****UNITED STATES****

****SECURITIES AND EXCHANGE COMMISSION****

****WASHINGTON, D.C. 20549****

**** ****

****FORM 10-Q****

 

| **x**          | **** **** | ****Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934****  |
|----------------|----------------|--------------------------------------------------------------------------------------------------------------|
| **** **** | **** **** | **** ****                                                                                               |
| ** **     | ** **     | ****For  the quarterly period ended March 31, 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.****                                                                  |

 

****Commission File Number: 000-51639****

 

****Argyle Security, Inc.****

(Exact name of registrant as specified in its charter)

 

| ****Delaware****                                              | **** **** | ****20-3101079****                  |
|---------------------------------------------------------------|----------------|-------------------------------------|
| (State or Other Jurisdiction ofIncorporation or Organization) |           | (I.R.S. EmployerIdentification No.) |

 

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

(Address of Principal Executive Offices including Zip Code)

 

****(210) 828-1700****

(Registrant’s Telephone Number, Including Area Code)

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant was requiredto file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  Noo

 

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

 

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o  Nox

 

Therewere 5,964,342 shares of the Registrant’s common stock issued and outstandingas of May 20, 2008.

 

 

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****Argyle Security, Inc. Index to Form 10-Q****

 
| ******Part I.******  | ******Financial Information******                                                                   | 1      |
|---------------------------|-----------------------------------------------------------------------------------------------------|--------|
|                      |                                                                                                |   |
|                      | Item 1. Consolidated Financial Statements (unaudited)                                               | 1      |
|                      |                                                                                                |   |
|                      | Consolidated Balance Sheets                                                                         | 1      |
|                      |                                                                                                |   |
|                      | Consolidated Statements of Operations                                                               | 2      |
|                      |                                                                                                |   |
|                      | Consolidated Statement of Stockholders’ Equity                                                 | 3      |
|                      |                                                                                                |   |
|                      | Consolidated Statement of Cash Flows                                                                | 4      |
|                      |                                                                                                |   |
|                      | Notes to Unaudited Consolidated Financial Statements                                                | 5      |
|                      |                                                                                                |   |
|                      | Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 31     |
|                      |                                                                                                |   |
|                      | Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 | 49     |
|                      |                                                                                                |   |
|                      | Item 4. Controls and Procedures                                                                     | 49     |
|                      |                                                                                                |   |
| ******Part II.****** | ******Other  Information******                                                                      |   |
|                      |                                                                                                |   |
|                      | Item  1. Legal Proceedings                                                                          | 50     |
|                      |                                                                                                |   |
|                      | Item  1A. Risk Factors                                                                              | 50     |
|                      |                                                                                                |   |
|                      | Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                | 50     |
|                      |                                                                                                |   |
|                      | Item 3. Defaults Upon Senior Securities                                                             | 50     |
|                      |                                                                                                |   |
|                      | Item 4. Submission of Matters to a Vote of Security  Holders                                        | 50     |
|                      |                                                                                                |   |
|                      | Item  5. Other Information                                                                          | 50     |
|                      |                                                                                                |   |
|                      | Item 6.  Exhibits                                                                                   | 51     |
|                      |                                                                                                |   |
| SIGNATURES                |                                                                                                |   |

 

----

 

****PART I - FINANCIALINFORMATION****

 

****ITEM 1 - CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)****

 

****ARGYLE SECURITY, INC.****

****CONSOLIDATED BALANCE SHEET****S

**(unaudited)**

 

(in thousands except share data)

 
| ** **                                                                                                                                                                                                   | ** ** | **March 31,** | ** **    | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|---------------|-----------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2008**           | ** **    | **2007**              | ** ** |
| ** **                                                                                                                                                                                                   | ** ** | **(Unaudited)**    | ** **    | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                   |       |               |          |                  |       |
| Current assets:                                                                                                                                                                                              |       |               |          |                  |       |
| Cash and cash equivalents                                                                                                                                                                                    |       | $                  | 2,532         |                  | $          | 3,556 |   |
| Receivables:                                                                                                                                                                                                 |       |               |          |                  |       |   |   |
| Contract – net of allowance for doubtful  accounts of $ 1,164 and $975 at March 31, 2008 and December 31,  2007, respectively                                                            |       | 34,843             |          | 14,459                |       |
| Contract receivables – related party                                                                                                                                                                    |       | 10,204             |          | 10,887                |       |
| Other receivables – related party                                                                                                                                                                       |       | 48                 |          | 42                    |       |
| Costs and estimated earnings in excess of  billings on incomplete contracts                                                                                                                                  |       | 5,739              |          | 7,665                 |       |
| Intangible assets                                                                                                                                                                                            |       | 3,650              |          | 2,959                 |       |
| Refundable income taxes                                                                                                                                                                                      |       | 491                |          | 561                   |       |
| Other current assets                                                                                                                                                                                         |       | 1,433              |          | 378                   |       |
| Deferred income taxes, net                                                                                                                                                                                   |       | 191                |          | —                | ** ** |
| Total current assets                                                                                                                                                                                         |       | 59,131             |          | 40,507                |       |
| Property and equipment, net                                                                                                                                                                                  |       | 6,717              |          | 5,227                 | ** ** |
| Goodwill                                                                                                                                                                                                     |       | 24,336             |          | 19,937                | ** ** |
| Intangible assets                                                                                                                                                                                            |       | 18,136             |          | 15,146                | ** ** |
| Deposits, deferred transaction costs, and  other assets                                                                                                                                                      |       | 547                |          | 331                   | ** ** |
| Total other assets                                                                                                                                                                                           |       | 49,736             |          | 40,641                |       |
| Total assets                                                                                                                                                                                                 |       | $                  | 108,867       |                  | $          | 81,148 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                |       |               |          |                  |       |
| Current liabilities:                                                                                                                                                                                         |       |               |          |                  |       |
| Accounts payable and accrued liabilities                                                                                                                                                                     |       | $                  | 21,207        |                  | $          | 14,318 | ** ** |
| Accounts payable – related party                                                                                                                                                                        |       | 53                 |          | 40                    |       |
| Billings in excess of costs and estimated  earnings on incomplete contracts                                                                                                                                  |       | 10,105             |          | 5,733                 |       |
| Notes and interest payable to stockholders                                                                                                                                                                   |       | 24                 |          | 40                    |       |
| Current portion of capitalized lease  obligations                                                                                                                                                            |       | 107                |          | 97                    |       |
| Current portion of long-term debt                                                                                                                                                                            |       | 413                |          | 81                    |       |
| Deferred income taxes                                                                                                                                                                                        |       | —             |          | 210                   | ** ** |
| Total current liabilities                                                                                                                                                                                    |       | 31,909             |          | 20,519                |       |
| Long-Term Liabilities:                                                                                                                                                                                       |       |               |          |                  |       |
| Deferred income taxes                                                                                                                                                                                        |       | 6,063              |          | 6,095                 |       |
| Long-term debt – less current portion                                                                                                                                                                   |       | 32,518             |          | 15,965                |       |
| Deferred rent and other long term  liabilities                                                                                                                                                               |       | 18                 |          | —                |       |
| Long-term capitalized lease obligations -  less current portion                                                                                                                                              |       | 1,871              |          | 1,904                 |       |
| Total long-term liabilities                                                                                                                                                                                  |       | 40,470             |          | 23,964                |       |
| Total liabilities                                                                                                                                                                                            |       | 72,379             |          | 44,484                |       |
| Stockholders’ Equity                                                                                                                                                                                    |       |               |          |                  |       |
| Preferred stock of Argyle  Security, Inc. - $.0001 par value; 1,000,000 shares authorized; 0 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  March 31, 2008 and 5,879,342 at December 31, 2007 |       | 1                  |          | 1                     |       |
| Additional paid in capital                                                                                                                                                                                   |       | 36,837             |          | 36,279                |       |
| Accumulated earnings (deficit)                                                                                                                                                                               |       | (350               | )             | 384                   |       |
| Total stockholders’ equity                                                                                                                                                                              |       | 36,488             |          | 36,664                |       |
| Total liabilities and stockholders’ equity                                                                                                                                                              |       | $                  |  108,867 |                  | $          |  81,148 |   |

 

See notes to unaudited consolidated financial statements

 

1

----

 

****ARGYLE SECURITY, INC.****

****CONSOLIDATED STATEMENT OFOPERATIONS****

****(unaudited)****

 

(in thousands except share data)

 
| ** **                                                                                                           | ** ** | ** **                       | ** ** | ** **                       | ** ** | **Predecessor (ISI)** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                                                                           | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
| ** **                                                                                                           | ** ** | **March 31,**               | ** ** | **March , 31**         | ** ** | **March 31,**         | ** ** |
| ** **                                                                                                           | ** ** | **2008**                         | ** ** | **2007**                         | ** ** | **2007**                   | ** ** |
| Revenues:                                                                                                            |       |                             |       |                             |       |                       |       |
| Contract revenues                                                                                                    |       | $                                | 25,188     |                             | $          | —                     |       | $ | 9,341 |   |
| Contract revenues - related party                                                                                    |       | 6,943                            |       | —                           |       | 5,801                      |       |
| Service and other revenues                                                                                           |       | 5,466                            |       | —                           |       | 3,710                      |       |
| Total revenues                                                                                                       |       | 37,597                           |       | —                           |       | 18,852                     |       |
| Cost of revenues:                                                                                                    |       |                             |       |                             |       |                       |       |
| Contract costs                                                                                                       |       | 25,670                           |       | —                           |       | 12,056                     |       |
| Service and other costs, including $1,252  of amortization of intangibles in 2008                                    |       | 5,523                            |       | —                           |       | 3,041                      |       |
| Total cost of revenues                                                                                               |       | 31,193                           |       | —                           |       | 15,097                     |       |
| Gross profit                                                                                                         |       | 6,404                            |       | —                           |       | 3,755                      |       |
| Operating expenses:                                                                                                  |       |                             |       |                             |       |                       |       |
| Salaries and related expenses, including  $558 in stock-based compensation                                           |       | 3,369                            |       | —                           |       | 1,462                      |       |
| Consulting fees and outside services                                                                                 |       | 945                              |       | 165                              |       | 92                         |       |
| Depreciation                                                                                                         |       | 459                              |       | 1                                |       | 241                        |       |
| Other general and administrative expenses                                                                            |       | 1,588                            |       | 125                              |       | 760                        |       |
| Amortization of intangible assets                                                                                    |       | 421                              |       | —                           |       | —                     |       |
| Total operating expenses                                                                                             |       | 6,782                            |       | 291                              |       | 2,555                      |       |
| Operating income (loss)                                                                                              |       | (378                             | )          | (291                             | )          | 1,200                      |       |
| Other income (expense):                                                                                              |       |                             |       |                             |       |                       |       |
| Interest income                                                                                                      |       | 26                               |       | 385                              |       | 4                          |       |
| Interest expense                                                                                                     |       | (799                             | )          | (15                              | )          | (984                       | )          |
| Total other income (expense)                                                                                         |       | (773                             | )          | 370                              |       | (980                       | )          |
| Income (loss) before provision for income  taxes                                                                     |       | (1,151                           | )          | 79                               |       | 220                        |       |
| Provision (benefit) for income taxes                                                                                 |       | (417                             | )          | 27                               |       | 97                         |       |
| Net income (loss)                                                                                                    |       | (734                             | )          | 52                               |       | 123                        |       |
| Deferred interest, net of taxes,  attributable to common stock subject to possible redemption                        |       | —                           |       | 50                               |       |                       |       |
| Net income (loss) allocable to holders of  non-redeemable common stock                                               |       | $                                | (734       | )                                | $          | 2                          |       |   |   |
|                                                                                                                 |       |                             |       |                             |       |                       |       |
| Weighted-average number of shares of common  stock outstanding:                                                      |       |                             |       |                             |       |                       |       |
| Basic                                                                                                                |       | 5,749,342                        |       | 4,781,307                        |       |                       |       |
| Diluted                                                                                                              |       | 5,749,342                        |       | 4,781,307                        |       |                       |       |
| Net income (loss) per share:                                                                                         |       |                             |       |                             |       |                       |       |
| Basic                                                                                                                |       | $                                | (0.13      | )                                | $          | 0.01                       |       |   |   |
| Diluted                                                                                                              |       | $                                | (0.13      | )                                | $          | 0.01                       |       |   |   |
| Weighted-average number of shares of common  stock outstanding exclusive of shares subject to possible redemption:   |       |                             |       |                             |       |                       |       |
| Basic                                                                                                                |       | 5,749,342                        |       | 4,016,680                        |       |                       |       |
| Diluted                                                                                                              |       | 5,749,342                        |       | 4,016,680                        |       |                       |       |
| Net income (loss) per share exclusive of  common stock and related deferred interest subject to possible redemption: |       |                             |       |                             |       |                       |       |
| Basic                                                                                                                |       | $                                | (0.13      | )                                | $          | 0.00                       |       |   |   |
| Diluted                                                                                                              |       | $                                | (0.13      | )                                | $          | 0.00                       |       |   |   |
|                                                                                                                      |            |                                  |            |                                  |            |                            |            |  |  |  |

 

See notes to unaudited consolidated financial statements

 

2

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****ARGYLE SECURITY, INC.****

****CONSOLIDATED STATEMENT OFCHANGES IN STOCKHOLDERS’ EQUITY****

****DECEMBER 31, 2007 THROUGH MARCH 31, 2008****

****(unaudited)****

 

(in thousands except per share data)

 
| ** **                        | ** ** | ** **            | ** ** | ** **       | ** ** | **Additional**      | ** ** | **Accumulated**        | ** ** | **Total**  | ** ** |
|-----------------------------------|------------|-----------------------|------------|------------------|------------|---------------------|------------|------------------------|------------|------------|------------|
| ** **                        | ** ** | **Common Stock** | ** ** | **Paid in** | ** ** | **Earnings /** | ** ** | **Stockholders’** | ** ** |
| ** **                        | ** ** | **Shares**            | ** ** | **Amount**       | ** ** | **Capital**         | ** ** | **(Deficit)**          | ** ** | **Equity** | ** ** |
| Balance at December 31, 2007 |       | 5,879,342             |       | $                | 1          |                | $          | 36,279                 |       | $          | 384        |   | $ | 36,664 |   |
| Stock-based compensation          |       | 85,000                |       | —           |       | 558                 |       | —                 |       | 558        |       |
| Net income (loss)                 |       | —                |       | —           |       | —              |       | (734                   | )          | (734       | )          |
| Balance at March 31, 2008    |       | 5,964,342             |       | $                | 1          |                | $          | 36,837                 |       | $          | (350       | ) | $ | 36,488 |   |

 

See notes to unaudited consolidated financial statements

 

3

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****ARGYLE SECURITY, INC.****

****CONSOLIDATED STATEMENT OFCASH FLOWS****

****(unaudited)****

**** ****

****(in thousands)****

**** ****
| ** **                                                                                         | ** ** | ** **                       | ** ** | ** **                       | ** ** | **Predecessor (ISI)** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                                                         | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
| ** **                                                                                         | ** ** | **March 31,**               | ** ** | **March 31,**               | ** ** | **March 31,**         | ** ** |
| ** **                                                                                         | ** ** | **2008**                         | ** ** | **2007**                         | ** ** | **2007**                   | ** ** |
| **Cash flows from operating activities:**                                                          |       |                             |       |                             |       |                       |       |
| Net income (loss)                                                                                  |       | $                                | (734       | )                                | $          | 52                         |       | $ | 123 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities |       |                             |       |                             |       |                       |       |
| Stock-based compensation                                                                           |       | 558                              |       | —                           |       | —                     |       |
| Amortization                                                                                       |       | 1,673                            |       | —                           |       | —                     |       |
| Depreciation                                                                                       |       | 488                              |       | 1                                |       | 328                        |       |
| Interest earned on assets held in trust                                                            |       | —                           |       | (381                             | )          | —                     |       |
| Tax payments relapsed from the trust                                                               |       | —                           |       | 119                              |       | —                     |       |
| Decrease (increase) in contract receivables                                                        |       | (15,552                          | )          | —                           |       | (1,052                     | )          |
| Decrease (increase) in related party  contract receivables                                         |       | 684                              |       | —                           |       | —                     |       |
| Decrease (increase) in related party  receivables                                                  |       | (6                               | )          | —                           |       | —                     |       |
| Decrease (increase) in costs and estimated  earnings in excess of billings                         |       | 2,702                            |       | —                           |       | 53                         |       |
| Decrease (increase) in other assets                                                                |       | 237                              |       | (66                              | )          | (146                       | )          |
| Increase (decrease) in accounts payable and  accrued expenses                                      |       | 3,569                            |       | (145                             | )          | (1,033                     | )          |
| Increase (decrease) in other long-term  liabilities                                                |       | 18                               |       | —                           |       | —                     |       |
| Increase (decrease) in deferred income  taxes                                                      |       | (392                             | )          | 22                               |       | 63                         |       |
| Increase (decrease) in billings in excess  of costs and estimated earnings                         |       | 3,854                            |       | —                           |       | 262                        |       |
| **Net cash used in operating activities**                                                          | ** ** | **$**                            | **(2,901** | **)**                            | **$**      | **(398**                   | **)**      | **$** | **(1,402** | **)** |
|                                                                                               |       |                             |       |                             |       |                       |       |
| **Cash flows from investing activities:**                                                          |       |                             |       |                             |       |                       |       |
| Purchase of investments held in trust                                                              |       | —                           |       | (70,375                          | )          | —                     |       |
| Maturity of investments held in trust                                                              |       | —                           |       | 70,375                           |       | —                     |       |
| Acquisitions, net of cash acquired                                                                 |       | (5,259                           | )          | —                           |       | (73                        | )          |
| Purchase of property and equipment                                                                 |       | (781                             | )          | —                           |       | (534                       | )          |
| Transaction costs                                                                                  |       | (223                             | )          | (160                             | )          | (44                        | )          |
| Increase / (decrease) in other assets                                                              |       | —                           |       | (6                               | )          | —                     |       |
| **Net cash used in investing activities**                                                          | ** ** | **$**                            | **(6,263** | **)**                            | **$**      | **(166**                   | **)**      | **$** | **(651** | **)** |
|                                                                                               |       |                             |       |                             |       |                       |       |
| **Cash flows from financing activities:**                                                          |       |                             |       |                             |       |                       |       |
| Offering costs                                                                                     |       | (7                               | )          | (7                               | )          | —                     |       |
| Payments on borrowings                                                                             |       | (12,071                          | )          | —                           |       | (20                        | )          |
| Proceeds from borrowings                                                                           |       | 15,136                           |       | —                           |       | 1,801                      |       |
| Proceeds from notes payable                                                                        |       | 5,105                            |       | —                           |       | —                     |       |
| Payments on capital lease obligations                                                              |       | (23                              | )          | —                           |       | (25                        | )          |
| **Net cash provided by (used in) financing  activities**                                           | ** ** | **$**                            | **8,140**  | ** **                       | **$**      | **(7**                     | **)**      | **$** | **1,756** | ** ** |
|                                                                                               |       |                             |       |                             |       |                       |       |
| **Net decrease in cash and cash equivalents**                                                      | ** ** | **$**                            | **(1,024** | **)**                            | **$**      | **(571**                   | **)**      | **$** | **(297** | **)** |
| Cash and cash equivalents at beginning of  year                                                    | ** ** | **3,556**                        | ** ** | **694**                          | ** ** | **359**                    | ** ** |
| **Cash and cash equivalents at end of year**                                                       | ** ** | **$**                            | **2,532**  | ** **                       | **$**      | **123**                    | ** ** | **$** | **62** | ** ** |

 

See notes to unaudited consolidated financial statements

 

4

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****ARGYLE SECURITY, INC.****

****NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS****

****MARCH 31, 2008****

 

**Note 1 — Basis of Presentation**

 

Argyle Security, Inc.is the parent company whose primary business operations are conducted under thename Argyle Security USA (which consists of the business of our wholly-ownedsubsidiary ISI Security Group, Inc. and all of its operatingsubsidiaries). We refer to Argyle Security USA as “AUSA” in this document andwhere the context indicates, to the historical business of ISI Security Group, Inc.as ISI.

 

ArgyleSecurity, Inc. (formerly Argyle Security Acquisition Corporation) (theCompany, we, us, our, or Argyle) was incorporated in Delaware in June 2005as a blank check company formed to acquire, through merger, capital stockexchange, asset acquisition, or other similar business combination, a businessin the security industry. On July 31, 2007, Argyle consummated its initialacquisition through the acquisition of 100% of the outstanding capital stock ofISI Detention Contracting Group, Inc. (ISI) and its subsidiaries. Prior tothe acquisition of ISI, Argyle had no operations and was considered adevelopmental stage enterprise. ISI is deemed to be a “predecessor” to theCompany.   As a result, the statements ofoperations and statements of cash flows of ISI for three months ended March 31,2007 are presented for comparative purposes. The results of operations and cashflows on a consolidated basis subsequent to the acquisition of ISI are notcomparative to the predecessor ISI results of operations and cash flows becausethe basis for the acquired assets and liabilities of ISI have been adjusted tofair value pursuant to Statement of Financial Accounting Standards (SFAS) No. 141,*Business Combinations*.

 

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 consistsof all of our businesses in the corrections sector including ISI, MetroplexControl Systems (MCS) as well as Com-Tec Security LLC (Com-Tec) and PetersonDetention, Inc. (PDI).  Com-Tec andPDI were acquired in January 2008. This segment includes:

 

· ISI (also referred to historically asISI-Detention) designs, engineers, supplies, installs, and maintains a fullarray of detention systems and equipment, targeting correctional facilitiesthroughout the United States;

 

· Metroplex Control Systems (also referred tohistorically as MCS-Detention) designs, engineers, supplies, installs andmaintains complex, customized security, access control, video and electronicsecurity control system solutions 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.

 

ArgyleCommercial Securityfocuses 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.

 

AUSA is a detention andcommercial equipment contractor that specializes in turnkey installations,including design, engineering, supply, and installation of various detentionequipment for correctional facilities and institutions. The work is performedunder fixed-price contracts. The projects are located in various cities in theUnited States. The length of the contracts varies but is typically less thantwo years. AUSA also provides turnkey installations covering the full spectrumof electronic 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 of the partnership interests of which are directly orindirectly 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.

 

5

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****ARGYLE SECURITY, INC.****

****NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS****

****MARCH 31, 2008****

 

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

 

OnJanuary 4, 2008, AUSA acquired substantially all of the business assetsand liabilities of PDI.  PDI is afull-service, turnkey solutions provider that manufactures high security metalbarriers, high security observation window systems, detention furniture andaccessories.

 

OnJanuary 31, 2008, ISI Controls, Ltd. (ISI-Controls), a wholly ownedsubsidiary of AUSA, which in turn is a wholly owned subsidiary of the Company,closed a transaction, pursuant to which ISI-Controls acquired 100% of theoutstanding units of Com-Tec, resulting in Com-Tec becoming a wholly owned subsidiaryof ISI-Controls. Com-Tec is engaged in the business of custom design,manufacture and installation of electronic security and communication systems.

 

Theunaudited consolidated financial statements of Argyle as of March 31, 2008and for the three months ended March 31, 2008 and 2007 include theaccounts of the Company and all wholly-owned subsidiaries. All significantintercompany transactions and balances have been eliminated inconsolidation.  In the opinion ofmanagement, all normal recurring adjustments considered necessary for a fairpresentation 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 ofOperations*

 

Theaccompanying unaudited consolidated statements of operations only reflect theoperating results of companies acquired following the date of acquisition anddo not reflect the operating results prior to the acquisitions. Following arepro forma unaudited results of operations for the Company for the three monthsended March 31, 2008 and 2007 assuming the Fire Quest, PDI and Com-Tecacquisitions occurred on January 1, 2008 and 2007, respectively.

 

TheCompany derived the unaudited pro forma results of operations from (i) theunaudited consolidated financial statements of ISI from January 1, 2007 toMarch 31, 2007, (ii) the unaudited consolidated financial statementsof Com-Tec for the one month ended January 31, 2008 and the three monthsended March 31, 2007, (iii) the unaudited financial statements of PDIfor the three months ended March 31, 2007, (iv) the unauditedfinancial statements of Fire Quest for the three months ended March 31,2007 and (v) the unaudited consolidated financial statements of theCompany for the three months ended March 31, 2008 and 2007. The unauditedpro forma results of operations are not necessarily indicative of results ofoperations that may have actually occurred had the acquisitions taken place onthe dates noted, or the future financial position or operating results of theCompany. The pro forma adjustments are based upon available information andassumptions that the Company believes are reasonable. The pro forma adjustmentsinclude adjustments for interest expense and increased depreciation andamortization expense as a result of the application of the purchase method ofaccounting based on the fair values of the tangible and intangible assets.

 

6

----

 

**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

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

 

**Pro Forma Consolidated Statements of Operations (unaudited)**

 

(in thousands, except share data)

 
| ** **                                                                                 | ** ** | **Three Months Ended** | ** **  |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|
| ** **                                                                                 | ** ** | **March, 31**               | ** **  | **March 31,** | ** ** |
| ** **                                                                                 | ** ** | **2008**                         | ** **  | **2007** | ** ** |
| Revenues:                                                                                  |       |                             |        |   |   |
| Contract revenues                                                                          |       | $                                | 26,906      |   | $ | 11,806 |   |
| Contract revenues - related party                                                          |       | 6,943                            |        | 5,801 |   |
| Service and other revenues                                                                 |       | 5,466                            |        | 5,566 |   |
| Total revenues                                                                             |       | 39,315                           |        | 23,173 |   |
| Cost of revenues:                                                                          |       |                             |        |   |   |
| Contract costs                                                                             |       | 27,040                           |        | 13,813 |   |
| Service and other costs, including  amortization of intangibles ($1,289 for 2008 and 2007) |       | 5,559                            |        | 5,620 |   |
| Total cost of revenues                                                                     |       | 32,599                           |        | 19,433 |   |
| Gross profit                                                                               |       | 6,716                            |        | 3,740 |   |
| Operating expenses:                                                                        |       |                             |        |   |   |
| Salaries and related expense, including $558  stock-based compensation in 2008             |       | 3,577                            |        | 2,489 |   |
| Consulting fees and outside services                                                       |       | 948                              |        | 295 |   |
| Depreciation                                                                               |       | 462                              |        | 302 |   |
| Other general and administrative expenses                                                  |       | 1,668                            |        | 1,165 |   |
| Amortization of intangible assets                                                          |       | 442                              |        | 442 |   |
| Total operating expenses                                                                   |       | 7,097                            |        | 4,693 |   |
| Operating loss                                                                             |       | (381                             | )           | (953 | ) |
| Other income (expense):                                                                    |       |                             |        |   |   |
| Interest income                                                                            |       | 26                               |        | 59 |   |
| Interest expense                                                                           |       | (844                             | )           | (754 | ) |
| Total other income (expense)                                                               |       | (818                             | )           | (695 | ) |
| Loss before provision for income taxes                                                     |       | (1,199                           | )           | (1,648 | ) |
| Provision (benefit) for income taxes                                                       |       | (451                             | )           | (691 | ) |
| Net income (loss)                                                                          |       | $                                | (748        | ) | $ | (957 | ) |
|                                                                                       |       |                             |        |   |   |
| Weighted-average number of shares  outstanding:                                            |       |                             |        |   |   |
| Basic                                                                                      |       | 5,749,342                        |        | 5,749,342 |   |
| Diluted                                                                                    |       | 5,749,342                        |        | 5,749,342 |   |
| Net loss per share:                                                                        |       |                             |        |   |   |
| Basic                                                                                      |       | $                                | (0.13       | ) | $ | (0.17 | ) |
| Diluted                                                                                    |       | $                                |  (0.13 | ) | $ |  (0.17 | ) |

 

7

----

 

**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 2 — Background, Formation, and Summaryof Significant Accounting Policies**

 

Argylecompleted a private placement (the Private Placement) in January 2006 andreceived net proceeds of approximately $0.9 million. Also in January 2006,the registration statement for Argyle’s initial public offering (PublicOffering) was declared effective, and the net proceeds from the sale of Argyle’sunits, after deducting certain offering expenses of approximately $2.4 million,including underwriting discounts of approximately $1.8 million, wereapproximately $28.2 million. Approximately $27.3 million of the proceeds fromthe Public Offering and the Private Placement were placed in a trust accountfor Argyle’s benefit. Except for $0.6 million in interest that was earned onthe funds contained in the trust account and that was released to Argyle to beused as working capital, and the amounts released to Argyle for the payment oftaxes, Argyle was not able to access the amounts held in the trust until itconsummated a business combination. The amounts held outside of the trustaccount were used by Argyle to provide for business, legal, and accounting duediligence on prospective acquisitions and continuing general and administrativeexpenses. Prior to releasing the funds held in trust, the trust accountcontained $1.4 million reserved for the compensation of Argyle’s underwritersin its Public Offering which was paid to them upon completion of the businesscombination. All amounts held in trust were released at July 31, 2007 tofund the ISI acquisition.

 

OnMarch 14, 2007, the underwriters from Argyle’s Public Offering agreed toforfeit any and all rights or claims to a pro-rata portion of the deferredunderwriting costs and associated interest with respect to any shares of commonstock redeemed in connection with any acquisition (see Note 16). In connectionwith the Public Offering and the Private Placement, Argyle’s officers anddirectors placed all the shares owned by them before the Private Placement andthe Public Offering into an escrow account. Except in certain circumstances,the shares held in escrow may not be released prior to January 24, 2009.

 

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 (seeNote 14). The per share redemption price was equal to $7.80 per share includinginterest earned thereon in the trust account, net of taxes 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 $45,000 plus interest). Approximately $1.7million was paid to redemptive shareholders in August of 2007.

 

***Cash and Cash Equivalents***

 

TheCompany considers all highly liquid investments with original maturities ofthree months or less to be cash equivalents, and the carrying amountsapproximate fair value.

 

***Contracts Receivable***

 

Contractsreceivable are recorded at the invoiced amount and do not bear interest. Theallowance for doubtful accounts is established as losses are estimated to haveoccurred through a provision for bad debts charged to earnings. Losses arecharged against the allowance when management believes the uncollectibility ofa receivable is confirmed. Subsequent recoveries, if any, are credited to theallowance. The allowance for doubtful accounts is evaluated on a regular basisby management and is based on historical experience and specifically identifiedquestionable receivables. The evaluation is inherently subjective as it requiresestimates that are susceptible to significant revision as more informationbecomes available.

 

8

----

 

**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 2 — Background, Formation, and Summaryof Significant Accounting Policies – (continued)**

 

***Revenue Recognition***

 

Amajority of the Company’s revenues are performed under fixed-price constructioncontacts.  Revenues under fixed-pricecontracts are recognized under the percentage-of-completion methodology. *** ***Service revenues are recognized when theservices have been delivered to and accepted by the customer. Other revenuesconsists of product sales and are recognized upon shipment , or later ifrequired by shipping terms, provided title is transferred, prices are fixed andcollection is deemed probable.

 

***Construction Contracts***

 

Constructioncontracts are those as defined in the American Institute of Certified PublicAccountants’ Statement of Position 81-1 (SOP 81-1), *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts*.

 

Mostof the Company’s contracts extend over a period of 12 to 16 months, which isthe period the Company considers to be its operating cycle. Such contractsgenerally provide that the customers accept completion of progress to date andcompensate the Company for services rendered measured in terms of unitsinstalled, hours expended, or some other measure of progress. Revenues fromconstruction contracts are recognized on the percentage-of-completion method inaccordance with SOP 81-1. The Company recognizes revenue on signed contractsand change orders. The Company generally recognizes revenue on unsigned changeorders where it has written notices to proceed from the customer and wherecollection is deemed probable. Percentage-of-completion for constructioncontracts is measured principally by the percentage of costs incurred andaccrued to date for each contract to the estimated total costs for eachcontract 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-contractcosts are costs that are incurred for a specific anticipated contract and thatwill result in no future benefits unless the contract is obtained. Such costsare expensed as incurred.

 

Thebalances billed but not paid by customers pursuant to retainage provisions inconstruction contracts will be due upon completion of the contracts andacceptance by the customer. Based on the Company’s experience with similarcontracts in recent years, the retention balance at each balance sheet datewill be collected within the subsequent fiscal year.

 

Thecurrent asset, “costs and estimated earnings in excess of billings onincomplete contracts,” represents revenues recognized in excess of amountsbilled which management believes will be billed and collected within thesubsequent year. The current liability, “billings in excess of costs andestimated earnings on incomplete contracts,” represents billings in excess ofrevenues recognized.

 

9

----

 

**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 2 — Background, Formation, and Summaryof Significant Accounting Policies – (continued)**

 

***Service Sales***

 

Servicesale revenue are recognized when the services have been delivered to andaccepted by the customer.  These aregenerally short-term projects which are evidenced by signed service agreementsor customer work orders or purchase orders. These sales agreements/customer orders generally provide for billing tocustomers based on time at quoted hourly or project rates plus costs ofmaterials and supplies furnished by the Company.

 

***Inventory***

 

Inventoryis valued at the lower of cost or market and consists primarily of finishedgoods. Costs of finished goods are determined using the average cost method forall segments of AUSA. Inventory that was acquired from ISI has been stated atfair value at July 31, 2007; all subsequent purchases are recorded basedon cost. The $1.0 million of inventory that was acquired from the Fire Quest,Com-Tec, and PDI acquisitions have been stated at fair value at the date ofacquisition (see Note 3).  At March 31,2008 and December 31, 2007, the Company’s inventory balance was $1.1million and $138,000, respectively, which is included in other current assetson the consolidated balance sheet.

 

***Property andEquipment***

 

Propertyand equipment is stated at cost less accumulated depreciation, except for theplant and equipment acquired in the ISI acquisition which has been recorded atfair value at July 31, 2007; all subsequent purchases are recorded basedon cost. The $1.2 millionof property and equipment from the Fire Quest, Com-Tec, and PDI acquisitions have been stated at fairvalue at the date of acquisition (see Note 3). Depreciation is calculated on the straight-line method.

 

TheCompany reviews the carrying value of property and equipment for impairmentwhenever events and circumstances indicate the carrying value of the asset maynot be recoverable from the estimated future cash flows expected to result fromits use and eventual disposition. In cases where undiscounted expected futurecash flows are less than the carrying value, an impairment loss is recognizedequal to an amount by which the carrying value exceeds the fair value ofassets. The factors considered by management in performing this assessmentinclude current operating results, trends, and prospects, and the effects ofobsolescence, demand, competition, and other economic factors.

 

***Assets Held UnderCapital Leases***

 

Assetsheld under capital leases are recorded at the lower of the net present value ofthe minimum lease payments or the fair value of the asset at the inception ofthe lease. Amortization expense is computed using the straight-line method overthe shorter of the estimated useful life of the asset or the lease term. Assetsheld under capital leases that were acquired from ISI have been stated at fairvalue as of July 31, 2007.

 

10

----

 

**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 2 — Background, Formation, and Summaryof Significant Accounting Policies – (continued)**

 

***Goodwill and OtherIntangible Assets***

 

Goodwillrepresents the excess of consideration paid over the fair value of net assetsacquired in the business combination in accordance with SFAS No. 142, *Goodwill and 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 has determined that noimpairment existed at March 31, 2008.

 

TheCompany has two primary reporting units (Corrections and Commercial) thatprovide different services and products. Accordingly, goodwill was allocated toeach.  Management believes that therelationship between allocation of identified tangible and intangible assets tobe in similar proportion to how goodwill is to be allocated among its reportingunits. Accordingly, each reporting division was allocated its share of goodwillbased upon its percentage of purchase price allocation related to identifiedtangible and intangible assets.

 

Intangibleassets that have finite useful lives are amortized over their useful liveswhich range from 96 to 120 months for customer relationships, 12 to 16 monthsfor backlog and 24 to 36 months for non-competes.

 

Asummary of the activity in goodwill by segment is as follows (in thousands):

 
| ** **                     | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-----------------|------------|----------------|------------|-----------|------------|
| Balance December 31, 2007 |       | $               | 13,275     |           | $          | 6,662     |       | $ | 19,937 |   |
| ISI Adjustments                |       | 101             |       | (34            | )          | 67        |       |
| Com-Tec Acquisition            |       | 2,380           |       | —         |       | 2,380     |       |
| PDI Acquisition                |       | 1,223           |       | —         |       | 1,223     |       |
| Fire Quest Acquisition         |       | —          |       | 729            |       | 729       |       |
| Balance March 31, 2008    |       | $               | 16,979     |           | $          | 7,357     |       | $ | 24,336 |   |

 

During the first quarterof 2008, the Company increased goodwill from the ISI acquisition by $67,000 asa result of $26,000 of additional transaction costs ($22,000 registration feesand $4,000 in legal fees), a $12,000 write-down of stale checks outstanding(decrease in cash), and a $29,000 reduction in refundable taxes (current taxasset).

 

***Software Costs***

 

Softwarecosts represent internally-developed software that is proprietary to theCompany and assists in its operations. According to Statement of Position 98-1,*Accounting for the Costs of ComputerSoftware Developed or Obtained for Internal Use*, the costs ofcomputer software developed or obtained for internal use are to be amortized ona straight-line basis unless another systematic and rational basis is morerepresentative of the software’s use. Management does not believe there isanother more rational basis and therefore the assets are amortized on thestraight-line basis over a 36-month period.

 

11

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**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 2 — Background, Formation, and Summaryof Significant Accounting Policies – (continued)**

 

***Self Insurance***

 

AUSA and Com-Tec areself-insured to certain limits under its group health and dental plans.  On an annual basis, the Company estimates its health insurance cost,for its self insured employee base at AUSA, based upon expected healthinsurance claims for the current year. The insurance company which providesboth the stop loss and total aggregate insurance coverages also provides theaverage or expected and maximum claims for each class. The average and maximumclaims are based on the Company’s demographics and prior claim history. TheCompany uses the average claims history for the trailing twelve months as itsbasis for accruing health care cost.

 

***Warranty Reserve***

 

One of the Company’ssubsidiaries warrants its products against defects in design, materials andworkmanship generally for periods ranging from one to two years.  A provision for estimated future costsrelating to warranty expense is recorded when products are sold.  Management estimates the provision basedprimarily on historical warranty claim experience.  As of March 31, 2008, the warrantyreserve was $118,000 and included in accounts payable and accrued expenses onthe unaudited consolidated balance sheet.

 

***Fair Value of Financial Instruments***

 

Therecorded values of financial instruments, including contracts receivable, otherassets, and accounts payable, approximate fair value due to their shortmaturity. The carrying value of the revolving line of credit approximates fairvalue due to its variable interest rate. The recorded value of the long-termdebt approximates fair value based on borrowing rates currently available tothe Company for financing arrangements with similar terms and averagematurities.

 

***Income Taxes***

 

TheCompany accounts for income taxes in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 109, *Accountingfor Income Taxes*. Deferred income taxes are recorded pursuant toFASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, aninterpretation of FASB No. 109 (FIN 48) and are based on enacted statutoryrates to reflect the tax consequences in future years of the differencesbetween the tax bases of assets and liabilities and their financial reportingamounts. Deferred tax assets which will generate future tax benefits arerecognized 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***

 

Prioryear balances have been reclassified to conform to current year presentation.

 

***Recently Issued AccountingPronouncements***

 

InSeptember 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 thosethat are 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.

 

12

----

 

**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 2 — Background, Formation, and Summaryof Significant Accounting Policies – (continued)**

 

InFebruary 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assetsand Liabilities*. 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.

 

InDecember 2007, the FASB issued SFAS No. 141(R), *Business Combinations—a replacement of FASB StatementNo. 141*, which significantly changes the principles andrequirements for how the acquirer of a business recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,and any non-controlling interest in the acquiree. The statement also providesguidance for recognizing and measuring the goodwill acquired in the businesscombination and determines what information to disclose to enable users of thefinancial statements to evaluate the nature and financial effects of thebusiness combination. This statement is effective prospectively, except forcertain retrospective adjustments to deferred tax balances, for fiscal yearsbeginning after December 15, 2008. We are currently evaluating the impactthat SFAS No. 141(R) will have on our accounting for acquisitionsprior to the effective date of the first fiscal year beginning after December 31,2008.

 

InDecember 2007, the FASB issued SFAS No. 160, *Non-controllingInterests in Consolidated Financial Statements – an amendment of ARB No. 51*.SFAS 160 requires non-controlling interests held by parties other than theparent in subsidiaries be clearly identified, labeled, and presented in theconsolidated statement of financial position within equity, but separate fromthe parent’s equity. SFAS No. 160 is effective for fiscal years beginningafter December 15, 2008. We are currently evaluating the impact SFAS No. 160will have on our financial position and results of operations.

 

***Use of Estimates***

 

Thepreparation of financial statements in conformity with U.S. GAAP requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities at the date of the financial statements. Actualresults could differ from those estimates.

 

***Contingencies***

 

Certainconditions may exist as of the date of the consolidated balance sheet, whichmay result in a loss to the Company but which will only be resolved when one ormore future events occur or fail to occur. The Company’s management and itslegal counsel assess such contingent liabilities, and such assessmentinherently involves an exercise of judgment. In assessing loss contingenciesrelated to legal proceedings that are pending against the Company or itssubsidiaries or unasserted claims that may result in such proceedings, theCompany’s legal counsel evaluates the perceived merits of any legal proceedingsor unasserted claims, as well as the perceived merits of the amount of reliefsought or expected to be sought therein.

 

Ifthe assessment of a contingency indicates that it is probable that a materialloss has been incurred and the amount of the liability can be estimated, thenthe estimated liability would be accrued in the Company’s consolidatedfinancial statements. If the assessment indicates that a potentially materialloss contingency is not probable but is reasonably possible, or is probable butcannot be estimated, then the nature of the contingent liability, together withan estimate of the range of possible loss if determinable and material, wouldbe disclosed in the notes to the consolidated financial statements.

 

Losscontingencies considered remote are generally not disclosed unless they involveguarantees, in which case the guarantees would be disclosed.  As of March 31, 2008, the Company didnot have any loss contingencies.

 

13

----

 

**ARGYLE SECURITY, INC.**

**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 2 — Background, Formation, and Summaryof Significant Accounting Policies – (continued)**

 

***Concentrations of Credit Risk***

 

Financialinstruments that potentially expose the Company to concentrations of creditrisk, as defined by SFAS No. 105, *Disclosureof Information about Financial Instruments with Off-Balance Sheet Risk andFinancial Instruments with Concentrations of Credit Risk*, consistprimarily of contract receivables. During the three months ended March 31,2008, revenue from our top three customers (all from the Corrections segment),represented 42% of total Company revenues. During the three months ended March 31, 2008, the Company hadrevenues from our top two customers (all from the Corrections segment), whichrepresented 20% and 12% of total Company revenues. See Related-PartyTransactions footnote (see Note 19) for discussion of transactions withISI*MCS, Ltd.

 

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

 

Netincome (loss) per share (basic) is calculated by dividing net income (loss) bythe weighted average number of common shares outstanding during the period. Netincome (loss) per share (diluted) is calculated by adjusting the number ofshares of common stock outstanding using the treasury stock method. Under thetreasury stock method, an increase in the fair market value of the Company’scommon stock results in a greater dilutive effect from outstanding warrants,options, restricted stock awards and convertible securities (common stockequivalents).

 

Thefollowing table reconciles the components of the basic and diluted net income(loss) per share:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** |
| ** **                                            | ** ** | **2008**                         | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |   |   |
| Weighted average common shares outstanding  - basic   |       | 5,749,342                        |       | 4,781,307 |   |
| Effect of convertible securities                      |       | —                           |       | — |   |
| Weighted average common shares outstanding  - diluted |       | 5,749,342                        |       | 4,781,307 |   |

 

Stockoptions to acquire 225,000 shares and promissory notes convertible into 192,500shares of common stock were excluded from the computation of diluted net income(loss) per share for three months ended March 31, 2008 as the effect ofincluding them would have been anti-dilutive.

 

InApril 2008, as noted in the Note 22 – Subsequent Events, the Companyissued 18,750 shares of $0.001 par value Series A Convertible PreferredStock pursuant to a $15.0 million private placement.

 

**Note 3 — Acquisitions**

 

***Fire Quest***

 

On January 1, 2008,MCFSA, all of the partnership interests of which are directly or indirectlywholly owned by AUSA, acquired substantially all of the business assets andliabilities of Fire Quest for a total purchase price of $1.1 million as follows(in thousands):

 
| Cash               |   | $   | 764    |   |
|--------------------|--------|-----|--------|--------|
| Promissory note    |   | 250 |   |
| Transaction costs  |   | 116 |   |
| Net purchase price |   | $   | 1,130  |   |

 

14

----

 

**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note3 — Acquisitions (continued)**

 

***PDI***

 

On January 4, 2008,AUSA acquired substantially all of the business assets and liabilities ofPeterson Detention, Inc. (PDI) for a total purchase price of $4.8 millionas follows (in thousands):

 
| Cash               |   | $     | 1,500  |   |
|--------------------|--------|-------|--------|--------|
| Promissory note    |   | 3,000 |   |
| Transaction costs  |   | 251   |   |
| Net purchase price |   | $     | 4,751  |   |

 

***Com-Tec***

 

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

 
| Cash               |   | $     | 3,000  |   |
|--------------------|--------|-------|--------|--------|
| Promissory note    |   | 3,515 |   |
| Transaction costs  |   | 186   |   |
| Net purchase price |   | $     | 6,701  |   |

 

The Fire Quest, PDI and Com-Tec acquisitions 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 preliminary third party valuations, and the values of certain assetsand liabilities are based on these preliminary valuations and are subject toadjustment as additional information is obtained. Such additional informationincludes, but is not limited to accounts receivable, inventory, and leases. Thefollowing table summarizes the estimated fair value of assets acquired andliabilities assumed and related deferred income taxes at the date of theacquisition.

 
| ** **                | ** ** | **Fire Quest** | ** ** | **PDI** | ** ** | **Com-Tec** | ** ** | **Total** | ** ** |
|---------------------------|------------|---------------------|------------|---------|------------|-------------|------------|-----------|------------|
| Current assets            |       | $                   | 126        |    | $          | 2,210       |       | $         | 4,638      |   | $ | 6,974 |   |
| Property and equipment    |       | 37                  |       | 1,126   |       | 72          |       | 1,235     |       |
| Goodwill                  |       | 729                 |       | 1,223   |       | 2,380       |       | 4,332     |       |
| Customer relationships    |       | 90                  |       | 500     |       | 760         |       | 1,350     |       |
| Customer backlog          |       | 84                  |       | 1,270   |       | 590         |       | 1,944     |       |
| Trade name                |       | —              |       | —  |       | 1,300       |       | 1,300     |       |
| Software                  |       | —              |       | —  |       | 250         |       | 250       |       |
| Non-compete agreements    |       | 70                  |       | 250     |       | 190         |       | 510       |       |
| Total assets acquired     |       | 1,136               |       | 6,579   |       | 10,180      |       | 17,895    |       |
|                      |       |                |       |    |       |        |       |      |       |
| Current liabilities       |       | (6                  | )          | (738    | )          | (2,619      | )          | (3,363    | )          |
| Debt                      |       | —              |       | (1,090  | )          | (860        | )          | (1,950    | )          |
| Total liabilities assumed |       | (6                  | )          | (1,828  | )          | (3,479      | )          | (5,313    | )          |
|                      |       |                |       |    |       |        |       |      |       |
| Net purchase price        |       | $                   | 1,130      |    | $          | 4,751       |       | $         | 6,701      |   | $ | 12,582 |   |

 

15

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note3 — Acquisitions (continued)**

 

Wehave not identified any material unrecorded pre-acquisition contingencies wherethe related asset, liability, or impairment is probable and the amount can bereasonably estimated. Prior to the end of the one-year purchase priceallocation period, if information becomes available that would indicate it isprobable that such events had occurred and the amounts can be reasonablyestimated, such items will be included in the final purchase price allocationand may adjust goodwill.

 

**Note4 — Contract Receivables**

 

Contract receivablesconsist of the following (in thousands):

 
| ** **                                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                      | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| Completed contracts and contracts in progress                   |       | $                  | 29,058     |                  | $          | 12,126 |   |
| Retainage                                                       |       | 5,785              |       | 2,333                 |       |
| Completed contracts and contracts in progress - related parties |       | 8,330              |       | 8,468                 |       |
| Retainage - related parties                                     |       | 1,874              |       | 2,419                 |       |
| Contract receivables                                            |       | $                  | 45,047     |                  | $          | 25,346 |   |

 

**Note5 — Costs and Estimated Earnings on Incomplete Contracts and BacklogInformation**

 

Costs and estimatedearnings on incomplete contracts and backlog information are as follows (inthousands): 

 
| ** **                                                                  | ** ** | **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 |   |

 

----

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

 

The various subsidiarycompanies often function as subcontractors to other subsidiary companies. Theabove schedule was computed on a consolidated basis in 2007. The companyreorganized in January 2008 to report the business in two segments –Corrections and Commercial (see note 1 and note 20).  Since then the Company has determined thatthe most valid indicator of the next year’s performance will be more closelytied to the Corrections backlog versus the Commercial backlog which is morevolatile given the shorter nature of completion for the contracts.

 

Intercompany contractamounts and billings have been eliminated, and costs and estimated earnings inexcess of billings and billings in excess of costs and estimated earnings havebeen recomputed based on actual combined costs of the companies. 

 

Backlog is the aggregatecontract amount less revenue recognized using percentage-of-completionaccounting as described in Note 2 of these consolidated financial statements.The Company recognizes as backlog only those contracts on which it has receivedsigned contracts or executed letters of intent to award a contract from itscustomers. The Company also verifies funding is in place on the contracts priorto inclusion in backlog. 

 

16

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**ARGYLESECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note6 — Property and Equipment**

 

Property and equipmentconsists of the following (in thousands):

 
| ** **                        | ** ** | **Estimated**         | ** ** | ** **         | ** ** | ** **            | ** ** |
|-----------------------------------|------------|-----------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **Useful Lives** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                        | ** ** | **In Years**     | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| Buildings                         |       | 10  - 40              |       | 1,888              |       | 1,888                 |       |
| Leasehold improvements            |       | 12                    |       | 975                |       | 593                   |       |
| Furniture, fixtures and equipment |       | 3  - 10               |       | 2,591              |       | 1,254                 |       |
| Vehicles                          |       | 3  - 7                |       | 2,443              |       | 2,189                 |       |
| Website costs                     |       | 3                     |       | 39                 |       | 39                    |       |
|                              |       |                  |       | 7,936              |       | 5,963                 |       |
| Less - accumulated depreciation   |       |                  |       | 1,219              |       | 736                   |       |
| Property and equipment, net       |       |                  |       | $                  | 6,717      |                  | $          | 5,227 |   |
|                                   |            |                       |            |                    |            |                       |            |  |  |

 

Depreciation expenserelating to property and equipment was $488,000 and $1,000 for three monthsended March 31, 2008 and 2007, respectively.  Depreciation and amortization expense was$241,000 for the Predecessor period January 1, 2007 through March 31,2007.

 

**Note 7****—****Intangible Assets and OtherAssets**

 

At March 31, 2008,intangible assets consisted of the following (in thousands):

 
| ** **                           | ** ** | **Gross Carrying** | ** ** | **Accumulated**  | ** ** | **Net Carrying** | ** ** | **Weighted Average**    | ** ** |
|--------------------------------------|------------|-------------------------|------------|------------------|------------|-----------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **Amount**              | ** ** | **Amortization** | ** ** | **Amount**            | ** ** | **Amortization Period** | ** ** |
| **Amortizable Intangible Assets:**   | ** ** | ** **              | ** ** | ** **       | ** ** | ** **            | ** ** | ** **                   | ** ** |
| Customer relationships               |       | $                       | 12,975     |             | $          | 853                   |       | $                            | 12,122     |   | 113  months |   |
| Customer backlog                     |       | 6,303                   |       | 2,653            |       | 3,650                 |       | 15  months                   |       |
| Software                             |       | 550                     |       | 80               |       | 470                   |       | 36  months                   |       |
| Non-compete                          |       | 510                     |       | 42               |       | 468                   |       | 30  months                   |       |
|                                 |       | $                       | 20,338     |             | $          | 3,628                 |       | $                            | 16,710     |   |   |   |
| **Unamortizable Intangible Assets:** |       |                    |       |             |       |                  |       |                         |       |
| Trade name                           |       | $                       | 5,076      |             | $          | —                |       | $                            | 5,076      |   |   |   |

 

Amortizationexpense was $1.7 million for the three months ended March 31, 2008.  As of March 31, 2008 and December 31,2007, intangible assets not subject to amortization included trade names of$5.1 million and $3.8 million, respectively. Estimated amortization expense forthe next five years and thereafter is as follows (in thousands):

 
| **Years ending December 31:** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008 (remaining nine months)                 |       | $          | 4,791      |   |
| 2009                                         |       | 1,952      |       |
| 2010                                         |       | 1,638      |       |
| 2011                                         |       | 1,389      |       |
| 2012                                         |       | 1,382      |       |
| Thereafter                                   |       | 5,558      |       |
|                                         |       | $          | 16,710     |   |

 

17

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** **

**ARGYLESECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note8 — Long-Term Debt**

 

Notes payable andlong-term debt consists of the following (in thousands):

 
| ** **                                | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **Collateral**                            | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| Notes payable:                            |       |               |       |                  |       |
| Vehicles and equipment                    |       | $                  | 214        |                  | $          | 190 |   |
| Unsecured debt - related party            |       | 11,057             |       | 5,952                 |       |
| Unsecured convertible debt - stockholders |       | 1,925              |       | 1,925                 |       |
| Seller notes                              |       | 6,765              |       | —                |       |
| Line of credit and acquisition line       |       | 12,970             |       | 7,979                 |       |
|                                      |       | $                  | 32,931     |                  | $          | 16,046 |   |
| Less - current maturities                 |       | 413                |       | 81                    |       |
| Long term debt                            |       | $                  | 32,518     |                  | $          | 15,965 |   |

 

*** Vehicles andEquipment***

 

Amountsinclude notes related to Company vehicles and various equipment lines. Vehicleand equipment notes are staggered in regards to their maturity, each amortizingover 36 – 48 month periods. Interest rates on the individual notes range from fixed rate of 7% up toPrime plus 1.0%. Included with the equipment is a note related to the phone systemwith a fixed rate of interest at 9.0% which matures in April 2008.  The weighted average interest rate for theseborrowings was 8.0% and 8.2% at March 31, 2008 and December 31, 2007.

 

***Unsecured Debt — Related Party***

 

On January 2, 2008an additional $5.0 million in unsecured debt was funded by the same relatedparty for which $6.0 million was outstanding. All notes are unsecured andsubordinated to the line of credit facility. The unsecured note agreementscontain prepayment options with prepayment penalties. Interest accrues at11.58% per annum and is payable quarterly in arrears, deferred interest at therate of 8.42% per annum, and default interest at 2% per annum. The total debtof $11.0 million 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 March 31,2008, the Company was in compliance with all covenants except two technical,non financial, covenants.  The Companyobtained a waiver from the lender to remedy these defaults.

 

***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.

 

18

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**ARGYLESECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note8 — Long-Term Debt — (continued)**

 

***Seller Notes***

 

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

 

In connection with the PDI acquisition, the Companyissued convertible promissory notes (the PDI Promissory Notes) in the aggregateprincipal amount of $3.0 million. The aggregate principal amount of the PDIPromissory Notes may be reduced depending on the occurrence of certain eventsdescribed in the Asset Purchase Agreement. The payment of the PDI PromissoryNotes are guaranteed by and secured by the assets of AUSA and Argyle and bearinterest 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.  On 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 March 31, 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.  Thevaluations of these derivatives held a nominal value as of March 31, 2008. 

 

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 PromissoryNote). The Com-Tec Promissory Note is guaranteed by and secured by the assetsof AUSA and Argyle, bears interest at 7% per year and will become due andpayable on April 1, 2011.

 

***Line of Credit Facility***

 

At March 31, 2008,the Company had a line of credit facility totaling $12.0 million and anacquisition loan facility in the amount of $4.3 million. The line of credit issecured by all tangible and intangible assets of AUSA excluding vehicles. Theline calls for all accounts receivable collections to be deposited directly toa lockbox. The outstanding balance on the credit facility and the acquisitionloan facility at March 31, 2008 was $8.7 million, due January 23,2010, and $4.3 million, due June 30, 2011, respectively.  Interest ispayable quarterly at prime plus 0.75% for the credit facility and at prime plus1.25% for the 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 March 31,2008, the Company was in compliance with all covenants except four technical,non financial, covenants.  The Company obtained a 90 day extension toremedy two defaults which it believes is probable to cure during the graceperiod. The Company obtained a waiver from the lender to remedy the remainingtwo defaults.

 

The Company has agreed topay an annual commitment fee of 0.5% per year on the unused borrowing capacity,which was $3.3 million and $1.0 million at March 31, 2008 and December 31,2007, respectively.

 

Aggregate maturitiesrequired on all debt at March 31, 2008 are as follows (in thousand):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining nine months)                |       | $          | 163        |   |
| 2009                                        |       | 292        |       |
| 2010                                        |       | 21,735     |       |
| 2011                                        |       | 7,741      |       |
| 2012                                        |       | 3,000      |       |
| Thereafter                                  |       | —     |       |
|                                        |       | $          | 32,931     |   |

 

19

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**ARGYLESECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note9 — Capital Leases**

 

ISI sold itsowner-occupied real estate to a partnership owned by ISI’s stockholders during2004 and entered into a leaseback of the properties with the partnership. ISIentered into a second lease on another property owned by the same partnershipin 2006. Both leases were triple net leases. A triple net lease is a leaseagreement on a property where the tenant or lessee agrees to pay all realestate taxes, building insurance, and maintenance (the three ‘Nets’) on theproperty in addition to any normal fees that are expected under the agreement(rent, etc.). In such a lease, the tenant or lessee is responsible for allcosts associated with repairs or replacement of the structural buildingelements of the property.

 

The terms of theaforementioned leases 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 following is asummary of leased property, included in property and equipment, in theaccompanying consolidated financial statements:

 
| ** **                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|--------------------|------------|-----------------------|------------|
| **Collateral**                  | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| Buildings                       |       | $                  | 1,888      |                  | $          | 1,888 |   |
| Less - accumulated amortization |       | 112                |       | 69                    |       |
| Net                             |       | $                  | 1,776      |                  | $          | 1,819 |   |

 

The Company reassessedthese leases for proper classification under SFAS No. 13, *Accounting for Leases*, and determined theyremain properly classified as capital leases. The following is a schedule byyears of future minimum lease payments under capital leases together with thepresent value of net minimum lease payments at March 31, 2008:

 
| **Year Ending December 31:**                      | ** ** | ** ** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|
| 2008 (remaining nine months)                      |       | $          | 216        | ** ** |
| 2009                                                             |       | 288        |       |
| 2010                                                             |       | 288        |       |
| 2011                                                             |       | 288        |       |
| 2012                                                             |       | 288        |       |
| Thereafter                                                       |       | 1,917      |       |
| Future minimum lease payments                                    |       | $          | 3,285      |   |
| Less - amount of minimum lease payments attributable to interest |       | 1,307      |       |
| Present value of net minimum lease payments                      |       | $          | 1,978      |   |
| Current portion of capitalized lease obligations                 |       | $          | 107        |   |
| Long-term portion of capitalized lease obligations               |       | 1,871      |       |
|                                                             |       | $          | 1,978      |   |

 

20

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note10 — Commitments**

 

AUSA leases office spaceand equipment 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 6,500 square feet for a total expense in2008 of $121,000.  

 

As part of the PDIacquisition that occurred at January 4, 2008 the Company assumed theexisting leases.  The PDI lease is a 4year lease, for the 42,000 square foot facilities, with monthly payments at$16,000.   As part of the Com-Tecacquisition that occurred at January 31, 2008 the Company signed newleases for the existing facility.  TheCom-Tec lease is a 5 year lease, for the 33,000 square foot facility, withmonthly payments at $14,000 beginning in year 3 with the total rent expensebeing recognized on a straight line basis over the life of the lease.

 

Rental expense was$196,000 and $17,000 for the three months ended March 31, 2008 and 2007,respectively, and $71,000 for the three months ended March 31, 2007(Predecessor).

 

Minimum rentalcommitments at March 31, 2008 are as follows (in thousands):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining nine months)                |       | $          | 394        |   |
| 2009                                        |       | 421        |       |
| 2010                                        |       | 522        |       |
| 2011                                        |       | 422        |       |
| 2012                                        |       | 312        |       |
| Thereafter                                  |       | 187        |       |
| Total commitment outstanding                |       | $          | 2,258      |   |

 

In August 2007 theCompany entered into a letter of credit facility with a financial institution.The letter 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

 

**Note11 — Self Insurance**

 

AUSA and Com-Tec areself-insured to certain limits under its group health and dental plans.Stop-loss coverage is provided for claims above $75,000 per employee up to amaximum $0.9 million for AUSA and above $30,000 per employee up to a maximum of$2.0 million for Com-Tec. Operations are charged with the cost of claimsreported and an estimate of claims incurred but not reported based on priorexperience. The determination of such claims and expenses and theappropriateness of the related liability are continually reviewed and updated.Total claims payable and claims incurred but not reported were $0.5 million at March 31,2008 and $0.3 million at December 31, 2007. AUSA and Com-Tec have not yetmet its stop-loss limit for 2008.

 

**Note12 — Offerings**

 

***Public Offering***

 

In January 2006,Argyle sold 3,700,046 units (which included 75,046 units sold by theunderwriters pursuant to a partial exercise of their over-allotment option) tothe public at a price of $8.00 per unit. Each unit consists of one share of theCompany’s common stock, $0.0001 par value, and one redeemable common stockpurchase warrant (warrant). Each warrant entitles the holder to purchase fromthe Company one share of common stock at an exercise price of $5.50 andexpiring January 24, 2011. The warrants are redeemable by the Company at aprice of $.01 per warrant upon 30 days’ notice, only in the event that the lastsale price of the common stock is at least $11.50 per share for any 20 tradingdays within a 30-trading-day period ending three business days before a noticeof redemption is delivered.

 

21

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

***Private Placement***

 

In January 2006,Argyle sold to its officers an aggregate of 125,000 units identical to theunits sold in the Public Offering at a price of $8.00 per unit.

 

**Note13 — Common Stock Reserved for Issuance**

 

As of March 31,2008, 4,087,546 shares of common stock were reserved for issuance upon exerciseof redeemable warrants and options and 375,000 shares of common stock werereserved for issuance pursuant to the underwriters’ unit purchase optiondescribed in Note 17. This includes the warrants that were issued in connectionwith the April 2007 notes to stockholders entitling the holder to exercisethe warrants for a total of 37,500 shares of stock. In 2007, the Companygranted certain employees incentive stock options (ISOs) and non-qualifiedstock options entitling the holder to exercise options for a total of 125,000shares of stock and 130,000 shares of restricted stock (see Note 17).  Additionally, in 2008 the Company grantedcertain employees incentive stock options (ISOs) and non-qualified stockoptions entitling the holder to exercise options for a total of 100,000 sharesof stock and 85,000 shares of restricted stock (see Note 17).

 

**Note14 — Redemptive Status of Common Stock**

 

The registrationstatement for Argyle’s initial public offering indicated that, after signing adefinitive agreement for the acquisition of a target business, Argyle wouldsubmit such transaction for stockholder approval. Based on the votes submitted,211,965 shares voted against the proposed ISI business combination and soughtto be redeemed for cash. As a result, $1.7 million of net proceeds from theinitial public offering which included interest was redeemed to stockholders inAugust 2007. The 211,965 shares of common stock were cancelled as of August 2007.

 

**Note15 — Preferred Stock**

 

The Company is authorizedto issue 1,000,000 shares of preferred stock with such designations, voting,and other rights and preferences, as may be determined from time to time by theBoard of Directors. No shares of preferred stock are currently issued oroutstanding.

 

In connection with themerger, and immediately prior to the merger, one of ISI’s unsecured debtholders converted $10.0 million of long-term debt with ISI into shares of ISIpreferred stock. Upon closing of the purchase of ISI, the same debt holderreceived $10.0 million for the preferred stock of ISI.

 

 In April 2008, as noted in the Note 22 –Subsequent Events, the Company issued 18,750 shares of $0.001 par value Series AConvertible Preferred Stock pursuant to a $15.0 million private placement.

 

**Note16 — Agreement with Underwriters**

 

In March 2007, theunderwriters from Argyle’s Public Offering agreed to forfeit any and all rightsor claims to a pro-rata portion of the deferred underwriting costs andassociated accrued interest with respect to any shares of common stock that areredeemed in connection with the proposed acquisition. This fee was chargedagainst additional paid-in capital and was payable upon a successful businesscombination. Based on the redemption of 211,965 shares, $80,000 related to thesewaived underwriter fees were paid to redemptive stockholders. Upon closing ofthe purchase of ISI, Argyle paid approximately $1.4 million for servicesperformed related to Argyle’s Public Offering.

 

22

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**ARGYLESECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note17 — 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) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues. Following is a description of the various grants made and the impact tothe financial statements.

 

***2005 — 2006 Options***

 

In July 2005, Argylegranted to its officers, directors, and their respective affiliates certainoptions, which were exercisable only in the event the underwriters exercisedthe over-allotment option, to purchase that number of shares enabling them tomaintain their 20% ownership interest in the Company (without taking intoaccount the units they purchased in the private placement). The measurementdate was deemed to be January 30, 2006, the date the over-allotment wasexercised because the number of options to be issued was not known until thatdate.

 

In January 2006, theunderwriters exercised a portion of the over-allotment option in the amount of75,046 units. In February 2006, the officers and directors exercised theiroptions and purchased 18,761 units for an aggregate cost of $507 (or $0.027 pershare). The compensation cost, recorded in operating expenses, resulting fromthese share-based payments was $130,632 at January 30, 2006, using theBlack-Scholes pricing model. This model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. The fair value of the options was estimated at the measurementdate using the assumptions of weighted-average volatility factor of 0.10; noexpected dividend payments; weighted-average risk-free interest rate of 5%; anda weighted-average expected life of 0.13 years.

 

The fair value of eachoption was $6.99 per share. All options vested immediately at the measurementdate and no further options may be exercised. Compensation expense wasrecognized immediately and recorded as an operating expense for the year ended December 31,2006.

 

***Underwriter Options***

 

Argyle sold to itsunderwriters options to purchase up to an aggregate of 187,500 units for $100.The units issuable upon exercise of these options are identical to those soldin the Public Offering. These options are exercisable at $8.80 per unit andexpiring January 24, 2011. The options to purchase the 187,500 units and theSecurities underlying such units were deemed compensation by the NationalAssociation of Securities Dealers (NASD) and were therefore subject to a180-day lock-up pursuant to Rule 2710(g) (1) of the NASD ConductRules.

 

Argyle accounted forthese purchase options as a cost of raising capital and included the instrumentas equity in its consolidated balance sheet. Accordingly, there is no netimpact on Argyle’s financial position or results of operations, except for therecording of the $100 proceeds from the sale. Argyle has estimated, based upona Black-Scholes model, that the fair value of the purchase options on the dateof sale was approximately $3.40 per unit, (a total value of approximately $0.6million) using an expected life of five years, volatility of 44%, and arisk-free rate of 5%. However, because Argyle’s units 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 proposed industry. Argyle 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.

 

23

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

** **

**Note17 — Stockholders’ Equity and Stock-Based Compensation– (continued)**

** **

***2007 Incentive Plan***

*** ***

The 2007 OmnibusSecurities and Incentive Plan provides for the grant of distribution equivalentrights, incentive stock options, nonqualified stock options, performance shareawards, performance unit awards, restricted stock awards, stock appreciationrights, tandem stock appreciation rights, and unrestricted stock awards for anaggregate of not more than 1,000,000 shares of Argyle’s common stock, todirectors, officers, employees, and consultants of Argyle or its affiliates. Ifany award expires, is cancelled, or terminates unexercised or is forfeited, thenumber of shares subject thereto, if any, is again available for grant underthe 2007 Incentive Plan. The number of shares of common stock, with respect towhich stock options or stock appreciation rights may be granted to aparticipant under the 2007 Incentive Plan in any calendar year, cannot exceed150,000.

 

Except as provided in the2007 Incentive Plan, awards granted under the 2007 Incentive Plan are nottransferable and may be exercised only by the participant or by theparticipant’s guardian or legal representative. Each award agreement willspecify, among other things, the effect on an award of the disability, death,retirement, authorized leave of absence or other termination of employment ofthe participant. Argyle may require a participant to pay Argyle the amount ofany required withholding in connection with the grant, vesting, exercise, ordisposition of an award. A participant is not considered a stockholder withrespect to the shares underlying an award until the shares are issued to theparticipant.

 

**RestrictedStock**

** **

On January 25, 2008, theCompany granted an aggregate of 85,000 shares of the Company’s restrictedcommon stock to certain of its executive officers and directors. Shares grantedto the directors vested immediately and shares grant to the executive officersvest one-third on December 31 of each of 2008, 2009 and 2010.

 

The following tablesummarizes the restricted stock activity 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 March 31, 2008        |       | 165,000            |       | $                     | 7.44       |          | 2.75       |   |
| Expected to vest at March 31, 2008 |       | 165,000            |       | $                     | 7.44       |          | 2.75       |   |
| Vested at March 31, 2008           |       | —             |       | $                     | —     |          | —     |   |

 

24

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**ARGYLE SECURITY,INC.  NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note 17 — Stockholders’ Equity andStock-Based Compensation – (continued)**

 

Duringthe three months ended March 31, 2008, the Company recognized $505,000 incompensation expense, net of tax benefit of $183,000, related to the Company’sissuance of restricted stock.  As of March 31,2008, there was $910,000 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 2.75 years.

 

**Performance Share Awards**

 

OnJanuary 25, 2008, the Company granted an aggregate of 55,000 performanceunits to certain of its officers, subject to terms and conditions to be setforth in a performance unit agreement and in accordance with the Company’s 2007Incentive Plan.  These awards vest on December 31,2010 if certain performance goals to be determined by the Board of Directorsare achieved.  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.  The final plan metricsfor determination of the award was not approved by the Board of Directors untilMarch 25, 2008.  As a result, duringthe three months ended March 31, 2008, the Company recognized nocompensation expense related to the performance share awards.  Additionally, no compensation expense wasrecognized during the year ended December 31, 2007.

 

Thefollowing table summarizes the performance unit activity under the 2007Incentive 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 March 31, 2008        |       | 170,000            |       | $                     | —     |          | 2.75       |   |
| Expected to vest at March 31, 2008 |       | 170,000            |       | $                     | —     |          | 2.75       |   |
| Vested at March 31, 2008           |       | —             |       | $                     | —     |          | —     |   |

 

**Incentive and Nonqualified Stock Options**

 

OnJanuary 25, 2008, the Company granted stock options to purchase anaggregate of 100,000 shares of the Company’s common stock to various employees,of which all were ISO. The options have a strike price of $7.55 and vest December 31in three equal tranches on each of 2008, 2009 and 2010.

 

25

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**MARCH 31, 2008**

 

**Note 17 — Stockholders’ Equity andStock-Based Compensation – (continued)**

 

Thefollowing table summarizes the stock option activity under the 2007 IncentivePlan:

 

| ** **                                          | ** ** | ** **         | ** ** | ** **                | ** ** | **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 March 31, 2008                  |       | 225,000            |       | $                         | 7.74       |          | 2.75       |          | $          | — |   |
| Vested and expected to vest at  March 31, 2008 |       | 225,000            |       | $                         | 7.74       |          | 2.75       |          | $          | — |   |
| Exercisable at March 31, 2008                  |       | —             |       | $                         | —     |          | —     |          | $          | — |   |

 

TheCompany has estimated, based upon a Black-Scholes model, that the fair value ofthe stock options granted on January 25, 2008 was approximately $1.78 perunit, (a total value of approximately $178,000), using an expected life ofthree years, volatility of 40%, and a risk-free rate of 2.5%. However, becausethe shares did not have a trading history, the volatility assumption was basedon information currently available to management. The volatility estimate wasderived using historical data of public companies in the related industry. TheCompany believes the volatility estimate calculated from these companies was areasonable benchmark to use in estimating the expected volatility of our units;however, the use of an index to estimate volatility may not necessarily berepresentative of the volatility of the underlying securities.

 

Duringthe three months ended March 31, 2008, the Company recognized $53,000 incompensation expense, net of tax benefit of $19,000, related to the Company’sstock options.  As of March 31,2008, there was $341,000 of unrecognized compensation costs, net of estimatedforfeitures, related to the Company’s non-vested stock options, which isexpected to be recognized over a weighted average period of 2.75 years.

 

26

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note 18 — Income Taxes**

 

Theprovision for income taxes decreased $444,000 in the first quarter of 2008compared to the same period in 2007.  Thedecrease in income taxes was primarily due to the decrease in income beforeincome taxes of $1,230,000.  Oureffective tax rate was 36.2% in the first quarter of 2008 and 34.2% for thesame period in 2007.  The increase in oureffective tax rate was due to the recognition of additional state income taxesassociated with AUSA in 2008.

 

**Note 19 — Related-Party Transactions**

 

Duringthe quarter ended March 31, 2008 the Company entered into a Board approvedagreement with Sec-Tec Global to share certain expenses related to commonoffice space in New York City, New York and administrative type expenses.  These expenses are being borne by the Companyto reflect realistic expenses associated with the Company’s presence to conductits business.  The Company has agreed toshare expenses totaling $175,000 on an annual basis that are to be paid in quarterlypayments of $43,750.   Sec Tec Global isa wholly-owned subsidiary of Electronics Line 3000 to which the Company’s co-CEOsare stock holders and board members.

 

AtMarch 31, 2008 and December 31, 2007, other receivables include$47,000 and $42,000, respectively, of receivables from related parties, all ofwhich is attributable to AUSA. Amounts represent monies or other assetsadvanced to employees. Amounts have been paid on these receivables andmanagement believes they are fully collectible.

 

The Company leases various propertiesfrom Green Wing Management, Ltd., an entity owned and controlled by the ChiefExecutive Officer and President of AUSA under capital leases.  The leases on these properties were amendedas part of the acquisition of ISI to reflect a term of 12 years ending in 2019and to require that an appraisal be completed by a qualified appraiser todetermine the market rate of the leases. The rental rate to be paid on theseproperties, after the acquisition of ISI, is limited to no more than 90% of themarket rate determined by the third-party appraiser. Additional appraisals by athird-party appraiser are to be conducted every three years during the 12 yearterms and the annual lease rate in the leases can increase at the time of theseappraisals, but only to a level that does not to exceed 90% of the market ratedetermined by the third-party appraiser. Argyle has the right to purchase thesethree properties at any time, at the then current market value; however, thepurchase price cannot be less than the value determined in the last appraisalpreceding the effective date of the acquisition of ISI.****Duringthe three months ended March 31, 2008, the Company made lease payments of$72,000 under these leases.  See Note 9for the remaining payments due under these leases.

 

Inconjunction with the major refinancing of ISI in 2004, the majoritystockholders formed a new company in 2004 (ISI*MCS, Ltd.) which was used as thecontracting entity on all future bonded contracts. ISI transferred certainexisting bonded contracts at their remaining contract values, and no gain orloss was recognized on the transfers to ISI*MCS, Ltd. at the time of itsformation. All contracts of ISI*MCS, Ltd. were subcontracted to ISI for thefull contract amount, less a 2% fee. AUSA recorded contract revenue based onthe ISI*MCS, Ltd.’s contract amount, net of the 2% fee. Contract receivablesfrom ISI*MCS, Ltd. at March 31, 2008 and December 31, 2007 totaled$10.2 million and $10.9 million, respectively, which is disclosed as contractreceivables - related party on the face of the consolidated balance sheet sinceISI*MCS, Ltd. is not consolidated in the balance sheet. Contract revenuesreported by the Company from ISI*MCS, Ltd. were $6.9 million for the threemonths ended March 31, 2008. ISI*MCS, Ltd. revenues reported by the predecessor (ISI) were $5.8million for the three months ended March 31, 2007.  Argyle has agreed to indemnify theshareholders of ISI*MCS, Ltd. from claims brought by the bonding companyagainst their personal guarantees for those contracts that have not been paidin full as of the closing of the merger. The merger agreement provides thatthese indemnification obligations will survive for a period of four years afterthe closing date of the merger and the obligations are not subject to cap, ormaximum amount.

 

27

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note 19 — Related-Party Transactions –(continued)**

 

Subsequentto July 31, 2007, AUSA will receive 100% of the remaining contract amountsand ISI*MCS, Ltd. will forego its 2% fee. Remaining amounts to be billed onthese contracts as of March 31, 2008 totaled $11.5 million. All futurecontracts, bonded and un-bonded, will be contracted directly by AUSA withoutinvolvement by ISI*MCS, Ltd.

 

**Unsecured Debt — Related Party**

 

Aspart of the ISI merger transaction, debt totaling $16.0 million was owed to ashareholder of ISI, of which $10.0 million was paid prior to its originalterms. The shareholder became a shareholder of Argyle as part of the merger andholds 486,237 shares of Argyle common stock as of July 31, 2007 and assuch, became a related party. At March 31, 2008 and December 31,2007, the remaining debt to the shareholder (see Note 8) totaled $11.1 millionand $6.0 million, respectively.

 

**Note 20 — Segment Information**

 

TheCompany’s segments are strategic business units that offer different productsand services and are managed accordingly. Under GAAP segment reporting rules,management analyzes the various operating segments based on segment incomebefore income taxes. During the first quarter of 2008, the Company changed itssegment reporting to better align the Company’s recently acquired companies withits existing business units and its global and strategic direction.  Thischange resulted in ISI Detention and MSC Detention combining into theCorrections reportable segment and MCS Commercial into the Commercial reportingsegment.  Segment information for the Predecessor for the three monthsended March 31, 2007 has been restated to conform to current yearpresentation.  The customers andlong-lived assets of the reportable segments are in the United States.

 

AUSAis a detention and commercial equipment contractor that specializes in turnkeyinstallations, including design, engineering, supply, and installation ofvarious detention equipment for correctional facilities and institutions. Thework is performed under fixed-price contracts. The projects are located invarious cities in the United States. The length of the contracts varies but istypically less than two years. AUSA also provides turnkey installationscovering the full spectrum of electronic security and low voltage systems,including fire alarm, access control, closed circuit television, intercom,sound/paging, and other custom designed systems.

 

Argyle Corrections consistsof all of our businesses in the corrections sector including ISI, MetroplexControl Systems (MCS) as well as Com-Tec Security LLC (Com-Tec) and PetersonDetention, Inc. (PDI).  Com-Tec andPDI were acquired in January 2008. This segment includes:

 

· ISI (also referred to historically asISI-Detention) designs, engineers, supplies, installs, and maintains a fullarray of detention systems and equipment, targeting correctional facilitiesthroughout the United States;

 

· Metroplex Control Systems (also referred tohistorically as MCS-Detention) designs, engineers, supplies, installs andmaintains complex, customized security, access control, video and electronicsecurity control system solutions 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.

 

28

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note 20 — Segment Information – (continued)**

 

ArgyleCorrections offers a complete array of electronic security system solutionsrevolving around electronic locking systems and hardware, security doors and frames,jail furniture, security glazing, and other security-based systems andspecializes in turnkey installations for public- and privately-owned/operateddetention facilities in designs, assembles, supplies, installs, and maintainsaccess control, video, and integrated electronic control systems forcorrectional and government facilities throughout the United States. It alsoprovides the above goods and services to detention market integrators,electrical contractors, and competitors of AUSA that lack their own in-houseelectronic solutions. Whether acting as prime contractor or as a subcontractorfor projects spanning all levels of security, Corrections’ product offeringsinclude security locking systems, security hollow metal doors and wall panels,security windows, security glass and glazing, security furnishings andaccessories, design support, and full installation capabilities.

 

Argyle Commercial Securityhas built a parallel business to Corrections targeting commercial andindustrial facilities.  Argyle Commercial Security groupfocuses 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 segment and is referred to historically asMCS-Commercial.  Commercial currentlyoperates out of its own San Antonio headquarters and five regional offices. Theoffices in Austin, Houston, and Denver resulted from acquisitions made by ISI.

 

| ** **                          | ** ** | ** **                       | ** ** | **Predecessor (ISI)**       | ** ** |
|-------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
| ** **                          | ** ** | **March 31,**               | ** ** | **March 31,**               | ** ** |
| ** **                          | ** ** | **2008**                         | ** ** | **2007**                         | ** ** |
| **Industry Segment (in thousands)** |       |                             |       |                             |       |
| Revenues:                           |       |                             |       |                             |       |
| Corrections                         |       | $                                | 30,038     |                             | $          | 9,970 |   |
| Commercial                          |       | 7,559                            |       | 8,882                            |       |
| Corporate                           |       | —                           |       | —                           |       |
| Eliminations                        |       | —                           |       | —                           |       |
| Total                               |       | $                                | 37,597     |                             | $          | 18,852 |   |
| Operating income (loss):            |       |                             |       |                             |       |
| Corrections                         |       | $                                | 1,610      |                             | $          | 798 |   |
| Commercial                          |       | (136                             | )          | 402                              |       |
| Corporate                           |       | (1,852                           | )          | —                           |       |
| Eliminations                        |       | —                           |       | —                           |       |
| Total                               |       | $                                | (378       | )                                | $          | 1,200 |   |
| Total assets:                       |       |                             |       |                             |       |
| Corrections                         |       | $                                | 99,920     |                             | $          | 27,250 |   |
| Commercial                          |       | 5,752                            |       | 4,818                            |       |
| Corporate                           |       | 37,353                           |       | —                           |       |
| Eliminations                        |       | (34,158                          | )          | —                           |       |
| Total                               |       | $                                | 108,867    |                             | $          | 32,068 |   |
| Capital expenditures:               |       |                             |       |                             |       |
| Corrections                         |       | $                                | 650        |                             | $          | 414 |   |
| Commercial                          |       | 121                              |       | 120                              |       |
| Corporate                           |       | 10                               |       | —                           |       |
| Total                               |       | $                                | 781        |                             | $          | 534 |   |

 

 

29

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**ARGYLE SECURITY, INC.NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTSMARCH 31, 2008**

 

**Note 21 — Supplemental Disclosures of CashFlow Information**

** **

| ** **                                                   | ** ** | ** **                       | ** ** | ** **                       | ** ** | **Predecessor (ISI)** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                   | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
| ** **                                                   | ** ** | **March 31,**               | ** ** | **March 31,**               | ** ** | **March 31,**         | ** ** |
| ** **                                                   | ** ** | **2008**                         | ** ** | **2007**                         | ** ** | **2007**                   | ** ** |
| Cash paid for interest                                       |       | $                                | 489        |                             | $          | —                     |       | $ | — |   |
| Cash paid for income taxes                                   |       | 300                              |       | —                           |       | —                     |       |
| **Supplemental schedule of non-cash investing  activities:** |       |                             |       |                             |       |                       |       |
| Accrual for deferred transaction costs                       |       | $                                | 405        |                             | $          | 174                        |       | $ | — |   |
| **Supplemental schedule of non-cash financing  activities:** |       |                             |       |                             |       |                       |       |
| Notes issued for acquisitions                                |       | $                                | 6,765      |                             | $          | —                     |       | $ | — |   |
| Accrual of offering costs                                    |       | 302                              |       | —                           |       | —                     |       |

 

**Note 22— Subsequent Events**

 

InApril 2008, the Company issued 18,750 shares of $0.0001 par value Series AConvertible Preferred Stock for aggregate proceeds of $15.0 million.  Thepreferred stock accrue dividends at a rate of 3% per annum and are convertibleinto 100 shares of the Company’s common stock at any time at the option of theholder at a conversion price of $8.00 per share.  Upon liquidation(voluntary or otherwise), dissolution, winding up or a change of control of theCompany, 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.  The Series APreferred Stock will be classified in Stockholders’ Equity on the Company’sConsolidated Balance Sheet.

 

30

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****ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS****

 

****ForwardLooking Statements****

 

ThisQuarterly Report on Form 10-Q includes forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. These forward-looking statements are subject to known andunknown risks, uncertainties and assumptions about us that may cause our actualresults, levels of activity, performance or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by such forward-looking statements. In somecases, you can identify forward-looking statements by terminology such as “may,”“should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,”“continue,” or the negative of such terms or other similar expressions. Factorsthat might cause or contribute to such a discrepancy include, but are notlimited to, those described in our other Securities and Exchange Commissionfilings. The following discussion should be read in conjunction with ourunaudited Financial Statements and related Notes thereto included elsewhere inthis report.

 

****Overview****

 

Argyle Security, Inc.is a Delaware corporation incorporated on June 22, 2005 in order to serveas a vehicle for the acquisition of an operating business through a merger,capital stock exchange, asset acquisition or other similar businesscombination.  Argyle completed its initial public offering in January 2006.  As provided in its certificate ofincorporation, Argyle was required, by July 30, 2007, to consummate abusiness combination or enter a letter of intent, agreement in principle ordefinitive agreement relating to a business combination, in which case Argylewould be allowed an additional six months to complete the transactionscontemplated by such agreement.

 

OnJuly 31, 2007, pursuant to the terms of a merger agreement, dated December 8,2006, as amended on June 29, 2007 and July 11, 2007 (the MergerAgreement), Argyle acquired all of the assets and liabilities of ISI-DetentionContracting Group, Inc. (ISI), currently referred to as Argyle SecurityUSA (AUSA).  As a result of the merger,ISI now referred to as AUSA became a wholly owned subsidiary of Argyle. AUSA isa provider of physical security solutions to commercial, governmental andcorrectional customers.

 

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 and ArgyleCommercial Security.

 

Argyle Corrections consistsof all of our businesses in the corrections sector including ISI, MetroplexControl Systems (MCS) as well as Com-Tec Security LLC (Com-Tec) and PetersonDetention, Inc. (PDI).  Com-Tec andPDI were acquired in January 2008. This segment includes:

 

· ISI (also referred to historically asISI-Detention) designs, engineers, supplies, installs, and maintains a fullarray of detention systems and equipment, targeting correctional facilitiesthroughout the United States;

 

· Metroplex Control Systems (also referred tohistorically as MCS-Detention) designs, engineers, supplies, installs andmaintains complex, customized security, access control, video and electronicsecurity control system solutions 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.

 

ArgyleCommercial Securityfocuses 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.

 

31

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On January 1, 2008,MCFSA, Ltd. (MCFSA), all of the partnership interests of which are directly orindirectly 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.

 

OnJanuary 4, 2008, AUSA acquired substantially all of the business assetsand liabilities of PDI.  PDI is afull-service, turnkey solutions provider that manufactures high security metalbarriers, high security observation window systems, detention furniture andaccessories.

 

OnJanuary 31, 2008, ISI Controls, Ltd. (ISI-Controls), a wholly ownedsubsidiary of AUSA, which in turn is a wholly owned subsidiary of the Company,closed a transaction, pursuant to which ISI-Controls acquired 100% of theoutstanding units of Com-Tec Security, LLC (Com-Tec), resulting in Com-Tecbecoming a wholly owned subsidiary of ISI-Controls. Com-Tec is engaged in thebusiness of custom design, manufacture and installation of electronic securityand communication systems.

 

**Critical Accounting Policies**

 

Ourdiscussion and analysis of our financial condition and results of operations isbased on the accompanying consolidated financial statements, which have beenprepared in accordance with U.S. generally accepted accounting principles. Assuch, we are required to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand liabilities at the date of the consolidated financial statements and thereported amounts of revenues and expenses during the reporting period. By theirnature, these estimates and judgments are subject to an inherent degree ofuncertainty. Our management reviews its estimates on an on-going basis,including those related to revenue recognition based on thepercentage-of-completion methodology, sales allowances, recognition of servicesales revenues, the allowance for doubtful accounts, inventories and relatedreserves, long-lived assets, investments and income taxes. We base ourestimates and assumptions on historical experience, knowledge of currentconditions and our understanding of what we believe to be reasonable that mightoccur in the future considering available information. Actual results maydiffer from these estimates, and material effects on our operating results andfinancial position may result.

 

*Percentage-of-Completion Estimates* - AUSA uses percentage-of-completionaccounting to determine revenue and gross margin earned on projects. Estimatingthe percentage completion on a project is a major critical estimate that AUSAdepends on. This estimate is determined as follows:

 

ConstructionContracts:

 
| · |   | 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.                                                                                              |

 

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Theseestimates of percentage completion of a project determine the amounts ofrevenues and gross margin that are earned to date on a project. For example, ifa contract is $100,000 with a 20% gross margin of $20,000, then a project thatis estimated to be 50% complete accrues $50,000 in revenues and $10,000 ingross margin. If the percentage completed is adjusted to 25%, then the revenueson the contact would be $25,000, and the earned gross margin would be $5,000.These estimates would be changed in the current month, and the actual accrual ofthe revenue and gross margin earned on this project would be reduced in thecurrent month.

 

Anothereffect of the change in the estimated costs and percentage complete is that itchanges the percentage of gross margin earned. For example, in the project mentionedabove, 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.

 

Costsincurred prior to award of contracts are expensed as incurred. The balancesbilled but not paid by customers pursuant to retainage provisions inconstruction contracts will be due upon completion of the contracts andacceptance by the customer. Based on the Company’s experience with similarcontracts in recent years, the retention balance at each balance sheet datewill be collected within the subsequent fiscal year.

 

Thecurrent asset “Costs and estimated earnings in excess of billings on incompletecontracts” represents revenues recognized in excess of amounts billed whichmanagement believes will be billed and collected within the subsequent year.The current liability “Billings in excess of costs and estimated earnings onincomplete contracts” represents billings in excess of revenues recognized.

 

*Service Sales -** ***Service revenues are recognized when the services have beendelivered to and accepted by the customer. These are generally short-termprojects which are evidenced by signed service agreements or customer workorders or purchase orders. These sales agreements/customer ordersgenerally provide for billing to customers based on time at quoted hourly orproject rates, plus costs of materials and supplies furnished by the Company.

 

*IBNR Estimates for Health Insurance* - On an annual basis, Argyle estimates itshealth insurance cost, for its self-insured employee base at the acquiredcompanies AUSA and Com-Tec, based upon expected health insurance claims for thecurrent year. The insurance company which provides both the stop loss and totalaggregate insurance coverages also provides the average or expected and maximumclaims for each class. The average and maximum claims are based on ourdemographics and prior claim history. Argyle uses the average claims historyfor the trailing the twelve months as its basis for accruing health care cost.This accrual is automated and is part of the payroll function for each payperiod.

 

*Deferred income taxes* - Deferred income taxes are provided fortemporary differences between the carrying amount of assets and liabilities forfinancial reporting purposes and the amounts for tax purposes. Valuationallowances are provided against the deferred tax asset amounts when therealization is uncertain.

 

*Allowance for Doubtful Accounts* - Argyle provides an allowance for bad debtthrough an analysis in which the bad debts that had been written off over aprevious  period are compared on apercentage basis to the aggregate sales for the same period. 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).

 

33

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*Non Cash Compensation Expense* - On January 1, 2006, Argyle adoptedSFAS No. 123 (revised 2004), *ShareBased 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.

 

Purchaseoptions (ISO / non-qualified) grants:

 

Ona quarterly basis, Argyle computes the value of newly issued purchase options(ISO and non-qualified) by utilizing the Black-Scholes valuation model basedupon their expected life vesting period, industry comparables for volatilityand the risk-free rate on US Government securities with matching maturities.The value of the purchase options are then straight-line expensed over the lifeof the purchase options.

 

Restrictedand performance stock grants:

 

Ona quarterly basis, Argyle computes the value of newly issued stock grants basedon the share price as of the award date. The values of the common shares arethen straight-line expensed over the life of the corresponding vesting period.

 

TheCompany recognizes compensation expense on the performance share awards basedon the fair value of the underlying common stock at the end of each quarterover the remaining vesting period.

 

**Pro Forma and Adjusted Pro Forma FinancialInformation**

 

Sincewe acquired ISI in July 2007 and Fire Quest, PDI and Com-Tec in January 2008,we do not believe a comparison of the results of operations and cash flowsfor the three months ended March 31, 2008 versus March 31, 2007 isbeneficial to our stockholders. In order to assist investors in betterunderstanding the changes in our business between the three months ended March 31,2007 and March 31, 2008, we are presenting in management’s discussion andanalysis section below in the pro forma and adjusted pro forma results ofoperations for the Company and the acquisitions for the three months ended March 31,2008 and March 31, 2007 as if the acquisitions occurred on January 1,2008 and January 1, 2007, respectively. We derived the pro forma resultsand adjusted pro forma results of operations from (i) the unauditedconsolidated financial statements of ISI from January 1, 2007 to March 31,2007, (ii) the unaudited consolidated financial statements of Com-Tec forthe one month ended January 31, 2008 and the three months ended March 31,2007, (iii) the unaudited financial statements of PDI for the three monthsended March 31, 2007, (iv) the unaudited financial statements of FireQuest for the three months ended March 31, 2007 and (v) the unauditedconsolidated financial statements of the Company for the three months ended March 31,2008 and 2007. We are presenting the pro forma and the adjusted pro formainformation in order to provide a more meaningful comparison of our operatingresults with prior periods. The

 

Adjustedpro forma net income is an alternative view of performance used by managementand we believe that investors’ understanding of our performance is enhanced bydisclosing this performance measure. We report adjusted pro forma net income inorder to present the results of our major operations - the construction,installation, marketing, and sale of various electronic security systems forcommercial accounts and detention hardware (including security doors andframes, jail furniture, security glazing, and other security-based systems) andelectronic control systems for correctional facilities - prior to consideringcertain income statement elements, principally amortization of intangibleassets. **We have defined adjusted pro forma net income asnet income before the impact of purchase accounting for acquisitions,acquisition-related costs, discontinued operations and certain significantitems including one time expenses associated with stock appreciation rights.The adjusted pro forma net income measure is not, and should not be viewed as,a substitute for U.S. GAAP net income.**

 

Theadjusted pro forma net income measure is an important internal measurement forus. We measure the performance of the overall Company on this basis. Thefollowing are examples of how the adjusted pro forma net income measure isbeing 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. |

 

34

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Despitethe importance 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 also recognize that, as an internal measure of performance, theadjusted pro forma net income and the associated earnings per share measure haslimitations and we do not restrict our performance-management process solely tothis metric. A limitation of the adjusted pro forma net income measure is thatit provides a view of our operations without including all events during aperiod such as the effects of an acquisition or amortization of purchasedintangibles and does not provide a comparable view of our performance to othercompanies in the security detention and construction industry.**

 

**In addition, annual and long-term compensation, including annual cashbonuses, merit-based salary adjustments and share-based payments for variouslevels of management that will be made in future years will likely includea non-discretionary formula that measures our performance using revenue growthand relative total shareholder return.**

 

 EBITDA is used by management as a performancemeasure for benchmarking against the Company’s peers and competitors. The Companybelieves EBITDA is useful to investors because it is frequently used bysecurities analysts, investors and other interested parties to evaluatecompanies in the security industry. Additionally, we use EBITDA for internalperformance measurements. EBITDA is not a recognized term under GAAP. Argyleand AUSA compute EBITDA using the same consistent method from quarter toquarter. EBITDA includes net income, interest, taxes, depreciation, andamortization. The presentation of EBITDA is not intended to be considered inisolation or as a substitute for the financial information prepared andpresented in accordance with GAAP.

 

 The adjusted pro forma results of operationsare not necessarily indicative of the results of operations that may haveactually occurred had the merger taken place on the dates noted, or the futurefinancial position or operating results of us or AUSA. The pro formaadjustments are based upon available information and assumptions that webelieve are reasonable. The presentation of EBITDA (earnings before interest,taxes, depreciation and amortization) and adjusted pro forms results is notintended to be considered in isolation or as a substitute for the financialinformation prepared and presented in accordance with GAAP.

 

35

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Belowis a table showing Argyle’s Adjusted Pro Forma Consolidated Statements ofOperations.  The Pro Forma ConsolidatedStatements of Operations are included in the notes to the financial statementsincluded elsewhere in this report.

 

**Argyle Security, Inc**

**Adjusted Pro Forma Consolidated Statements of Operations**

**(unaudited)**

** **

(inthousands except share data)

 
| ** **                                                                     | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                     | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** |
| ** **                                                                     | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| Revenues:                                                                      |       |                             |       |   |   |
| Contract revenues                                                              |       | $                                | 26,906     |   | $ | 11,806 |   |
| Contract revenues - related party                                              |       | 6,943                            |       | 5,801 |   |
| Service and other revenues                                                     |       | 5,466                            |       | 5,566 |   |
| Total revenues                                                                 |       | 39,315                           |       | 23,173 |   |
| Cost of revenues:                                                              |       |                             |       |   |   |
| Contract costs                                                                 |       | 27,040                           |       | 13,813 |   |
|  Service and other costs, excluding  amortization of intangibles          |       | 4,270                            |       | 4,332 |   |
| Total cost of revenues                                                         |       | 31,310                           |       | 18,145 |   |
| Gross profit                                                                   |       | 8,005                            |       | 5,028 |   |
| Operating expenses:                                                            |       |                             |       |   |   |
| Salaries and related expense, including $558  stock-based compensation in 2008 |       | 3,577                            |       | 2,489 |   |
| Consulting fees and outside services                                           |       | 948                              |       | 295 |   |
| Depreciation                                                                   |       | 462                              |       | 302 |   |
| Other general and administrative expenses                                      |       | 1,668                            |       | 1,165 |   |
| Amortization of intangible assets                                              |       | —                           |       | — |   |
| Total operating expenses                                                       |       | 6,655                            |       | 4,251 |   |
| Operating income                                                               |       | 1,350                            |       | 777 |   |
| Other income (expense):                                                        |       |                             |       |   |   |
| Interest income                                                                |       | 26                               |       | 59 |   |
| Interest expense                                                               |       | (844                             | )          | (754 | ) |
| Total other income (expense)                                                   |       | (818                             | )          | (695 | ) |
| Income before provision for income taxes                                       |       | 532                              |       | 82 |   |
| Provision (benefit) for income taxes                                           |       | 207                              |       | (33 | ) |
| Net income (loss)                                                              |       | $                                | 325        |   | $ | 115 |   |
|                                                                           |       |                             |       |   |   |
| EBITDA Calculation:                                                            |       |                             |       |   |   |
| Interst, net                                                                   |       | $                                | 818        |   | $ | 695 |   |
| Depreciation                                                                   |       | 462                              |       | 352 |   |
| Taxes, net                                                                     |       | 207                              |       | (33 | ) |
| EBITDA                                                                         |       | $                                | 1,812      |   | $ | 1,129 |   |
|                                                                           |       |                             |       |   |   |
| Weighted-average number of shares  outstanding:                                |       |                             |       |   |   |
| Basic                                                                          |       | 5,749,342                        |       | 5,749,342 |   |
| Diluted                                                                        |       | 6,707,072                        |       | 6,751,123 |   |
| Net income per share:                                                          |       |                             |       |   |   |
| Basic                                                                          |       | $                                | 0.06       |   | $ | 0.02 |   |
| Diluted                                                                        |       | $                                | 0.05       |   | $ | 0.02 |   |

 

36

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Belowis a reconciliation of GAAP net income (loss) to: pro forma net income (loss);adjusted pro forma net income (loss); and to pro forma EBITDA. **The presentation of EBITDA is not intended to be considered inisolation or as a substitute for the financial information prepared andpresented in accordance with GAAP.**

 

**Reconciliation of GAAP Net Income to ProForma Net Income**

**Adjusted Pro Forma Net Income and Pro FormaEBITDA**

** (unaudited)**

 

(in thousands)

 
| ** **                                                                             | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                             | ** ** | **March 31,**               | ** ** | **March 31,** | ** ** |
| ** **                                                                             | ** ** | **2008**                         | ** ** | **2007** | ** ** |
| **GAAP net income (loss)**                                                             | ** ** | **$**                            | **(734**   | **)** | **$** | **52** | ** ** |
| Pro forma adjustments - addbacks  (reductions)                                         |       |                             |       |   |   |
| Argyle salary expense (increase) for  management team in 2007                          |       | —                           |       | (222 | ) |
| Non-cash compensation expense (increase)  for 2007                                     |       | —                           |       | (142 | ) |
| Depreciation expense (increase) on revalued  assets in 2007                            |       | —                           |       | (78 | ) |
| Amortization of intangible expense  (increase) in cost of goods sold for 2008 and 2007 |       | (37                              | )          | (1,289 | ) |
| Amortization of intangible expense  (increase) in operating expenses for 2008 and 2007 |       | (21                              | )          | (354 | ) |
| Reduction in rent expense for 2008 and 2007                                            |       | 5                                |       | 17 |   |
| Interest income increase / (reduction) for  2008 and 2007                              |       | —                           |       | (324 | ) |
| Interest expense (increase) / reduction for  2008 and 2007                             |       | (39                              | )          | 247 |   |
| Income / (loss) from predecessor - Argyle  Security USA for Q1 2007                    |       |                             |       | 123 |   |
| Income / (loss) from predecessor -  Firequest for Q1 2007                              |       | —                           |       | 80 |   |
| Income / (loss) from predecessor - PDI for Q1  2007                                    |       | —                           |       | 156 |   |
| Income / (loss) from predecessor - Com-Tec  for January 2008 and Q1 2007          |       | 44                               |       | (38 | ) |
| Provision (benefit) for income taxes on pro  forma adjustments for 2008 and 2007       |       | 34                               |       | 815 |   |
| **Pro forma net income (loss)**                                                        | ** ** | **$**                            | **(748**   | **)** | **$** | **(957** | **)** |
| Amortization of intangible expense in cost  of goods sold for 2008 and 2007            |       | 1,289                            |       | 1,289 |   |
| Amortization of intangible expense in  operating expenses for 2008 and 2007            |       | 442                              |       | 442 |   |
| Provision (benefit) for income taxes on pro  forma adjustments for 2008 and 2007       |       | (658                             | )          | (659 | ) |
| **Adjusted pro forma net income (loss)**                                               | ** ** | **$**                            | **325**    | ** ** | **$** | **115** | ** ** |
| Interest, net                                                                          |       | 818                              |       | 695 |   |
| Depreciation expense                                                                   |       | 462                              |       | 352 |   |
| Taxes, net                                                                             |       | 207                              |       | (33 | ) |
| **Pro forma EBITDA**                                                                   | ** ** | **$**                            | **1,812**  | ** ** | **$** | **1,129** | ** ** |

 

37

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Belowis a table of adjusted pro forma revenues, cost of sales, and gross margins forthe three months ended March 31, 2008 and 2007.

 
| ** **                                             | ** ** | **Three Months March 31, 2008** | ** ** | **Three Months March 31, 2007** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **Corrections**                                     | ** ** | **Commercial**                                      | ** ** | **Total**                                 | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
| Net revenues                                           |       |                                                |       |                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | $                                                   | 28,251     |                                                | $          | 5,598                                     |       | $ | 33,849 |   | $ | 12,101 |   | $ | 5,506 |   | $ | 17,607 |   | 133.5 | % | 1.7 | % | 92.2 | % |
| Service and other  revenues                            |       | 3,505                                               |       | 1,961                                               |       | 5,466                                     |       | $ | 1,914 |   | $ | 3,652 |   | 5,566 |   | 83.1 | % | -46.3 | % | -1.8 | % |
| Total net  revenues                                    |       | $                                                   | 31,756     |                                                | $          | 7,559                                     |       | $ | 39,315 |   | $ | 14,015 |   | $ | 9,158 |   | $ | 23,173 |   | 126.6 | % | -17.5 | % | 69.7 | % |
| *% of  total*                                          |       |                                                |       |                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of revenues                                       |       |                                                |       |                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract costs /  contract costs - related party       |       | $                                                   | 22,595     |                                                | $          | 4,445                                     |       | $ | 27,040 |   | $ | 9,245 |   | $ | 4,568 |   | $ | 13,813 |   | 144.4 | % | -2.7 | % | 95.8 | % |
| Service and other  costs                               |       | 2,620                                               |       | 1,650                                               |       | 4,270                                     |       | 1,320 |   | 3,012 |   | 4,332 |   | 98.5 | % | -45.2 | % | -1.4 | % |
| Total cost of  revenues                                |       | $                                                   | 25,215     |                                                | $          | 6,095                                     |       | $ | 31,310 |   | $ | 10,565 |   | $ | 7,580 |   | $ | 18,145 |   | 138.7 | % | -19.6 | % | 72.6 | % |
| Gross margin                                           |       |                                                |       |                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract margins  / contract margins - related party   |       | $                                                   | 5,656      |                                                | $          | 1,153                                     |       | $ | 6,809 |   | $ | 2,856 |   | $ | 938 |   | $ | 3,794 |   | 98.0 | % | 22.9 | % | 79.5 | % |
| Service and other  margins                             |       | $                                                   | 885        |                                                | $          | 311                                       |       | $ | 1,196 |   | 594 |   | 640 |   | 1,234 |   | -49.0 | % | -51.4 | % | -3.1 | % |
| Total gross  margin                                    |       | $                                                   | 6,541      |                                                | $          | 1,464                                     |       | $ | 8,005 |   | $ | 3,450 |   | $ | 1,578 |   | $ | 5,028 |   | 89.6 | % | -7.2 | % | 59.2 | % |
| Gross margin  percentage                               |       |                                                |       |                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | 20.0                                                | %          | 20.6                                                | %          | 20.1                                      | %          | 23.6 | % | 17.0 | % | 21.5 | % | -15.3 | % | 21.2 | % | -6.5 | % |
| Service and other  revenues                            |       | 25.2                                                | %          | 15.9                                                | %          | 21.9                                      | %          | 31.0 | % | 17.5 | % | 22.2 | % | 18.7 | % | -9.1 | % | -1.4 | % |
| Total gross margin  percentage                         |       | 20.6                                                | %          | 19.4                                                | %          | 20.4                                      | %          | 24.6 | % | 17.2 | % | 21.7 | % | -16.3 | % | 12.8 | % | -6.0 | % |

 

Correctionssegment revenues increased by 126.7% of total Company revenues from the sameperiod in 2007. Commercial segment revenues fell by 17.5%, but when a single$1.8 million service revenue transaction in 2007 is excluded, the growth forthe same period was 2.7%.  The totalCompany margin decrease from 21.7% to 20.4% was directly attributable to thedecreased margins in the Corrections segment (decreased 16.3%) while the Commercialsegment margins increased by 12.8% over the same period.

 

**Discussion ofFinancial Results**

 

*Revenues*

 

Morethan 90% of AUSA’s revenues are generated by fixed-price contracts. The successof a fixed-price contract is based in large part upon the quality of theprocess utilized when estimating the costs that will be incurred in performingthe contract. The larger the project and the longer the term of completion ofthe contract, the greater the number of variable factors there are to beconsidered and evaluated in estimating costs. A successful estimating processrequires substantial experience and judgment. Management is aware of thesignificant need for experience and qualified estimating personnel andregularly monitors the estimating process and its results.

 

Themost obvious benchmark that management considers in evaluating the estimatingprocess is whether the amount estimated, and submitted as a bid, was reasonablysimilar to the amount bid by AUSA’s competitors on the same project. Otherbidders may bid exceptionally low (even at a loss) in order to secure acontract that the competitor may desperately need in order to maintain atleast a modest level of cash flow, or for other reasons. Management mustevaluate the bids that were submitted in competition with AUSA’s bid, based ontheir knowledge of each competitor’s history and character (for example, sometypically bid high, some typically bid low), the condition of the market, thecomplexity of the project, the type of construction and other factors. Thisreview, conducted regularly, provides management with an ongoing general basisfor evaluating the estimating process that result in fixed price contracts.Evaluating the results of bidding competitions allows management to evaluatethe Company’s estimating capabilities at the beginning or “front-end” of a newcontract or project. Other benchmarks are used to evaluate the estimatingprocess while a project is ongoing.

 

38

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AUSAalso generates service revenues. These are generally short-term projects whichare evidenced by signed service agreements, customer work orders or purchaseorders. These sales agreements/customer orders generally provide forbilling to customers based on time at quoted hourly or project rates, pluscosts of materials and supplies furnished by AUSA. Service revenues arerecognized when the services have been delivered to and accepted by thecustomer.

 

Thisis our third quarter of reportable revenues. Prior to our acquisition of AUSA,we had no revenues.

 

*Cost of Revenues*

 

Costof revenues consists of the direct costs to complete a material fixed-pricecontract and includes variable costs related to the project, such as material,direct labor, project management costs, travel related expenses to theprojects, hotel costs spent while the project is on-going, truck expensesutilized on those projects and cell phones of the personnel while they are onthose projects. We also review our inventories for indications of obsolescenceor impairment and provide reserves as deemed necessary.

 

*Selling, General and Administrative Expenses*

 

Selling,general and administrative expenses consist primarily of salaries and benefitsfor selling and administrative personnel, including the human resources,executive, finance and legal. These expenses also include fees for professionalservices and other administrative expenses.

 

**Results ofOperations for the Three Months Ended March 31, 2008**

 

**Revenues**

 

Thisis our third quarter of reportable revenues. Prior to our acquisition of AUSA,we had no revenues.

 

*Pro Forma Net Revenues*

 

Thefollowing table presents pro forma net revenues for the three months ended March 31,2008 and 2007 (in thousands):

 
| ** **                            | ** ** | **Pro Forma Revenue**  | ** ** | ** **                       | ** ** | ** **                 | ** ** |
|---------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** | ** **                 | ** ** |
| ** **                            | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007**     | ** ** | **Year to Year** | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | **% of**                    | ** ** | ** **                 | ** ** | **% of** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                            | ** ** | **Amount**                       | ** ** | **Revenues**                     | ** ** | **Amount**                 | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract revenues**                 |       | $                                | 26,906     |                             | 68.4       | %                          | $          | 11,806 |   | 51.0 | % | $ | 15,100 |   | 127.9 | % |
| **Contract revenues - related party** |       | 6,943                            |       | 17.7                             | %          | 5,801                      |       | 25.0 | % | 1,142 |   | 19.7 | % |
| **Service and other revenues**        |       | 5,466                            |       | 13.9                             | %          | 5,566                      |       | 24.0 | % | (100 | ) | -1.8 | % |
| **Total revenues**                    |       | $                                | 39,315     |                             | 100.0      | %                          | $          | 23,173 |   | 100.0 | % | $ | 16,142 |   | 69.7 | % |

 

Ona pro forma basis, the Company had revenues of $39.3 million (including relatedparty revenue of $6.9 million) and $23.2 million (including related partyrevenue of $5.8 million) for the three months ended March 31, 2008and 2007, respectively, representing an increase of $16.1 million or 69.7%. 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 havedecreased by ($0.1) million for the quarter ended March 31, 2008 versus2007.  There is such a significantdecrease because we had an unusually large $1.8 million service revenuecontract recognized in the same period 2007. When excluding the $1.8 million opportunity in the quarter-ended March 31,2007 service and other sales actually increased by $1.7 million or 45.1% overthe same period.  The Company has focusedon building its service revenue base by adding salespeople and improvingperformance to retain more customers and to the increase service revenues.

 

39

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Asused in this analysis, “related party” revenue is that revenue that isgenerated by work sub-contracted from ISI*MCS (an entity owned by SamYoungblood, President of AUSA, and by Don Carr, President of AUSA –Corrections).  Messrs. Youngblood and Carr created ISI*MCS in 2004 toprovide bonding on contracts that required bonding. The performance of those contractswas subcontracted to ISI as a subcontractor to ISI*MCS.  Thesub-contracted work was for third party customers of ISI*MCS that requiredbonded contracts.  After the acquisition of ISI by Argyle, ISI*MCS nolonger provided bonding and subcontract work to ISI now referred to AUSA in2008.  AUSA is in the process of securingits own bonding capacity and will use that bonding capacity to directly enterinto bonded contracts with third party customers.  After the merger, the amount of “Revenues -related party” will continue to decrease as the contracts with ISI*MCS,outstanding at the time of the merger, are completed.

 

Thepro forma revenue mix was 86.1% contract revenues and 13.9% service revenuesfor the three months ended March 31, 2008 compared to 76.0% and 24.0%,respectively, for the corresponding period in 2007.

 

In the last three years the entire corrections and commercial securitymarkets have been growing, which has been a factor in a portion of the Company’ssuccess.  Should these markets continueto grow, the Company with its strong market position should continue to seeincreasing revenue opportunities.   SinceJanuary 2008, the Company has been implementing plans to increaserevenues.  Some of the expected increaseswill be derived from the marketing of packaged products from the portfolios ofthe companies Argyle acquired in January 2008.

 

**Cost of Revenues**

 

Thishas been our third quarter of reportable cost of revenues. Prior to ouracquisition of AUSA, we had no cost of revenues.

 

*Adjusted Pro Forma Cost of Revenues*

 

Thefollowing table reconciles adjusted pro forma cost of revenues to pro formacost of revenues for the three months ended March 31, 2008 and 2007 (inthousands):

 
| ** **                                                             | ** ** | **Adjusted Pro Forma Cost of Revenue** | ** ** | ** **                       | ** ** | ** **                 | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                             | ** ** | **Three Months Ended**                                | ** ** | **Three Months Ended** | ** ** | ** **                 | ** ** |
| ** **                                                             | ** ** | **March 31, 2008**                                    | ** ** | **March 31, 2007**     | ** ** | **Year to Year** | ** ** |
| ** **                                                             | ** ** | ** **                                                      | ** ** | **% of**                    | ** ** | ** **                 | ** ** | **% of** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                                             | ** ** | **Amount**                                                      | ** ** | **Revenues**                     | ** ** | **Amount**                 | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract costs**                                                     |       | $                                                               | 27,040     |                             | 68.8       | %                          | $          | 13,813 |   | 59.6 | % | $ | 13,227 |   | 95.8 | % |
| **Service and other costs, excluding amortization  of intangibles**    |       | 4,270                                                           |       | 10.9                             | %          | 4,332                      |       | 18.7 | % | (62 | ) | -1.4 | % |
| **Adjusted pro forma total cost of revenues**                          |       | 31,310                                                          |       | 79.6                             | %          | 18,145                     |       | 78.3 | % | 13,165 |   | 72.6 | % |
| **Amortization of intangibles**                                        |       | 1,289                                                           |       | 3.3                              | %          | 1,289                      |       | 5.6 | % | — |   | 0.0 | % |
| **Pro forma cost of revenues, including  amortization of intangibles** |       | $                                                               | 32,599     |                             | 82.9       | %                          | $          | 19,434 |   | 83.9 | % | $ | 13,165 |   | 67.7 | % |

 

Ona pro forma basis, cost of revenues increased by $13.2 million, or 67.9%, to$32.6 million for the three months ended March 31, 2008, compared to $19.4million for the corresponding period in 2007. On an adjusted pro forma basis,cost of revenues increased by $13.2 million, or 72.6%, to $31.3 million for thethree months ended March 31, 2008, compared to $18.1 million for thecorresponding period in 2007. The increase in cost of sales resulted from AUSAworking on a greater number of projects in 2008 than in 2007.

 

Theamortization of acquired backlog has been allocated to cost of revenues. Theimpact of this amortization (which was excluded from adjusted pro forma cost ofrevenues) for the three months ended March 31, 2008 was $1.3 million.

 

40

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TheCompany has been implementing its plan to reduce costs and improveefficiencies.  Some of these effortsinclude implementing the best technology in all organizations.  For example, we discovered that some of thetechnology used by the acquired companies was superior to our own, especiallywith respect to production costs. Additionally, we discovered that some of the technology we developed isfaster and more efficient than that of the acquired companies. The currenteffort to “swap technology” is proceeding as planned and production costsavings are expected results of these efforts.

 

**Gross Margin**

 

Thishas been our third quarter of reportable gross margin. Prior to our acquisitionof AUSA, we had no gross margin.

 

*Adjusted Pro Forma Gross Margin*

 

Thefollowing table reconciles adjusted pro forma gross margin to pro forma grossmargin for the three months ended March 31, 2008 and 2007 (in thousands):

 
| ** **                          | ** ** | **Adjusted Pro Forma Gross Margin** | ** ** | ** **                       | ** ** | ** **                 | ** ** |
|-------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | **Three Months Ended**                        | ** ** | **Three Months Ended** | ** ** | ** **                 | ** ** |
| ** **                          | ** ** | **March 31, 2008**                            | ** ** | **March 31, 2007**     | ** ** | **Year to Year** | ** ** |
| ** **                          | ** ** | ** **                                              | ** ** | **% of**                    | ** ** | ** **                 | ** ** | **% of** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                          | ** ** | **Amount**                                              | ** ** | **Revenues**                     | ** ** | **Amount**                 | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma gross margin** |       | $                                                       | 8,005      |                             | 20.4       | %                          | $          | 5,028 |   | 21.7 | % | $ | 2,977 |   | 59.2 | % |
| **Amortization of intangibles**     |       | (1,289                                                  | )          | -3.3                             | %          | (1,289                     | )          | -5.6 | % | — |   | 0.0 | % |
| **Pro forma gross margin**          |       | $                                                       | 6,716      |                             | 17.1       | %                          | $          | 3,739 |   | 16.1 | % | $ | 2,977 |   | 79.6 | % |

 

Ona pro forma basis for the three months ended March 31, 2008, there wasgross margin of $6.7 million compared to a gross margin of $3.8 million for thecorresponding period in 2007. On an adjusted pro forma basis for the threemonths ended March 31, 2008, there was gross margin of $8.0 millioncompared to a gross margin of $5.0 million for the corresponding period in2007. The increase in adjusted gross margin was directly attributableto the Company’s stronger pricing position which provides higher marginsand development of software to automate production, which allows forefficiencies in production and thus lowers costs, thus increasing grossmargins. A major contributor to the increase in gross margin is the increase inservice revenues as a percentage of the overall revenues. Service revenuesenjoy a higher gross margin than the contract revenues. The company alsoincreased gross margin by controlling costs through the upgrading of projectmanagement processes to support installations and services.

 

Theamortization of acquired backlog in the cost of sales section has beenallocated to cost of revenues and represents the only difference between proforma gross margins and adjusted pro forma gross margins for the three monthsended March 31, 2008 and 2007.

 

Aspreviously discussed in revenues and cost of revenues sections Argyle has beenimplementing its plans to increase revenues, improve efficiencies, and reducecosts, all with the expectation to improve gross margins in coming periods.  Argyle has also seen margins improve over thelast year due to the following:

 

·                  Lower margin work was completed in prioryears and quarters;

 

·                  Service revenues with higher margins continueto increase, therefore increasing overall margin percentages; and

 

·                  Production and delivery variable costs havebeen reduced through software tools development, code compression, and trainingwhich has improved margin percentages.

 

41

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**Operating Expenses**

 

Operatingexpenses consist primarily of salaries and benefits for selling andadministrative personnel, including human resources, executive, finance, andlegal. These expenses also include fees for professional services and otheradministrative expenses as well as amortization of intangible assets.  Operating expenses increased to $6.8 millionfor the three months ended March 31, 2008, compared to $0.3 million forthe corresponding period in 2007. Substantially all of the expense increase isattributed to the acquisition of ISI on July 31, 2007 and Com-Tec, PDI ,and Fire Quest in the quarter ended March 31, 2008.

 

*Adjusted Pro Forma Operating Expenses*

 

Thefollowing table reconciles adjusted pro forma operating expenses to pro formaoperating expenses for the three months ended March 31, 2008 and 2007 (inthousands):

 
| ** **                                      | ** ** | **Adjusted Pro Forma Operating Expenses** | ** ** | ** **                       | ** ** | ** **                 | ** ** |
|-------------------------------------------------|------------|---------------------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                      | ** ** | **Three Months Ended**                              | ** ** | **Three Months Ended** | ** ** | ** **                 | ** ** |
| ** **                                      | ** ** | **March 31, 2008**                                  | ** ** | **March 31, 2007**     | ** ** | **Year to Year** | ** ** |
| ** **                                      | ** ** | ** **                                                    | ** ** | **% of**                    | ** ** | ** **                 | ** ** | **% of** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                      | ** ** | **Amount**                                                    | ** ** | **Revenues**                     | ** ** | **Amount**                 | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma total operating expenses** |       | $                                                             | 6,655      |                             | 16.9       | %                          | $          | 4,251 |   | 18.3 | % | $ | 2,404 |   | 56.6 | % |
| **Amortization of intangible assets**           |       | 442                                                           |       | 1.1                              | %          | 442                        |       | 1.9 | % | — |   | 0.0 | % |
| **Pro forma total operating expenses**          |       | $                                                             | 7,097      |                             | 18.1       | %                          | $          | 4,693 |   | 20.3 | % | $ | 2,404 |   | 51.2 | % |
|                                                 |            |                                                               |            |                                  |            |                            |            |  |  |  |  |  |  |  |  |  |  |

 

 On a pro forma basis, operating expensesincreased $2.4 million, or 51.2% to $7.1 million for the three months ended March 31,2008 from $4.7 million for the corresponding period in 2007. On an adjusted proforma basis, operating expenses increased $2.4 million, or 56.6% to $6.7million for the three months ended March 31, 2008 from $4.3 million forthe corresponding period in 2007. The increase is primarily due to additionalexpenses needed to support the increased number of projects on which AUSAis working, increased sales and marketing efforts to promote future growth, andcorporate services expenses associated with the parent company entity.  Growth in operating expenses for 2008 isplanned at approximately the same rate as the growth in revenues to buildinfrastructure to support growth in the coming years

 

Additionally,$0.6 million in non-cash compensation expense related to restricted stockgrants and employee stock options was included in the operating expenses forthe quarter ended March 31, 2008 and $0.2 million for the same period in2007. The amortization of customer base and software has been allocated tooperating expenses and primarily relates to the acquisition of ISI on July 31,2007 and Com-Tec, PDI , and Fire Quest in the quarter ended March 31,2008.  The impact of this amortization,which was excluded from pro forma operating expenses, was $0.4 million.

 

**Other Income / Expense**

 

Priorto July 2007, total other income/expense represented interest earned onthe net proceeds of our initial public offering and the private placement heldin trust through the date of the acquisition of ISI.  Interest expense represents interest on ourline of credit, unsecured subordinated debt, and notes issued in January 2008in connection with the acquisition of Com-Tec, PDI, and Fire Quest. Total otherincome/expense for the three months ended March 31, 2008 was an expense of$0.8 million compared to income of $0.4 million for the corresponding period in2007.

 

*Pro Forma Interest Income and InterestExpense*

 

Thefollowing table presents pro forma interest and other income for the threemonths ended March 31, 2008 and 2007 (in thousands):

 
| ** **                       | ** ** | **Pro Forma Other Income (Expense)** | ** ** | ** **                       | ** ** | ** **                 | ** ** |
|----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **Three Months Ended**                         | ** ** | **Three Months Ended** | ** ** | ** **                 | ** ** |
| ** **                       | ** ** | **March 31, 2008**                             | ** ** | **March 31, 2007**     | ** ** | **Year to Year** | ** ** |
| ** **                       | ** ** | ** **                                               | ** ** | **% of**                    | ** ** | ** **                 | ** ** | **% of** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                       | ** ** | **Amount**                                               | ** ** | **Revenues**                     | ** ** | **Amount**                 | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Interest income**              |       | $                                                        | 26         |                             | 0.1        | %                          | $          | 59 |   | 0.3 | % | $ | (33 | ) | -55.9 | % |
| **Interest expense**             |       | (844                                                     | )          | -2.1                             | %          | (754                       | )          | -3.3 | % | (90 | ) | 11.9 | % |
| **Total other income (expense)** |       | $                                                        | (818       | )                                | -2.1       | %                          | $          | (695 | ) | -3.0 | % | $ | (123 | ) | 17.7 | % |

 

42

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Proforma net interest for the three months ended March 31, 2008 mainlyrepresents interest earned on the net proceeds of our initial public offeringand the private placement held in trust through the date of the acquisition ofISI. Interest expense increased to ($0.8) million for the three months ended March 31,2008 from ($0.7) million for the corresponding period in 2007. Interest expensefor the three months ended March 31, 2008 and 2007 mainly representsinterest on our line of credit, unsecured subordinated debt, and our notesissued in January 2008 for the acquisition of Com-Tec, PDI and Fire Quest.

 

**Net Income / (Loss)**

 

Forthe three months ended March 31, 2008, we had net loss of ($0.7) millioncompared to a net income of $52,000 for the corresponding period in 2007. Theresults of operations for the three months ended March 31, 2008 includethe results of operations for AUSA, Fire Quest and PDI from January 1,2008 and the results of operations of Com-Tec from February 1, 2008. Ourprimary source of income prior to the consummation of our initial businesscombination with ISI was interest earned on the funds held in the trustaccount.

 

** ***Adjusted Pro Forma Net Income (Loss)*

 

Thefollowing table reconciles adjusted pro forma net income (loss) to pro formaincome / (loss) for the three months ended March 31, 2008 and 2007 (inthousands):

 
| ** **                               | ** ** | **Pro Forma Net Income (Loss)** | ** ** | ** **                       | ** ** | ** **                 | ** ** |
|------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                               | ** ** | **Three Months Ended**                    | ** ** | **Three Months Ended** | ** ** | ** **                 | ** ** |
| ** **                               | ** ** | **March 31, 2008**                        | ** ** | **March 31, 2007**     | ** ** | **Year to Year** | ** ** |
| ** **                               | ** ** | ** **                                          | ** ** | **% of**                    | ** ** | ** **                 | ** ** | **% of** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                               | ** ** | **Amount**                                          | ** ** | **Revenues**                     | ** ** | **Amount**                 | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted pro forma net income (loss)** |       | $                                                   | 325        |                             | 0.8        | %                          | $          | 115 |   | 0.5 | % | $ | 210 |   | 182.6 | % |
| **Amortization of intangible assets**    |       | (1,731                                              | )          | -4.4                             | %          | (1,731                     | )          | -7.5 | % | — |   | 0.0 | % |
| **Taxes, net**                           |       | 658                                                 |       | 1.7                              | %          | 659                        |       | 2.8 | % | (1 | ) | -0.2 | % |
| **Total pro forma net income (loss)**    |       | $                                                   | (748       | )                                | -1.9       | %                          | $          | (957 | ) | -4.1 | % | $ | 209 |   | -21.8 | % |

 

Forthe three months ended March 31, 2008, we had a pro forma net loss of($0.7) million compared to a pro forma net loss of ($1.0) million for thecorresponding period in 2007. For the three months ended March 31, 2008,we had an adjusted pro forma net income of $0.3 million compared to an adjustedpro forma net income of $115,000 for the corresponding period in 2007. Theadjusted pro forma results for the three months ended March 31, 2008include the pro forma results of operations for AUSA, Fire Quest and PDI from January 1,2008 and the results of operations of Com-Tec from February 1, 2008. Ourprimary source of income prior to the consummation of our initial businesscombination with AUSA was interest earned on the funds held in a trust account.

 

**Earnings before Interest, Taxes, Depreciationand Amortization (“EBITDA”)**

 
| ** **           | ** ** | **Pro Forma EBITDA**   | ** ** | ** **                       | ** ** | ** **                 | ** ** |
|----------------------|------------|----------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** | ** **                 | ** ** |
| ** **           | ** ** | **March 31, 2008**     | ** ** | **March 31, 2007**     | ** ** | **Year to Year** | ** ** |
| ** **           | ** ** | ** **                       | ** ** | **% of**                    | ** ** | ** **                 | ** ** | **% of** | ** ** | **Increase (Decrease)** | ** ** |
| ** **           | ** ** | **Amount**                       | ** ** | **Revenues**                     | ** ** | **Amount**                 | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Pro forma EBITDA** |       | $                                | 1,812      |                             | 4.6        | %                          | $          | 1,129 |   | 4.9 | % | $ | 683 |   | 60.5 | % |
|                      |            |                                  |            |                                  |            |                            |            |  |  |  |  |  |  |  |  |  |

 

Proforma EBITDA rose by $0.7 million to $1.8 million in the three months ended March 31,2008, compared to $1.1 million in the corresponding period in 2007. The EBITDAmargin decreased to 4.5 % from 4.9% in the corresponding period in 2007.   The March 31, 2008 EBITDA includes $0.6million in non-cash compensation expense related to restricted stock grants andemployee stock options for that period compared to $0.2 million for the sameperiod in 2007.

 

43

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****Liquidityand Capital Resources****

 

Asof March 31, 2008, we had $2.5 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.

 

Net proceeds from the sale of Argyle’sunits, after deducting certain offering expenses of approximately $2.4 million,including underwriting discounts of approximately $1.8 million, wereapproximately $28.2 million. Approximately $27.3 million of the proceeds fromthe Public Offering and the Private Placement were placed in a trust accountfor Argyle’s benefit. Except for $0.6 million in interest that was earned onthe funds contained in the trust account and that was released to Argyle to beused as working capital, and the amounts released to Argyle for the payment oftaxes, Argyle was not able to access the amounts held in the trust until itconsummated a business combination. The amounts held outside of the trustaccount were used by Argyle to provide for business, legal, and accounting duediligence on prospective acquisitions and continuing general and administrativeexpenses. Prior to releasing the funds held in trust, the trust accountcontained $1.4 million reserved for the compensation of Argyle’s underwritersin its Public Offering which was paid to them upon completion of the businesscombination. All amounts held in trust were released at July 31, 2007 tofund the ISI acquisition.

 

In connection with the Public Offeringand the Private Placement, Argyle’s officers and directors placed all theshares owned by them before the Private Placement and the Public Offering intoan escrow account. Except in certain circumstances, the shares held in escrowmay not be released prior to January 24, 2009.

 

On April 16, 2007, Argyle’s officersand directors, an affiliate of Bob Marbut, 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 37,500 shares of Argyle’scommon stock. The promissory notes were repaid in full plus accrued interest inAugust 2007.

 

On July 31, 2007, Argyle consummateda business combination, acquiring 100% of the outstanding capital stock of ISIDetention Contracting Group, Inc. and its subsidiaries, the value of whichthe Board of Directors determined was greater than 80% of Argyle’s assets atthe time of the merger. Prior to the acquisition of ISI, Argyle had nooperations and was considered a developmental stage enterprise. ISI is deemedto be a ‘‘predecessor’’ to the combined company. The accompanying consolidatedbalance sheet includes the assets and liabilities related to the acquisition ofISI, adjusted to fair value pursuant to Statement of Financial AccountingStandards (SFAS) No. 141, *BusinessCombinations*.

 

Argyle used an estimated $20.5 million(excluding Argyle and AUSA transaction costs) of the net proceeds of theinitial public offering to acquire ISI. At the closing of the merger, thefollowing consideration was paid by the Company to the stockholders and debtholders of ISI:

 

·                  $18.6million in cash;

 

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

 

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

 

44

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Additionally, Argyle incurred totaltransaction costs of approximately $1.7 million, including legal costs paid toLoeb & Loeb of $0.5 million, $0.6 million related to certain MacquarieSecurities (USA) Inc.’s (formerly Giuliani Capital Advisors) advisory fees andfairness opinion, $0.3 million paid in M&A fees to WFG Investments andadditional costs of $0.3 million related to accountants, consultants, printerfees and other miscellaneous expenses. Such costs do not include transactioncosts of approximately $1.0 million incurred by ISI (related primarily toattorney, brokerage and accounting fees).

 

As part of the ISI merger, publicstockholders holding 211,965 of the aggregate number of shares sold in thePublic Offering elected to redeem such shares. The per share redemption pricewas equal to $7.80 per share including interest earned thereon in the trustaccount, net of taxes paid and payable, $0.6 million of interest income whichwas released from the trust account in September 2006 to fund our workingcapital, and amounts owed to the underwriter for the Private Placement(approximately $0.5 million plus interest). Approximately $1.6 million was paidto redemptive shareholders in August of 2007.

 

In April 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 $15million. 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 112,500 shares of Argyle’s common stock; exercisable at $8.00 pershare as a placement fee.

 

 ***Working Capital***

 

Our primary liquidity needs are forfinancing AUSA’s working capital (including premiums and fees incurred inconnection with bid and performance bonds) and their purchase of computers andrelated equipment. The nature of its business and operations as a detention contractorcauses cash flow from operations to be highly volatile. Its large constructioncontracts can produce or consume cash. The production or consumption of cash isdependent on factors inherent to the construction industry, including billingand payment terms of the contracts. AUSA has in place a credit facility toallow it to manage its working capital requirements.

 

At March 31,2008, we had current assets of $59.1 million and current liabilities of $31.9million resulting in a working capital surplus of approximately $27.2 millioncompared 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):

 
| ** **                                | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **Collateral**                            | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| Notes  payable:                           |       |               |       |                  |       |
| Vehicles and equipment                    |       | $                  | 214        |                  | $          | 190 |   |
| Unsecured debt - related party            |       | 11,057             |       | 5,952                 |       |
| Unsecured convertible debt - stockholders |       | 1,925              |       | 1,925                 |       |
| Seller notes                              |       | 6,765              |       | —                |       |
| Line of  credit and acquisition line      |       | 12,970             |       | 7,979                 |       |
|                                      |       | $                  | 32,931     |                  | $          | 16,046 |   |
| Less -  current maturities                |       | 413                |       | 81                    |       |
| Long term  debt                           |       | $                  | 32,518     |                  | $          | 15,965 |   |

 

***Vehicles and Equipment***

 

Amount includes notes related to Company vehiclesand various equipment. Vehicle and equipment notes are staggered in regards totheir maturity, each amortizing over 36 – 48 month periods.  Interest rates on the individual notes rangefrom fixed rate of 7% up to Prime plus 1.0%. Included with the equipment is anote related to the phone system with a fixed rate of interest at 9.0% whichmatures in April 2008.

 

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***Unsecured Debt — RelatedParty***

 

Theserefer to notes payable to a significant stockholder of Argyle. On January 2,2008 an additional $5.0 million in unsecured debt was funded by the samerelated party for which $6.0 million is due. All notes are unsecured andsubordinated to the line of credit facility. The unsecured note agreementscontain prepayment options with prepayment penalties. Interest accrues at11.58% per annum and is payable quarterly in arrears, deferred interest at therate of 8.42% per annum, and default interest at 2% per annum. The total debtof $11.0 million is due and payable in one single payment on January 31,2010. There are both financial and restrictive covenants associated with the noteagreements.  As of March 31, 2008,the Company was in compliance with all covenants except two technical, nonfinancial, covenants.  The Companyobtained a waiver from the lender to remedy these defaults.

 

***Unsecured ConvertibleDebt — 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.

 

***UnsecuredDebt — Stockholders***

 

InApril 2007, Argyle’s officers and directors, an affiliate of Argyle’sChairman and Co-Chief Executive Officer, and certain of Argyle’s consultants,pursuant to a note and warrant acquisition agreement, loaned Argyle anaggregate of $0.3 million and in exchange received promissory notes in theaggregate principal amount of $0.3 million and warrants to purchase anaggregate of 37,500 shares of Argyle’s common stock. The warrants areexercisable at $5.50 per share of common stock and expire on January 24,2011.

 

Thewarrants also may be exercised on a net-share basis by the holders of thewarrants. The Company has estimated, based upon a Black-Scholes model, that thefair value of the warrants on the date of issue was approximately $2.48 perwarrant (a total value of approximately $93,000 using an expected life of 2 years, volatility of 2.39%, and a risk-freerate of 5%. However, because the Company’s warrants have a limited tradinghistory, the volatility assumption was based on information currently availableto management. The promissory notes had an interest at a rate of 4% per yearand were repayable 30 days after the consummation of a business combination.The notes and the associated accrued interest 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 (Fire Quest Promissory Note). The Fire QuestPromissory Notes bear interest at the rate of 7.25% per year and will becomedue and payable on January 1, 2009.

 

Inconnection with the PDI acquisition, the Company issued convertible promissorynotes (the PDI Promissory Notes) in the aggregate principal amount of $3.0million. The aggregate principal amount of the PDI Promissory Notes may bereduced depending on the occurrence of certain events described in the AssetPurchase Agreement. The payment of the PDI Promissory Notes are guaranteed byand secured by the assets of AUSA and Argyle and bear interest at 6% paidquarterly through December 2009. After December 2009, principal and interest payments of $133,000are due monthly with final payment occurring on December 31, 2012.  On 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 period; or (ii) extendthe payment date to January 3, 2011 for an additional payment of $15,000plus accrued interest.  Theaforementioned options to convert or extend the PDI Promissory Notes haveresulted in the creation of compound embedded derivatives for which the Companyhas performed valuations as of March 31, 2008. The Company will mark to market the derivatives, for which any changesin fair value will be recognized in the statement of operations, in all thesubsequent quarters until they are exercised or have expired.  The valuations of these derivatives held a nominalvalue as of March 31, 2008. 

 

Inconnection with the Com-Tec acquisition, the Company issued a securedsubordinated promissory note in the aggregate principal amount of $3.5 million(the Com-Tec Promissory Note). The Com-Tec Promissory Note is guaranteed by andsecured by the assets of AUSA and Argyle, bears interest at 7% per year andwill become due and payable on April 1, 2011.

 

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***Line of Credit Facility***

 

AtMarch 31, 2008, the Company had a line of credit facility totaling $12.0million and an acquisition loan facility in the amount of $4.3 million. Theline of credit is secured by all tangible and intangible assets of AUSAexcluding vehicles. The line calls for all accounts receivable collections tobe deposited directly to a lockbox. The outstanding balance on the creditfacility and the acquisition loan facility at March 31, 2008 was $8.7million, due January 23, 2010, and $4.3 million, due June 30, 2011,respectively.  Interest is payable quarterly at prime plus 0.75% for thecredit 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.  Theagreement contains both financial and restrictive covenants, including arestriction on the payment of dividends. The Company obtained a 90 day extension to remedy two defaults which itbelieves is probable to cure during the grace period. The Company obtained awaiver from the lender to remedy the remaining two defaults.  Inthe event that the Company does not receive a permanent waiver or cure by othermeans during the 90 day extension period, Argyle may cure such default byagreeing to guarantee the obligations of AUSA to its senior lender.

 

TheCompany has agreed to pay an annual commitment fee of 0.5% per year on theunused borrowing capacity, which was $3.3 million and $1.0 million at March 31,2008 and December 31, 2007, respectively.

 

***Capital Leases***

 

ISIsold its owner-occupied real estate to a partnership owned by ISI’sstockholders during 2004 and entered into a leaseback of the properties withthe partnership. ISI entered into a second lease on another property owned bythe same partnership in 2006. Both leases were triple net leases. A triple netlease is a lease agreement on a property where the tenant or lessee agrees topay all real estate taxes, building insurance, and maintenance (the three ‘Nets’)on the property in addition to any normal fees that are expected under theagreement (rent, etc.). In such a lease, the tenant or lessee is responsiblefor all costs associated with repairs or replacement of the structural buildingelements of the property.

 

The terms of the aforementioned leases weremodified on July 31, 2007 to extend the expiration date from 2018 to 2019and increase the monthly rental from $23,667 to $24,000. The modification didnot materially affect the carrying value of the assets or related liabilitiesrecorded in the accompanying consolidated balance sheet.  The Company reassessed these leases forproper classification under SFAS No. 13, *Accountingfor Leases*, and determined they remain properly classified ascapital leases.

 

***Commitments***

 

AUSAleases office space and equipment under operating leases expiring through2012.   The corporate office lease spaceof Argyle expired as of July 31, 2007 and Argyle operated under amonth-to-month lease arrangement until it was renewed in January 2008.  The new lease expands the space fromapproximately 2,500 square feet to 6,500 square feet for a total expense in2008 of $121,000.  Rental expense was$196,000 and $17,000 for the three months ended March 31, 2008 and 2007,respectively, and $71,000 for the three months ended March 31, 2007(Predecessor).

 

As part of the PDI acquisition thatoccurred at January 4, 2008 the Company assumed the existing leases.  The PDI lease is a 4 year lease, for the42,000 square foot facilities, with monthly payments at $16,000.   As part of the Com-Tec acquisition that occurredat January 31, 2008 the Company signed new leases for the existing facility.  The Com-Tec lease is a 5 year lease, for the33,000 square foot facility, with month payments at $14,000 beginning in year 3with the total rent expense being straight line amortized over the life of thelease.

 

In August 2007 weentered 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. Thecommitment fee is to be paid quarterly.

 

**Off BalanceSheet Arrangements**

 

Argyle does not have anyoff-balance sheet arrangements.

 

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**Contractual Obligations**

 

**Contractual Obligations as of March 31, 2008(Unaudited)**

** **
| ** **                               | ** ** | **Total** | ** ** | **< 1 Year** | ** ** | **1- 3 Years** | ** ** | **3 - 5 Years** | ** ** | **> 5 Years** | ** ** |
|------------------------------------------|------------|-----------|------------|-----------------|------------|----------------|------------|-----------------|------------|------------------|------------|
| Principal on  Long Term Debt Obligations |       | $         | 32,931     |            | $          | 413            |       | $               | 21,777     |             | $          | 10,741 |   | $ | — |   |
| Capital  Lease Obligations               |       | 3,285     |       | 216             |       | 576            |       | 576             |       | 1,917            |       |
| Operating  Lease Obligations             |       | 2,258     |       | 394             |       | 943            |       | 734             |       | 187              |       |
| Interest on  Long Term Debt Obligations  |       | 9,495     |       | 3,380           |       | 4,717          |       | 1,398           |       | —           |       |
| **Total**                                | ** ** | **$**     | **47,969** | ** **      | **$**      | **4,403**      | ** ** | **$**           | **28,013** | ** **       | **$**      | **13,449** | ** ** | **$** | **2,104** | ** ** |

 

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

 

Market risk is the sensitivity of incometo changes in interest rates, foreign exchanges, commodity prices, equityprices, and other market-driven rates or prices.

 

At March 31, 2008, the Company had aline of credit facility totaling $12.0 million and an acquisition loan facilityin the amount of $4.3 million. The line of credit is secured by all tangibleand intangible assets of AUSA excluding vehicles. The outstanding balance onthe credit facility and the acquisition loan facility at March 31, 2008was $8.7 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 4.CONTROLS AND PROCEDURES**

 

Anevaluation of the effectiveness of our disclosure controls and procedures as ofMarch 31, 2008 was made under the supervision and with the participationof our management. Based on that evaluation, our management concluded that ourdisclosure controls and procedures are effective as of the end of the periodcovered by this report 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.

 

Managementhas excluded ISI, PDI, Com-Tec, and Fire Quest which was integrated into theCommercial segment from its evaluation of internal control over financialreporting as of March 31, 2008.  ISIwas acquired on July 31, 2007, Fire Quest 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 shell company when it acquired ISI and each of PDI, FireQuest and Com-Tec would be considered significant subsidiaries of Argyle.

 

Duringthe most recently completed fiscal quarter, there has been no significantchange in our internal control over financial reporting that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

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****PART II - OTHERINFORMATION****

 

****ITEM 1. LEGAL PROCEEDINGS****

 

Fromtime to time, the Company has various lawsuits, claims, and contingentliabilities arising from the conduct of its business; however, in the opinionof management, they are not expected to have a material adverse effect on thecombined results of operations, cash flows, or financial position of theCompany.

 

****ITEM 1A. RISK FACTORS****

 

Inaddition to the other information set forth in this report, you shouldcarefully consider the factors discussed in Part I, “Item 1A. 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 a significant portion ofour revenues from a small number of customers and the loss of a significantcustomer could significantly reduce our revenues.***

 

Our customer base and revenues are concentratedamong a limited number of customers and the loss of any one of these customerscould significantly reduce our revenues.  During the three months ended March 31,2008, revenue from our top three customers, which were all from the Correctionssegment, represented 42% of total Company revenues.  During the three months ended March 31,2008, the Company had revenues from our top two customers, which were all fromthe Corrections segment, which represented 20% and 12% of total Companyrevenues.

 

***If outstanding public warrants areexercised, the underlying common shares will be eligible for future resale inthe public market. ‘‘Market overhang’’ from the warrants results in dilutionand could keep the market price of our stock lower than it would otherwise be.***

 

Outstandingpublic warrants and unit purchase options to purchase an aggregate of 4,075,046shares of common stock issued in connection with Argyle’s initial publicoffering and those for services rendered in connection with a financingtransaction are currently exercisable. If they are exercised, a substantialnumber of additional shares of our common stock will be eligible for resale inthe public market, which could keep the market price of our stock lower than itwould otherwise be.

 

****ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS****

 

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 $15million. Argyle issued warrants to purchase 112,500 shares of its common stock,exercisable at $8.00 per share, to Rodman & Renshaw, LLC, which servedas the exclusive placement agent for the offering, as a portion of itsplacement fee.  Argyle did not pay any fees in connection with theissuance of the warrants.  The securities were issued inreliance on the exemption from registration contained in Section 4(2) ofthe Securities Act since Rodman is an accredited investor.

 

****ITEM 3. DEFAULTS UPON SENIOR SECURITIES****

 

None.

 

****ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS****

 

None.

 

****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 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 |

 

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****SIGNATURES****

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
| ** **          | ARGYLE SECURITY, INC | ** **                                                            | ** ** |
|---------------------|----------------------|-----------------------------------------------------------------------|------------|
| ** **          | ** **           | ** **                                                            | ** ** | ** ** |
| ** **          | ** **           | ** **                                                            | ** ** | ** ** |
| May 20,  2008  | By:                  | /s/ Bob  Marbut                                                  |
|                |                 | Bob Marbut                                                            |       |
|                |                 | Co-Chief  Executive Officer   (Principal Executive Officer)           |       |
|  

       |                 |                                                                  |       |   |
| May 20,  2008  | By:                  | /s/ Ron  Chaimovski                                              |
|                |                 | Ron  Chaimovski                                                       |       |   |
|                |                 | Co-Chief  Executive Officer(Principal Executive Officer)              |       |   |
|                |                 |                                                                  |       |   |
|                |                 |                                                                  |       |   |
| May   20, 2008 | By:                  | /s/ Donald  F. Neville                                      |
|                |                 | Donald  F. Neville                                                    |       |   |
|                |                 | Chief  Financial Officer(Principal Accounting and  Financial Officer) |       |   |

 

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