ofthe amount of relief sought or expected to be sought therein.

 

If the assessment of a contingency indicates that itis probable that a material loss has been incurred and the amount of theliability can be estimated, then the estimated liability would be accrued inthe Company’s consolidated financial statements. If the assessment indicatesthat a potentially material loss contingency is not probable but is reasonablypossible, or is probable but cannot be estimated, then the nature of thecontingent liability, together with an estimate of the range of possible lossif determinable and material, would be disclosed in the notes to theconsolidated financial statements.

 

Loss contingencies considered remote are generally notdisclosed unless they involve guarantees, in which case the guarantees would bedisclosed.  As of June 30, 2008, theCompany did not have any loss contingencies requiring disclosures or accruals.

 

***Concentrations ofCredit Risk***

 

Financial instruments that potentially expose theCompany to concentrations of credit risk, as defined by SFAS No. 105, *Disclosure of Information about Financial Instrumentswith Off-Balance Sheet Risk and Financial Instruments with Concentrations ofCredit Risk*, consist primarily of contract receivables.  During the three and six months ended June 30,2008, revenue from our top three customers (all from the Corrections segment),represented 26% and 33% of total Company revenues, respectively.  During the three months ended June 30,2008, the Company had revenues from our top two customers (all from theCorrections segment), which represented 11% and 9% of total Company revenues.During the six months ended June 30, 2008, the Company had revenues fromour top two customers (all from the Corrections segment), which represented 15%and 9% of total Company revenues. These concentrations are down from the threemonths ended March 31, 2008 when the top three customers represented 42%of total Company revenues.  SeeRelated-Party Transactions footnote (see Note 19) for discussion oftransactions with ISI*MCS, Ltd.

 

***Net Income (Loss)Per Share***

 

Net income (loss) per share (basic) is calculated inaccordance with the provisions of SFAS No. 128, *Earnings Per Share*, by dividing net income (loss) by theweighted average number of common shares outstanding during the period. Ourconvertible preferred stock is considered a participating security as thepreferred stockholders are entitled to receive dividends when dividends arepaid to common stockholders. We include the participating convertible preferredstock in the computation of earnings per share using the two-class method inaccordance with EITF No. 03-06, *ParticipatingSecurities and the Two-Class Method under FASB Statement No. 128*.Net income (loss) per share (diluted) is calculated by adjusting the number ofshares of common stock outstanding using the “treasury stock” method foroptions and warrants and the “if converted” method for convertible preferredstock and convertible debt, to the extent the effect on EPS is dilutive.Because we incurred a net loss for all periods, the diluted EPS calculation isthe same as the basic EPS calculation.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 2 — Background,Formation, and Summary of Significant Accounting Policies (continued)**

 

Stock options to acquire 225,000 shares and promissorynotes convertible into 192,500 shares of common stock were excluded from thecomputation of diluted net income (loss) per share for three and six monthsended June 30, 2008 as the effect of including them would have beenanti-dilutive.

 

As of June 30, 2008 the Company has granted215,000 shares of restricted stock, of which 50,000 shares are vested.

 

In April 2008, (see Note 15) the Company issued18,750 shares of $0.0001 par value Series A Convertible Preferred Stock inconnection with a private placement financing, resulting in gross proceeds of$15.0 million.

 

**Note 3 — Acquisitions**

 

***Fire Quest***

 

On January 1, 2008, MCFSA, all of the partnershipinterests of which are directly or indirectly wholly owned by AUSA, acquiredsubstantially all of the business assets and liabilities of Fire Quest for atotal purchase price of $1.1 million as follows (in thousands):

 
| Cash               |   | $   | 764    |   |
|--------------------|--------|-----|--------|--------|
| Promissory note    |   | 250 |   |
| Transaction costs  |   | 130 |   |
| Net purchase price |   | $   | 1,144  |   |

 

***PDI***

 

On January 4, 2008, AUSA acquired substantiallyall of the business assets and liabilities of Peterson Detention, Inc.(PDI) for a total purchase price of $4.8 million as follows (in thousands):

 
| Cash               |   | $     | 1,500  |   |
|--------------------|--------|-------|--------|--------|
| Promissory note    |   | 3,000 |   |
| Transaction costs  |   | 318   |   |
| Net purchase price |   | $     | 4,818  |   |

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 3 — Acquisitions(continued)**

 

***Com-Tec***

 

On January 31, 2008, ISI Controls, Ltd.(ISI-Controls), a wholly owned subsidiary of AUSA, which in turn is a whollyowned subsidiary of the Company, closed a transaction, pursuant to whichISI-Controls acquired 100% of the outstanding units of Com-Tec Security, LLC(Com-Tec), resulting in Com-Tec becoming a wholly owned subsidiary ofISI-Controls. The total purchase price for the Com-Tec acquisition was $6.7million as follows (in thousands):

 
| Cash               |   | $     | 3,000  |   |
|--------------------|--------|-------|--------|--------|
| Promissory note    |   | 3,515 |   |
| Transaction costs  |   | 236   |   |
| Net purchase price |   | $     | 6,751  |   |

 

The acquisitions of Fire Quest, PDI and Com-Tec wereaccounted for as business combinations in accordance with SFAS No. 141.  Under the purchase method of accounting, theassets and liabilities acquired were recorded as of the acquisition date attheir respective fair values.  We haveobtained third party valuations, and the values of certain assets andliabilities are based on these valuations, but they are subject to adjustmentas additional information is obtained. Such additional information includes,but is not limited to changes in transaction costs and working capital. Thefollowing table summarizes the estimated fair value of assets acquired andliabilities assumed at the date of the acquisition.

 
| ** **                | ** ** | **Fire Quest** | ** ** | **PDI** | ** ** | **Com-Tec** | ** ** | **Total** | ** ** |
|---------------------------|------------|---------------------|------------|---------|------------|-------------|------------|-----------|------------|
| Current assets            |       | $                   | 140        |    | $          | 2,210       |       | $         | 4,638      |   | $ | 6,988 |   |
| Property and equipment    |       | 37                  |       | 1,126   |       | 72          |       | 1,235     |       |
| Goodwill                  |       | 729                 |       | 1,421   |       | 2,691       |       | 4,841     |       |
| Customer relationships    |       | 90                  |       | 470     |       | 730         |       | 1,290     |       |
| Customer backlog          |       | 84                  |       | 1,240   |       | 590         |       | 1,914     |       |
| Trade name                |       | —              |       | —  |       | 1,080       |       | 1,080     |       |
| Software                  |       | —              |       | —  |       | 240         |       | 240       |       |
| Non-compete agreements    |       | 70                  |       | 200     |       | 180         |       | 450       |       |
| Total assets acquired     |       | 1,150               |       | 6,667   |       | 10,221      |       | 18,038    |       |
|                      |       |                |       |    |       |        |       |      |       |
| Current liabilities       |       | (6                  | )          | (739    | )          | (2,610      | )          | (3,355    | )          |
| Debt                      |       | —              |       | (1,110  | )          | (860        | )          | (1,970    | )          |
| Total liabilities assumed |       | (6                  | )          | (1,849  | )          | (3,470      | )          | (5,325    | )          |
|                      |       |                |       |    |       |        |       |      |       |
| Net purchase price        |       | $                   | 1,144      |    | $          | 4,818       |       | $         | 6,751      |   | $ | 12,713 |   |

 

We have not identified any material unrecordedpre-acquisition contingencies where the related asset, liability, or impairmentis probable and the amount can be reasonably estimated. Prior to the end of theone-year purchase price allocation period, if information becomes availablethat would indicate it is probable that such events had occurred and the amountscan be reasonably estimated, such items will be included in the final purchaseprice allocation and may adjust goodwill.

 

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** **

**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 4 — ContractReceivables**

 

Contract receivables consist of the following (inthousands):

 
| ** **                                                      | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Completed contracts and contracts in progress                   |       | $                 | 22,840     |                  | $          | 12,126 |   |
| Retainage                                                       |       | 6,662             |       | 2,333                 |       |
| Completed contracts and contracts in progress - related parties |       | 9,139             |       | 8,468                 |       |
| Retainage - related parties                                     |       | 1,705             |       | 2,419                 |       |
| Contract receivables                                            |       | $                 | 40,346     |                  | $          | 25,346 |   |

 

**Note 5 — Costs andEstimated Earnings on Incomplete Contracts and Backlog Information**

 

Costs and estimated earnings on incomplete contractsand backlog information are as follows (in thousands):

 
| ** **                                                                  | ** ** | **Total**         | ** ** | **Corrections**   | ** ** | **Commercial**    | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                  | ** ** | **June 30,** | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                  | ** ** | **2008**          | ** ** | **2008**          | ** ** | **2008**          | ** ** |
| Amended contract amount                                                     |       | $                 | 260,504    |              | $          | 196,689           |       | $ | 59,239 |   |
| Revenue recognized to date                                                  |       | 185,466           |       | 139,338           |       | 46,127            |       |
| Unearned contract amount - backlog                                          |       | $                 | 75,038     |              | $          | 57,351            |       | $ | 13,112 |   |
| Costs incurred to date                                                      |       | $                 | 153,866    |              | $          | 117,354           |       | $ | 36,512 |   |
| Estimated costs to complete                                                 |       | 59,513            |       | 45,210            |       | 10,185            |       |
| Estimated total cost                                                        |       | $                 | 213,379    |              | $          | 162,564           |       | $ | 46,697 |   |
| Billings to date                                                            |       | $                 | 189,612    |              | $          | 143,873           |       | $ | 45,739 |   |
| Costs and estimated earnings in excess of billings on incomplete  contracts |       | $                 | 6,754      |              | $          | 4,233             |       | $ | 2,521 |   |
| Billing in excess of costs and estimated earnings on incomplete  contracts  |       | $                 | 10,273     |              | $          | 8,357             |       | $ | 1,917 |   |

 
| ** **                                                                  | ** ** | **Total**          | ** ** | **Corrections**    | ** ** | **Commercial**     |   |
|-----------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|--------------------|--------|
| ** **                                                                  | ** ** | **March 31,** | ** ** | **March 31,** | ** ** | **March 31,** |   |
| ** **                                                                  | ** ** | **2008**           | ** ** | **2008**           | ** ** | **2008**           |   |
| Amended contract amount                                                     |       | $                  | 231,191    |               | $          | 178,504            |   | $ | 52,687 |   |
| Revenue recognized to date                                                  |       | 153,707            |       | 112,049            |       | 41,658             |   |
| Unearned contract amount - backlog                                          |       | $                  | 77,484     |               | $          | 66,455             |   | $ | 11,029 |   |
| Costs incurred to date                                                      |       | $                  | 127,062    |               | $          | 93,770             |   | $ | 33,292 |   |
| Estimated costs to complete                                                 |       | 61,376             |       | 52,969             |       | 8,407              |   |
| Estimated total cost                                                        |       | $                  | 188,438    |               | $          | 146,739            |   | $ | 41,699 |   |
| Billings to date                                                            |       | $                  | 159,562    |               | $          | 116,869            |   | $ | 42,693 |   |
| Costs and estimated earnings in excess of billings on incomplete  contracts |       | $                  | 5,739      |               | $          | 4,077              |   | $ | 1,662 |   |
| Billing in excess of costs and estimated earnings on incomplete  contracts  |       | $                  | 10,105     |               | $          | 7,801              |   | $ | 2,304 |   |

 
| ** **                                                                 | ** ** | **Total**             | ** ** | **Corrections**       | ** ** | **Commercial**        |   |
|----------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|--------|
| ** **                                                                 | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** |   |
| ** **                                                                 | ** ** | **2007**              | ** ** | **2007**              | ** ** | **2007**              |   |
| Amended contract amount                                                    |       | $                     | 196,030    |                  | $          | 147,996               |   | $ | 48,034 |   |
| Revenue recognized to date                                                 |       | 109,179               |       | 72,978                |       | 36,201                |   |
| Unearned contract amount - backlog                                         |       | $                     | 86,851     |                  | $          | 75,018                |   | $ | 11,833 |   |
| Costs incurred to date                                                     |       | $                     | 89,863     |                  | $          | 60,583                |   | $ | 29,280 |   |
| Estimated costs to complete                                                |       | 70,496                |       | 61,364                |       | 9,132                 |   |
| Estimated total cost                                                       |       | $                     | 160,359    |                  | $          | 121,947               |   | $ | 38,412 |   |
| Billings to date                                                           |       | $                     | 109,658    |                  | $          | 72,372                |   | $ | 37,286 |   |
| Costs and estimated earnings in excess of billings on incomplete contracts |       | $                     | 7,665      |                  | $          | 5,751                 |   | $ | 1,914 |   |
| Billing in excess of costs and estimated earnings on incomplete  contracts |       | $                     | 5,733      |                  | $          | 3,217                 |   | $ | 2,517 |   |

 

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* Backlog associated with PDI is not included in thetable above for Total Company and Corrections Segment as the associatedrevenues are not accounted for under percentage of completion method as definedin SOP 81-1.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 5 — Costs andEstimated Earnings on Incomplete Contracts and Backlog Information**

 

The various subsidiary companies often function assubcontractors to other subsidiary companies. The above schedule was computedon a consolidated basis in 2007. The company reorganized in January 2008to report the business in two segments – Corrections and Commercial (see Note 1and Note 20). Since then the Company has determined that the most validindicator of the next year’s performance will be more closely tied to theCorrections backlog versus the Commercial backlog which is more volatile giventhe shorter nature of completion for the contracts.

 

Intercompany contract amounts and billings have beeneliminated, and costs and estimated earnings in excess of billings and billingsin excess of costs and estimated earnings have been recomputed based on actualcombined costs of the companies.

 

Backlog is the aggregate contract amount less revenuerecognized using percentage-of-completion accounting as described in Note 2 ofthese consolidated financial statements. The Company recognizes as backlog onlythose contracts on which it has received signed contracts, executed letters ofintent to award a contract from its customers or in limited instances, whenwarranted, verbal commitments. The Company also verifies funding is in place onthe contracts prior to inclusion in backlog.

 

**Note 6 — Property and Equipment**

 

Property and equipment consists of the following (inthousands):

 
| ** **                        | ** ** | **Estimated**         | ** ** | ** **        | ** ** | ** **            | ** ** |
|-----------------------------------|------------|-----------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **Useful Lives** | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                        | ** ** | **In Years**     | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Land                              |       | N/A                   |       | $                 | —     |                  | $          | — |   |
| Buildings                         |       | 10  - 40              |       | 3,622             |       | 1,888                 |       |
| Leasehold improvements            |       | 12                    |       | 1,147             |       | 593                   |       |
| Furniture, fixtures and equipment |       | 3  - 10               |       | 3,026             |       | 1,254                 |       |
| Vehicles                          |       | 3  - 7                |       | 2,722             |       | 2,189                 |       |
| Website costs                     |       | 3                     |       | 42                |       | 39                    |       |
|                              |       |                  |       | 10,559            |       | 5,963                 |       |
| Less - accumulated depreciation   |       |                  |       | 1,837             |       | 736                   |       |
| Property and equipment, net       |       |                  |       | $                 | 8,722      |                  | $          | 5,227 |   |

 

Depreciation expense relating to property andequipment was $0.6 million and $1,000 for three months ended June 30, 2008and 2007, respectively, and $1.1 million and $1,000 for six months ended June 30,2008 and 2007, respectively. Depreciation expense was $226,000 and $467,000 forthe Predecessor for the three and six months ended June 30, 2007,respectively.

 

**Note 7 — Intangible Assets and OtherAssets**

 

At June 30, 2008, intangible assets consisted ofthe following (in thousands):

 
| ** **                                   | ** ** | **Gross Carrying** | ** ** | **Accumulated**  | ** ** | **Net Carrying** | ** ** | **Weighted Average**    | ** ** |
|----------------------------------------------|------------|-------------------------|------------|------------------|------------|-----------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **Amount**              | ** ** | **Amortization** | ** ** | **Amount**            | ** ** | **Amortization Period** | ** ** |
| **Amortizable Intangible Assets:** |       |                    |       |             |       |                  |       |                         |       |
| Customer relationships                       |       | $                       | 12,915     |             | $          | 1,195                 |       | $                            | 11,720     |   | 113  months |   |
| Customer backlog                             |       | 6,273                   |       | 3,927            |       | 2,346                 |       | 15  months                   |       |
| Software                                     |       | 540                     |       | 125              |       | 415                   |       | 36  months                   |       |
| Non-compete                                  |       | 450                     |       | 83               |       | 367                   |       | 30  months                   |       |
|                                         |       | $                       | 20,178     |             | $          | 5,330                 |       | $                            | 14,848     |   |   |   |
| **Unamortizable Intangible Assets:**         |       |                    |       |             |       |                  |       |                         |       |
| Trade name                                   |       | $                       | 4,856      |             | $          | —                |       | $                            | 4,856      |   |   |   |

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 7 — Intangible Assets and OtherAssets (continued)**

 

Amortization expense was $1.7 and $3.4 million for thethree and six months ended June 30, 2008, respectively. As of June 30,2008 and December 31, 2007, intangible assets not subject to amortizationincluded trade names of $4.9 million and $3.8 million, respectively. Estimatedamortization expense for the next five years and thereafter is as follows (inthousands):

 
| **Years ending December 31:** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008 (remaining six months)                  |       | $          | 3,029      |   |
| 2009                                         |       | 1,920      |       |
| 2010                                         |       | 1,611      |       |
| 2011                                         |       | 1,382      |       |
| 2012                                         |       | 1,375      |       |
| Thereafter                                   |       | 5,531      |       |
|                                         |       | $          | 14,848     |   |

 

**Note 8 — Long-Term Debt**

 

Notes payable and long-term debt consists of thefollowing (in thousands):

 
| ** **                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **Collateral**                            | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Notes payable:                            |       |              |       |                  |       |
| Vehicles and equipment                    |       | $                 | 168        |                  | $          | 190 |   |
| Unsecured debt - related party            |       | 11,167            |       | 5,952                 |       |
| Unsecured convertible debt - stockholders |       | 1,925             |       | 1,925                 |       |
| Seller notes                              |       | 6,765             |       | —                |       |
| Line of credit and acquisition line       |       | 14,125            |       | 7,979                 |       |
|                                      |       | $                 | 34,150     |                  | $          | 16,046 |   |
| Less - current maturities                 |       | 2,400             |       | 81                    |       |
| Long term debt                            |       | $                 | 31,750     |                  | $          | 15,965 |   |

 

***Vehicles andEquipment***

 

Amounts include notes related to Company vehicles andvarious equipment lines. Vehicle and equipment notes are staggered in regardsto their maturity, each amortizing over 36 — 48 month periods. Interestrates on the individual notes range from fixed rate of 6% up to Prime plus1.0%. The weighted average interest rate for these borrowings was 6.15% and8.2% at June 30, 2008 and December 31, 2007, respectively.

 

***UnsecuredDebt — Related Party***

 

On January 2, 2008 an additional $5.0 million inunsecured debt was funded by the same related party for which $6.0 million wasoutstanding at December 31, 2007. All notes are unsecured and subordinatedto the line of credit facility. The unsecured note agreements containprepayment options with prepayment penalties. Interest accrues at 11.58% perannum and is payable quarterly in arrears, deferred interest at the rate of8.42% per annum, and default interest at 2% per annum. The total debt of $11.0million plus accrued and unpaid interest is due and payable in one singlepayment on January 31, 2010. There are both financial and restrictivecovenants associated with the note agreements. As of June 30, 2008, theCompany was in compliance with all covenants.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 8 — Long-Term Debt(continued)**

 

***UnsecuredConvertible Debt — Stockholders***

 

As part of the ISI merger consideration, the Companyissued unsecured convertible debt to the stockholders in the amount of $1.9million which bears interest at 5% per annum, paid semiannually. The notesmature five years from the date of issuance on July 31, 2012. The notesmay be converted in whole or in part into shares of the Company’s common stockat the election of the note holder at a share price of $10.00 any time after January 1,2008. The debt may be redeemed by the Company at $10.00 per share any timeafter January 1, 2009.

 

In April 2007, Argyle’s officers and directors,an affiliate of Argyle’s Chairman and Co-Chief Executive Officer, and certainof Argyle’s consultants, pursuant to a note and warrant acquisition agreement,loaned Argyle an aggregate of $0.3 million and in exchange received promissorynotes in the aggregate principal amount of $0.3 million and warrants topurchase an aggregate of up to 37,500 shares of Argyle’s common stock. Thewarrants are exercisable at $5.50 per share of common stock and expire on January 24,2011.

 

The warrants also may be exercised on a net-sharebasis by the holders of the warrants. The Company has estimated, based upon aBlack-Scholes model, that the fair value of the warrants on the date of issuewas approximately $2.48 per warrant (a total value of approximately $93,000using an expected life of 2 years, volatility of 2.39%, and a risk-free rate of5%). However, because the Company’s warrants have a limited trading history,the volatility assumption was based on information currently available tomanagement. The promissory notes had an interest at a rate of 4% per year andwere repayable 30 days after the consummation of a business combination. Thenotes and the associated accrued interest were paid in full in August 2007.

 

***Seller Notes***

 

In connection with the acquisition of Fire Quest, theCompany issued a promissory note in the aggregate principal amount of $250,000(the “Fire Quest Promissory Note”). The Fire Quest Promissory Note bearsinterest at the rate of 7.25% per year and will become due and payable on January 1,2009.

 

In connection with the acquisition of PDI, the Companyissued convertible promissory notes (the “PDI Promissory Notes”) in theaggregate principal amount of $3.0 million. The aggregate principal amount ofthe PDI Promissory Notes may be reduced depending on the occurrence of certainevents described in the Asset Purchase Agreement. The payment of the PDIPromissory Notes are guaranteed by and secured by the assets of AUSA and Argyleand bear interest at 6% paid quarterly through December 2009. After December 2009,principal and interest payments of $133,000 are due monthly with final paymentoccurring on December 31, 2012. From June 1, 2009 through November 15,2009, the Company has the option to (i) convert $500,000 of theoutstanding principal into common stock of the Company based on 95% of theclosing price of the Company’s common stock for a 20 day trading periodpreceding notice of the Company’s intent to convert; or (ii) extend the$500,000 principal due in 2010 to January 3, 2011 for an additionalpayment of $15,000 plus accrued interest. The aforementioned options to convertor extend the PDI Promissory Notes have resulted in the creation of compoundembedded derivatives for which the Company has performed valuations as of June 30,2008. The Company will mark to market the derivatives, for which any changes infair value will be recognized in the statement of operations, in all thesubsequent quarters until they are exercised or have expired. The valuation ofthese derivatives held a value of $20,000 as of June 30, 2008 and wasreflected in other long term liabilities.

 

In connection with the acquisition of Com-Tec, theCompany issued a secured subordinated promissory note in the aggregateprincipal amount of $3.5 million (the “Com-Tec Promissory Note”). The Com-TecPromissory Note is guaranteed by and secured by the assets of AUSA and Argyle,bears interest at 7% per year and will become due and payable on April 1,2011.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 8 — Long-Term Debt(continued)**

 

***Line of CreditFacility***

 

At June 30, 2008, the Company had a line ofcredit facility totaling $12.0 million and an acquisition loan facility in theamount of $4.3 million. The line of credit is secured by all tangible andintangible assets of AUSA excluding vehicles. The line calls for all accountsreceivable collections to be deposited directly to a lockbox. The outstandingbalance on the credit facility and the acquisition loan facility at June 30,2008 was $9.9 million, due January 23, 2010, and $4.3 million, due June 30,2011, respectively.  Interest is payable quarterly at prime plus 0.75% forthe credit facility and at prime plus 1.25% for the acquisition loan through December 31,2008.  After December 31, 2008, the interest rate is based on a ratioof total debt to earnings before interest, taxes, depreciation and amortizationranging from prime to prime plus 0.75% for the credit facility and ranging fromprime plus 0.5% to prime plus 1.25% for the acquisition note.  The agreementcontains both financial and restrictive covenants, including a restriction onthe payment of dividends by AUSA. At June 30, 2008, the Company was incompliance with all covenants.

 

The Company has agreed to pay an annual commitment feeof 0.5% per year on the unused borrowing capacity, which was $2.1 million and$1.0 million at June 30, 2008 and December 31, 2007, respectively.

 

Aggregate maturitiesrequired on all debt at June 30, 2008 are as follows (in thousand):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining six months)                 |       | $          | 1,003      |   |
| 2009                                        |       | 2,518      |       |
| 2010                                        |       | 26,694     |       |
| 2011                                        |       | 2,518      |       |
| 2012                                        |       | 850        |       |
| Thereafter                                  |       | 567        |       |
|                                        |       | $          | 34,150     |   |

 

**Note 9 — Capital Leases**

 

ISI sold its owner-occupied real estate to apartnership owned by ISI’s stockholders during 2004 and entered into aleaseback of the properties with the partnership. ISI entered into a secondlease on another property owned by the same partnership in 2006. AUSA enteredinto a third lease on another property owned by the same partnership in June 2008.All three leases are triple net leases. A triple net lease is a lease agreementon a property where the tenant or lessee agrees to pay all real estate taxes,building insurance, and maintenance (the three ‘Nets’) on the property inaddition to any normal fees that are expected under the agreement (rent, etc.).In such a lease, the tenant or lessee is responsible for all costs associatedwith repairs or replacement of the structural building elements of theproperty.

 

The terms of the two aforementioned leases enteredinto prior to 2008 were modified on July 31, 2007 to extend the expirationdate from 2018 to 2019. The modification did not materially affect the carryingvalue of the assets or related liabilities recorded in the accompanyingconsolidated balance sheet. The Company reassessed these leases for properclassification under SFAS No. 13, *Accountingfor Leases*, and determined they remain properly classified ascapital leases.

 

The following is a summary of leased property,included in property and equipment, in the accompanying consolidated financialstatements:

 
| ** **                      | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-------------------|------------|-----------------------|------------|
| **Collateral**                  | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Buildings                       |       | $                 | 3,622      |                  | $          | 1,888 |   |
| Less - accumulated amortization |       | 166               |       | 69                    |       |
| Net                             |       | $                 | 3,456      |                  | $          | 1,819 |   |

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 9 — Capital Leases(continued)**

 

The following is a schedule by years of future minimumlease payments under capital leases together with the present value of netminimum lease payments at June 30, 2008:

 
| **Year Ending December 31:**                      | ** ** | ** ** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|
| 2008 (remaining six months)                                      |       | $          | 247        |   |
| 2009                                                             |       | 493        |       |
| 2010                                                             |       | 493        |       |
| 2011                                                             |       | 493        |       |
| 2012                                                             |       | 493        |       |
| Thereafter                                                       |       | 3,338      |       |
| Future minimum lease payments                                    |       | $          | 5,557      |   |
| Less - amount of minimum lease payments attributable to interest |       | 1,887      |       |
| Present value of net minimum lease payments                      |       | $          | 3,670      |   |
| Current portion of capitalized lease obligations                 |       | 212        |       |
| Long-term portion of capitalized lease obligations               |       | 3,458      |       |
|                                                             |       | $          | 3,670      |   |

 

**Note 10 — Commitments**

 

AUSA leases office space and equipment under operatingleases expiring through 2012. The corporate office lease space of Argyleexpired as of July 31, 2007 and Argyle operated under a month-to-monthlease arrangement until it was renewed in January 2008. The new leaseexpands the space from approximately 2,500 square feet to 5,500 square feet fora total expense in 2008 of $121,000.

 

As part of the PDI acquisition that occurred on January 4,2008 the Company assumed the existing leases. The PDI leases are 4 year leases,for the two facilities that occupy a total of 42,000 square feet (26,000 squarefoot facility in Arizona and the 16,000 square foot facility in California)with aggregate monthly payments of $16,000. As part of the Com-Tec acquisitionthat occurred at January 31, 2008 the Company signed a new lease for theexisting facility. The Com-Tec lease is a 5 year lease, for the 33,000 squarefoot facility, with aggregate monthly payments of $14,000 beginning in year 3with the total rent expense being recognized on a straight line basis over thelife of the lease.

 

Rental expense was $217,000 and $17,000 for the threemonths ended June 30, 2008 and 2007, respectively, and $540,000 and$33,000 for the six months ended June 30, 2008 and 2007, respectively. Rentalexpense was $89,000 and $163,000 for the three and six months ended June 30,2007 (Predecessor), respectively.

 

Minimum rental commitments at June 30, 2008 areas follows (in thousands):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining six months)                 |       | $          | 398        |   |
| 2009                                        |       | 546        |       |
| 2010                                        |       | 649        |       |
| 2011                                        |       | 552        |       |
| 2012                                        |       | 445        |       |
| Thereafter                                  |       | 200        |       |
| Total commitment outstanding                |       | $          | 2,790      |   |

 

In August 2007 the Company entered into a letterof credit facility with a financial institution. The letter of credit may notexceed $500,000. The facility requires a 1% annual commitment fee on the unusedportion of the letter of credit facility and is paid quarterly.

 

In May 2008 the Company entered into a letter ofcredit facility with a financial institution. The letter of credit may notexceed $2.5 million. The facility does not have a fee on the unused portion ofthe letter of credit facility.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 11 — Self Insurance**

 

AUSA and Com-Tec are self-insured to certain limitsunder its group health and dental plans. Stop-loss coverage is provided forclaims above $75,000 per employee up to a maximum $0.9 million for AUSA andabove $30,000 per employee up to a maximum of $2.0 million for Com-Tec.Operations are charged with the cost of claims reported and an estimate ofclaims incurred but not reported based on prior experience. The determinationof such claims and expenses and the appropriateness of the related liabilityare continually reviewed and updated. Total claims payable and claims incurredbut not reported were $0.5 million at June 30, 2008 and $0.3 million at December 31,2007. AUSA has had one individual that has met the stop-loss limit of $75,000for 2008. Com-Tec has not had anyone meet the stop-loss limit for 2008.

 

**Note 12 — Pre-initialPublic Offering Financing and Public Offering**

 

***Public Offering***

 

In January 2006, Argyle sold 3,700,046 units(which included 75,046 units sold by the underwriters pursuant to a partialexercise of their over-allotment option) to the public at a price of $8.00 perunit. Each unit consists of one share of the Company’s common stock, $0.0001par value, and one redeemable common stock purchase warrant (warrant). Eachwarrant entitles the holder to purchase from the Company one share of commonstock at an exercise price of $5.50 and expiring January 24, 2011. Thewarrants are redeemable by the Company at a price of $.01 per warrant upon 30days’ notice, only in the event that the last sale price of the common stock isat least $11.50 per share for any 20 trading days within a 30-trading-dayperiod ending three business days before a notice of redemption is delivered.

 

***Private Placement***

 

In January 2006, Argyle sold to its officers anaggregate of 125,000 units identical to the units sold in the Public Offeringat a price of $8.00 per unit.

 

**Note 13 — Common StockReserved for Issuance**

 

As of June 30, 2008, 4,200,046 shares of commonstock were reserved for issuance upon exercise of redeemable warrants andoptions, 375,000 shares of common stock were reserved for issuance pursuant tothe underwriters’ unit purchase option described in Note 17 and 1,875,000shares of common stock were reserved for issuance pursuant to the preferredstock conversion option described in Note 15. This includes the warrants thatwere issued in connection with the April 2007 notes to stockholdersentitling the holder to exercise the warrants for a total of 37,500 shares ofstock. In 2007, the Company granted certain employees incentive stock options(ISOs) and non-qualified stock options entitling the holder to exercise optionsfor a total of 125,000 shares of stock and 130,000 shares of restricted stock(see Note 17). In 2008 the Company granted certain employees incentive stockoptions (ISOs) and non-qualified stock options entitling the holder to exerciseoptions for a total of 100,000 shares of stock and 85,000 shares of restrictedstock (see Note 17). Lastly, in April 2008 the Company issued warrants fora total of up to 112,500 shares of stock exercisable at $8.00 per share toRodman & Renshaw as partial consideration in connection with the $15.0million Preferred Stock issuance completed in April 2008 (see Note 15).

 

**Note 14 — Redemptive Statusof Common Stock**

 

The registration statement for Argyle’s initial publicoffering indicated that, after signing a definitive agreement for theacquisition of a target business, Argyle would submit such transaction forstockholder approval. Based on the votes submitted, 211,965 shares votedagainst the proposed ISI business combination and sought to be redeemed forcash. As a result, $1.7 million of net proceeds from the initial publicoffering which included interest was redeemed to stockholders in August 2007.The 211,965 shares of common stock were cancelled as of August 2007.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 15 — Preferred Stock**

 

The Company is authorized to issue 1,000,000 shares ofpreferred stock with such designations, voting, and other rights andpreferences, as may be determined from time to time by the Board of Directors. 18,750shares of preferred stock are currently issued and outstanding.

 

 In April 2008,the Company issued 18,750 shares of $0.0001 par value Series A ConvertiblePreferred Stock pursuant to a $15.0 million private placement. Each share ofthe Series A Convertible Preferred Stock accrues dividends at a rategreater of the declared dividend of the Company’s common stock or 3% per annumand are convertible into 100 shares of the Company’s common stock at any timeat the option of the holder at a conversion price of $8.00 per share. Upon liquidation (voluntary or otherwise), dissolution, winding up or a changeof control of the Company (to the extent approved by the Company’s Board ofDirectors), holders of the Series A Preferred Stock will be entitle toreceive, from the assets of the Company available for distribution, the greaterof the original issue price plus accrued but unpaid dividends or the amount theholder would receive if all the Series A Preferred Stock were convertedinto shares of Common Stock.  Series A Convertible Preferred Stockholders have no voting rights.

 

**Note 16 — Agreement withUnderwriters**

 

In March 2007, the underwriters from the PublicOffering agreed to forfeit any and all rights or claims to a pro-rata portionof the deferred underwriting costs and associated accrued interest with respectto any shares of common stock that are redeemed in connection with the proposedacquisition. This fee was charged against additional paid-in capital and waspayable upon a successful business combination. Based on the redemption of211,965 shares, $80,000 related to these waived underwriter fees were paid toredemptive stockholders. Upon closing of the purchase of ISI, Argyle paidapproximately $1.4 million for services performed related to the PublicOffering.

 

**Note 17 — Stockholders’Equity and Stock-Based Compensation**

 

On January 1, 2006, the Company adopted SFAS No. 123(revised 2004), *Share Based Payment*.SFAS No. 123(R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values. Following is a description of thevarious grants made and the impact to the financial statements.

 

***2005 — 2006Options***

 

In July 2005, Argyle granted to its officers,directors, and their respective affiliates certain options, which wereexercisable only in the event the underwriters exercised the over-allotmentoption, to purchase that number of shares enabling them to maintain their 20%ownership interest in the Company (without taking into account the units theypurchased in the private placement). The measurement date was deemed to be January 30,2006, the date the over-allotment was exercised because the number of optionsto be issued was not known until that date.

 

In January 2006, the underwriters exercised aportion of the over-allotment option in the amount of 75,046 units. In February 2006,the officers and directors exercised their options and purchased 18,761 unitsfor an aggregate cost of $507 (or $0.027 per share). The compensation cost,recorded in operating expenses, resulting from these share-based payments was$130,632 at January 30, 2006, using the Black-Scholes pricing model. Thismodel was developed for use in estimating the fair value of traded options thathave no vesting restrictions and are fully transferable. The fair value of theoptions was estimated at the measurement date using the assumptions ofweighted-average volatility factor of 0.10; no expected dividend payments;weighted-average risk-free interest rate of 5%; and a weighted-average expectedlife of 0.13 years.

 

The fair value of each option was $6.99 per share. Alloptions vested immediately at the measurement date and no further options maybe exercised. Compensation expense was recognized immediately and recorded asan operating expense for the year ended December 31, 2006.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 17 — Stockholders’Equity and Stock-Based Compensation (continued)**

 

***Underwriter Options***

 

Argyle sold to its underwriters options to purchase upto an aggregate of 187,500 units for $100. The units issuable upon exercise ofthese options are identical to those sold in the Public Offering. These optionsare exercisable at $8.80 per unit and expire January 24, 2011. The optionsto purchase up to 187,500 units and the Securities underlying such units weredeemed compensation by the National Association of Securities Dealers (“NASD”)and were therefore subject to a 180-day lock-up pursuant to Rule 2710(g) (1) ofthe NASD Conduct Rules.

 

Argyle accounted for these purchase options as a costof raising capital and included the instrument as equity in its consolidatedbalance sheet. Accordingly, there is no net impact on Argyle’s financialposition or results of operations, except for the recording of the $100proceeds from the sale. Argyle has estimated, based upon a Black-Scholes model,that the fair value of the purchase options on the date of sale wasapproximately $3.40 per unit, (a total value of approximately $0.6 million)using an expected life of five years, volatility of 44%, and a risk-free rateof 5%. However, because Argyle’s units did not have a trading history, thevolatility assumption was based on information currently available tomanagement. The volatility estimate was derived using historical data of publiccompanies in the proposed industry. Argyle believes the volatility estimatecalculated from these companies was a reasonable benchmark to use in estimatingthe expected volatility of our units; however, the use of an index to estimatevolatility may not necessarily be representative of the volatility of theunderlying securities.

 

***2007 Incentive Plan***

 

The 2007 Omnibus Securities and Incentive Planprovides for the grant of distribution equivalent rights, incentive stockoptions, nonqualified stock options, performance share awards, performance unitawards, restricted stock awards, stock appreciation rights, tandem stockappreciation rights, and unrestricted stock awards for an aggregate of not morethan 1,000,000 shares of Argyle’s common stock, to directors, officers,employees, and consultants of Argyle or its affiliates. If any award expires,is cancelled, or terminates unexercised or is forfeited, the number of sharessubject thereto, if any, is again available for grant under the 2007 IncentivePlan. The number of shares of common stock, with respect to which stock optionsor stock appreciation rights may be granted to a participant under the 2007Incentive Plan in any calendar year, cannot exceed 150,000.

 

Except as provided in the 2007 Incentive Plan, awardsgranted under the 2007 Incentive Plan are not transferable and may be exercisedonly by the participant or by the participant’s guardian or legalrepresentative. Each award agreement will specify, among other things, theeffect on an award of the disability, death, retirement, authorized leave ofabsence or other termination of employment of the participant. Argyle mayrequire a participant to pay Argyle the amount of any required withholding inconnection with the grant, vesting, exercise, or disposition of an award. Aparticipant is not considered a stockholder with respect to the sharesunderlying an award until the shares are issued to the participant.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 17 — Stockholders’Equity and Stock-Based Compensation (continued)**

 

**Restricted Stock**

 

On January 25, 2008, the Company granted anaggregate of 85,000 shares of the Company’s restricted common stock to certainof its executive officers and directors. Shares granted to the directors vestedimmediately and shares granted to the executive officers vest in three equaltranches on each of December 31, 2008, 2009 and 2010.

 

The following table summarizes the restricted stockactivity under the 2007 Incentive Plan:

 
| ** **                             | ** ** | ** **         | ** ** | ** **            | ** ** | **Average**   | ** ** |
|----------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **         | ** ** | **Weighted**          | ** ** | **Remaining** | ** ** |
| ** **                             | ** ** | ** **         | ** ** | **Average Fair** | ** ** | **Vesting**   | ** ** |
| ** **                             | ** ** | **Number of** | ** ** | **Value**             | ** ** | **Term**      | ** ** |
| **Restricted Stock**              | ** ** | **Shares**         | ** ** | **Per Share**    | ** ** | **(Years)**   | ** ** |
| Nonvested at December 31, 2007    |       | 110,000            |       | $                     | 7.39       |          |       |   |
| Granted                                |       | 85,000             |       | 7.55                  |       |          |       |
| Vested                                 |       | 30,000             |       | 7.55                  |       |          |       |
| Forfeited                              |       | —             |       | —                |       |          |       |
| Nonvested at June 30, 2008        |       | 165,000            |       | $                     | 7.44       |          | 2.50       |   |
| Expected to vest at June 30, 2008 |       | 165,000            |       | $                     | 7.44       |          | 2.50       |   |

 

During the three and six months ended June 30,2008, the Company recognized $159,000 and $664,000, respectively, incompensation expense, net of tax benefit of $54,000 and $226,000, respectively,related to the Company’s issuance of restricted stock. As of June 30, 2008,there was $751,000 of unrecognized compensation costs, net of estimatedforfeitures, related to the Company’s non-vested restricted stock, which isexpected to be recognized over a weighted average period of 2.5 years.

 

**Performance Share Awards**

 

On January 25, 2008, the Company granted anaggregate of 55,000 performance units to certain of its officers, subject toterms and conditions to be set forth in a performance unit agreement and inaccordance with the Company’s 2007 Incentive Plan. These awards vest on December 31,2010 if certain performance goals to be determined by the Board of Directorsare achieved. The Company recognizes compensation expense on the performanceshare awards based on the fair value of the underlying common stock at the endof each quarter over the remaining vesting period. The final plan metrics fordetermination of the award was not approved by the Board of Directors until March 25,2008. As a result, during the three months ended June 30, 2008, theCompany recognized $70,000 of compensation expense related to the performanceshare awards. Additionally, no compensation expense was recognized during theyear ended December 31, 2007.

 

The following table summarizes the performance unitactivity under the 2007 Incentive Plan:

 
| ** **                             | ** ** | ** **         | ** ** | ** **            | ** ** | **Average**   | ** ** |
|----------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------|------------|
| ** **                             | ** ** | ** **         | ** ** | **Weighted**          | ** ** | **Remaining** | ** ** |
| ** **                             | ** ** | ** **         | ** ** | **Average Fair** | ** ** | **Vesting**   | ** ** |
| ** **                             | ** ** | **Number of** | ** ** | **Value**             | ** ** | **Term**      | ** ** |
| **Performance Units**             | ** ** | **Units**          | ** ** | **Per Unit**     | ** ** | **(Years)**   | ** ** |
| Nonvested at December 31, 2007    |       | 115,000            |       | $                     | —     |          |       |   |
| Granted                                |       | 55,000             |       | —                |       |          |       |
| Vested                                 |       | —             |       | —                |       |          |       |
| Forfeited                              |       | —             |       | —                |       |          |       |
| Nonvested at June 30, 2008        |       | 170,000            |       | $                     | —     |          | 2.50       |   |
| Expected to vest at June 30, 2008 |       | 170,000            |       | $                     | —     |          | 2.50       |   |

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 17 — Stockholders’Equity and Stock-Based Compensation (continued)**

 

**Incentive and Nonqualified StockOptions**

 

On January 25, 2008, the Company granted stockoptions to purchase an aggregate of 100,000 shares of the Company’s commonstock to various employees, of which all were ISO. The options have a strikeprice of $7.55 and vest in three equal tranches on each of December 31,2008, 2009 and 2010.

 

The following table summarizes the stock optionactivity under the 2007 Incentive Plan:

 
| ** **                                        | ** ** | ** **         | ** ** | ** **                | ** ** | **Average**   | ** ** | ** **    | ** ** |
|---------------------------------------------------|------------|--------------------|------------|---------------------------|------------|---------------|------------|---------------|------------|
| ** **                                        | ** ** | ** **         | ** ** | **Weighted**              | ** ** | **Remaining** | ** ** | ** **    | ** ** |
| ** **                                        | ** ** | ** **         | ** ** | **Average Exercise** | ** ** | **Vesting**   | ** ** | **Average**   | ** ** |
| ** **                                        | ** ** | **Number of** | ** ** | **Price**                 | ** ** | **Term**      | ** ** | **Intrinsic** | ** ** |
| **Stock Options**                            | ** ** | **Shares**         | ** ** | **Per Share**        | ** ** | **(Years)**   | ** ** | **Value**     | ** ** |
| Outstanding at December 31, 2007             |       | 125,000            |       | $                         | 7.89       |          |       |          |       |   |
| Granted                                           |       | 100,000            |       | 7.55                      |       |          |       |          |       |
| Exercised                                         |       | —             |       | —                    |       |          |       |          |       |
| Forfeited                                         |       | —             |       | —                    |       |          |       |          |       |
| Outstanding at June 30, 2008                 |       | 225,000            |       | $                         | 7.74       |          | 2.50       |          | $          | — |   |
| Vested and expected to vest at June 30, 2008 |       | 225,000            |       | $                         | 7.74       |          | 2.50       |          | $          | — |   |
| Exercisable at June 30, 2008                 |       | —             |       | $                         | —     |          | —     |          | $          | — |   |

 

The Company has estimated, based upon a Black-Scholesmodel, that the fair value of the stock options granted on January 25,2008 was approximately $1.78 per unit, (a total value of approximately$178,000), using an expected life of three years, volatility of 40%, and arisk-free rate of 2.5%. However, because the shares did not have a tradinghistory, the volatility assumption was based on information currently availableto management. The volatility estimate was derived using historical data ofpublic companies in the related industry. The Company believes the volatilityestimate calculated from these companies was a reasonable benchmark to use inestimating the expected volatility of our units; however, the use of an indexto estimate volatility may not necessarily be representative of the volatilityof the underlying securities.

 

During the three and six months ended June 30,2008, the Company recognized $32,000 and $85,000, respectively, in compensationexpense, net of tax benefit of $11,000 and $29,000, respectively, related tothe Company’s stock options. As of June 30, 2008, there was $308,000 ofunrecognized compensation costs, net of estimated forfeitures, related to theCompany’s non-vested stock options, which is expected to be recognized over aweighted average period of 2.5 years.

 

**Note 18 — Income Taxes**

 

The provision for income taxes decreased $486,000 and$930,000 in the three months and six months ended June 30, 2008 comparedto the same period in 2007. The decrease in income taxes was primarily due tothe decrease in income before income taxes of $1,556,000 and $2,785,000. Oureffective tax rate was 33.3% in the six months ended June 30, 2008 and34.4% for the same period in 2007.

 

**Note 19 — Related-PartyTransactions**

 

During the first quarter of 2008, the Company enteredinto a Board-approved agreement with Sec-Tec Global to share certain expensesrelated to common office space in New York City, New York and administrativerelated expenses. These expenses are being borne by the Company to reflectrealistic expenses associated with the Company’s presence to conduct itsbusiness. The Company has agreed to share expenses totaling $175,000 on anannual basis that are to be paid in quarterly payments of $43,750. During thethree and six months ended June 30, 2008, the Company recognized $44,000and $88,000 in expenses related to this agreement. Sec-Tec Global is awholly-owned subsidiary of Electronics Line 3000 to which the Company’s co-CEOsare stock holders and board members.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 19 — Related-PartyTransactions (continued)**

 

At June 30, 2008 and December 31, 2007,other receivables include $34,000 and $42,000, respectively, of receivablesfrom related parties, all of which is attributable to AUSA. Amounts representmonies or other assets advanced to employees. Amounts have been paid on thesereceivables and management believes they are fully collectible.

 

The Company leasesvarious properties from Green Wing Management, Ltd., an entity owned andcontrolled by the Chief Executive Officer and President of AUSA under capitalleases. The leases on these properties include two that were amended as part ofthe acquisition of ISI to reflect a term of 12 years ending in 2019, a newlease executed in June 2008 and all require that an appraisal be completedby a qualified appraiser to determine the market rate of the leases. The rentalrate to be paid on these properties, after the acquisition of ISI, is limitedto no more than 90% of the market rate determined by the third-party appraiser.Additional appraisals by a third-party appraiser are to be conducted everythree years during the 12 year terms and the annual lease rate in the leasescan increase at the time of these appraisals, but only to a level that does notto exceed 90% of the market rate determined by the third-party appraiser.Argyle has the right to purchase these three properties at any time, at thethen current market value; however, the purchase price cannot be less than thevalue determined in the last appraisal preceding the effective date of theacquisition of ISI.****During thethree and six months ended June 30, 2008, the Company made lease paymentsof $89,000 and $161,000, respectively under these leases. See Note 9 for theremaining payments due under these leases.

 

In conjunction with the major refinancing of ISI in2004, the majority stockholders formed a new company in 2004 (ISI*MCS, Ltd.)which was used as the contracting entity on all future bonded contracts. ISItransferred certain existing bonded contracts at their remaining contractvalues, and no gain or loss was recognized on the transfers to ISI*MCS, Ltd. atthe time of its formation. All contracts of ISI*MCS, Ltd. were subcontracted toISI for the full contract amount, less a 2% fee. AUSA recorded contract revenuebased on the ISI*MCS, Ltd.’s contract amount, net of the 2% fee. Contractreceivables from ISI*MCS, Ltd. at June 30, 2008 and December 31, 2007totaled $10.8 million and $10.9 million, respectively, which is disclosed ascontract receivables - related party on the face of the consolidated balancesheet since ISI*MCS, Ltd. is not consolidated in the balance sheet. Contractrevenues reported by the Company from ISI*MCS, Ltd. were $5.3 million and $12.2million for the three and six months ended June 30, 2008. ISI*MCS, Ltd.revenues reported by the predecessor (ISI) were $7.4 million and $13.2 millionfor the three and six months ended June 30, 2007. Argyle has agreed toindemnify the shareholders of ISI*MCS, Ltd. from claims brought by the bondingcompany against their personal guarantees for those contracts that have notbeen paid in full as of the closing of the merger. The merger agreementprovides that these indemnification obligations will survive for a period offour years after the closing date of the merger and the obligations are notsubject to cap, or maximum amount.

 

Subsequent to July 31, 2007, AUSA will receive100% of the remaining contract amounts and ISI*MCS, Ltd. will forego its 2%fee. Remaining amounts to be billed on these contracts as of June 30, 2008totaled $6.6 million. All future contracts, bonded and un-bonded, will becontracted directly by AUSA without involvement by ISI*MCS, Ltd.

 

**Unsecured Debt — RelatedParty**

 

As part of the ISI merger transaction, debt totaling$16.0 million was owed to a shareholder of ISI, of which $10.0 million was paidprior to its original terms. The shareholder became a shareholder of Argyle aspart of the merger and holds 486,237 shares of Argyle common stock as of July 31,2007 and as such, became a related party. At June 30, 2008 and December 31,2007, the remaining debt to the shareholder (see Note 8) totaled $11.2 millionand $6.0 million, respectively.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 20 — SegmentInformation**

 

The Company’s segments are strategic business unitsthat offer different products and services and are managed accordingly. UnderGAAP segment reporting rules, management analyzes the various operatingsegments based on segment income before income taxes. During the first quarterof 2008, the Company changed its segment reporting to better align the Company’srecently acquired companies with its existing business units and its global andstrategic direction.  This change resulted in ISI Detention and MCSDetention combining into the Corrections reportable segment and MCS Commercialinto the Commercial reporting segment.  Segment information for thePredecessor for the three and six months ended June 30, 2007 has beenrestated to conform to current year presentation. The customers and long-livedassets of the reportable segments are in the United States.

 

AUSA is a detention and commercial equipmentcontractor that specializes in turnkey installations, including design,engineering, supply, and installation of various detention equipment forcorrectional facilities and institutions. The work is performed underfixed-price contracts. The projects are located in various cities in the UnitedStates. The length of the contracts varies but is typically less than twoyears. AUSA also provides turnkey installations covering the full spectrum ofelectronic security and low voltage systems, including fire alarm, accesscontrol, closed circuit television, intercom, sound/paging, and other customdesigned systems.

 

Argyle Corrections consists of all of our businessesin the corrections sector including ISI, MCS as well as Com-Tec and PDI. Com-Tecand PDI were acquired in January 2008. This segment includes:

 

·ISI (also referred to historically as “ISI-Detention”) designs, engineers,supplies, installs, and maintains a full array of detention systems andequipment, targeting correctional facilities throughout the United States;

 

·MCS (also referred to historically as “MCS-Detention”) designs, engineers,supplies, installs and maintains complex, customized security, access control,video and electronic security control system solutions at correctional andgovernment facilities;

 

·PDI is a full-service, turnkey solutions provider that manufactures highsecurity metal barriers, high security observation window systems, detentionfurniture and accessories; and

 

·Com-Tec is an industry leader in the custom design and manufacture ofelectronic security and communications systems.

 

Argyle Corrections offers a complete array ofelectronic security system solutions revolving around electronic lockingsystems and hardware, security doors and frames, jail furniture, securityglazing, and other security-based systems and specializes in turnkeyinstallations for public- and privately-owned/operated detention facilities indesigns, assembles, supplies, installs, and maintains access control, video,and integrated electronic control systems for correctional and government facilitiesthroughout the United States. It also provides the above goods and services todetention market integrators, electrical contractors, and competitors of AUSAthat lack their own in-house electronic solutions. Whether acting as primecontractor or as a subcontractor for projects spanning all levels of security,Corrections’ product offerings include security locking systems, securityhollow metal doors and wall panels, security windows, security glass andglazing, security furnishings and accessories, design support, and fullinstallation capabilities.

 

Argyle Commercial Security has built a parallelbusiness to Corrections targeting commercial and industrial facilities. ArgyleCommercial Security group focuses on the commercial security sector and providesturnkey, electronic security systems to the commercial market. Currently, MCSCommercial Fire & Security is the only member of this segment and isreferred to historically as MCS-Commercial. Commercial currently operates outof its own San Antonio headquarters and five regional offices. The offices inAustin, Houston, and Denver resulted from acquisitions made by ISI.

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 20 — SegmentInformation (continued)**

 

**SummarySegment Information**

 
| ** **                          | ** ** | ** **                       | ** ** | **Predecessor (ISI)**       | ** ** | ** **                     | ** ** | **Predecessor (ISI)**     | ** ** |
|-------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
| ** **                          | ** ** | **June 30,**                | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **June 30,**              | ** ** |
| ** **                          | ** ** | **2008**                         | ** ** | **2007**                         | ** ** | **2008**                       | ** ** | **2007**                       | ** ** |
| **Industry Segment (in thousands)** |       |                             |       |                             |       |                           |       |                           |       |
| Revenues:                           |       |                             |       |                             |       |                           |       |                           |       |
| Corrections                         |       | $                                | 28,843     |                             | $          | 11,024                         |       | $                              | 58,881     |   | $ | 20,994 |   |
| Commercial                          |       | 7,663                            |       | 6,762                            |       | 15,222                         |       | 15,645                         |       |
| Corporate                           |       | —                           |       | —                           |       | —                         |       | —                         |       |
| Eliminations                        |       | —                           |       | —                           |       | —                         |       | —                         |       |
| Total                               |       | $                                | 36,506     |                             | $          | 17,786                         |       | $                              | 74,103     |   | $ | 36,639 |   |
| Operating income (loss):            |       |                             |       |                             |       |                           |       |                           |       |
| Corrections                         |       | $                                | 103        |                             | $          | 889                            |       | $                              | 1,713      |   | $ | 1,687 |   |
| Commercial                          |       | 522                              |       | 588                              |       | 387                            |       | 991                            |       |
| Corporate                           |       | (1,304                           | )          | —                           |       | (3,156                         | )          | —                         |       |
| Eliminations                        |       | —                           |       | —                           |       | —                         |       | —                         |       |
| Total                               |       | $                                | (679       | )                                | $          | 1,477                          |       | $                              | (1,056     | ) | $ | 2,678 |   |
| Capital expenditures:               |       |                             |       |                             |       |                           |       |                           |       |
| Corrections                         |       | $                                | 2,356      |                             | $          | 286                            |       | $                              | 3,151      |   | $ | 700 |   |
| Commercial                          |       | 191                              |       | 109                              |       | 312                            |       | 229                            |       |
| Corporate                           |       | 77                               |       | —                           |       | 87                             |       | —                         |       |
| Total                               |       | $                                | 2,624      |                             | $          | 395                            |       | $                              | 3,405      |   | $ | 929 |   |
| Total assets:                       |       |                             |       |                             |       |                           |       |                           |       |
| Corrections                         |       | $                                | 98,377     |                             | $          | 30,092                         |       | $                              | 98,377     |   | $ | 30,092 |   |
| Commercial                          |       | 5,942                            |       | 5,118                            |       | 5,942                          |       | 5,118                          |       |
| Corporate                           |       | 49,404                           |       | —                           |       | 49,404                         |       | —                         |       |
| Eliminations                        |       | (34,206                          | )          | —                           |       | (34,206                        | )          | —                         |       |
| Total                               |       | $                                | 119,517    |                             | $          | 35,210                         |       | $                              | 119,517    |   | $ | 35,210 |   |

 

**Note 21 — SupplementalDisclosures of Cash Flow Information**

 
| ** **                                                    | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                                                    | ** ** | **March 31,**             | ** ** | **March 31,**             | ** ** | **March 31,** | ** ** |
| ** **                                                    | ** ** | **2008**                       | ** ** | **2007**                       | ** ** | **2007** | ** ** |
| Cash paid for interest                                        |       | $                              | 1,335      |                           | $          | — |   | $ | 1,334 |   |
| Cash paid for income taxes                                    |       | 520                            |       | —                         |       | — |   |
| **Supplemental schedule of non-cash investing  activities:**  |       |                           |       |                           |       |   |   |
| Accrual for transaction costs                                 |       | 426                            |       | —                         |       | — |   |
| Issuance of warrants associated with notes to related parties |       | —                         |       | 93                             |       | — |   |
| **Supplemental schedule of non-cash financing  activities:**  |       |                           |       |                           |       |   |   |
| Notes issued for acquisitions                                 |       | $                              | 6,765      |                           | $          | — |   | $ | — |   |
| Dividends accrued                                             |       | 86                             |       |                           |       |   |   |
| Accrual of offering costs                                     |       | 302                            |       | 93                             |       | — |   |
| Accrual of deferred interest                                  |       | 215                            |       | —                         |       | 1,344 |   |
| Execution of capital leases                                   |       | 1,734                          |       | —                         |       | — |   |

 

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**ARGYLESECURITY, INC.**

**NOTES TOUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**JUNE 30,2008**

 

**Note 22— Subsequent Events**

 

On July 8, 2008, the AUSA Commercial segmentexecuted an operating lease for a 9,255 square foot facility located in Denver,Colorado. The lease is expected to commence on August 22, 2008 and theterm expires on September 30, 2013. The total amount of payments for thelease period is equal to $364,953 or approximately $7.89 per square foot.

 

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS**

 

**ForwardLooking Statements**

 

This Quarterly Report on Form 10-Qincludes forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. We have based these forward-lookingstatements on our current expectations and projections about future events.These forward-looking statements are subject to known and unknown risks,uncertainties and assumptions about us that may cause our actual results,levels of activity, performance or achievements to be materially different fromany future results, levels of activity, performance or achievements expressedor implied by such forward-looking statements. In some cases, you can identifyforward-looking statements by terminology such as “may,” “should,” “could,” “would,”“expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or thenegative of such terms or other similar expressions. Factors that might causeor contribute to such a discrepancy include, but are not limited to, thosedescribed in our other Securities and Exchange Commission filings. Thefollowing discussion should be read in conjunction with our unaudited FinancialStatements and related Notes thereto included elsewhere in this report.

 

**Overview**

 

Argyle Security, Inc. (“Argyle”)is a Delaware corporation that was incorporated on June 22, 2005 in orderto serve as a vehicle for the acquisition of an operating business through amerger, capital stock exchange, asset acquisition or other similar businesscombination.  Argyle completed itsinitial public offering in January 2006. As provided in its certificate of incorporation, Argyle was required, byJuly 30, 2007, to consummate a business combination or enter a letter ofintent, agreement in principle or definitive agreement relating to a businesscombination, in which case Argyle would be allowed an additional six months tocomplete the transactions contemplated by such agreement.

 

On July 31, 2007,pursuant to the terms of a merger agreement, dated December 8, 2006, asamended on June 29, 2007 and July 11, 2007 (the “Merger Agreement”),Argyle acquired all of the assets and liabilities of ISI-Detention ContractingGroup, Inc. (“ISI”), currently referred to as Argyle Security USA (“AUSA”).  As a result of the merger, ISI now referredto as AUSA became a wholly owned subsidiary of Argyle. AUSA is a provider ofphysical security solutions to commercial, governmental and correctionalcustomers.

 

In February 2008, wereorganized our business under the name of Argyle Security USA, or AUSA,through which we provide physical security solutions to commercial,governmental, and correctional customers. Argyle Security USA has two reporting segments, Argyle Corrections andArgyle Commercial Security.

 

“Argyle Corrections”consists of all of our businesses in the corrections sector including ISI,Metroplex Control Systems (“MCS”) as well as Com-Tec Security LLC (“Com-Tec”)and Peterson Detention, Inc. (“PDI”). Com-Tec and PDI were acquired in January 2008.  This segment includes:

 

· ISI (also referred to historically as “ISI-Detention”)designs, engineers, supplies, installs, and maintains a full array of detentionsystems and equipment, targeting correctional facilities throughout the UnitedStates;

 

· MCS (also referred to historically as “MCS-Detention”)designs, engineers, supplies, installs and maintains complex, customizedsecurity, access control, video and electronic security control systemsolutions at correctional and government facilities;

 

· PDI is a full-service, turnkey solutionsprovider that manufactures high security metal barriers, high securityobservation window systems, detention furniture and accessories; and

 

· Com-Tec is an industry leader in the customdesign and manufacture of electronic security and communications systems.

 

“Argyle Commercial Security”focuses on the commercial security sector and provides turnkey, electronicsecurity systems to the commercial market. Currently, MCS Commercial Fire &Security is the only member of this group and is referred to historically asMCS-Commercial.

 

On January 1, 2008,MCFSA, Ltd. (“MCFSA”), all of the partnership interests of which are directlyor indirectly wholly owned by AUSA, acquired substantially all of the businessassets and liabilities of Fire Quest Inc. (“Fire Quest”). Fire Quest is engagedin the business of alarm system sales and service.

 

On January 4, 2008,AUSA acquired substantially all of the business assets and liabilities ofPDI.  PDI is a full-service, turnkeysolutions provider that manufactures high security metal barriers, high securityobservation window systems, detention furniture and accessories.

 

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On January 31, 2008,ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of AUSA, whichin turn is a wholly owned subsidiary of the Company, closed a transaction,pursuant to which ISI-Controls acquired 100% of the outstanding units ofCom-Tec, resulting in Com-Tec becoming a wholly owned subsidiary ofISI-Controls. Com-Tec is engaged in the business of custom design, manufactureand installation of electronic security and communication systems.

 

**CriticalAccounting Policies**

 

Our discussion and analysisof our financial condition and results of operations is based on theaccompanying consolidated financial statements, which have been prepared inaccordance with U.S. generally accepted accounting principles. As such, we arerequired to make estimates and assumptions that affect the reported amounts ofassets and liabilities and disclosure of contingent assets and liabilities atthe date of the consolidated financial statements and the reported amounts ofrevenues and expenses during the reporting period. By their nature, theseestimates and judgments are subject to an inherent degree of uncertainty. Ourmanagement reviews its estimates on an on-going basis, including those relatedto revenue recognition based on the percentage-of-completion methodology, salesallowances, recognition of service sales revenues and the allowance fordoubtful accounts. We base our estimates and assumptions on historicalexperience, knowledge of current conditions and our understanding of what webelieve to be reasonable that might occur in the future considering availableinformation. Actual results may differ from these estimates, and materialeffects on our operating results and financial position may result.

 

*Percentage-of-CompletionEstimates* - AUSA usespercentage-of-completion accounting to determine revenue and gross marginearned on projects. Estimating the percentage completion on a project is amajor critical estimate that AUSA depends on. This estimate is determined asfollows:

 
| · |   | The contract amount and  all contract estimates are input into a job cost accounting system with  detail of all significant estimates of purchases by vendor type,  subcontractor, and labor.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| · |   | As the project is  performed and purchases and costs are incurred, these are recorded in the  same detail as the original estimate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| · |   | The contract amount and  estimated contract costs are updated monthly to record the effect of any  contract change order received.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| · |   | On a monthly basis,  management, along with project managers who are overseeing the contracts,  review these estimated costs to complete the project and compare them to the  original estimate and the estimate that was used in the prior month to  determine the percentage-of-completion. If the cost to complete, determined  by management and the project managers for the current month, confirms that  the estimate used in the prior month is correct, then no action is taken to  change the estimate and/or the percentage complete in that current month.  However, if the current cost to complete estimate calculated by the  management and the project managers differs, then adjustments are made. If  the costs are in excess of the estimate used in the prior month, then a  decrease in the percentage complete on the project through the current month  in the accounting period is made. If the costs are less than the estimate  used in the prior accounting period, then the new estimate increases the  percentage complete on the project. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| · |   | Revenues from construction  contracts are recognized on the percentage-of-completion method in accordance  with SOP 81-1. AUSA recognizes revenues on signed contracts and change  orders. AUSA generally recognizes revenues on unsigned change orders where it  has written notices to proceed from the customer and where collection is  deemed probable. Percentage-of-completion for construction contracts is  measured principally by the percentage of costs incurred and accrued to date  for each contract to the estimated total costs for each contract at  completion. AUSA generally considers contracts to be substantially complete  upon departure from the work site and acceptance by the customer. If any jobs  are identified during the review process which are estimated to be a loss job  (where estimated costs exceed contract price), the entire estimated loss is  recorded in full, without regard to the computed percentage of completion.                                                                                               |

 

These estimates ofpercentage completion of a project determine the amounts of revenues and grossmargin that are earned to date on a project. For example, if a contract is$100,000 with a 20% gross margin of $20,000, then a project that is estimatedto be 50% complete accrues $50,000 in revenues and $10,000 in gross margin. Ifthe percentage completed is adjusted to 25%, then the revenues on the contactwould be $25,000, and the earned gross margin would be $5,000. These estimateswould be changed in the current month, and the actual accrual of the revenueand gross margin earned on this project would be reduced in the current month.

 

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Another effect of the changein the estimated costs and percentage complete is that it changes thepercentage of gross margin earned. For example, in the project mentioned above,if the estimated costs changed to 90% from 80% because of projected costoverruns, this would then reduce the gross margin percentage to 10% from 20%.Management attempts to recognize losses (overruns of cost estimates) as soon asthey can be quantified. Management attempts to recognize gains (under-runs ofcost estimates) when they can be quantified and are certain.

 

Costs incurred prior toaward of contracts are expensed as incurred. The balances billed but not paidby customers pursuant to retainage provisions in construction contracts will bedue upon completion of the contracts and acceptance by the customer. Based onthe Company’s experience with similar contracts in recent years, the retentionbalance at each balance sheet date will be collected within the subsequentfiscal year.

 

The current asset “Costs andestimated earnings in excess of billings on incomplete contracts” representsrevenues recognized in excess of amounts billed which management believes willbe billed and collected within the subsequent year. The current liability “Billingsin excess of costs and estimated earnings on incomplete contracts” representsbillings in excess of revenues recognized.

 

*ServiceSales -** ***Service revenues are recognized when theservices have been delivered to and accepted by the customer. These aregenerally short-term projects which are evidenced by signed service agreementsor customer work orders or purchase orders. These salesagreements/customer orders generally provide for billing to customers based ontime at quoted hourly or project rates, plus costs of materials and suppliesfurnished by the Company.

 

*IBNREstimates for Health Insurance* - On an annual basis, Argyle estimates its health insurance cost, forits self-insured employee base at the acquired companies AUSA and Com-Tec,based upon expected health insurance claims for the current year. The insurancecompany which provides both the stop loss and total aggregate insurancecoverages also provides the average or expected and maximum claims for eachclass. The average and maximum claims are based on our demographics and priorclaim history. Argyle uses the average claims history for the trailing thetwelve months as its basis for accruing health care cost. This accrual isautomated and is part of the payroll function for each pay period.

 

*Deferredincome taxes* -Deferred income taxes are provided for temporary differences between thecarrying amount of assets and liabilities for financial reporting purposes andthe amounts for tax purposes. Valuation allowances are provided against thedeferred tax asset amounts when the realization is uncertain.

 

*Allowancefor Doubtful Accounts*- Argyle provides an allowance for bad debt through an analysis in which thebad debts that had been written off over previous periods are compared on apercentage basis to the aggregate sales for the same periods. The resultingpercentage is applied to the sales for year to date and a monthly reserve isaccrued accordingly. Additionally, management analyzes specific customeraccounts receivable for any potentially uncollectible accounts and will addsuch accounts to the reserve or write them off if warranted, after consideringlien and bond rights, and then considers the adequacy of the remainingunallocated reserve compared to the remaining accounts receivable balance (netof specific doubtful accounts).

 

*Non CashCompensation Expense*- On January 1, 2006, Argyle adopted SFAS No. 123 (revised 2004), *Share Based Payment*. SFAS No. 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues.

 

Purchase options (ISO / non-qualified)grants:

 

On a quarterly basis, Argylecomputes the value of newly issued purchase options (ISO and non-qualified) byutilizing the Black-Scholes valuation model based upon their expected lifevesting period, industry comparables for volatility and the risk-free rate onUS Government securities with matching maturities. The value of the purchaseoptions are then straight-line expensed over the life of the purchase options.

 

Restricted and performancestock grants:

 

On a quarterly basis, Argylecomputes the value of newly issued stock grants based on the share price as ofthe award date. The values of the common shares are then straight-line expensedover the life of the corresponding vesting period.

 

The Company recognizescompensation expense on the performance share awards based on the fair value ofthe underlying common stock at the end of each quarter over the remainingvesting period.

 

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**Pro Formaand Adjusted Pro Forma Financial Information; Non-GAAP Presentation**

 

Because we acquired ISI in July 2007and Fire Quest, PDI and Com-Tec in January 2008, we do not believe acomparison of the results of operations and cash flows for the three and sixmonths ended June 30, 2008 versus June 30, 2007 is beneficial to ourstockholders. In order to assist investors in better understanding the changesin our business between the three and six months ended June 30, 2007 and June 30,2008, we are presenting in management’s discussion and analysis section belowin the pro forma and adjusted pro forma results of operations for the Companyand the acquisitions for the three and six months ended June 30, 2008 and June 30,2007 as if the acquisitions occurred on January 1, 2008 and January 1,2007, respectively. We derived the pro forma results and adjusted pro formaresults of operations from (i) the unaudited consolidated financialstatements of ISI for the three and six months ended June 30, 2007, (ii) theunaudited consolidated financial statements of Com-Tec for the one month ended January 31,2008 and the three and six months ended June 30, 2007, (iii) theunaudited financial statements of PDI for the three and six months ended June 30,2007, (iv) the unaudited financial statements of Fire Quest for the threeand six months ended June 30, 2007 and (v) the unaudited consolidatedfinancial statements of the Company for the three and six months ended June 30,2008 and 2007. We are presenting the pro forma and the adjusted pro formainformation in order to provide, what we believe to be, a more meaningfulcomparison of our operating results with prior periods.

 

Adjusted pro forma netincome is an alternative view of performance used by management and we believethat investors’ understanding of our performance is enhanced by disclosing thisperformance measure. We report adjusted pro forma net income in order topresent the results of our major operations - the construction, installation,marketing, and sale of various electronic security systems for commercialaccounts and detention hardware (including security doors and frames, jailfurniture, security glazing, and other security-based systems) and electroniccontrol systems for correctional facilities - prior to considering certainincome statement elements, principally amortization of intangible assets. **We have defined adjusted pro forma net income as netincome before the impact of purchase accounting for acquisitions, acquisition-relatedcosts, discontinued operations and certain significant items including one timeexpenses associated with stock appreciation rights. The adjusted pro forma netincome measure is not, and should not be viewed as, a substitute for U.S. GAAPnet income.**

 

The adjusted pro forma netincome measure is an important internal measurement for us. We measure theperformance of the overall Company on this basis. The following are examples ofhow the adjusted pro forma net income measure is being utilized:

 
| · |   | Senior management receives  a monthly analysis of our operating results that is prepared on an adjusted  pro forma net income basis;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| · |   | Our annual budgets are  prepared on an adjusted pro forma net income basis; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| · |   | Annual and long-term  compensation, including annual cash bonuses, merit-based salary adjustment,  and share-based payments for various levels of management will consider  financial measures that include adjusted pro forma net income and the  associated earnings per share. The adjusted pro forma net income measure will  represent a significant portion of target objectives that are utilized to  determine the annual compensation for various levels of management, although  the actual weighting of the objective may vary by level of management and job  responsibility and may be considered in the determination of certain  long-term compensation plans. |

 

**Despite theimportance of this measure to management in goal setting and performancemeasurement, we stress that adjusted pro forma net income is a non-GAAPfinancial measure that has no standardized meaning under US-GAAP and therefore,has limits in its usefulness to investors. Because of its non-standardizeddefinition, adjusted pro forma net income (unlike U.S. GAAP net income) may notbe comparable with the calculation of similar measures for other companies.Adjusted pro forma net income is presented solely to permit investors to morefully understand how management assesses our performance.**

 

**We alsorecognize that, as an internal measure of performance, the adjusted pro formanet income and the associated earnings per share measure has limitations and wedo not restrict our performance-management process solely to this metric. Alimitation of the adjusted pro forma net income measure is that it provides aview of our operations without including all events during a period such as theeffects of an acquisition or amortization of purchased intangibles and does notprovide a comparable view of our performance to other companies in the securitydetention and construction industry.**

 

**Inaddition, annual and long-term compensation, including annual cash bonuses,merit-based salary adjustments and share-based payments for various levels ofmanagement that will be made in future years will likely include a non-discretionaryformula that measures our performance using revenue growth and relative totalshareholder return.**

 

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EBITDA is used by managementas a performance measure for benchmarking against the Company’s peers andcompetitors. The Company believes EBITDA is useful to investors because it isfrequently used by securities analysts, investors and other interested partiesto evaluate companies in the security industry. Additionally, we use EBITDA forinternal performance measurements. EBITDA is not a recognized term under GAAP.Argyle and AUSA compute EBITDA using the same consistent method fromquarter to quarter. EBITDA includes net income before interest, taxes,depreciation, and amortization. The presentation of EBITDA is not intended tobe considered in isolation or as a substitute for the financial informationprepared and presented in accordance with GAAP.

 

**Theadjusted pro forma results of operations are not necessarily indicative of theresults of operations that may have actually occurred had the merger takenplace on the dates noted, or the future financial position or operating resultsof us or AUSA. The pro forma adjustments are based upon available informationand assumptions that we believe are reasonable. The presentation of EBITDA(earnings before interest, taxes, depreciation and amortization) and adjustedpro forms results is not intended to be considered in isolation or as asubstitute for the financial information prepared and presented in accordancewith GAAP.**

 

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Below is a table showingArgyle’s Adjusted Pro Forma Consolidated Statements of Operations.  The Pro Forma Consolidated Statements ofOperations are included in the notes to the financial statements includedelsewhere in this report.

 

**Argyle Security, Inc**

**Adjusted Pro Forma Consolidated Statements of Operations**

**(unaudited)**

 

(inthousands except share data)

 
| ** **                                                                                                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                           | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                                                                           | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                                                                            |       |                             |       |                           |       |   |   |   |   |
| Contract revenues                                                                                                                    |       | $                                | 24,711     |                           | $          | 10,730 |   | $ | 51,617 |   | $ | 22,536 |   |
| Contract revenues - related party                                                                                                    |       | 5,282                            |       | 7,365                          |       | 12,225 |   | 13,166 |   |
| Service and other revenues                                                                                                           |       | 6,513                            |       | 3,836                          |       | 11,979 |   | 9,402 |   |
| Total revenues                                                                                                                       |       | 36,506                           |       | 21,931                         |       | 75,821 |   | 45,104 |   |
| Cost of revenues:                                                                                                                    |       |                             |       |                           |       |   |   |   |   |
| Contract costs                                                                                                                       |       | 24,424                           |       | 13,465                         |       | 51,464 |   | 27,278 |   |
| Service and other costs, excluding  amortization of intangibles                                                                      |       | 4,742                            |       | 2,611                          |       | 9,012 |   | 6,942 |   |
| Total cost of revenues                                                                                                               |       | 29,166                           |       | 16,076                         |       | 60,476 |   | 34,220 |   |
| Gross profit                                                                                                                         |       | 7,340                            |       | 5,855                          |       | 15,345 |   | 10,884 |   |
| Operating expenses:                                                                                                                  |       |                             |       |                           |       |   |   |   |   |
| Salaries and related expense, including  stock-based compensation of $191 and $749 for the three and six months 2008,  respectively. |       | 3,410                            |       | 2,294                          |       | 6,987 |   | 4,783 |   |
| Consulting fees and outside services                                                                                                 |       | 637                              |       | 311                            |       | 1,586 |   | 606 |   |
| Depreciation                                                                                                                         |       | 598                              |       | 289                            |       | 1,060 |   | 591 |   |
| Other general and administrative expenses                                                                                            |       | 1,671                            |       | 1,581                          |       | 3,340 |   | 2,746 |   |
| Amortization of intangible assets                                                                                                    |       | —                           |       | —                         |       | — |   | — |   |
| Total operating expenses                                                                                                             |       | 6,316                            |       | 4,475                          |       | 12,973 |   | 8,726 |   |
| Operating loss                                                                                                                       |       | 1,024                            |       | 1,380                          |       | 2,372 |   | 2,158 |   |
| Other income (expense):                                                                                                              |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                                                                                      |       | 52                               |       | 51                             |       | 78 |   | 111 |   |
| Interest expense                                                                                                                     |       | (854                             | )          | (916                           | )          | (1,698 | ) | (1,757 | ) |
| Total other income (expense)                                                                                                         |       | (802                             | )          | (865                           | )          | (1,620 | ) | (1,646 | ) |
| Income (loss) before provision for income  taxes                                                                                     |       | 222                              |       | 515                            |       | 752 |   | 512 |   |
| Provision (benefit) for income taxes                                                                                                 |       | 186                              |       | 393                            |       | 393 |   | 326 |   |
| Net income (loss)                                                                                                                    |       | $                                | 36         |                           | $          | 122 |   | $ | 359 |   | $ | 186 |   |
| Deferred interest, net of taxes, subject to  possible redemption                                                                     |       | —                           |       | —                         |       | — |   | — |   |
| Dividends on convertible preferred  stockholders                                                                                     |       | 86                               |       | —                         |       | 86 |   | — |   |
| Net income (loss) allocable to holders of  non-redeemable common stock                                                               |       | $                                | (50        | )                              | $          | 122 |   | $ | 273 |   | $ | 186 |   |
|                                                                                                                                 |       |                             |       |                           |       |   |   |   |   |
| EBITDA Calculation:                                                                                                                  |       |                             |       |                           |       |   |   |   |   |
| Interest, net                                                                                                                        |       | 802                              |       | 865                            |       | 1,620 |   | 1,646 |   |
| Depreciation                                                                                                                         |       | 626                              |       | 334                            |       | 1,116 |   | 680 |   |
| Taxes, net                                                                                                                           |       | 186                              |       | 393                            |       | 393 |   | 326 |   |
| EBITDA                                                                                                                               |       | $                                | 1,650      |                           | $          | 1,714 |   | $ | 3,488 |   | $ | 2,838 |   |
|                                                                                                                                 |       |                             |       |                           |       |   |   |   |   |
| Weighted-average number of shares of common  stock outstanding exclusive of shares subject to possible redemption:                   |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                                                                |       | 5,799,342                        |       | 5,799,342                      |       | 5,795,221 |   | 5,799,342 |   |
| Diluted                                                                                                                              |       | 5,799,342                        |       | 7,061,764                      |       | 6,641,411 |   | 7,021,839 |   |
| Net income (loss) per share allocable to  holders of non-redeemable common stock:                                                    |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                                                                |       | $                                | (0.01      | )                              | $          | 0.02 |   | $ | 0.04 |   | $ | 0.03 |   |
| Diluted                                                                                                                              |       | $                                | (0.01      | )                              | $          | 0.02 |   | $ | 0.04 |   | $ | 0.03 |   |

 

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Below is a reconciliation ofGAAP net income (loss) to pro forma net income (loss), adjusted pro forma netincome (loss) and to pro forma EBITDA. **Thepresentation of EBITDA is not intended to be considered in isolation or as asubstitute for the financial information prepared and presented in accordancewith GAAP.**

 

**Reconciliation of GAAP Net Income to Pro Forma Net Income,**

**Adjusted Pro Forma Net Income and Pro Forma EBITDA**

**(unaudited)**

 

(inthousands)

 
| ** **                                                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                             | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                                             | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| **GAAP net income (loss)**                                                             | ** ** | **$**                            | **(1,020** | **)**                          | **$**      | **50** | ** ** | **$** | **(1,754** | **)** | **$** | **101** | ** ** |
| Pro forma adjustments - addbacks  (reductions)                                         |       |                             |       |                           |       |   |   |   |   |
| Argyle salary expense (increase) for  management team in 2007                          |       | —                           |       | (222                           | )          | — |   | (444 | ) |
| Non-cash compensation expense (increase)  for 2007                                     |       | —                           |       | (141                           | )          | — |   | (283 | ) |
| Depreciation expense (increase) on revalued  assets in 2007                            |       | —                           |       | (80                            | )          | — |   | (158 | ) |
| Amortization of intangible expense  (increase) in cost of goods sold for 2008 and 2007 |       | —                           |       | (1,274                         | )          | (37 | ) | (2,564 | ) |
| Amortization of intangible expense  (increase) in operating expenses for 2008 and 2007 |       | —                           |       | (426                           | )          | (21 | ) | (868 | ) |
| Reduction in rent expense                                                              |       | —                           |       | 53                             |       | 6 |   | 70 |   |
| Interest income increase / (reduction) for  2008 and 2007                              |       | —                           |       | (330                           | )          | — |   | (654 | ) |
| Interest expense (increase) / reduction for  2008 and 2007                             |       | —                           |       | 1,151                          |       | (39 | ) | 1,398 |   |
| Income / (loss) from predecessor - Argyle  Security USA for 2007                       |       | —                           |       | (619                           | )          | — |   | (496 | ) |
| Income / (loss) from predecessor -  Firequest for 2007                                 |       | —                           |       | 80                             |       | — |   | 160 |   |
| Income / (loss) from predecessor - PDI for  2007                                       |       | —                           |       | 157                            |       | — |   | 313 |   |
| Income / (loss) from predecessor - Com-Tec  for January 2008 and 2007             |       | —                           |       | 190                            |       | 44 |   | 152 |   |
| Provision (benefit) for income taxes on pro  forma adjustments for 2008 and 2007       |       | —                           |       | 480                            |       | 32 |   | 1,331 |   |
| **Pro forma net income (loss)**                                                        | ** ** | **$**                            | **(1,020** | **)**                          | **$**      | **(931** | **)** | **$** | **(1,769** | **)** | **$** | **(1,942** | **)** |
| Amortization of intangible expense in cost  of goods sold for 2008 and 2007            |       | 1,276                            |       | 1,274                          |       | 2,565 |   | 2,564 |   |
| Amortization of intangible expense in  operating expenses for 2008 and 2007            |       | 427                              |       | 426                            |       | 868 |   | 868 |   |
| Provision (benefit) for income taxes on pro  forma adjustments for 2008 and 2007       |       | (647                             | )          | (647                           | )          | (1,305 | ) | (1,304 | ) |
| **Adjusted pro forma net income (loss)**                                               | ** ** | **$**                            | **36**     | ** **                     | **$**      | **122** | ** ** | **$** | **359** | ** ** | **$** | **186** | ** ** |
| Interest, net                                                                          |       | 802                              |       | 865                            |       | 1,620 |   | 1,646 |   |
| Depreciation expense                                                                   |       | 626                              |       | 334                            |       | 1,116 |   | 680 |   |
| Taxes, net                                                                             |       | 186                              |       | 393                            |       | 393 |   | 326 |   |
| **Pro forma EBITDA**                                                                   | ** ** | **$**                            | **1,650**  | ** **                     | **$**      | **1,714** | ** ** | **$** | **3,488** | ** ** | **$** | **2,838** | ** ** |

 

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Below is a table of adjustedpro forma revenues, cost of sales, and gross margins for the three months endedJune 30, 2008 and 2007.

 

**Adjusted Pro Forma Segment P&L**

**(unaudited)**

 

(inthousands)

 
| ** **                                             | ** ** | **Three Months June 30, 2008** | ** ** | **Three Months June 30, 2007** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **Corrections**                                    | ** ** | **Commercial**                                     | ** ** | **Total**                                 | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
| Net revenues                                           |       |                                               |       |                                               |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | $                                                  | 24,510     |                                               | $          | 5,483                                     |       | $ | 29,993 |   | $ | 12,976 |   | $ | 5,119 |   | $ | 18,095 |   | 88.9 | % | 7.1 | % | 65.8 | % |
| Service and other  revenues                            |       | 4,332                                              |       | 2,181                                              |       | 6,513                                     |       | 1,915 |   | 1,921 |   | 3,836 |   | 126.2 | % | 13.5 | % | 69.8 | % |
| Total net  revenues                                    |       | $                                                  | 28,842     |                                               | $          | 7,664                                     |       | $ | 36,506 |   | $ | 14,891 |   | $ | 7,040 |   | $ | 21,931 |   | 93.7 | % | 8.9 | % | 66.5 | % |
| *% of  total*                                          | * *   | *79.0*                                             | *%*        | *21.0*                                             | *%*        | * *                                  | * *   | *68* | *%* | *32* | % |   |   |   |   |   |   |   |   |
| Cost of revenues                                       |       |                                               |       |                                               |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract costs /  contract costs - related party       |       | $                                                  | 20,232     |                                               | $          | 4,192                                     |       | $ | 24,424 |   | $ | 9,457 |   | $ | 4,008 |   | $ | 13,465 |   | 113.9 | % | 4.6 | % | 81.4 | % |
| Service and other  costs                               |       | 3,336                                              |       | 1,406                                              |       | 4,742                                     |       | 1,349 |   | 1,262 |   | 2,611 |   | 147.3 | % | 11.4 | % | 81.6 | % |
| Total cost of  revenues                                |       | $                                                  | 23,568     |                                               | $          | 5,598                                     |       | $ | 29,166 |   | $ | 10,806 |   | $ | 5,270 |   | $ | 16,076 |   | 118.1 | % | 6.2 | % | 81.4 | % |
| Gross margin                                           |       |                                               |       |                                               |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract margins  / contract margins - related party   |       | $                                                  | 4,278      |                                               | $          | 1,291                                     |       | $ | 5,569 |   | $ | 3,519 |   | $ | 1,111 |   | $ | 4,630 |   | 21.6 | % | 16.2 | % | 20.3 | % |
| Service and other  margins                             |       | 996                                                |       | 775                                                |       | 1,771                                     |       | 566 |   | 659 |   | 1,225 |   | -76.0 | % | 17.6 | % | 44.6 | % |
| Total gross  margin                                    |       | $                                                  | 5,274      |                                               | $          | 2,066                                     |       | $ | 7,340 |   | $ | 4,085 |   | $ | 1,770 |   | $ | 5,855 |   | 29.1 | % | 16.7 | % | 25.4 | % |
| Gross margin  percentage                               |       |                                               |       |                                               |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | 17.5                                               | %          | 23.5                                               | %          | 18.6                                      | %          | 27.1 | % | 21.7 | % | 25.6 | % | -35.4 | % | 8.3 | % | -27.3 | % |
| Service and other  revenues                            |       | 23.0                                               | %          | 35.5                                               | %          | 27.2                                      | %          | 29.6 | % | 34.3 | % | 31.9 | % | 22.3 | % | 3.5 | % | -14.7 | % |
| Total gross  margin percentage                         |       | 18.3                                               | %          | 27.0                                               | %          | 20.1                                      | %          | 27.4 | % | 25.1 | % | 26.7 | % | -33.2 | % | 7.6 | % | -24.7 | % |

 

For the three months ended June 30,2008, Argyle Corrections revenues increased by 93.7% of total Company revenuesfrom the same period in 2007. Argyle Commercial Security’s revenues rose by8.9%.  The total Company margin decreasefrom 26.7% to 20.1% was directly attributable to the decreased margins inArgyle Corrections (decreased 33.2%) while the Argyle Commercial Security’smargins increased by 7.6% over the same period.

 

According to the RoseReport, the corrections market grew by 45% from 2006 to 2007 and is estimatedan additional 48% growth in 2008.  ArgyleCorrections captured additional market share due to its repeat customers.  This capture rate enabled Argyle Correctionsto enjoy revenue growth.  However,although the Argyle Corrections enjoyed an increase in revenues during thethree months ended June 30, 2008, gross margins eroded largely as a resultof the inability to adequately staff a number of projects brought in during2007.  Initially, a lack of experience(of our existing workforce and newly hired workforce) resulted in a largelearning curve to become efficient in our operations. The need to properlytrain our workforce resulted in a high level of inefficiencies that causedgreater labor hours to be utilized which were not initially accounted for inthe projected project budget. Management believes that the increased number oftrained workers will likely improve management’s ability to continue to reducethe erosion of gross margin on our projects. Argyle Commercial Security has increased its gross margin relative tothe results in 2007 primarily as a result of controlling project costs during2008.  This transition is a result ofcontinued training of project managers and installers along with the continualupdating of our estimating tools to more adequately project the labor needs andtiming required for project completion.

 

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Below is a table of adjustedpro forma revenues, cost of sales, and gross margins for the six months ended June 30,2008 and 2007.

 

**Adjusted Pro Forma Segment P&L**

**(unaudited)**

 

(inthousands)

 
| ** **                                             | ** ** | **Six Months June 30, 2008** | ** ** | **Six Months June 30, 2007** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **Corrections**                                  | ** ** | **Commercial**                                   | ** ** | **Total**                                 | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
| Net revenues                                           |       |                                             |       |                                             |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | $                                                | 52,761     |                                             | $          | 11,081                                    |       | $ | 63,842 |   | $ | 25,077 |   | $ | 10,625 |   | $ | 35,702 |   | 110.4 | % | 4.3 | % | 78.8 | % |
| Service and other  revenues                            |       | 7,838                                            |       | 4,141                                            |       | 11,979                                    |       | 3,828 |   | 5,574 |   | 9,402 |   | 104.8 | % | -25.7 | % | 27.4 | % |
| Total net  revenues                                    |       | $                                                | 60,599     |                                             | $          | 15,222                                    |       | $ | 75,821 |   | $ | 28,905 |   | $ | 16,199 |   | $ | 45,104 |   | 109.6 | % | -6.0 | % | 68.1 | % |
| *% of  total*                                          | * *   | *79.9*                                           | *%*        | *20.1*                                           | *%*        | * *                                  | * *   | *64.1* | *%* | *35.9* | % |   |   |   |   |   |   |   |   |
| Cost of revenues                                       |       |                                             |       |                                             |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract costs /  contract costs - related party       |       | $                                                | 42,827     |                                             | $          | 8,637                                     |       | $ | 51,464 |   | $ | 18,729 |   | $ | 8,549 |   | $ | 27,278 |   | 128.7 | % | 1.0 | % | 88.7 | % |
| Service and other  costs                               |       | 5,956                                            |       | 3,056                                            |       | 9,012                                     |       | 2,688 |   | 4,254 |   | 6,942 |   | 121.6 | % | -28.2 | % | 29.8 | % |
| Total cost of  revenues                                |       | $                                                | 48,783     |                                             | $          | 11,693                                    |       | $ | 60,476 |   | $ | 21,417 |   | $ | 12,803 |   | $ | 34,220 |   | 127.8 | % | -8.7 | % | 76.7 | % |
| Gross margin                                           |       |                                             |       |                                             |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract margins  / contract margins - related party   |       | $                                                | 9,934      |                                             | $          | 2,444                                     |       | $ | 12,378 |   | $ | 6,348 |   | $ | 2,076 |   | $ | 8,424 |   | 56.5 | % | 17.7 | % | 46.9 | % |
| Service and other  margins                             |       | 1,882                                            |       | 1,085                                            |       | 2,967                                     |       | 1,140 |   | 1,320 |   | 2,460 |   | -65.1 | % | -17.8 | % | 20.6 | % |
| Total gross  margin                                    |       | $                                                | 11,816     |                                             | $          | 3,529                                     |       | $ | 15,345 |   | $ | 7,488 |   | $ | 3,396 |   | $ | 10,884 |   | 57.8 | % | 3.9 | % | 41.0 | % |
| Gross margin  percentage                               |       |                                             |       |                                             |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | 18.8                                             | %          | 22.1                                             | %          | 19.4                                      | %          | 25.3 | % | 19.5 | % | 23.6 | % | -25.7 | % | 13.3 | % | -17.8 | % |
| Service and other  revenues                            |       | 24.0                                             | %          | 26.2                                             | %          | 24.8                                      | %          | 29.8 | % | 23.7 | % | 26.2 | % | 19.5 | % | 10.5 | % | -5.3 | % |
| Total gross  margin percentage                         |       | 19.5                                             | %          | 23.2                                             | %          | 20.2                                      | %          | 25.9 | % | 21.0 | % | 24.1 | % | -24.7 | % | 10.5 | % | -16.2 | % |

 

For the six months ended June 30,2008, Argyle Corrections revenues increased by 109.6% of total Company revenuesfrom the same period in 2007. Argyle Commercial Security’s segment revenuesfell by 6.0%, but when a single $1.8 million service revenue transaction in2007 is excluded, the growth for the same period was 5.7%.  The total Company margin decrease from 24.1%to 20.2% was directly attributable to the decreased margins in the ArgyleCorrections (decreased 24.7%) while Argyle Commercial Security’s marginsincreased by 10.5% over the same period.

 

**Discussion of Financial Results**

 

*Revenues*

 

More than 90% of AUSA’srevenues are generated by fixed-price contracts. The success of a fixed-pricecontract is based in large part upon the quality of the process utilized whenestimating the costs that will be incurred in performing the contract. Thelarger the project and the longer the term of completion of the contract, thegreater the number of variable factors there are to be considered and evaluatedin estimating costs. A successful estimating process requires substantialexperience and judgment. Management is aware of the significant need forexperience and qualified estimating personnel and regularly monitors theestimating process and its results.

 

The most obvious benchmarkthat management considers in evaluating the estimating process is whether theamount estimated, and submitted as a bid, was reasonably similar to the amountbid by AUSA’s competitors on the same project. Other bidders may bidexceptionally low (even at a loss) in order to secure a contract that thecompetitor may desperately need in order to maintain at least a modestlevel of cash flow, or for other reasons. Management must evaluate the bidsthat were submitted in competition with AUSA’s bid, based on their knowledge ofeach competitor’s history and character (for example, some typically bid high,some typically bid low), the condition of the market, the complexity of theproject, the type of construction and other factors. This review, conductedregularly, provides management with an ongoing general basis for evaluating theestimating process that result in fixed price contracts. Evaluating the resultsof bidding competitions allows management to evaluate the Company’s estimatingcapabilities at the beginning or “front-end” of a new contract or project.Other benchmarks are used to evaluate the estimating process while a project isongoing.

 

AUSA also generates servicerevenues. These are generally short-term projects which are evidenced by signedservice agreements, customer work orders or purchase orders. These salesagreements/customer orders generally provide for billing to customers based ontime at quoted hourly or project rates, plus costs of materials and suppliesfurnished by AUSA. Service revenues are recognized when the services have beendelivered to and accepted by the customer.

 

This is our fourth quarterof reportable revenues.  Prior to ouracquisition of AUSA, we had no revenues.

 

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*Cost ofRevenues*

 

Cost of revenues consists ofthe direct costs to complete a fixed-price contract and includes variable costsrelated to the project, such as material, direct labor, project managementcosts, travel related expenses to the projects, hotel costs spent while theproject is on-going, truck expenses utilized on those projects and cell phonesof the personnel while they are on those projects. We also review ourinventories for indications of obsolescence or impairment and provide reservesas deemed necessary.

 

*Selling,General and Administrative Expenses*

 

Selling, general andadministrative expenses consist primarily of salaries and benefits for sellingand administrative personnel, including the human resources, executive, financeand legal. These expenses also include fees for professional services and otheradministrative expenses.

 

**Results ofOperations for the Three Months Ended June 30, 2008 and 2007**

 

**Revenues**

 

This is our fourth quarterof reportable revenues. Prior to our acquisition of AUSA, we had no revenues.

 

*Pro FormaNet Revenues*

 

The following table presentspro forma net revenues for the three months ended June 30, 2008 and 2007(in thousands):

 
| ** **                            | ** ** | **Pro Forma Revenue**                                     | ** ** | ** **                                                | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                            | ** ** | **Three Months Ended  June 30, 2008** | ** ** | **Three Months Ended  June 30, 2007** | ** ** | **Year to Year  Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Amount**                                                | ** ** | **% of   Revenues**                             | ** ** | **Amount** | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract revenues**                 |       | $                                                         | 24,711     |                                                      | 67.7       | % | $ | 10,730 |   | 48.9 | % | $ | 13,981 |   | 130.3 | % |
| **Contract revenues - related party** |       | 5,282                                                     |       | 14.5                                                      | %          | 7,365 |   | 33.6 | % | (2,083 | ) | -28.3 | % |
| **Service and other revenues**        |       | 6,513                                                     |       | 17.8                                                      | %          | 3,836 |   | 17.5 | % | 2,677 |   | 69.8 | % |
| **Total revenues**                    |       | $                                                         | 36,506     |                                                      | 100.0      | % | $ | 21,931 |   | 100.0 | % | $ | 14,575 |   | 66.5 | % |

 

On a pro forma basis, theCompany had revenues of $36.5 million (including related party revenue of $5.3million) and $21.9 million (including related party revenue of $7.4million) for the three months ended June 30, 2008 and 2007,respectively, representing an increase of $14.6 million or 66.5%. Thesignificant increase in contract revenues is primarily due to several majorfactors including, but not limited to, the addition of new products through thedevelopment of internal software applications that has allowed the company tocapture a larger part of its market. Year over year service revenues (whenexcluding other revenues from manufacturing) have increased by $1.5 million forthe three months ended June 30, 2008 versus 2007. On a pro forma basisother revenues from manufacturing were $3.8 million and $1.9 million for thethree months ended June 30, 2008 and 2007. The Company has focused on building its service revenue base by addingsalespeople and improving performance to retain more customers and to increaseservice revenues.

 

The pro forma revenue mixwas 82.2% contract revenues and 17.8% service and other revenues for the threemonths ended June 30, 2008 compared to 82.5% and 17.5%, respectively, forthe corresponding period in 2007.

 

In the last three years theentire corrections and commercial security markets have been growing, which hasbeen a factor in the Company’s success. Should these markets continue to grow, the Company with its strongmarket position should continue to see increasing revenue opportunities.   Since January 2008, the Company hasbeen implementing plans to increase revenues. Some of the expected increases will be derived from the marketing ofpackaged products from the portfolios of the companies Argyle acquired in January 2008.

 

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As used in this analysis, “relatedparty” revenue is that revenue that is generated by work sub-contracted fromISI*MCS (an entity owned by Sam Youngblood, President of AUSA, and by Don Carr,President of AUSA – Corrections).  Messrs. Youngblood and Carrcreated ISI*MCS in 2004 to provide bonding on contracts that required bonding.The performance of those contracts was subcontracted to ISI as a subcontractorto ISI*MCS.  The sub-contracted work was for third party customers ofISI*MCS that required bonded contracts.  Since the acquisition of ISI byArgyle, ISI*MCS no longer provides bonding and subcontract work to ISI (nowreferred to AUSA).  AUSA has secured itsown bonding capacity and will use that bonding capacity to directly enter intobonded contracts with third party customers. After the merger, the amount of “Revenues - related party” will continueto decrease as the contracts with ISI*MCS outstanding at the time of the mergerare completed.

 

**Cost ofRevenues**

 

This has been our fourthquarter of reportable cost of revenues. Prior to our acquisition of AUSA, wehad no cost of revenues.

 

*AdjustedPro Forma Cost of Revenues*

 

The following tablereconciles adjusted pro forma cost of revenues to pro forma cost of revenuesfor the three months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                                                             | ** ** | **Adjusted Pro Forma Cost of Revenue** | ** ** | ** **                       | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                             | ** ** | **Three Months Ended**                                | ** ** | **Three Months Ended** | ** ** | **Year to Year** | ** ** |
| ** **                                                             | ** ** | **June 30, 2008**                                     | ** ** | **June 30, 2007**      | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                                             | ** ** | **Amount**                                                      | ** ** | **% of  Revenues**               |       | **Amount** |   | **% of  Revenues** |   | **Amount** |   | **%** |   |
| **Contract costs**                                                     |       | $                                                               | 24,424     |                             | 66.9       | % | $ | 13,465 |   | 61.4 | % | $ | 10,959 |   | 81.4 | % |
| **Service and other costs, excluding amortization  of intangibles**    |       | 4,742                                                           |       | 13.0                             | %          | 2,611 |   | 11.9 | % | 2,131 |   | 81.6 | % |
| **Adjusted pro forma total cost of revenues**                          |       | 29,166                                                          |       | 79.9                             | %          | 16,076 |   | 73.3 | % | 13,090 |   | 81.4 | % |
| **Amortization of intangibles**                                        |       | 1,276                                                           |       | 3.5                              | %          | 1,274 |   | 5.8 | % | — |   | 0.0 | % |
| **Pro forma cost of revenues, including amortization  of intangibles** |       | $                                                               | 30,442     |                             | 83.4       | % | $ | 17,350 |   | 79.1 | % | $ | 13,090 |   | 75.4 | % |

 

On a pro forma basis, costof revenues increased by $13.1 million, or 75.4%, to $30.4 million for thethree months ended June 30, 2008, compared to $17.3 million for thecorresponding period in 2007. On an adjusted pro forma basis, cost of revenuesincreased by $13.1 million, or 81.4%, to $29.2 million for the three monthsended June 30, 2008, compared to $16.1 million for the correspondingperiod in 2007. The increase in cost of revenues resulted from AUSA working ona greater number of projects in 2008 than in 2007.  The percentage of cost of revenues has increasedin 2008 due to a large number of projects that were completed in the finalmonth of the quarter.  Due to limitedresources and the inability to delay the work until the following quartermonth, the Company incurred higher travel, overtime and contracting expenses tocomplete the work.

 

The amortization of acquiredbacklog has been allocated to cost of revenues. The impact of this amortization(which was excluded from adjusted pro forma cost of revenues) for the threemonths ended June 30, 2008 was $1.3 million.

 

The Company has been implementingits plan to reduce costs and improve efficiencies.  Some of these efforts include implementingthe best technology in all organizations. For example, we discovered that some of the technology used by theacquired companies was superior to our own, especially with respect toproduction costs.  Additionally, wediscovered that some of the technology we developed is faster and moreefficient than that of the acquired companies. The current effort to “swaptechnology” is proceeding as planned and production cost savings are expectedresults of these efforts.

 

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**GrossMargin**

 

This has been our fourthquarter of reportable gross margin. Prior to our acquisition of AUSA, we had nogross margin.

 

*AdjustedPro Forma Gross Margin*

 

The following tablereconciles adjusted pro forma gross margin to pro forma gross margin for thethree months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                          | ** ** | **Adjusted Pro Forma Gross Margin** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                          | ** ** | **Three Months Ended**                        | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                          | ** ** | **June 30, 2008**                             | ** ** | **June 30, 2007**      | ** ** | **Increase (Decrease)** | ** ** |
| ** **                          | ** ** | **Amount**                                              | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma gross margin** |       | $                                                       | 7,340      |                             | 20.1       | %                            | $          | 5,855 |   | 26.7 | % | $ | 1,485 |   | 25.4 | % |
| **Amortization of intangibles**     |       | (1,276                                                  | )          | -3.5                             | %          | (1,274                       | )          | -5.8 | % | (2 | ) | 0.2 | % |
| **Pro forma gross margin**          |       | $                                                       | 6,064      |                             | 16.6       | %                            | $          | 4,581 |   | 20.9 | % | $ | 1,483 |   | 32.4 | % |

 

On a pro forma basis for thethree months ended June 30, 2008, there was gross margin of $6.1 millioncompared to a gross margin of $4.6 million for the corresponding period in2007. On an adjusted pro forma basis for the three months ended June 30,2008, there was gross margin of $7.3 million compared to a gross margin of $5.9million for the corresponding period in 2007. The proforma gross margin fell from 26.7% to 20.1% and the adjusted proforma gross margin fell from 20.9% to 16.6% due to cost of sales increases aspreviously discussed.

 

The amortization of acquiredbacklog in the cost of sales section has been allocated to cost of revenues andrepresents the only difference between pro forma gross margins and adjusted proforma gross margins for the three months ended June 30, 2008 and 2007.

 

**OperatingExpenses**

 

Operating expenses consistprimarily of salaries and benefits for selling and administrative personnel,including human resources, executive, finance, and legal. These expenses alsoinclude fees for professional services and other administrative expenses aswell as amortization of intangible assets. Operating expenses increased to $6.7 million for the three months ended June 30,2008, compared to $0.2 million for the corresponding period in 2007.Substantially all of the expense increase is attributed to the acquisitions ofISI on July 31, 2007 and Com-Tec, PDI, and Fire Quest in the quarter endedMarch 31, 2008.

 

*AdjustedPro Forma Operating Expenses*

 

The following tablereconciles adjusted pro forma operating expenses to pro forma operatingexpenses for the three months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                                      | ** ** | **Adjusted Pro Forma Operating Expenses** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | **Three Months Ended**                              | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                                      | ** ** | **June 30, 2008**                                   | ** ** | **June 30, 2007**      | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                      | ** ** | **Amount**                                                    | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma total operating expenses** |       | $                                                             | 6,318      |                             | 17.3       | %                            | $          | 4,511 |   | 20.6 | % | $ | 1,807 |   | 40.1 | % |
| **Amortization of intangible assets**           |       | 427                                                           |       | 1.2                              | %          | 426                          |       | 1.9 | % | 1 |   | 0.2 | % |
| **Pro forma total operating expenses**          |       | $                                                             | 6,745      |                             | 18.5       | %                            | $          | 4,937 |   | 22.5 | % | $ | 1,808 |   | 36.6 | % |

 

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On a pro forma basis,operating expenses increased $1.8 million, or 36.6% to $6.7 million for thethree months ended June 30, 2008, from $4.9 million for the correspondingperiod in 2007. On an adjusted pro forma basis, operating expenses increased$1.8 million, or 40.1% to $6.3 million for the three months ended June 30,2008 from $4.5 million for the corresponding period in 2007. The increase isprimarily due to additional expenses needed to support the increased number ofprojects on which AUSA is working, increased sales and marketing effortsto promote future growth, and corporate services expenses associated with theparent company entity.  The increase inoperating expenses is attributable to the increase in accounting personnelrequired in migrating from a privately held company to a public company.  In addition to the reporting requirements ofa public company, the growth in revenue and corresponding increase in projectsalso required additional personnel and the related recruiting cost.  Other increased cost associated with a publiccompany included legal fees along with external accounting and consulting fees.

 

Additionally, $191,000 innon-cash compensation expense related to restricted stock grants and employeestock options was included in the operating expenses for the quarter ended June 30,2008 and $142,000 for the same period in 2007. The amortization of customerbase and software has been allocated to operating expenses and primarilyrelates to the acquisition of ISI on July 31, 2007 and Com-Tec, PDI, andFire Quest in the quarter ended March 31, 2008.  The impact of this amortization, which wasexcluded from pro forma operating expenses, was $0.4 million.

 

**OtherIncome / Expense**

 

Prior to July 2007,total other income/expense represented interest earned on the net proceeds ofour initial public offering and the private placement held in trust through thedate of the acquisition of ISI.  Interestexpense represents interest on our line of credit, unsecured subordinated debt,and notes issued in January 2008 in connection with the acquisition ofCom-Tec, PDI, and Fire Quest. Total other income/expense for the three monthsended June 30, 2008 was an expense of ($0.8) million compared to income of$0.3 million for the corresponding period in 2007.

 

*Pro FormaOther Income / Expense*

 

The following table presentspro forma interest and other income for the three months ended June 30,2008 and 2007 (in thousands):

 
| ** **                       | ** ** | **Pro Forma Other Income (Expense)** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Three Months Ended**                         | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                       | ** ** | **June 30, 2008**                              | ** ** | **June 30, 2007**      | ** ** | **Increase (Decrease)** | ** ** |
| ** **                       | ** ** | **Amount**                                               | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Interest income**              |       | $                                                        | 52         |                             | 0.1        | %                            | $          | 51 |   | 0.2 | % | $ | 1 |   | 2.0 | % |
| **Interest expense**             |       | (854                                                     | )          | -2.3                             | %          | (916                         | )          | -4.2 | % | 62 |   | -6.8 | % |
| **Total other income (expense)** |       | $                                                        | (802       | )                                | -2.2       | %                            | $          | (865 | ) | -3.9 | % | $ | 63 |   | -7.3 | % |

 

Pro forma net other incomefor the three months ended June 30, 2008 mainly represents interest earnedon the excess cash from the net proceeds of our preferred stock offering.  Pro forma interest expense decreased to($0.8) million for the three months ended June 30, 2008 from ($0.9)million for the corresponding period in 2007. Pro forma interest expense for the three months ended June 30, 2008and 2007 mainly represents interest on our line of credit, unsecuredsubordinated debt, and our notes issued in January 2008 for theacquisitions of Com-Tec, PDI and Fire Quest.

 

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**Net Income/ (Loss)**

 

For the three months ended June 30,2008, we had net loss of ($1.0) million compared to a net income of $50,000 forthe corresponding period in 2007.  Ouronly source of income prior to the consummation of our initial businesscombination with ISI was interest earned on the funds held in the trustaccount.

 

*AdjustedPro Forma Net Income (Loss)*

 

The following tablereconciles adjusted pro forma net income (loss) to pro forma net income /(loss) for the three months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                               | ** ** | **Pro Forma Net Income (Loss)** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **Three Months Ended**                    | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                               | ** ** | **June 30, 2008**                         | ** ** | **June 30, 2007**      | ** ** | **Increase (Decrease)** | ** ** |
| ** **                               | ** ** | **Amount**                                          | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma net income (loss)** |       | $                                                   | 1,317      |                             | 3.6        | %                            | $          | 100 |   | 0.5 | % | $ | 1,217 |   | 1217.0 | % |
| **Amortization of intangible assets**    |       | (1,703                                              | )          | -4.7                             | %          | (1,700                       | )          | -7.8 | % | (3 | ) | 0.2 | % |
| **Taxes, net**                           |       | (656                                                | )          | -1.8                             | %          | (658                         | )          | -3.0 | % | 2 |   | -0.3 | % |
| **Total pro forma net income (loss)**    |       | $                                                   | (1,042     | )                                | -2.9       | %                            | $          | (2,258 | ) | -10.3 | % | $ | 1,216 |   | -53.9 | % |

 

For the three months ended June 30,2008, we had a pro forma net loss of ($1.0) million compared to a pro forma netloss of ($2.3) million for the corresponding period in 2007.  For the three months ended June 30,2008, we had an adjusted pro forma net income of $1.3 million compared to anadjusted pro forma net income of $100,000 for the corresponding period in 2007.Our only source of income prior to the consummation of our initial businesscombination with AUSA was interest earned on the funds held in a trust account.

 

**Earningsbefore Interest, Taxes, Depreciation and Amortization (“EBITDA”)**

 
| ** **           | ** ** | **Pro Forma EBITDA**   | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|----------------------|------------|----------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **           | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **           | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**      | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Amount**                       | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Pro forma EBITDA** |       | $                                | 1,648      |                             | 4.5        | %                            | $          | 1,678 |   | 7.7 | % | $ | (30 | ) | -1.8 | % |
|                      |            |                                  |            |                                  |            |                              |            |  |  |  |  |  |  |  |  |  |

 

Pro forma EBITDA decreasedby $30,000 to $1.6 million in the three months ended June 30, 2008,compared to $1.7 million in the corresponding period in 2007. The EBITDA margindecreased to 4.5% from 7.7% in the corresponding period in 2007.   The June 30, 2008 EBITDA includes$191,000 in non-cash compensation expense related to restricted stock grantsand employee stock options for that period compared to $142,000 for the sameperiod in 2007.

 

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**Results ofOperations for the Six Months Ended June 30, 2008 and 2007**

 

**Revenues**

 

This is our fourth quarterof reportable revenues. Prior to our acquisition of AUSA, we had no revenues.

 

*Pro FormaNet Revenues*

 

The following table presentspro forma net revenues for the six months ended June 30, 2008 and 2007 (inthousands):

 
| ** **                            | ** ** | **Pro Forma Revenue** | ** ** | ** **                     | ** ** | ** **                   | ** ** |
|---------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                            | ** ** | **Six Months Ended**  | ** ** | **Six Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                            | ** ** | **June 30, 2008**     | ** ** | **June 30, 2007**    | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Amount**                      | ** ** | **% of  Revenues**        | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract revenues**                 |       | $                               | 51,617     |                           | 68.1       | %                            | $          | 22,536 |   | 50.0 | % | $ | 29,081 |   | 129.0 | % |
| **Contract revenues - related party** |       | 12,225                          |       | 16.1                           | %          | 13,166                       |       | 29.2 | % | (941 | ) | -7.1 | % |
| **Service and other revenues**        |       | 11,979                          |       | 15.8                           | %          | 9,402                        |       | 20.8 | % | 2,577 |   | 27.4 | % |
| **Total revenues**                    |       | $                               | 75,821     |                           | 100.0      | %                            | $          | 45,104 |   | 100.0 | % | $ | 30,717 |   | 68.1 | % |

 

On a pro forma basis, theCompany had revenues of $75.8 million (including related party revenue of $12.2million) and $45.1 million (including related party revenue of $13.2million) for the six months ended June 30, 2008 and 2007,respectively, representing an increase of $30.7 million or 68.1%. Thesignificant increase in contract revenues is primarily due to several majorfactors including, but not limited to, the addition of new products through thedevelopment of internal software applications that has allowed the company tocapture a larger part of its market. Year over year service revenues (whenexcluding other revenues from manufacturing) have decreased by ($0.7) millionfor the six months ended June 30, 2008 versus 2007.  There is such a significant decrease becausewe had an unusually large $1.8 million service revenue contract recognized inthe same period 2007.  When excluding the$1.8 million opportunity in the quarter-ended June 30, 2007 service andother sales actually increased by $1.1 million or 28.9% over the sameperiod.  On a pro forma basis otherrevenues from manufacturing were $7.0 million and $3.8 million for the sixmonths ended June 30, 2008 and 2007. The Company has focused on building its service revenue base by addingsalespeople and improving performance to retain more customers and to theincrease service revenues.

 

The pro forma revenue mixwas 84.2% contract revenues and 15.8% service and other revenues for the sixmonths ended June 30, 2008 compared to 79.2% and 20.8%, respectively, forthe corresponding period in 2007.

 

In the last three years theentire corrections and commercial security markets have been growing, which hasbeen a factor in the Company’s success. Should these markets continue to grow, the Company, with its strongmarket position, should continue to see increasing revenue opportunities.   Since January 2008, the Company hasbeen implementing plans to increase revenues through the marketing of packagedproducts from the portfolios of the companies Argyle acquired in January 2008.

 

As used in this analysis, “relatedparty” revenue is that revenue that is generated by work sub-contracted fromISI*MCS (an entity owned by Sam Youngblood, President of AUSA, and by Don Carr,President of AUSA – Corrections).  Messrs. Youngblood and Carrcreated ISI*MCS in 2004 to provide bonding on contracts that required bonding.The performance of those contracts was subcontracted to ISI as a subcontractorto ISI*MCS.  The sub-contracted work was for third party customers ofISI*MCS that required bonded contracts.  After the acquisition of ISI byArgyle, ISI*MCS no longer provided bonding and subcontract work to ISI now referredto AUSA in 2008.  AUSA has secured itsown bonding capacity and will use that bonding capacity to directly enter intobonded contracts with third party customers. After the merger, the amount of “Revenues - related party” will continueto decrease as the contracts with ISI*MCS, outstanding at the time of themerger, are completed.

 

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**Cost ofRevenues**

 

This has been our fourthquarter of reportable cost of revenues. Prior to our acquisition of AUSA, wehad no cost of revenues.

 

*AdjustedPro Forma Cost of Revenues*

 

The following tablereconciles adjusted pro forma cost of revenues to pro forma cost of revenuesfor the six months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                                                             | ** ** | **Adjusted Pro Forma Cost of Revenue** | ** ** | ** **                     | ** ** | ** **                   | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **Six Months Ended**                                  | ** ** | **Six Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                                                             | ** ** | **June 30, 2008**                                     | ** ** | **June 30, 2007**    | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                                             | ** ** | **Amount**                                                      | ** ** | **% of  Revenues**        | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract costs**                                                     |       | $                                                               | 51,464     |                           | 67.9       | %                            | $          | 27,278 |   | 60.5 | % | $ | 24,186 |   | 88.7 | % |
| **Service and other costs, excluding**                                 |       |                                                            |       |                           |       |                         |       |   |   |   |   | 0.0 | % |
| **amortization of intangibles**                                        |       | 9,012                                                           |       | 11.9                           | %          | 6,942                        |       | 15.4 | % | 2,070 |   | 29.8 | % |
| **Adjusted pro forma total cost of revenues**                          |       | 60,476                                                          |       | 79.8                           | %          | 34,220                       |       | 75.9 | % | 26,256 |   | 76.7 | % |
| **Amortization of intangibles**                                        |       | 2,565                                                           |       | 3.4                            | %          | 2,564                        |       | 5.7 | % | — |   | 0.0 | % |
| **Pro forma cost of revenues, including  amortization of intangibles** |       | $                                                               | 63,041     |                           | 83.1       | %                            | $          | 36,784 |   | 81.6 | % | $ | 26,256 |   | 71.4 | % |

 

On a pro forma basis, costof revenues increased by $26.3 million, or 71.4%, to $63.0 million for the sixmonths ended June 30, 2008, compared to $36.7 million for thecorresponding period in 2007.  On anadjusted pro forma basis, cost of revenues increased by $26.3 million, or 76.7%,to $60.5 million for the six months ended June 30, 2008, compared to $34.2million for the corresponding period in 2007. The increase in cost of revenuesresulted from AUSA working on a greater number of projects in 2008 than in2007. The percentage of cost of revenues has increased in 2008 due to a largenumber of projects that were completed in the final month of the quarter.  Due to limited resources and the inability todelay the work until the following quarter month, the Company incurred higher travel,overtime and contracting expenses to complete the work.

 

The amortization of acquiredbacklog has been allocated to cost of revenues. The impact of this amortization(which was excluded from adjusted pro forma cost of revenues) for the sixmonths ended June 30, 2008 was $2.5 million.

 

The Company has beenimplementing its plan to reduce costs and improve efficiencies.  Some of these efforts include implementingthe best technology in all organizations. For example, we discovered that some of the technology used by theacquired companies was superior to our own, especially with respect toproduction costs.  Additionally, wediscovered that some of the technology we developed is faster and moreefficient than that of the acquired companies. The current effort to “swaptechnology” is proceeding as planned and production cost savings are expectedresults of these efforts.

 

**GrossMargin**

 

This has been our fourthquarter of reportable gross margin. Prior to our acquisition of AUSA, we had nogross margin.

 

*AdjustedPro Forma Gross Margin*

 

The following tablereconciles adjusted pro forma gross margin to pro forma gross margin for thesix months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                          | ** ** | **Adjusted Pro Forma Gross Margin** | ** ** | ** **                     | ** ** | ** **                   | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                          | ** ** | **Six Months Ended**                          | ** ** | **Six Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                          | ** ** | **June 30, 2008**                             | ** ** | **June 30, 2007**    | ** ** | **Increase (Decrease)** | ** ** |
| ** **                          | ** ** | **Amount**                                              | ** ** | **% of  Revenues**        | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma gross margin** |       | $                                                       | 15,345     |                           | 20.2       | %                            | $          | 10,884 |   | 24.1 | % | $ | 4,461 |   | 41.0 | % |
| **Amortization of intangibles**     |       | (2,565                                                  | )          | -3.4                           | %          | (2,564                       | )          | -5.7 | % | (1 | ) | 0.0 | % |
| **Pro forma gross margin**          |       | $                                                       | 12,780     |                           | 16.9       | %                            | $          | 8,320 |   | 18.4 | % | $ | 4,460 |   | 53.6 | % |

 

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On a pro forma basis for thesix months ended June 30, 2008, there was gross margin of $12.8 millioncompared to a gross margin of $8.3 million for the corresponding period in2007. On an adjusted pro forma basis for the six months ended June 30,2008, there was gross margin of $15.3 million compared to a gross margin of$10.8 million for the corresponding period in 2007. The proforma gross marginfell from 18.4% to 16.9% and the adjusted pro forma gross margin fell from24.1% to 20.2% due to cost of sales increases as previously discussed.

 

The amortization of acquiredbacklog in the cost of sales section has been allocated to cost of revenues andrepresents the only difference between pro forma gross margins and adjusted proforma gross margins for the six months ended June 30, 2008 and 2007.

 

**OperatingExpenses**

 

Operating expenses consistprimarily of salaries and benefits for selling and administrative personnel,including human resources, executive, finance, and legal. These expenses alsoinclude fees for professional services and other administrative expenses aswell as amortization of intangible assets. Operating expenses increased to $13.5 million for the six months ended June 30,2008, compared to $0.5 million for the corresponding period in 2007.Substantially all of the expense increase is attributed to the acquisitions ofISI on July 31, 2007 and Com-Tec, PDI, and Fire Quest in the quarter endedMarch 31, 2008.

 

*AdjustedPro Forma Operating Expenses*

 

The following tablereconciles adjusted pro forma operating expenses to pro forma operatingexpenses for the six months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                                      | ** ** | **Adjusted Pro Forma Operating Expenses** | ** ** | ** **                     | ** ** | ** **                   | ** ** |
|-------------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                      | ** ** | **Six Months Ended**                           | ** ** | **Six Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                                      | ** ** | **June 30, 2008**                              | ** ** | **June 30, 2007**    | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                      | ** ** | **Amount**                                               | ** ** | **% of  Revenues**        | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma total operating expenses** |       | $                                                        | 12,973     |                           | 17.1       | %                            | $          | 8,762 |   | 19.4 | % | $ | 4,211 |   | 48.1 | % |
| **Amortization of intangible assets**           |       | 869                                                      |       | 1.1                            | %          | 868                          |       | 1.9 | % | 1 |   | 0.1 | % |
| **Pro forma total operating expenses**          |       | $                                                        | 13,842     |                           | 18.3       | %                            | $          | 9,630 |   | 21.4 | % | $ | 4,212 |   | 43.7 | % |

 

On a pro forma basis,operating expenses increased $4.2 million, or 43.7% to $13.8 million for thesix months ended June 30, 2008 from $9.6 million for the correspondingperiod in 2007. On an adjusted pro forma basis, operating expenses increased$4.2 million, or 48.1% to $13.0 million for the six months ended June 30,2008 from $8.8 million for the corresponding period in 2007. The increase isprimarily due to additional expenses needed to support the increased number ofprojects on which AUSA is working, increased sales and marketing effortsto promote future growth, and corporate services expenses associated with theparent company entity.  The increase inoperating expenses is attributable to the increase in accounting personnelrequired in migrating from a privately held company to a public company.  In addition to the reporting requirements ofa public company, the growth in revenue and corresponding increase in projectsalso required additional personnel and the related recruiting cost.  Other increased cost associated with a publiccompany included legal fees along with external accounting and consulting fees.

 

Additionally, $0.7 millionin non-cash compensation expense related to restricted stock grants andemployee stock options was included in the operating expenses for the sixmonths ended June 30, 2008 and $0.3 million for the same period in 2007.The amortization of customer base and software has been allocated to operatingexpenses and primarily relates to the acquisition of ISI on July 31, 2007and Com-Tec, PDI, and Fire Quest in the quarter ended March 31, 2008.  The impact of this amortization, which wasexcluded from pro forma operating expenses, was $0.9 million.

 

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**OtherIncome / Expense**

 

Prior to July 2007,total other income/expense represented interest earned on the net proceeds ofour initial public offering and the private placement held in trust through thedate of the acquisition of ISI.  Interestexpense represents interest on our line of credit, unsecured subordinated debt,and notes issued in January 2008 in connection with the acquisition ofCom-Tec, PDI, and Fire Quest. Total other income/expense for the six monthsended June 30, 2008 was an expense of ($1.6) million compared to income of$0.7 million for the corresponding period in 2007.

 

*Pro FormaOther Income / Expense*

 

The following table presentspro forma interest and other income for the six months ended June 30, 2008and 2007 (in thousands):

 
| ** **                       | ** ** | **Pro Forma Other Income (Expense)** | ** ** | ** **                     | ** ** | ** **                   | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Six Months Ended**                 | ** ** | **Six Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                       | ** ** | **June 30, 2008**                    | ** ** | **June 30, 2007**    | ** ** | **Increase (Decrease)** | ** ** |
| ** **                       | ** ** | **Amount**                                     | ** ** | **% of  Revenues**        | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Interest income**              |       | $                                              | 78         |                           | 0.1        | %                            | $          | 111 |   | 0.2 | % | $ | (33 | ) | -29.7 | % |
| **Interest expense**             |       | (1,698                                         | )          | -2.2                           | %          | (1,757                       | )          | -3.9 | % | 59 |   | -3.4 | % |
| **Total other income (expense)** |       | $                                              | (1,620     | )                              | -2.1       | %                            | $          | (1,646 | ) | -3.6 | % | $ | 26 |   | -1.6 | % |

 

Pro forma net other incomefor the six months ended June 30, 2008 mainly represents interest earnedon the excess cash from the net proceeds of our preferred stock offering.  Pro forma interest expense decreased to($1.7) million for the six months ended June 30, 2008 from ($1.8) millionfor the corresponding period in 2007. Pro forma interest expense for the six months ended June 30, 2008and 2007 mainly represents interest on our line of credit, unsecured subordinateddebt, and our notes issued in January 2008 for the acquisitions ofCom-Tec, PDI and Fire Quest.

 

**Net Income/ (Loss)**

 

For the six months ended June 30,2008, we had net loss of ($1.8) million compared to a net income of $101,000for the corresponding period in 2007. The results of operations for the sixmonths ended June 30, 2008 include the results of operations for AUSA,Fire Quest and PDI from January 1, 2008 and the results of operations ofCom-Tec from February 1, 2008. Our only source of income prior to theconsummation of our initial business combination with ISI was interest earnedon the funds held in the trust account.

 

*AdjustedPro Forma Net Income (Loss)*

 

The following tablereconciles adjusted pro forma net income (loss) to pro forma net income /(loss) for the six months ended June 30, 2008 and 2007 (in thousands):

 
| ** **                               | ** ** | **Pro Forma Net  Income (Loss)** | ** ** | ** **                     | ** ** | ** **                   | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **Six Months Ended**             | ** ** | **Six Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                               | ** ** | **June 30, 2008**                | ** ** | **June 30, 2007**    | ** ** | **Increase (Decrease)** | ** ** |
| ** **                               | ** ** | **Amount**                                 | ** ** | **% of  Revenues**        | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma net income (loss)** |       | $                                          | 1,642      |                           | 2.2        | %                            | $          | 164 |   | 0.4 | % | $ | 1,478 |   | 901.2 | % |
| **Amortization of intangible assets**    |       | (3,434                                     | )          | -4.5                           | %          | (3,432                       | )          | -7.6 | % | (2 | ) | 0.1 | % |
| **Taxes, net**                           |       | —                                     |       | 0.0                            | %          | —                       |       | 0.0 | % | — |   | 0.0 | % |
| **Total pro forma net income (loss)**    |       | $                                          | (1,792     | )                              | -2.4       | %                            | $          | (3,268 | ) | -7.2 | % | $ | 1,476 |   | -45.2 | % |

 

For the six months ended June 30,2008, we had a pro forma net loss of ($1.8) million compared to a pro forma netloss of ($3.3) million for the corresponding period in 2007. For the six monthsended June 30, 2008, we had an adjusted pro forma net income of $1.6million compared to an adjusted pro forma net income of $164,000 for thecorresponding period in 2007. Our only source of income prior to theconsummation of our initial business combination with AUSA was interest earnedon the funds held in a trust account.

 

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**Earningsbefore Interest, Taxes, Depreciation and Amortization (“EBITDA”)**

 
| ** **           | ** ** | **Pro forma EBITDA**           | ** ** | ** **                     | ** ** | ** **                   | ** ** |
|----------------------|------------|--------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **           | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **           | ** ** | **June 30, 2008**    | ** ** | **June 30, 2007**    | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Amount**                     | ** ** | **% of  Revenues**        | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Pro forma EBITDA** |       | $                              | 3,488      |                           | 4.6        | %                            | $          | 2,802 |   | 6.2 | % | $ | 686 |   | 24.5 | % |
|                      |            |                                |            |                                |            |                              |            |  |  |  |  |  |  |  |  |  |

 

Pro forma EBITDA rose by$0.7 million to $3.5 million in the six months ended June 30, 2008,compared to $2.8 million in the corresponding period in 2007. The EBITDA margindecreased to 4.6% from 6.2% in the corresponding period in 2007.   The June 30, 2008 EBITDA includes $0.7million in non-cash compensation expense related to restricted stock grants andemployee stock options for that period compared to $0.3 million for the sameperiod in 2007.

 

**Liquidityand Capital Resources**

 

Asof June 30, 2008, we had $13.8 million in cash and cash equivalents.

 

InJanuary 2006, Argyle completed a private placement of 125,000 units to itsexecutive officers and their affiliates and received net proceeds of approximately$0.9 million. On January 30, 2006, Argyle consummated its initial publicoffering of 3,700,046 units (which included 75,046 units sold as part of theunderwriter’s over-allotment option). Each unit in both the private placementand the public offering consisted of one share of common stock and oneredeemable common stock purchase warrant. Each warrant entitles the holder topurchase from Argyle one share of Argyle’s common stock at an exercise price of$5.50 per share.

 

Netproceeds from the sale of Argyle’s units, after deducting certain offeringexpenses of approximately $2.4 million, including underwriting discounts ofapproximately $1.8 million, were approximately $28.2 million. Approximately$27.3 million of the proceeds from the Public Offering and the PrivatePlacement were placed in a trust account for Argyle’s benefit. Except for $0.6million in interest that was earned on the funds contained in the trust accountand that was released to Argyle to be used as working capital, and the amountsreleased to Argyle for the payment of taxes, Argyle was not able to access theamounts held in the trust until it consummated a business combination. Theamounts held outside of the trust account were used by Argyle to provide forbusiness, legal, and accounting due diligence on prospective acquisitions andcontinuing general and administrative expenses. Prior to releasing the fundsheld in trust, the trust account contained $1.4 million reserved for thecompensation of Argyle’s underwriters in its Public Offering which was paid tothem upon completion of the business combination. All amounts held in trustwere released at July 31, 2007 to fund the ISI acquisition.

 

Inconnection with the Public Offering and the Private Placement, Argyle’sofficers and directors placed all the shares owned by them before the PrivatePlacement and the Public Offering into an escrow account. Except in certaincircumstances, the shares held in escrow may not be released prior to January 24,2009.   Theonly circumstance other than the date which would trigger release of shareswould be a liquidation of the Company or the consummation of a liquidation,merger, stock exchange or other similar transaction which results in all of ourstockholders having the right to exchange their shares of common stock forcash, securities or other property.

 

OnApril 16, 2007, Argyle’s officers and directors, an affiliate of BobMarbut, Argyle’s Chairman and Co-Chief Executive Officer, and certain of Argyle’sconsultants, pursuant to a note and warrant acquisition agreement, loanedArgyle an aggregate of $0.3 million and in exchange received promissory notesin the aggregate principal amount of $0.3 million and warrants to purchase anaggregate of up to 37,500 shares of Argyle’s common stock at an exercise priceof $5.50 per share. The promissory notes were repaid in full plus accruedinterest in August 2007.

 

OnJuly 31, 2007, Argyle consummated a business combination, acquiring 100%of the outstanding capital stock of ISI Detention Contracting Group, Inc.and its subsidiaries, the value of which the Board of Directors determined wasgreater than 80% of Argyle’s assets at the time of the merger. Prior to theacquisition of ISI, Argyle had no operations and was considered a developmentalstage enterprise. ISI is deemed to be a ‘‘predecessor’’ to the combinedcompany. The accompanying consolidated balance sheet includes the assets andliabilities related to the acquisition of ISI, adjusted to fair value pursuantto Statement of Financial Accounting Standards (SFAS) No. 141, *Business Combinations*.

 

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Argyleused an estimated $20.5 million (excluding Argyle and AUSA transaction costs)of the net proceeds of the initial public offering to acquire ISI. At theclosing of the merger, the following consideration was paid by the Company tothe stockholders and debt holders of ISI:

 

·                  $18.6 million in cash;

 

·                  1,180,000 shares of common stock of Argyle(valued at approximately $9.2 million); and

 

·                  $1.9 million of unsecured promissory notesconvertible into shares of common stock of the Company at a conversion price of$10 per share.

 

Additionally,Argyle incurred total transaction costs of approximately $1.7 million,including legal costs paid to Loeb & Loeb LLP of $0.5 million, $0.6million related to certain Macquarie Securities (USA) Inc.’s (formerly GiulianiCapital Advisors) advisory fees and fairness opinion, $0.3 million paid inM&A fees to WFG Investments and additional costs of $0.3 million related toaccountants, consultants, printer fees and other miscellaneous expenses. Suchcosts do not include transaction costs of approximately $1.0 million incurredby ISI (related primarily to attorney, brokerage and accounting fees).

 

Aspart of the ISI merger, public stockholders holding 211,965 of the aggregatenumber of shares sold in the Public Offering elected to redeem such shares. Theper share redemption price was equal to $7.80 per share including interestearned thereon in the trust account, net of taxes paid and payable, $0.6million of interest income which was released from the trust account in September 2006to fund our working capital, and amounts owed to the underwriter for thePrivate Placement (approximately $0.5 million plus interest). Approximately$1.6 million was paid to redemptive shareholders in August of 2007.

 

InApril 2008, Argyle completed a private placement of 18,750 shares of Series AConvertible Preferred Stock (convertible initially into 1,875,000 shares ofcommon stock) to two accredited investors and received gross proceeds of $15.0million. Rodman & Renshaw, LLC, a wholly owned subsidiary of Rodman &Renshaw Capital Group, Inc., served as the exclusive placement agent forthe offering and received $900,000 and 112,500 warrants to purchase anaggregate of up to 112,500 shares of Argyle’s common stock; exercisable at$8.00 per share, as a placement fee.

 

 ***Working Capital***

 

Ourprimary liquidity needs are for financing AUSA’s working capital (includingpremiums and fees incurred in connection with bid and performance bonds) andthe purchase of computers and related equipment. The nature of its business andoperations as a detention contractor causes cash flow from operations to behighly volatile. Its large construction contracts can produce or consume cash.The production or consumption of cash is dependent on factors inherent to theconstruction industry, including billing and payment terms of the contracts.AUSA has in place a $12.0 million credit facility to allow it to manage itsworking capital requirements.

 

AtJune 30, 2008, we had current assets of $68.2 million and currentliabilities of $29.7 million resulting in a working capital surplus ofapproximately $38.5 million compared to a surplus of $20.0 million at December 31,2007.

 

***Long-Term Debt***

 

Notespayable and long-term debt consists of the following (in thousands):

 
| ** **                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **Collateral**                            | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| Notes payable:                            |       |              |       |                  |       |
| Vehicles and equipment                    |       | $                 | 168        |                  | $          | 190 |   |
| Unsecured debt - related party            |       | 11,167            |       | 5,952                 |       |
| Unsecured convertible debt - stockholders |       | 1,925             |       | 1,925                 |       |
| Seller notes                              |       | 6,765             |       | —                |       |
| Line of credit and acquisition line       |       | 14,125            |       | 7,979                 |       |
|                                      |       | $                 | 34,150     |                  | $          | 16,046 |   |
| Less - current maturities                 |       | 2,400             |       | 81                    |       |
| Long term debt                            |       | $                 | 31,750     |                  | $          | 15,965 |   |

 

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***Vehicles and Equipment***

 

Amounts include notesrelated to Company vehicles and various equipment lines. Vehicle and equipmentnotes are staggered in regards to their maturity, each amortizing over 36 – 48month periods.  Interest rates on the individualnotes range from fixed rate of 6% up to Prime plus 1.0%. The weighted averageinterest rate for these borrowings was 6.15% and 8.2% at June 30, 2008 andDecember 31, 2007, respectively.

 

***Unsecured Debt — Related Party***

 

On January 2, 2008 anadditional $5.0 million in unsecured debt was funded by the same related partyfor which $6.0 million was outstanding at December 31, 2007.  All notes are unsecured and subordinated tothe line of credit facility. The unsecured note agreements contain prepaymentoptions with prepayment penalties. Interest accrues at 11.58% per annum and ispayable quarterly in arrears, deferred interest at the rate of 8.42% per annum,and default interest at 2% per annum. The total debt of $11.0 million plusaccrued and unpaid interest is due and payable in one single payment on January 31,2010. There are both financial and restrictive covenants associated with thenote agreements.  As of June 30,2008, the Company was in compliance with all covenants.

 

***Unsecured Convertible Debt — Stockholders***

 

As part of the ISI mergerconsideration, the Company issued unsecured convertible debt to thestockholders in the amount of $1.9 million which bears interest at 5% perannum, paid semiannually. The notes mature five years from the date of issuanceon July 31, 2012. The notes may be converted in whole or in part intoshares of the Company’s common stock at the election of the note holder at ashare price of $10.00 any time after January 1, 2008. The debt may beredeemed by the Company at $10.00 per share any time after January 1,2009.

 

In April 2007, Argyle’sofficers and directors, an affiliate of Argyle’s Chairman and Co-ChiefExecutive Officer, and certain of Argyle’s consultants, pursuant to a note andwarrant acquisition agreement, loaned Argyle an aggregate of $0.3 million andin exchange received promissory notes in the aggregate principal amount of $0.3million and warrants to purchase an aggregate of up to 37,500 shares of Argyle’scommon stock. The warrants are exercisable at $5.50 per share of common stockand expire on January 24, 2011.

 

The warrants also may beexercised on a net-share basis by the holders of the warrants. The Company hasestimated, based upon a Black-Scholes model, that the fair value of thewarrants on the date of issue was approximately $2.48 per warrant (a totalvalue of approximately $93,000 using an expected life of 2 years, volatility of2.39%, and a risk-free rate of 5%). However, because the Company’s warrantshave a limited trading history, the volatility assumption was based oninformation currently available to management. The promissory notes had aninterest at a rate of 4% per year and were repayable 30 days after theconsummation of a business combination. The notes and the associated accruedinterest were paid in full in August 2007.

 

***Seller Notes***

 

In connection with the FireQuest acquisition, the Company issued a promissory note in the aggregateprincipal amount of $250,000 (the “Fire Quest Promissory Note”). The Fire QuestPromissory Note bears interest at the rate of 7.25% per year and will becomedue and payable on January 1, 2009.

 

In connection with the PDIacquisition, the Company issued convertible promissory notes (the “PDIPromissory Notes”) in the aggregate principal amount of $3.0 million. Theaggregate principal amount of the PDI Promissory Notes may be reduced dependingon the occurrence of certain events described in the Asset Purchase Agreement.The payment of the PDI Promissory Notes are guaranteed by and secured by theassets of AUSA and Argyle and bear interest at 6% paid quarterly through December 2009.  After December 2009, principal andinterest payments of $133,000 are due monthly with final payment occurring on December 31,2012.  From June 1, 2009 through November 15,2009, the Company has the option to (i) convert $500,000 of theoutstanding principal into common stock of the Company based on 95% of theclosing price of the Company’s common stock for a 20 day trading periodpreceding notice of the Company’s intent to convert; or (ii) extend the$500,000 principal due in 2010 to January 3, 2011 for an additionalpayment of $15,000 plus accrued interest. The aforementioned options to convert or extend the PDI Promissory Noteshave resulted in the creation of compound embedded derivatives for which theCompany has performed valuations as of June 30, 2008.  The Company will mark to market thederivatives, for which any changes in fair value will be recognized in thestatement of operations, in all the subsequent quarters until they areexercised or have expired.  The valuationof these derivatives held a value of $20,000 as of June 30, 2008.

 

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In connection with theCom-Tec acquisition, the Company issued a secured subordinated promissory notein the aggregate principal amount of $3.5 million (the “Com-Tec Promissory Note”).The Com-Tec Promissory Note is guaranteed by and secured by the assets of AUSAand Argyle Security, Inc., bears interest at 7% per year and will becomedue and payable on April 1, 2011.

 

***Line of Credit Facility***

 

At June 30, 2008, theCompany had a line of credit facility totaling $12.0 million and an acquisitionloan facility in the amount of $4.3 million. The line of credit is secured byall tangible and intangible assets of AUSA excluding vehicles. The line callsfor all accounts receivable collections to be deposited directly to a lockbox.The outstanding balance on the credit facility and the acquisition loanfacility at June 30, 2008 was $9.9 million, due January 23, 2010, and$4.3 million, due June 30, 2011, respectively.  Interest is payablequarterly at prime plus 0.75% for the credit facility and at prime plus 1.25% forthe acquisition loan through December 31, 2008.  After December 31,2008, the interest rate is based on a ratio of total debt to earnings beforeinterest, taxes, depreciation and amortization ranging from prime to prime plus0.75% for the credit facility and ranging from prime plus 0.5% to prime plus1.25% for the acquisition note.  The agreement contains both financial andrestrictive covenants, including a restriction on the payment of dividends. At June 30,2008, the Company was in compliance with all covenants.

 

The Company has agreed topay an annual commitment fee of 0.5% per year on the unused borrowing capacity,which was $2.1 million and $1.0 million at June 30, 2008 and December 31,2007, respectively.

 

Aggregate maturitiesrequired on all debt at June 30, 2008 are as follows (in thousands):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining six months)                 |       | $          | 1,003      |   |
| 2009                                        |       | 2,518      |       |
| 2010                                        |       | 26,694     |       |
| 2011                                        |       | 2,518      |       |
| 2012                                        |       | 850        |       |
| Thereafter                                  |       | 567        |       |
|                                        |       | $          | 34,150     |   |

 

***Capital Leases***

 

ISI sold its owner-occupiedreal estate to a partnership owned by ISI’s stockholders during 2004 andentered into a leaseback of the properties with the partnership. ISI enteredinto a second lease on another property owned by the same partnership in 2006.AUSA entered into a third lease on another property owned by the samepartnership in June 2008.  All threeleases are triple net leases. A triple net lease is a lease agreement on aproperty where the tenant or lessee agrees to pay all real estate taxes,building insurance, and maintenance (the three ‘Nets’) on the property inaddition to any normal fees that are expected under the agreement (rent, etc.).In such a lease, the tenant or lessee is responsible for all costs associatedwith repairs or replacement of the structural building elements of theproperty.

 

The terms of theaforementioned leases were modified on July 31, 2007 to extend theexpiration date from 2018 to 2019. The modification did not materially affectthe carrying value of the assets or related liabilities recorded in theaccompanying consolidated balance sheet.

 

***Commitments***

 

AUSA leases office space andequipment under operating leases expiring through 2012.   The corporate office lease space of Argyleexpired as of July 31, 2007 and Argyle operated under a month-to-monthlease arrangement until it was renewed in January 2008.  The new lease expands the space fromapproximately 2,500 square feet to 5,500 square feet for a total expense in2008 of $121,000.

 

As part of the acquisitionof PDI on January 4, 2008, the Company assumed PDI’s existing leases.  The PDI leases are 4 year leases, for the twofacilities that occupy a total of 42,000 square feet (26,000 square footfacility in Arizona and the 16,000 square foot facility in California) with aggregatemonthly payments of $16,000.   As part ofthe Com-Tec acquisition that occurred at January 31, 2008 the Companysigned a new lease for the existing facility. The Com-Tec lease is a 5 year lease, for the 33,000 square footfacility, with aggregate monthly payments of $14,000 beginning in year 3 withthe total rent expense being recognized on a straight line basis over the lifeof the lease.

 

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Rental expense was $217,000and $17,000 for the three months ended June 30, 2008 and 2007,respectively, and $540,000 and $33,000 for the six months ended June 30,2008 and 2007, respectively.  Rentalexpense was $89,000 and $163,000 for the three and six months ended June 30,2007 (Predecessor), respectively.

 

August 2007 the Companyentered into a letter of credit facility with a financial institution. Theletter of credit may not exceed $500,000. The facility requires a 1% annualcommitment fee on the unused portion of the letter of credit facility and ispaid quarterly.

 

In May 2008 the Companyentered into a letter of credit facility with a financial institution. Theletter of credit may not exceed $2.5 million. The facility does not have a feeon the unused portion of the letter of credit facility.

 

**Off BalanceSheet Arrangements**

 

Argyle does not have anyoff-balance sheet arrangements.

 

**ContractualObligations**

 

Aggregate amounts at June 30,2008 are as follows (in thousands):

 
| ** **                              | ** ** | **Total** | ** ** | **< 1 Year** | ** ** | **1 < 3 Years** | ** ** | **3 < 5 Years** | ** ** | **> 5 Years** | ** ** |
|-----------------------------------------|------------|-----------|------------|---------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|----------------------------|------------|
| Principal on Long Term Debt Obligations |       | $         | 34,150     |                      | $          | 1,003                             |       | $                                 | 29,212     |                       | $          | 3,368 |   | $ | 567 |   |
| Capital Lease Obligations               |       | 5,557     |       | 247                       |       | 986                               |       | 986                               |       | 3,338                      |       |
| Operating Lease Obligations             |       | 2,790     |       | 398                       |       | 1,195                             |       | 997                               |       | 200                        |       |
| Interest on Long Term Debt Obligations  |       | 7,952     |       | 3,072                     |       | 3,931                             |       | 949                               |       | —                     |       |
| **Total**                               | ** ** | **$**     | **50,449** | ** **                | **$**      | **4,720**                         | ** ** | **$**                             | **35,324** | ** **                 | **$**      | **6,300** | ** ** | **$** | **4,105** | ** ** |

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLSOURES ABOUT MARKET RISK**

 

Market risk is thesensitivity of income to changes in interest rates, foreign exchanges, commodityprices, equity prices, and other market-driven rates or prices.

 

At June 30, 2008, the Company had a line ofcredit facility totaling $12.0 million and an acquisition loan facility in theamount of $4.3 million. The line of credit is secured by all tangible andintangible assets of AUSA excluding vehicles. The outstanding balance on thecredit facility and the acquisition loan facility at June 30, 2008 was$9.9 million, due January 23, 2010, and $4.3 million, due June 30,2011, respectively.  Interest is payable quarterly at prime plus 0.75% forthe credit facility and at prime plus 1.25% for the acquisition loan through December 31,2008.  After December 31, 2008, the interest rate is based on a ratioof total debt to earnings before interest, taxes, depreciation and amortizationranging from prime to prime plus 0.75% for the credit facility and ranging fromprime plus 0.5% to prime plus 1.25% for the acquisition note.

 

Changes in market rates may impact the bank’s LIBORrate or prime rate. For instance, if either the LIBOR or prime rate were toincrease or decrease by one percentage point (1.0%), our annual interestexpense would change by approximately $163,000 based on the total creditavailable to Argyle.

 

**ITEM 4T. CONTROLS AND PROCEDURES**

 

**Evaluation of Disclosure Controls andProcedures**

 

An evaluation of the effectiveness of our disclosurecontrols and procedures as of June 30, 2008 was made under the supervisionand with the participation of our co-Chief Executive Officers, Chief FinancialOfficer and Corporate Controller. Based on that evaluation, our co-ChiefExecutive Officers and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective as of the end of the period covered bythis report.  Our disclosure controls andprocedures are designed to ensure that information required to be disclosed byus in reports that we file or submit under the Securities Exchange Act of 1934is recorded, processed, summarized and reported within the time periodsspecified in Securities and Exchange Commission rules and forms.

 

Management has excluded ISI, PDI, Com-Tec, and FireQuest which was integrated into Argyle Commercial Security from its assessmentof internal control over financial reporting as of June 30, 2008.  ISI was acquired on July 31, 2007, FireQuest was acquired on January 1, 2008, PDI was acquired on January 4,2008, and Com-Tec was acquired on January 31, 2008. Argyle was a shellcompany when it acquired ISI and each of PDI, Fire Quest and Com-Tec would beconsidered significant subsidiaries of Argyle.

 

**Changes in Internal Control overFinancial Reporting**

 

During the most recently completed fiscal quarter,there has been no significant change in our internal control over financialreporting that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II- OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

From time to time, the Company has various lawsuits,claims, and contingent liabilities arising from the conduct of its business;however, in the opinion of management, they are not expected to have a materialadverse effect on the combined results of operations, cash flows, or financialposition of the Company.

 

**ITEM 1A. RISK FACTORS**

 

In addition to the other information set forth in thisreport, you should carefully consider the factors discussed in Part I, “Item1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31,2007, which could materially affect our business, financial condition or futureresults. The risks described in our Annual Report on Form 10-K are not theonly risks facing our Company. Additional risks and uncertainties not currentlyknown to us or that we currently deem to be immaterial also may materiallyadversely affect our business, financial condition and/or operatingresults.  In addition to the risk factorscontained in our Annual Report on form 10-K, you should also consider thefollowing:

 

***We derive asignificant portion of our revenues from a small number of customers and theloss of a significant customer could significantly reduce our revenues.***

 

Our customer base and revenues are concentrated amonga limited number of customers and the loss of any one of these customers couldsignificantly reduce our revenues.  During the three and six months ended June 30,2008, revenue from our top three customers, which were all from ArgyleCorrections, represented 26% and 33%, respectively, of our total revenues.  During the three months ended June 30,2008, we had revenues from our top two customers, which were all from ArgyleCorrections, which represented 11% and 9% of our total revenues.  During the six months ended June 30,2008, we had revenues from our top two customers, which were all from ArgyleCorrections, which represented 15% and 9% of our total revenues.  These concentrations are down from the threemonths ended March 31, 2008 when the top three customers represented 42%of our total revenues.

 

***If outstandingpublic warrants are exercised, the underlying common shares will be eligiblefor future resale in the public market. ‘‘Market overhang’’ from the warrantsresults in dilution and could keep the market price of our stock lower than itwould otherwise be.***

 

Outstanding publicwarrants and unit purchase options to purchase an aggregate of 4,075,046 sharesof common stock issued in connection with Argyle’s initial public offering andthose for services rendered in connection with a financing transaction arecurrently exercisable. If they are exercised, a substantial number ofadditional shares of our common stock will be eligible for resale in the publicmarket, which could keep the market price of our stock lower than it wouldotherwise be.

 

***Our ability toobtain payment and/or performance bonds is critical to our ability to conductbusiness.***

 

Performance and paymentbonds are an important component of our business, because many customersrequire that performance and payment bonds be delivered to the customer beforethe customer will enter into a contract. Approximately 39% of contract revenuesand 35% of overall company revenues for 2007 were generated by “bonded”contracts (contracts that require performance and payment bonds), andapproximately 37% of AUSA revenues in the past three years have been derivedfrom bonded contracts.

 

From 2004 through theacquisition of ISI in July 2007, bonding capacity had been made availableto ISI through ISI*MCS, an entity created and owned by the Chief ExecutiveOfficer and President of ISI, Sam Youngblood and Don Carr, respectively. Sincethe consummation of the acquisition of ISI, ISI*MCS has not provided any newbonded contracts for ISI or Argyle. Subject to the final determination by a bonding company, we believe thatsufficient new bonding capacity to address the total expected business in 2008will be available to us because in April 2008 we closed a privateplacement of our Series A Convertible Preferred Stock for gross proceedsof $15.0 million. However, if we are unable to secure increasing lines ofbonding capacity, then we will not be able to enter into contracts that requiresuch bonds. This would significantly reduce our expected sales and reduce thelevel of our future financial performance. Some of the additional factors thatmight cause AUSA to be unable to obtain such bonds include, but are not limitedto, unacceptably high premium rates for such bonds, the unavailability ofbonding capacity at an acceptable cost from a bonding company with anacceptable financial rating, or the collateral/financial requirements of thebonding company. Such requirements are generally intended to provide liquidityto a bonding company should it become obligated to pay a claim. Theserequirements can include minimum cash reserves, letters of credit for thebenefit of the bonding company and other irrevocable commitments of workingcapital that are unacceptably high. In addition, because ISI*MCS no longer hasa relationship with us, we no longer have the benefit of a long-standingrelationship with a bonding company.

 

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**ITEM 2. UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

None.

 

**ITEM 3. DEFAULTS UPON SENIORSECURITIES**

 

None.

 

**ITEM 4. SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

 

On May 30, 2008, we held our annual meeting ofstockholders.  Two matters were presentedto our stockholders at the meeting:

 

1.               The election of two directors to serve for athree-year term expiring at our 2011 annual meeting of stockholders, and

2.               The ratification of the appointment of Ernst &Young LLP as our independent registered public accounting firm for the fiscalyear ending December 31, 2008.

 

At the annual meeting, Lloyd Campbell and John Smithwere re-elected to our Board of Directors and the appointment of Ernst &Young LLP was ratified.  The below tablecontains information with respect to members of our Board of Directors who werenot up for election at this meeting and when their terms expire:

 
| **Name**          | ** ** | **Current  Board  Term  Expires** | ** ** |
|-------------------|------------|-----------------------------------|------------|
|              |       |                              |       |
| Bob Marbut        |       | 2010                              |       |
|              |       |                              |       |
| Ron Chaimovski    |       | 2010                              |       |
|              |       |                              |       |
| Gen. Wesley Clark |       | 2009                              |       |
|              |       |                              |       |
| Walter Klein      |       | 2009                              |       |

 

The following tables contain information relating tothe voting at the annual meeting:

 

In the vote for the election of directors:

 
| **Name**       | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** |
|----------------|------------|--------------------|------------|-------------------------|------------|
| John Smith     |       | 4,632,918          |       | 350                     |       |
| Lloyd Campbell |       | 4,632,918          |       | 350                     |       |

 

In the vote for the ratification of the appointment ofErnst & Young:

 
| **Votes For** | ** ** | **Votes Against** | ** ** | **Abstentions** | ** ** | **Broker Non-votes** | ** ** |
|--------------------|------------|------------------------|------------|-----------------|------------|---------------------------|------------|
| 4,632,918          |       | 350                    |       | 0               |       | 0                         |       |

 

**ITEM 5. OTHER INFORMATION**

 

None.

 

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**ITEM 6. EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                      |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                 |       | Certification of the Co-Chief Executive Officer  (Principal Executive Officer) pursuant to Rule 13a-14(a) of the  Securities Exchange Act, as amended                      |
| 31.2                 |       | Certification of the Co-Chief Executive Officer  (Principal Executive Officer) pursuant to Rule 13a-14(a) of the  Securities Exchange Act, as amended                      |
| 31.3                 |       | Certification of the Chief Financial Officer  (Principal Financial Officer) pursuant to Rule 13a-14(a) of the  Securities Exchange Act, as amended                         |
| 31.4                 |       | Certification of the Vice President and Corporate  Controller (Principal Accounting Officer) pursuant to  Rule 13a-14(a) of the Securities Exchange Act, as amended        |
| 32.1                 |       | Certification of the Co-Chief Executive Officers and  Chief Financial Officer pursuant to 18 U.S.C. 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |
| 99.1                 |       | Press Release dated August 14, 2008 announcing  Argyle Security Inc.’s Second Quarter 2008 financial results.                                                                   |

 

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**SIGNATURES**

 

In accordance with the requirements of the ExchangeAct, the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

 
|                      | ARGYLE SECURITY, INC |
|----------------------|----------------------|
| ** **           | ** **           |
| ** **           | ** **           |
| August 14, 2008 | By:                  | /s/ Bob Marbut |
|                 |                 | Bob Marbut |
|                 |                 | Co-Chief Executive Officer   (Principal Executive Officer) |
|                 |                 |   |
|                 |                 |   |
| August 14, 2008 | By:                  | /s/ Ron Chaimovski |
|                 |                 | Ron Chaimovski |
|                 |                 | Co-Chief Executive Officer  (Principal Executive Officer) |
|                 |                 |   |
|                 |                 |   |
| August 14, 2008 | By:                  | /s/ Donald F. Neville |
|                 |                 | Donald F. Neville |
|                 |                 | Chief Financial Officer   (Principal Financial Officer) |
|                 |                 |   |
|                 |                 |   |
| August 14, 2008 | By:                  | /s/ Dean A. Dresser |
|                 |                 | Dean A. Dresser |
|                 |                 | Vice President and Corporate Controller  (Principal Accounting Officer) |

 

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