Tableof Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 
| **x**      | ** ** | **Quarterly  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934**                                                                                                                                                            |
|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                         |
| ** ** | ** ** | **For  the quarterly period ended September 30, 2008.**                                                                                                                                                                                                       |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                         |
| **or**     | ** ** | ** **                                                                                                                                                                                                                                                         |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                         |
| **o**      | ** ** | **Transition  Report Pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934**                                                                                                                                                           |
| ** ** | ** ** | ** **                                                                                                                                                                                                                                                         |
| ** ** | ** ** | **For  the transition period from                      to                  .** |

 

**CommissionFile Number: 000-51639**

 

**ArgyleSecurity, Inc.**

(Exact name ofregistrant as specified in its charter)

 

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

 

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

(Address ofPrincipal Executive Offices including Zip Code)

 

**(210)828-1700**

(Registrant’sTelephone Number, Including Area Code)

 

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

 

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

 

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

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

 

There were 5,969,342,shares of the Registrant’s common stock issued and outstanding as of November 14,2008.

 

 

 

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Tableof Contents

 

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

 
| **Part I.**  | **Financial Information**                                                                           | 1      |
|-------------------|-----------------------------------------------------------------------------------------------------|--------|
|              |                                                                                                |   |
|              | Item  1. Financial Statements                                                                       | 1      |
|              |                                                                                                |   |
|              | Consolidated  Balance Sheets                                                                        | 1      |
|              |                                                                                                |   |
|              | Consolidated  Statements of Operations                                                              | 2      |
|              |                                                                                                |   |
|              | Consolidated  Statement of Stockholders’ Equity                                                | 4      |
|              |                                                                                                |   |
|              | Consolidated Statement of Cash Flows                                                                | 5      |
|              |                                                                                                |   |
|              | Notes to Unaudited Consolidated Financial Statements                                                | 6      |
|              |                                                                                                |   |
|              | Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 35     |
|              |                                                                                                |   |
|              | Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 | 62     |
|              |                                                                                                |   |
|              | Item 4T. Controls and Procedures                                                                    | 62     |
|              |                                                                                                |   |
| **Part II.** | **Other Information**                                                                               | 65     |
|              |                                                                                                |   |
|              | Item  1. Legal Proceedings                                                                          | 65     |
|              |                                                                                                |   |
|              | Item  1A. Risk Factors                                                                              | 65     |
|              |                                                                                                |   |
|              | Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                | 68     |
|              |                                                                                                |   |
|              | Item 3. Defaults Upon Senior Securities                                                             | 68     |
|              |                                                                                                |   |
|              | Item 4. Submission of Matters to a Vote of Security  Holders                                        | 68     |
|              |                                                                                                |   |
|              | Item  5. Other Information                                                                          | 68     |
|              |                                                                                                |   |
|              | Item 6.  Exhibits                                                                                   | 68     |
|              |                                                                                                |   |
| SIGNATURES        |                                                                                                | 69     |

 

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Table of Contents

 

**PART I - FINANCIAL INFORMATION**

 

**ITEM1 - CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

 

**ARGYLESECURITY, INC.**

**CONSOLIDATED BALANCE SHEET**S

(in thousandsexcept share data)

 
| ** **                                                                                                                                                                                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                 | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                                 | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                                                                 |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                                            |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                 |       | $                      | 12,054     |                  | $          | 3,556 |   |
| Restricted cash                                                                                                                                                                                            |       | 2,521                  |       | —                |       |
| Receivables:                                                                                                                                                                                               |       |                   |       |                  |       |
| Contract – net  of allowance for doubtful accounts of $1,445 and $975 at September 30,  2008 and December 31, 2007, respectively                                                            |       | 28,915                 |       | 14,459                |       |
| Contract  receivables – related party                                                                                                                                                                 |       | 7,352                  |       | 10,887                |       |
| Other  receivables – related party                                                                                                                                                                    |       | 10                     |       | 42                    |       |
| Costs and  estimated earnings in excess of billings on incomplete contracts                                                                                                                                |       | 7,485                  |       | 7,665                 |       |
| Intangible  assets                                                                                                                                                                                         |       | 1,125                  |       | 2,959                 |       |
| Refundable  income taxes                                                                                                                                                                                   |       | —                 |       | 561                   |       |
| Other current  assets                                                                                                                                                                                      |       | 2,768                  |       | 378                   |       |
| Deferred income  taxes, net                                                                                                                                                                                |       | 1,544                  |       | —                |       |
| Total current  assets                                                                                                                                                                                      |       | 63,774                 |       | 40,507                |       |
| Property and  equipment, net                                                                                                                                                                               |       | 8,985                  |       | 5,227                 |       |
| Goodwill                                                                                                                                                                                                   |       | 7,890                  |       | 19,937                |       |
| Intangible  assets                                                                                                                                                                                         |       | 16,924                 |       | 15,146                |       |
| Deposits,  deferred transaction costs, and other assets                                                                                                                                                    |       | 822                    |       | 331                   |       |
| Total other  assets                                                                                                                                                                                        |       | 34,621                 |       | 40,641                |       |
| Total assets                                                                                                                                                                                               |       | $                      | 98,395     |                  | $          | 81,148 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                             |       |                   |       |                  |       |
| Current  liabilities:                                                                                                                                                                                      |       |                   |       |                  |       |
| Accounts payable  and accrued liabilities                                                                                                                                                                  |       | $                      | 19,122     |                  | $          | 14,318 |   |
| Accounts payable  – related party                                                                                                                                                                     |       | 154                    |       | 40                    |       |
| Billings in  excess of costs and estimated earnings on incomplete contracts                                                                                                                                |       | 6,794                  |       | 5,733                 |       |
| Interest payable  to stockholders                                                                                                                                                                          |       | 24                     |       | 40                    |       |
| Current portion  of capitalized lease obligations                                                                                                                                                          |       | 216                    |       | 97                    |       |
| Current portion  of long-term debt                                                                                                                                                                         |       | 2,656                  |       | 81                    |       |
| Deferred income  taxes                                                                                                                                                                                     |       | —                 |       | 211                   |       |
| Total current  liabilities                                                                                                                                                                                 |       | 28,966                 |       | 20,520                |       |
| Long-Term  Liabilities:                                                                                                                                                                                    |       |                   |       |                  |       |
| Deferred income  taxes                                                                                                                                                                                     |       | 4,118                  |       | 6,095                 |       |
| Long-term debt –  less current portion                                                                                                                                                                |       | 30,355                 |       | 15,965                |       |
| Deferred rent  and other long term liabilities                                                                                                                                                             |       | 776                    |       | —                |       |
| Long-term  capitalized lease obligations - less current portion                                                                                                                                            |       | 3,404                  |       | 1,904                 |       |
| Total long-term  liabilities                                                                                                                                                                               |       | 38,653                 |       | 23,964                |       |
| Total  liabilities                                                                                                                                                                                         |       | 67,619                 |       | 44,484                |       |
| Stockholders’  Equity                                                                                                                                                                                 |       |                   |       |                  |       |
| Preferred stock  of Argyle Security, Inc. - $.0001 par value; 1,000,000 shares  authorized; 18,750 shares issued and outstanding                                                                      |       | —                 |       | —                |       |
| Common stock of  Argyle Security, Inc. - $.0001 par value; 89,000,000 shares authorized;  shares issued and outstanding 5,969,342 at September 30, 2008 and  5,879,342 at December 31, 2007 |       | 1                      |       | 1                     |       |
| Additional paid  in capital                                                                                                                                                                                |       | 50,713                 |       | 36,279                |       |
| Accumulated  earnings (deficit)                                                                                                                                                                            |       | (19,938                | )          | 384                   |       |
| Total  stockholders’ equity                                                                                                                                                                           |       | 30,776                 |       | 36,664                |       |
| Total liabilities  and stockholders’ equity                                                                                                                                                           |       | $                      | 98,395     |                  | $          | 81,148 |   |

 

See notes tounaudited consolidated financial statements

 

1

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**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF OPERATIONS**

**(unaudited)**

 

(in thousandsexcept share data)

 
| ** **                                                                                                           | ** ** | **Three Months Ended** | ** ** | **Predecessor (ISI)  One Month Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **September 30,**           | ** ** | **September 30,**                                | ** ** | **July 31,** | ** ** |
| ** **                                                                                                           | ** ** | **2008**                         | ** ** | **2007**                                              | ** ** | **2007** | ** ** |
| Revenues:                                                                                                            |       |                             |       |                                                  |       |   |   |
| Contract  revenues                                                                                                   |       | $                                | 22,583     |                                                  | $          | 10,670 |   | $ | 2,166 |   |
| Contract  revenues - related party                                                                                   |       | 2,906                            |       | 4,559                                                 |       | 3,573 |   |
| Service and  other revenues                                                                                          |       | 6,211                            |       | 1,864                                                 |       | 755 |   |
| Total revenues                                                                                                       |       | 31,700                           |       | 17,093                                                |       | 6,494 |   |
| Cost of  revenues:                                                                                                   |       |                             |       |                                                  |       |   |   |
| Contract costs                                                                                                       |       | 21,951                           |       | 11,586                                                |       | 4,532 |   |
| Service and  other costs, including $1,218 of amortization of intangibles in 2008                                    |       | 6,231                            |       | 1,840                                                 |       | 530 |   |
| Total cost of  revenues                                                                                              |       | 28,182                           |       | 13,426                                                |       | 5,062 |   |
| Gross profit                                                                                                         |       | 3,518                            |       | 3,667                                                 |       | 1,432 |   |
| Operating  expenses:                                                                                                 |       |                             |       |                                                  |       |   |   |
| Salaries and  related expenses, including $226 in stock-based compensation in 2008                                   |       | 3,068                            |       | 1,530                                                 |       | 1,859 |   |
| Consulting fees  and outside services                                                                                |       | 916                              |       | 419                                                   |       | (74 | ) |
| Depreciation                                                                                                         |       | 523                              |       | 285                                                   |       | 8 |   |
| Other general  and administrative expenses                                                                           |       | 1,965                            |       | 1,165                                                 |       | 292 |   |
| Goodwill  impairment                                                                                                 |       | 16,928                           |       | —                                                |       | — |   |
| Amortization of  intangible assets                                                                                   |       | 434                              |       | 222                                                   |       | — |   |
| Total operating  expenses                                                                                            |       | 23,834                           |       | 3,621                                                 |       | 2,085 |   |
| Operating income  (loss)                                                                                             |       | (20,316                          | )          | 46                                                    |       | (653 | ) |
| Other income  (expense):                                                                                             |       |                             |       |                                                  |       |   |   |
| Interest income                                                                                                      |       | 58                               |       | 175                                                   |       | — |   |
| Interest expense                                                                                                     |       | (997                             | )          | (327                                                  | )          | (336 | ) |
| Total other  income (expense)                                                                                        |       | (939                             | )          | (152                                                  | )          | (336 | ) |
| Income (loss)  before provision for income taxes                                                                     |       | (21,255                          | )          | (106                                                  | )          | (989 | ) |
| Provision  (benefit) for income taxes                                                                                |       | (2,888                           | )          | 10                                                    |       | (1,354 | ) |
| Net income  (loss)                                                                                                   |       | (18,367                          | )          | (116                                                  | )          | 365 |   |
| Deferred  interest, net of taxes, subject to possible redemption                                                     |       | —                           |       | —                                                |       |   |   |
| Dividends on  convertible preferred stockholders                                                                     |       | 114                              |       | —                                                |       |   |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                               |       | $                                | (18,481    | )                                                     | $          | (116 | ) |   |   |
|                                                                                                                 |       |                             |       |                                                  |       |   |   |
| Weighted-average  number of shares of commomn stock outstanding exclusive of shares subject to  possible redemption: |       |                             |       |                                                  |       |   |   |
| Basic                                                                                                                |       | 5,799,342                        |       | 5,436,200                                             |       |   |   |
| Diluted                                                                                                              |       | 5,799,342                        |       | 5,436,200                                             |       |   |   |
| Net income  (loss) per share allocable to holders of non-redeemable common stock:                                    |       |                             |       |                                                  |       |   |   |
| Basic                                                                                                                |       | $                                | (3.19      | )                                                     | $          | (0.02 | ) |   |   |
| Diluted                                                                                                              |       | $                                | (3.19      | )                                                     | $          | (0.02 | ) |   |   |
|                                                                                                                      |            |                                  |            |                                                       |            |  |  |  |  |  |

 

See notes tounaudited consolidated financial statements

 

2

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**ARGYLESECURITY, INC.**

**CONSOLIDATEDSTATEMENT OF OPERATIONS**

**(unaudited)**

 

(in thousandsexcept share data)

 
| ** **                                                                                                           | ** ** | **Nine Months Ended** | ** ** | **Predecessor (ISI)  Seven Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **September 30,**          | ** ** | **September 30,**                                   | ** ** | **July 31,** | ** ** |
| ** **                                                                                                           | ** ** | **2008**                        | ** ** | **2007**                                                 | ** ** | **2007** | ** ** |
| Revenues:                                                                                                            |       |                            |       |                                                     |       |   |   |
| Contract  revenues                                                                                                   |       | $                               | 72,482     |                                                     | $          | 10,670 |   | $ | 19,948 |   |
| Contract  revenues - related party                                                                                   |       | 15,131                          |       | 4,559                                                    |       | 16,739 |   |
| Service and  other revenues                                                                                          |       | 18,190                          |       | 1,864                                                    |       | 6,446 |   |
| Total revenues                                                                                                       |       | 105,803                         |       | 17,093                                                   |       | 43,133 |   |
| Cost of  revenues:                                                                                                   |       |                            |       |                                                     |       |   |   |
| Contract costs                                                                                                       |       | 72,045                          |       | 11,586                                                   |       | 28,626 |   |
| Service and  other costs, including $3,748 of amortization of intangibles in 2008                                    |       | 17,772                          |       | 1,840                                                    |       | 4,890 |   |
| Total cost of  revenues                                                                                              |       | 89,817                          |       | 13,426                                                   |       | 33,516 |   |
| Gross profit                                                                                                         |       | 15,986                          |       | 3,667                                                    |       | 9,617 |   |
| Operating  expenses:                                                                                                 |       |                            |       |                                                     |       |   |   |
| Salaries and  related expenses, including $975 in stock-based compensation in 2008                                   |       | 9,847                           |       | 1,530                                                    |       | 4,641 |   |
| Consulting fees  and outside services                                                                                |       | 2,498                           |       | 697                                                      |       | 194 |   |
| Depreciation                                                                                                         |       | 1,581                           |       | 286                                                      |       | 475 |   |
| Other general  and administrative expenses                                                                           |       | 5,224                           |       | 1,407                                                    |       | 2,282 |   |
| Goodwill  impairment                                                                                                 |       | 16,928                          |       | —                                                   |       | — |   |
| Amortization of  intangible assets                                                                                   |       | 1,281                           |       | 222                                                      |       | 204 |   |
| Total operating  expenses                                                                                            |       | 37,359                          |       | 4,142                                                    |       | 7,796 |   |
| Operating income  (loss)                                                                                             |       | (21,373                         | )          | (475                                                     | )          | 1,821 |   |
| Other income  (expense):                                                                                             |       |                            |       |                                                     |       |   |   |
| Interest income                                                                                                      |       | 136                             |       | 946                                                      |       | 4 |   |
| Interest expense                                                                                                     |       | (2,650                          | )          | (424                                                     | )          | (3,009 | ) |
| Total other  income (expense)                                                                                        |       | (2,514                          | )          | 522                                                      |       | (3,005 | ) |
| Income (loss)  before provision for income taxes                                                                     |       | (23,887                         | )          | 47                                                       |       | (1,184 | ) |
| Provision  (benefit) for income taxes                                                                                |       | (3,766                          | )          | 62                                                       |       | (1,053 | ) |
| Net income  (loss)                                                                                                   |       | (20,121                         | )          | (15                                                      | )          | (131 | ) |
| Deferred  interest, net of taxes, subject to possible redemption                                                     |       | —                          |       | —                                                   |       |   |   |
| Dividends on  convertible preferred stockholders                                                                     |       | 201                             |       | —                                                   |       |   |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                               |       | $                               | (20,322    | )                                                        | $          | (15 | ) |   |   |
|                                                                                                                 |       |                            |       |                                                     |       |   |   |
| Weighted-average  number of shares of commomn stock outstanding exclusive of shares subject to  possible redemption: |       |                            |       |                                                     |       |   |   |
| Basic                                                                                                                |       | 5,796,605                       |       | 5,002,003                                                |       |   |   |
| Diluted                                                                                                              |       | 5,796,605                       |       | 5,002,003                                                |       |   |   |
| Net income  (loss) per share allocable to holders of non-redeemable common stock:                                    |       |                            |       |                                                     |       |   |   |
| Basic                                                                                                                |       | $                               | (3.51      | )                                                        | $          | (0.00 | ) |   |   |
| Diluted                                                                                                              |       | $                               | (3.51      | )                                                        | $          | (0.00 | ) |   |   |
|                                                                                                                      |            |                                 |            |                                                          |            |  |  |  |  |  |

 

See notes tounaudited consolidated financial statements

 

3

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**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF CHANGES INSTOCKHOLDERS’ EQUITY**

**DECEMBER31, 2007 THROUGH SEPTEMBER 30, 2008**

**(unaudited)**

 

(in thousandsexcept share data)

 
| ** **                              | ** ** | **Common Stock** | ** ** | **Preferred Stock** | ** ** | **Additional  Paid in** | ** ** | **Accumulated  Earnings /** | ** ** | **Total  Stockholders’** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|--------------------------|------------|------------------------------|------------|----------------------------------|------------|-------------------------------|------------|
| ** **                              | ** ** | **Shares**            | ** ** | **Amount**               | ** ** | **Shares**                   | ** ** | **Amount**                       | ** ** | **Capital**                   | ** ** | **(Deficit)** | ** ** | **Equity** | ** ** |
| **Balance  at December 31, 2007**  | ** ** | **5,879,342**         | ** ** | **$**                    | **1**      | ** **                   | **—** | ** **                       | **$**      | **—**                    | ** ** | **$** | **36,279** | ** ** | **$** | **384** | ** ** | **$** | **36,664** | ** ** |
| Stock-based  compensation               |       | 85,000                |       | —                   |       | —                       |       | —                           |       | 975                           |       | — |   | 975 |   |
| Issuance of  preferred stock            |       | —                |       | —                   |       | 18,750                       |       | 0                                |       | 13,532                        |       | — |   | 13,532 |   |
| Dividends on  preferred stock           |       | —                |       | —                   |       | —                       |       | —                           |       | —                        |       | (201 | ) | (201 | ) |
| Common stock  registration costs        |       | —                |       | —                   |       | —                       |       | —                           |       | (73                           | )          | — |   | (73 | ) |
| Net income  (loss)                      |       | —                |       | —                   |       | —                       |       | —                           |       | —                        |       | (20,121 | ) | (20,121 | ) |
| **Balance  at September 30, 2008** | ** ** | **5,964,342**         | ** ** | **$**                    | **1**      | ** **                   | **18,750** | ** **                       | **$**      | **0**                         | ** ** | **$** | **50,713** | ** ** | **$** | **(19,938** | **)** | **$** | **30,776** | ** ** |

 

See notes tounaudited consolidated financial statements

 

4

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**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                                          | ** ** | ** **                      | ** ** | ** **                       | ** ** | **Predecessor (ISI)** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                                                          | ** ** | **Nine Months Ended** | ** ** | **Seven Months Ended** | ** ** |
| ** **                                                                                          | ** ** | **September 30,**          | ** ** | **September 30,**           | ** ** | **July 31,**          | ** ** |
| ** **                                                                                          | ** ** | **2008**                        | ** ** | **2007**                         | ** ** | **2007**                   | ** ** |
| **Cash flows from operating activities:**                                                           |       |                            |       |                             |       |                       |       |
| Net income (loss)                                                                                   |       | $                               | (20,121    | )                                | $          | (15                        | )          | $ | (131 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by (used  in) operating activities: |       |                            |       |                             |       |                       |       |
| Stock-based compensation                                                                            |       | 974                             |       | 50                               |       | 2,764                      |       |
| Amortization                                                                                        |       | 5,029                           |       | 875                              |       | —                     |       |
| Depreciation                                                                                        |       | 1,657                           |       | 286                              |       | 475                        |       |
| Goodwill impairment                                                                                 |       | 16,928                          |       | —                           |       | —                     |       |
| Payment to ISI*MCS Ltd on behalf of ISI                                                             |       | —                          |       | (1,919                           | )          | —                     |       |
| Accrued interest on deferred underwriting costs                                                     |       | —                          |       | 30                               |       | —                     |       |
| Deferred interest on Merit debt                                                                     |       | 327                             |       | —                           |       | —                     |       |
| Interest earned on assets held in trust                                                             |       | —                          |       | (896                             | )          | —                     |       |
| Tax payments relapsed from the trust                                                                |       | —                          |       | 149                              |       | —                     |       |
| Decrease (increase) in contract receivables                                                         |       | (9,624                          | )          | (2,387                           | )          | (636                       | )          |
| Decrease (increase) in related party contract receivables                                           |       | 3,535                           |       | (2,033                           | )          | (3,174                     | )          |
| Decrease (increase) in related party receivables                                                    |       | 33                              |       | (42                              | )          | (131                       | )          |
| Decrease (increase) in costs and estimated earnings in excess of billings                           |       | 956                             |       | (1,846                           | )          | (1,055                     | )          |
| Decrease (increase) in other assets                                                                 |       | (1,468                          | )          | 20                               |       | (368                       | )          |
| Increase (decrease) in accounts payable and accrued expenses                                        |       | 2,324                           |       | 2,462                            |       | 1,363                      |       |
| Increase (decrease) in other long-term liabilities                                                  |       | 575                             |       | —                           |       | —                     |       |
| Increase (decrease) in deferred income taxes                                                        |       | (3,171                          | )          | (105                             | )          | (1,190                     | )          |
| Increase (decrease) in billings in excess of costs and estimated earnings                           |       | 543                             |       | 87                               |       | 2,410                      |       |
| **Net cash used in operating activities**                                                           | ** ** | **$**                           | **(1,503** | **)**                            | **$**      | **(5,284**                 | **)**      | **$** | **327** | ** ** |
|                                                                                                |       |                            |       |                             |       |                       |       |
| **Cash flows from investing activities:**                                                           |       |                            |       |                             |       |                       |       |
| Purchase of investments held in trust                                                               |       | —                          |       | (171,375                         | )          | —                     |       |
| Maturity of investments held in trust                                                               |       | —                          |       | 171,375                          |       | —                     |       |
| Acquisitions, net of cash acquired                                                                  |       | (5,264                          | )          | (17,157                          | )          | —                     |       |
| Purchase of property and equipment                                                                  |       | 2,484                           |       | (54                              | )          | (1,004                     | )          |
| Transaction costs                                                                                   |       | 759                             |       | (928                             | )          | (624                       | )          |
| Increase / (decrease) in other assets                                                               |       | —                          |       | (16                              | )          | —                     |       |
| **Net cash used in investing activitise**                                                           | ** ** | **$**                           | **(8,507** | **)**                            | **$**      | **(18,155**                | **)**      | **$** | **(1,628** | **)** |
|                                                                                                |       |                            |       |                             |       |                       |       |
| **Cash flows from financing activities:**                                                           |       |                            |       |                             |       |                       |       |
| Issuance of preferred stock                                                                         |       | 15,000                          |       | —                           |       | —                     |       |
| Restricted cash                                                                                     |       | (2,521                          | )          | —                           |       | —                     |       |
| Offering and financing costs                                                                        |       | (1,779                          | )          | (1,377                           | )          | 240                        |       |
| Receipt of funds held in trust                                                                      |       | —                          |       | 30,200                           |       | —                     |       |
| Proceeds from borrowings                                                                            |       | 34,041                          |       | 5,020                            |       | 18,656                     |       |
| Payments on borrowings                                                                              |       | (31,117                         | )          | (5,138                           | )          | (16,512                    | )          |
| Proceeds from notes payable                                                                         |       | 5,000                           |       | —                           |       | —                     |       |
| Proceeds from notes payable and warrants to stockholders                                            |       | —                          |       | 300                              |       | —                     |       |
| Payments from notes payable and warrants to stockholders                                            |       | —                          |       | (300                             | )          | —                     |       |
| Redemption of common stock                                                                          |       | —                          |       | (1,661                           | )          |                       |       |
| Payments on capital lease obligations                                                               |       | (116                            | )          | (17                              | )          | —                     |       |
| **Net cash provided by (used in) financing activities**                                             | ** ** | **$**                           | **18,508** | ** **                       | **$**      | **27,027**                 | ** ** | **$** | **2,384** | ** ** |
|                                                                                                |       |                            |       |                             |       |                       |       |
| **Net increase (decrease) in cash and cash equivalents**                                            | ** ** | **$**                           | **8,498**  | ** **                       | **$**      | **3,588**                  | ** ** | **$** | **1,083** | ** ** |
| Cash and cash equivalents at beginning of year                                                      | ** ** | **3,556**                       | ** ** | **694**                          | ** ** | **359**                    | ** ** |
| **Cash and cash equivalents at end of period**                                                      | ** ** | **$**                           | **12,054** | ** **                       | **$**      | **4,282**                  | ** ** | **$** | **1,442** | ** ** |

 

See notes tounaudited consolidated financial statements

 

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**ARGYLESECURITY, INC.**

**NOTES TO UNAUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note1 — 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 and,where the context indicates, to the historical business of ISI Security Group, Inc.as ISI.

 

Argyle Security, Inc.(formerly Argyle Security Acquisition Corporation) (the “Company”, “we”, “us”, “our”,or “Argyle”) was incorporated in Delaware in June 2005 as a blank checkcompany formed to acquire, through merger, capital stock exchange, assetacquisition, or other similar business combination, a business in the securityindustry. On July 31, 2007, Argyle consummated its initial acquisitionthrough the acquisition of 100% of the outstanding capital stock of ISISecurity Group, Inc. (f/k/a ISI Detention Contracting Group, Inc.,referred to herein as “ISI”) and its subsidiaries. Prior to the acquisition ofISI, Argyle had no operations and was considered a developmental stageenterprise. ISI is deemed to be a “predecessor” to the Company.   Asa result, the statements of operations and statements of cash flows of ISI forone month and seven months ended July 31, 2007 are presented forcomparative purposes only. The results of operations and cash flows on aconsolidated basis subsequent to the acquisition of ISI are not comparative tothe predecessor ISI results of operations and cash flows because the basis forthe acquired assets and liabilities of ISI have been adjusted to fair valuepursuant to Statement of Financial Accounting Standards (“SFAS”) No. 141,*  BusinessCombinations*.

 

In February 2008, wereorganized our business under the name of Argyle Security USA, or AUSA,through which we provide physical security solutions to commercial, governmentaland correctional customers.  Argyle Security USA has two reportingsegments: “Argyle Corrections” and “Argyle Commercial Security”.

 

On January 1, 2008,MCFSA, Ltd. (“MCS Commercial”) and all of the partnership interests of whichare directly or indirectly wholly owned by AUSA, acquired substantially all ofthe business assets and liabilities of FireQuest Inc. (“Fire Quest”). FireQuest is engaged in the business of alarm system sales and service.

 

6

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Tableof Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note1 — Basis of Presentation (continued)**

** **

On January 4, 2008, AUSAacquired substantially all of the business assets and liabilities of PDI. PDI is a full-service, turnkey solutions provider that manufactures highsecurity metal barriers, high security observation window systems, detentionfurniture and accessories.

 

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

 

AUSA is a detention andcommercial equipment contractor that specializes in designing and integratingsecurity solutions, including turnkey installations, design, engineering,supply, and installation of various detention, surveillance and access controlequipment for correctional facilities and institutions. The work is performedunder fixed-price contracts. The projects are located in various citiesthroughout 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 Correctionsconsists of all of our businesses in the corrections sector, including ISI,Metroplex Control Systems (“MCS”) as well as Com-Tec Security LLC (“Com-Tec”)and Peterson Detention, Inc. (“PDI”).  Com-Tec and PDI were acquiredin January 2008.  The Argyle Corrections segment includes:

 

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

 

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

 

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

 

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

 

Argyle CommercialSecurity focuses on the commercial security sector and provides turnkey,electronic security systems to the commercial market. Currently, MCS CommercialFire & Security is the only member of this segment and is referred to historicallyas MCS-Commercial.

 

The unauditedconsolidated financial statements of Argyle, as of September 30, 2008 andfor the three and nine months ended September 30, 2008 and 2007, includethe accounts of the Company and all wholly-owned subsidiaries. All significantintercompany transactions and balances have been eliminated inconsolidation.  In the opinion of management, all normal recurringadjustments considered necessary for a fair presentation have beenincluded.  Operating results for the interim periods presented are notnecessarily indicative of the results to be expected for a full fiscal year.

 

*ProForma Results of Operations*

* *

The accompanyingunaudited consolidated statements of operations only reflect the operatingresults of companies acquired following the date of acquisition and do notreflect the operating results prior to the acquisitions. Following are proforma unaudited results of operations for the Company for the three and ninemonths ended September 30, 2008 and 2007, assuming the Fire Quest, PDI andCom-Tec acquisitions occurred on January 1, 2008 and 2007, respectively.

 

The Company derived theunaudited pro forma results of operations from (i) the unauditedconsolidated financial statements of ISI from January 1, 2007 to July 31,2007, (ii) the unaudited consolidated financial statements of Com-Tec forthe one month ended January 31, 2008 and the three and nine months ended September 30,2007, (iii) the unaudited financial statements of PDI for the three andnine months ended September 30, 2007, (iv) the unaudited financialstatements of Fire Quest for the three and nine months ended September 30,2007 and (v) the unaudited consolidated financial statements of theCompany for the three and nine months ended September 30, 2008 and 2007.The unaudited pro forma results of operations are not necessarily indicative ofresults of operations that may have actually occurred had the acquisitionstaken place on the dates noted, or the future financial position or operatingresults of the Company. The pro forma adjustments are based upon availableinformation and assumptions that the Company believes are reasonable. The proforma adjustments include adjustments for interest expense and increaseddepreciation and amortization expense as a result of the application of thepurchase method of accounting based on the fair values of the tangible andintangible assets.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note1 — Basis of Presentation (continued)**

** **

**ProForma Consolidated Statements of Operations**

**(unaudited)**

** **

(in thousands,except share data)

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                                    | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                                                                                     |       |                             |       |                            |       |   |   |   |   |
| Contract  revenues                                                                                                                            |       | $                                | 22,583     |                            | $          | 15,383 |   | $ | 74,200 |   | $ | 37,919 |   |
| Contract  revenues - related party                                                                                                            |       | 2,906                            |       | 8,132                           |       | 15,131 |   | 21,299 |   |
| Service and  other revenues                                                                                                                   |       | 6,211                            |       | 4,520                           |       | 18,191 |   | 13,923 |   |
| Total revenues                                                                                                                                |       | 31,700                           |       | 28,035                          |       | 107,522 |   | 73,141 |   |
| Cost of  revenues:                                                                                                                            |       |                             |       |                            |       |   |   |   |   |
| Contract costs                                                                                                                                |       | 21,951                           |       | 18,311                          |       | 73,415 |   | 45,589 |   |
| Service and  other costs, including amortization of intangibles ($1,218 for three months  2008 and $3,784 for nine months 2008, respectively) |       | 6,231                            |       | 4,501                           |       | 17,809 |   | 14,008 |   |
| Total cost of  revenues                                                                                                                       |       | 28,182                           |       | 22,812                          |       | 91,224 |   | 59,597 |   |
| Gross profit                                                                                                                                  |       | 3,518                            |       | 5,223                           |       | 16,298 |   | 13,544 |   |
| Operating  expenses:                                                                                                                          |       |                             |       |                            |       |   |   |   |   |
| Salaries and  related expense, including stock-based compensation of $226 and $975 for the  three and nine months 2008, respectively.         |       | 3,068                            |       | 2,185                           |       | 10,056 |   | 6,968 |   |
| Consulting fees  and outside services                                                                                                         |       | 916                              |       | 445                             |       | 2,501 |   | 1,052 |   |
| Depreciation                                                                                                                                  |       | 523                              |       | 340                             |       | 1,583 |   | 932 |   |
| Other general  and administrative expenses                                                                                                    |       | 1,965                            |       | 1,822                           |       | 5,304 |   | 4,568 |   |
| Goodwill  impairment                                                                                                                          |       | 16,928                           |       | —                          |       | 16,928 |   | — |   |
| Amortization of  intangible assets                                                                                                            |       | 434                              |       | 434                             |       | 1,301 |   | 1,301 |   |
| Total operating  expenses                                                                                                                     |       | 23,834                           |       | 5,226                           |       | 37,673 |   | 14,821 |   |
| Operating loss                                                                                                                                |       | (20,316                          | )          | (3                              | )          | (21,375 | ) | (1,277 | ) |
| Other income  (expense):                                                                                                                      |       |                             |       |                            |       |   |   |   |   |
| Interest income                                                                                                                               |       | 58                               |       | 60                              |       | 136 |   | 171 |   |
| Interest expense                                                                                                                              |       | (997                             | )          | (479                            | )          | (2,695 | ) | (2,235 | ) |
| Total other  income (expense)                                                                                                                 |       | (939                             | )          | (419                            | )          | (2,559 | ) | (2,064 | ) |
| Income (loss)  before provision for income taxes                                                                                              |       | (21,255                          | )          | (422                            | )          | (23,934 | ) | (3,341 | ) |
| Provision  (benefit) for income taxes                                                                                                         |       | (2,888                           | )          | (1,290                          | )          | (3,800 | ) | (2,268 | ) |
| Net income  (loss)                                                                                                                            |       | $                                | (18,367    | )                               | $          | 868 |   | $ | (20,134 | ) | $ | (1,073 | ) |
| Deferred  interest, net of taxes, subject to possible redemption                                                                              |       | —                           |       | —                          |       | — |   | — |   |
| Dividends on  convertible preferred stockholders                                                                                              |       | 115                              |       | —                          |       | 201 |   | — |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                                                        |       | $                                | (18,482    | )                               | $          | 868 |   | $ | (20,335 | ) | $ | (1,073 | ) |
|                                                                                                                                          |       |                             |       |                            |       |   |   |   |   |
| Weighted-average  number of shares of commomn stock outstanding exclusive of shares subject to  possible redemption:                          |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                                                                                         |       | 5,799,342                        |       | 5,466,200                       |       | 5,796,605 |   | 5,002,003 |   |
| Diluted                                                                                                                                       |       | 5,799,342                        |       | 6,843,646                       |       | 5,796,605 |   | 5,002,003 |   |
| Net income  (loss) per share allocable to holders of non-redeemable common stock:                                                             |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                                                                                         |       | $                                | (3.19      | )                               | $          | 0.16 |   | $ | (3.51 | ) | $ | (0.21 | ) |
| Diluted                                                                                                                                       |       | $                                | (3.19      | )                               | $          | 0.13 |   | $ | (3.51 | ) | $ | (0.21 | ) |

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies**

** **

Argyle completed aprivate placement (the “Private Placement”) in January 2006 and receivednet proceeds of approximately $0.9 million. Also in January 2006, theregistration statement for Argyle’s initial public offering (the “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 on July 31, 2007 tofund the ISI acquisition.

 

On March 14, 2007,the underwriters from the Public Offering agreed to forfeit any and all rightsor claims to a pro-rata portion of the deferred underwriting costs andassociated interest with respect to any shares of common stock redeemed inconnection with any acquisition (see Note 16). In connection with the PublicOffering and the Private Placement, Argyle’s officers and directors placed allthe shares owned by them before the Private Placement and the Public Offeringinto an escrow account. Except in certain circumstances, the shares held inescrow may not be released prior to January 24, 2009.

 

As part of the ISImerger, stockholders holding 211,965 of the aggregate number of shares sold inthe Public Offering elected to redeem such shares (see Note 14). The per-shareredemption price was equal to $7.80 per share including interest earned thereonin the trust account, less taxes payable, $0.6 million of interest income,which was released from the trust account in September 2006 to fund ourworking capital, and amounts owed to the underwriter for the Private Placement(approximately $45,000 plus interest). Approximately $1.7 million was paid toredemptive shareholders in August of 2007.

 

***Cash and Cash Equivalents***

*** ***

The Company considers allhighly liquid investments with original maturities of three months or less tobe cash equivalents, and the carrying amounts approximate fair value.

 

***Restricted Cash***

*** ***

Represents depositsrequired by the Company’s commercial bank letter of credit.

 

***Contracts Receivable***

*** ***

Contracts Receivable arerecorded at the invoiced amount and do not bear interest. The allowance fordoubtful accounts is established as losses are estimated to have occurredthrough a provision for bad debts charged to earnings. Losses are chargedagainst the allowance when management believes the inability to collect areceivable 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 itrequires estimates that are susceptible to significant revision as moreinformation becomes available.

 

***Revenue Recognition***

*** ***

A majority of the Company’sRevenues are generated under fixed-price construction contacts.  Revenuesunder fixed-price contracts are recognized under the percentage-of-completionmethodology.  Service Revenues arerecognized when the services have been delivered to and accepted by thecustomer. Other Revenues consists of product sales and are recognized uponshipment, or later if required by shipping terms, provided title istransferred, prices are fixed and collection is deemed probable.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

***Construction Contracts***

*** ***

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

 

Most of the Company’scontracts extend over a period of 6 to 14 months (6 to 9 months for theCommercial segment and 9 to 14 months for the Corrections segment), 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 revenues on signed contractsand change orders. Percentage-of-completion for Construction Contracts ismeasured principally by the percentage of costs incurred and accrued to datefor each contract to the estimated total costs for each contract at completion.The Company generally considers contracts to be substantially complete upondeparture from the work site and acceptance by the customer. Contract costsinclude all direct material, labor, subcontract, equipment costs, relatedpayroll taxes and insurance costs, and any other indirect costs related tocontract performance. Changes in job performance, job conditions, estimatedcontract costs, profitability and final contract settlements may result inrevisions to costs and income, and the effects of these revisions arerecognized in the period in which the revisions are determined. Provisions fortotal estimated losses on incomplete contracts are made in the period in whichsuch losses are determined.

 

Pre-contract costs arecosts that are incurred for a specific anticipated contract and that willresult in no future benefits unless the contract is obtained. Such costs areexpensed as incurred.

 

The balances billed butnot paid by customers pursuant to retainage provisions in constructioncontracts will be due upon completion of the contracts and acceptance by thecustomer. Based on the Company’s experience with similar contracts in recent years,the retention balance at each balance sheet date will be collected within thesubsequent fiscal year.

 

The current asset, “costsand estimated earnings in excess of billings on incomplete contracts,”represents revenues recognized in excess of amounts billed which managementbelieves will be billed and collected within the subsequent year. The currentliability, “billings in excess of costs and estimated earnings on incompletecontracts,” represents billings in excess of revenues recognized.

 

***Service Sales***

*** ***

Service Sales Revenuesare recognized when the services have been delivered to and accepted by thecustomer.  These are generally short-term projects which are evidenced bysigned service agreements or customer work orders or purchase orders.  Thesesales agreements/customer orders generally provide for billing to customersbased on time at quoted hourly or project rates plus costs of materials andsupplies furnished by the Company.

 

***Shipped Products***

*** ***

Revenue is recognized byPDI when the product is received by the customer in accordance with thecontractual shipping terms. All of the shipping of products to PDI’s customersis FOB Destination whereby title passes to the purchase when the productreaches its destination. When delivery to the customer’s delivery site hasoccurred, the customer takes title and assumes the risks and rewards ofownership.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

***Inventory***

*** ***

Inventory is valued atthe lower of cost or market and consists primarily of finished goods. Costs offinished goods are determined using the average cost method for all segments ofAUSA. Inventory that was acquired from ISI has been stated at fair value at July 31,2007; all subsequent purchases have been recorded based on cost. The $1.0million of inventory that was acquired from the Fire Quest, Com-Tec, and PDIacquisitions have been stated at fair value at the date of acquisition (seeNote 3).  At September 30, 2008 and December 31, 2007, theCompany’s inventory balance was $2.0 million and $138,000, respectively, whichis included in other current assets on the consolidated balance sheet.

 

***Property and Equipment***

*** ***

Property and Equipment isstated at cost less accumulated depreciation, except for the plant and equipmentacquired in the ISI acquisition which was recorded at fair value at July 31,2007; all subsequent purchases are recorded based on cost. The $1.2million of property and equipment from the Fire Quest, Com-Tec, and PDIacquisitions have been stated at fair value at the date of acquisition (seeNote 3).  Depreciation is calculated on the straight-line method.

 

The Company reviews thecarrying value of property and equipment for impairment whenever events andcircumstances indicate that the carrying value of the asset may not berecoverable from the estimated future cash flows expected to result from itsuse and eventual disposition. In cases where undiscounted expected future cashflows are less than the carrying value, an impairment loss is recognized equal toan amount by which the carrying value exceeds the fair value of assets. Thefactors considered by management in performing this assessment include currentoperating results, trends, and prospects, and the effects of obsolescence,demand, competition, and other economic factors.

 

***Assets Held Under Capital Leases***

*** ***

Assets Held Under CapitalLeases are classified under Property and Equipment on the Company’s balancesheet and are recorded at the lower of the net present value of the minimumlease payments or the fair value of the asset at the inception of the lease.Amortization expense is computed using the straight-line method over theshorter 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.

 

***Goodwill and Other Intangible Assets***

*** ***

Goodwill represents theexcess of consideration paid over the fair value of net assets acquired in thebusiness combination in accordance with SFAS No. 142,*Goodwill and Other Intangible Assets*(“SFAS 142”). Goodwill and otherindefinite-lived intangibles (i.e., trade names) are not amortized but aretested at least annually for impairment. The Company must recognize animpairment loss if, and to the extent that, goodwill exceeds fair value. TheCompany will perform impairment testing on an annual basis for each acquisitionunless impairment indicators exist that would require immediate testing.

 

The Company has twoprimary reporting segments (Argyle Corrections and Argyle Commercial Security)that have individual reporting units within each segment that provide differentservices and products. Accordingly, Goodwill was allocated to each. Management believes that the relationship between the allocation of identifiedtangible and intangible assets to be in similar proportion to how goodwill isto be allocated among its reporting units. Accordingly, each reporting segmentwas allocated its share of goodwill based upon its percentage of purchase priceallocation related to identified tangible and intangible assets.

 

Intangible assets thathave finite useful lives are amortized over their useful lives, which rangefrom 96 to 120 months for customer relationships, 12 to 16 months for backlog,36 months for software and 24 to 36 months for non-competition agreements.

 

In accordance with SFAS142, we apply a fair value based impairment test to the net book value ofgoodwill and indefinite-lived intangible assets on an annual basis and, ifcertain events or circumstances indicate that an impairment loss may have beenincurred, on an interim basis. The analysis of potential impairment of goodwillrequires a two-step process. The first step is the estimation of fair value. Ifstep one indicates that impairment potentially exists, the second step isperformed to measure the amount of impairment, if any. Goodwill impairmentexists when the estimated fair value of goodwill is less than its carryingvalue.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

During our quarter ended September 30,2008, the Company began a Goodwill Impairment analysis in accordance with SFAS142, *Goodwill and Other Intangible Assets,*for the ISI acquisition completed July 31, 2007, the acquisition of FireQuest on January 1, 2008, the acquisition of PDI on January 4, 2008and the acquisition of Com-Tec on January 31, 2008.   The initial analysis (first step) wasperformed by the Company’s management team and a valuation firm after theconclusion of the quarter.  Based on acombination of factors, including the current economic environment, ouroperating results and a sustained decline in our market capitalization, weconcluded that there were a number of indicators which require us to perform a GoodwillImpairment analysis as of September 30, 2008. For the purposes of thisanalysis, our estimates of fair value are based on a combination of the incomeapproach, which estimates the fair value of our reporting units based on thefuture discounted cash flows, and the market approach, which estimates the fairvalue of our reporting units based on comparable market prices. As of thefiling of this Quarterly Report on Form 10-Q for the third quarter offiscal 2008, we had not completed the entire two-step analysis due to thecomplexities involved in determining the implied fair value of the goodwill ofeach business unit. However, based on the work performed to date, we haveconcluded that an impairment loss is probable and can be reasonably estimated.

 

Accordingly, we haverecorded a $16.9 million Non-Cash Goodwill Impairment Charge, representing ourbest estimate of the impairment loss, during the third quarter of fiscal2008.  We expect to finalize our goodwillimpairment analysis during the fourth quarter of fiscal 2008. There is a likelihoodthat adjustments to the goodwill impairment charge would need to be made whenthe goodwill impairment test is completed. Any adjustments to our preliminaryestimates as a result of completing this evaluation will be recorded in ourfinancial statements for the quarter and fiscal year ended December 31,2008.   Management believes that the$16.9 million adjustment and any subsequent adjustments did not and will nothave any impact to the Company’s tangible net book value, liquidity or debtcovenant measurements.

 

A summary of the activityin goodwill by segment is as follows (in thousands):

 
| ** **                                  | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|-----------------|------------|----------------|------------|-----------|------------|
| Balance  December 31, 2007             |       | $               | 13,275     |           | $          | 6,662     |       | $ | 19,937 |   |
| ISI Adjustments                             |       | 91              |       | (33            | )          | 58        |       |
| Com-Tec  Acquisition (Net of Impairment)    |       | 1,473           |       | —         |       | 1,473     |       |
| Peterson  Acquisition (Net of Impairment)   |       | —          |       | —         |       | —    |       |
| Fire Quest  Acquisition (Net of Impairment) |       | —          |       | —         |       | —    |       |
| ISI Goodwill  Impairment                    |       | (7,784          | )          | (5,794         | )          | (13,578   | )          |
| Balance  September 30, 2008            |       | $               | 7,055      |           | $          | 835       |       | $ | 7,890 |   |

 

During the nine monthsended September 30, 2008, the Company increased Goodwill from the ISIacquisition by $58,000 as a result of $34,000 of additional transaction costs($4,000 accounting fees, $9,000 in insurance costs and $21,000 in legal fees),a $13,000 write-down of stale checks outstanding (decrease in cash), a $29,000reduction in refundable taxes (current tax asset) and an $8,000 increase tointangible assets.  The Goodwill ImpairmentCharge attributable to the original acquisition amounted to $14.3 million.

 

During the nine monthsended September 30, 2008, the Company decreased Goodwill from the Com-Tecacquisition by $0.9 million (over the original valuation amount of $2.4million), as a result of $30,000 of additional transaction costs and a $270,000adjustment to intangible assets due to a change in the valuation inputsassociated with the discount rate applied to the cash flows associated withthose intangible assets and a $1.2 million Goodwill Impairment Charge.

 

During the nine monthsended September 30, 2008, the Company decreased goodwill from the PDIacquisition by $1.2 million (over the original valuation amount of $1.2million), as a result of $57,000 of additional transaction costs and a$110,000 adjustment to intangible assets due to a change in the valuationinputs associated with the discount rate applied to the cash flows associatedwith those intangible assets, a $20,000 increase in current liabilities for thePDI Promissory Note derivative (see Note 8) and a $1.4 million Goodwill ImpairmentCharge.

 

During the nine monthsended September 30, 2008, the Company had $9,000 of additional transactioncosts to the $0.7 million in the originally booked goodwill from theacquisition of Fire Quest.

 

12

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

***Software Costs***

*** ***

Software costs representinternally-developed software that is proprietary to the Company and assists inits operations. According to Statement of Position 98-1,*Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use*, the costs of computersoftware developed or obtained for internal use are to be amortized on astraight-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.

 

***Self Insurance***

*** ***

AUSA and Com-Tec areself-insured to certain limits under their respective group health and dental plans. On a quarterly basis, the Company estimates its health insurance cost, for itsself-insured employee base at AUSA, based upon expected health insurance claimsfor the current year. The insurance company which provides both the stop lossand total aggregate insurance coverages also provides the average or expectedand maximum, claims for each class. The average and maximum claims are based onthe Company’s demographics and prior claim history. The Company uses theaverage claims history for the trailing twelve months as its basis for accruinghealth care cost.

 

***Warranty Reserve***

*** ***

AUSA warrants itsproducts against defects in design, materials and workmanship generally forperiods ranging from one to two years.  A provision for estimated futurecosts related to warranty expense is recorded when products are sold. Management estimates the provision based primarily on historical warranty claimexperience.  As of September 30, 2008, the warranty reserve was$213,000 and is included in accounts payable and accrued expenses on theunaudited consolidated balance sheet.

 

***Fair Value of Financial Instruments***

*** ***

The recorded Fair Valueof Financial Instruments, including contracts receivable, other assets andaccounts payable, approximate the fair value amount 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***

*** ***

The Company accounts forincome taxes in accordance with Statement of Financial Accounting Standards (“SFAS”)No. 109,*Accounting for Income Taxes*.Deferred income taxes are recorded pursuant to FASB Interpretation No. 48,*  Accountingfor Uncertainty in Income Taxes, an interpretation of FASB No. 109*  (FIN 48) and are based on enacted statutoryrates to reflect the tax consequences in future years of the differences betweenthe tax bases of assets and liabilities and their financial reporting amounts.Deferred tax assets which will generate future tax benefits are recognized tothe extent that realization of such benefits through future taxable earnings oralternative tax strategies in the foreseeable short-term future is more likelythan not. A valuation allowance is established when necessary to reducedeferred tax assets to the amount expected to be realized.

 

***Reclassifications***

*** ***

Prior Year Balances havebeen reclassified to conform to current-year presentation.  The balancesheet includes a reclassification of website development costs that was inOther Assets to Property, Plant and Equipment.

 

***Recently Issued Accounting Pronouncements***

*** ***

In September 2006,the FASB issued SFAS No. 157,*FairValue Measurements*. SFAS No. 157 defines Fair Value,establishes a framework for measuring Fair Value and expands disclosures aboutFair Value measurements, but does not change existing guidance as to whether ornot an instrument is carried at Fair Value.  In February 2008, theFASB released a FASB Staff Position, which delayed the effective date of SFAS No. 157for all non financial assets and liabilities, except those that are recognizedor disclosed at fair value in the condensed consolidated financial statementson a recurring basis. SFAS No. 157 was first effective for the Company on January 1,2008.  The impact of the adoption of SFASNo. 157 on our financial assets and liabilities, which are comprised ofcash equivalents, did not have a significant impact on their Fair Valuemeasurements or require expanded disclosures.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

***Recently Issued Accounting Pronouncements (continued)***

*** ***

In February 2007,the FASB issued SFAS No. 159,*The FairValue Option for Financial Assets and Liabilities*. SFAS No. 159permits all entities to choose to elect to measure eligible financialinstruments at fair value. SFAS No. 159 applies to fiscal years beginningafter November 15, 2007, with early adoption permitted for an entity thathas also elected to apply the provisions of SFAS No. 157. The Companyelected not to adopt the fair value option for valuation of those assets andliabilities which are eligible; therefore, there is no impact on our financialposition or results of operations.

 

In December 2007,the FASB issued SFAS No. 141(R),*Business Combinations—a replacement of FASB Statement No. 141* ,which significantly changes the principles and requirements for how theacquirer of a business recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed and any non-controllinginterest in the acquiree. The statement also provides guidance for recognizingand measuring the goodwill acquired in the business combination and determineswhich information to disclose to enable users of the financial statements toevaluate the nature and financial effects of the business combination. Thisstatement is effective prospectively, except for certain retrospectiveadjustments to deferred tax balances, for fiscal years beginning after December 15,2008. We are currently evaluating the impact that SFAS No. 141(R) willhave on our accounting for acquisitions prior to the effective date of thefirst fiscal year beginning after December 31, 2008.

 

In December 2007,the FASB issued SFAS No. 160,*Non-controlling Interests in Consolidated Financial Statements — an amendmentof ARB No. 51*. SFAS 160 requires non-controlling interests heldby parties other than the parent in subsidiaries be clearly identified,labeled, and presented in the consolidated statement of financial positionwithin equity, but separate from the parent’s equity. SFAS No. 160 iseffective for fiscal years beginning after December 15, 2008. We arecurrently evaluating the impact SFAS No. 160 will have on our financialposition and results of operations.

 

In March 2008, theFASB issued SFAS No. 161 “Disclosures about Derivative Instruments andHedging Activities an amendment of FASB Statement No. 133”. The newstandard requires additional disclosures regarding a company’s derivativeinstruments and hedging activities by requiring disclosure of the fair valuesof derivative instruments and their gains and losses in a tabular format. Italso requires disclosure of derivative features that are credit risk-related aswell as cross-referencing within the notes to the financial statements toenable financial statement users to locate important information aboutderivative instruments, financial performance and cash flows. The standard iseffective for our fiscal year and interim periods beginning January 1,2009, with early application encouraged. The principal impact from thisstandard will be to require us to have disclosures regarding our derivativeinstruments that will be held starting in December 2008 pursuant to theterms of the new senior credit facility described below (see Note 22).

 

In April 2008, theFASB issued Staff Position No. FAS 142-3, “Determination of Useful Life ofIntangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developingrenewal or extension assumptions used to determine the useful life of arecognized intangible asset under FASB Statement No. 142, “Goodwill andOther Intangible Assets.” FSP FAS 142-3 also requires expanded disclosuresrelated to the determination of intangible asset useful lives. This standardapplies prospectively to intangible assets acquired and/or recognized on orafter January 1, 2009. We do not believe that the adoption of thisstandard will have a material effect on our financial condition or results ofoperations.

 

In May 2008, theFASB issued FSP No. APB 14-1,*Accounting for Convertible Debt Instruments That May Be Settled in Cashupon Conversion (Including Partial Cash Settlement)*  (“APB 14-1”). APB 14-1 requires the issuer ofcertain convertible debt instruments that may be settled in cash (or otherassets) on conversion to separately account for the liability (debt) and equity(conversion option) components of the instrument in a manner that reflects theissuer’s nonconvertible debt borrowing rate. APB 14-1, which is appliedretrospectively, is effective for the Company beginning January 1, 2009.The Company is currently evaluating the potential impact of APB 14-1 on itsconsolidated financial statements.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

In June 2008, theFinancial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”)No. EITF 03-6-1,*Determining WhetherInstruments Granted in Share-Based Payment Transactions Are ParticipatingSecurities* (“EITF 03-6-1”). EITF 03-6-1 addresses whetherinstruments granted in share-based payment transactions are participatingsecurities prior to vesting and, therefore, need to be included in the earningsallocation under the two-class method of calculating earnings per share. EITF03-6-1, which is applied retrospectively. This regulation is effective for theCompany beginning January 1, 2009. The Company is currently evaluating thepotential impact of EITF 03-6-1 on its consolidated financial statements.

 

***Use of Estimates***

*** ***

The preparation offinancial statements in conformity with U.S. GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the date of the financial statements. Actual results coulddiffer from those estimates.

 

Although estimating is acontinuous and normal process for companies in the construction industry,material revisions in estimates of the percentage of completion requiredisclosure under FASB Statement No. 154, *AccountingChanges and Error Corrections*(“SFAS No 154”). The effect on incomefrom continuing operations, net income, and any related per-share amounts ofthe current period shall be disclosed for a change in estimate that affectsfuture periods. Additionally, the Statement requires that, if a change inestimate does not have a material effect in the period of change but isreasonably certain to have a material effect in later periods, a description ofthat change in estimate shall be disclosed whenever the financial statements ofthe period of change are presented.

 

During the nine monthsended September 30, 2008, the Company conducted regular reviews and evaluationsfor the cost estimates associated with all of the approximately 1,500 activeConstruction Contracts in the Company’s Work–in-Process.  As a result of the review, the cost estimatesfor the in-process Construction Contracts (that existed as of year-endedDecember 31, 2007) increased by a net $4.4 million. In a few cases, the reviewsresulted in a total of $0.5 million ($0.08 basic and diluted earnings pershare) in contract loss accruals that have been have been computed asCost-of-Sales for the nine months ended September 30, 2008.    Of the aforementioned net estimated costincreases of $4.4 million, 37 contracts had cost estimate changes ofapproximately $100,000 or greater resulting in $4.9 million of the netincrease.  26 of the 37 contractsresulted in cost estimate increases totaling $7.4 million while 11 contractshad estimated cost decreases totaling $2.5 million.  Approximately 1,450 of the remainingcontracts with variances of less than $100,000 resulted in a net decrease incost estimates of $0.5 million.

 

***Contingencies***

*** ***

Certain conditions mayexist as of the date of the consolidated balance sheet, which may result in aloss to the Company but which will only be resolved when one or more futureevents occur or fail to occur. The Company’s management and its legal counselassess such contingent liabilities, and such assessment inherently involves anexercise of judgment. In assessing loss contingencies related to legalproceedings that are pending against the Company or its subsidiaries orunasserted claims that may result in such proceedings, the Company’s legalcounsel evaluates the perceived merits of any legal proceedings or unassertedclaims, as well as the perceived merits of the amount of relief sought orexpected to be sought therein.

 

If the assessment of acontingency indicates that it is probable that a material loss has beenincurred and the amount of the liability can be estimated, then the estimatedliability would be accrued in the Company’s consolidated financial statements.If the assessment indicates that a potentially material loss contingency is notprobable, but is reasonably possible or is probable but cannot be estimated,then the nature of the contingent liability, together with an estimate of therange of possible loss if determinable and material, would be disclosed in thenotes to the consolidated financial statements.

 

Loss contingencies thatare considered remote are generally not disclosed unless they involveguarantees, in which case the guarantees would be disclosed.  As of September 30,2008, the Company did not have any loss contingencies requiring disclosures oraccruals.

 

We have recorded a $16.9million Non-Cash Goodwill Impairment Charge, representing our best estimate ofthe impairment loss, during the third quarter of fiscal 2008.  We expect to finalize our goodwill impairmentanalysis during the fourth quarter of fiscal 2008. There is a likelihood thatadjustments to the goodwill impairment charge would need to be made when thegoodwill impairment test is completed. Any adjustments to our preliminaryestimates as a result of completing this evaluation will be recorded in ourfinancial statements for the quarter and fiscal year ended December 31,2008 and such adjustment may result in an increased Non-Cash Goodwill ImpairmentCharge.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

***Concentrations of Credit Risk***

*** ***

Financial instrumentsthat potentially expose the Company to concentrations of credit risk, asdefined by SFAS No. 105,*Disclosure ofInformation about Financial Instruments with Off-Balance Sheet Risk andFinancial Instruments with Concentrations of Credit Risk*, consistprimarily of contract receivables.  During the three and nine months endedSeptember 30, 2008, Revenues from our top three customers (all from theArgyle Corrections segment) represented 18% and 30% of total Company Revenues,respectively.  During the three months ended September 30, 2008, theCompany had Revenues from our top two customers (all from the Correctionssegment), which represented 7% and 6% of total Company Revenues. During thenine months ended September 30, 2008, the Company had Revenues from ourtop two customers (all from the Argyle Corrections segment), which eachrepresented 11% of total Company Revenues. These concentrations are down fromthe three months ended March 31, 2008 and six months ended June 30,2008, when the top three customers represented 42% and 33% of total CompanyRevenues, respectively.  See Related-Party Transactions footnote (see Note19) for discussion of transactions with ISI*MCS, Ltd.

 

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

*** ***

Net Income/(Loss) PerShare (basic) is calculated in accordance with the provisions of SFAS No. 128,*Earnings Per Share*, by dividing NetIncome/(Loss) by the weighted average number of common shares outstandingduring the period. Our convertible preferred stock is considered aparticipating security because the preferred stockholders are entitled toreceive dividends when dividends are paid to common stockholders. We include theparticipating convertible preferred stock in the computation of earnings pershare, using the two-class method in accordance with EITF No. 03-06,*  ParticipatingSecurities and the Two-Class Method under FASB Statement No. 128*.. Net Income/(Loss) per share (diluted) is calculated by adjusting the numberof shares of common stock outstanding using the “treasury stock” method foroptions and warrants, and the “if converted” method for convertible preferredstock and convertible debt, to the extent the effect of the converted portionon EPS is dilutive. Because we incurred a net loss for all periods, the dilutedEPS calculation is the same as the basic EPS calculation.

 

As of September 30,2008 the Company has granted 220,000 shares of restricted stock, of which50,000 shares are vested.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note3 — Acquisitions**

** **

***Fire Quest***

*** ***

On January 1, 2008,MCFSA, all of the partnership interests of which are directly or indirectlywholly owned by ISI, acquired substantially all of the business assets andliabilities of Fire Quest for a total purchase price of $1.1 million and lessthe $0.7 million for Goodwill Impairment Charges (recognized in the quarterended September 30, 2008) has a $0.4 million net carrying value shown asfollows (in thousands):

 
| Fire Quest  Consideration: |   |   |   |
|----------------------------|--------|--------|--------|
| Cash                       |   | $      | 764    |   |
| Promissory note            |   | 250    |   |
| Transaction  costs         |   | 121    |   |
| Net purchase  price        |   | $      | 1,135  |   |
| Goodwill  impairment       |   | (733   | )      |
| Carrying value             |   | $      | 402    |   |

 

***PDI***

*** ***

On January 4, 2008, ISIacquired substantially all of the business assets and liabilities of PetersonDetention, Inc. (“PDI”) for a total purchase price of $4.8 million andless the $1.4 million for Goodwill Impairment Charges (recognized in thequarter ended September 30, 2008) has a $3.4 million net carrying valueshown as follows (in thousands):

 
| PDI Consideration:   |   |   |   |
|----------------------|--------|--------|--------|
| Cash                 |   | $      | 1,500  |   |
| Promissory note      |   | 3,000  |   |
| Transaction  costs   |   | 313    |   |
| Net purchase  price  |   | $      | 4,813  |   |
| Goodwill  impairment |   | (1,416 | )      |
| Carrying value       |   | $      | 3,397  |   |

 

***Com-Tec***

*** ***

On January 31, 2008,ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI, 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 and less the $1.2 million for Goodwill Impairment Charges(recognized in the quarter ended September 30, 2008) has a $5.5 millioncarrying value shown as follows (in thousands):

 
| Com-Tec  Consideration: |   |   |   |
|-------------------------|--------|--------|--------|
| Cash                    |   | $      | 3,000  |   |
| Promissory note         |   | 3,515  |   |
| Transaction  costs      |   | 199    |   |
| Net purchase  price     |   | $      | 6,714  |   |
| Goodwill  impairment    |   | (1,201 | )      |
| Carrying value          |   | $      | 5,513  |   |

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note3 — Acquisitions (continued)**

** **

The acquisitions of FireQuest, PDI and Com-Tec were accounted for as business combinations inaccordance with SFAS No. 141.  Under the purchase method ofaccounting, the assets and liabilities acquired were recorded as of theacquisition date at their respective fair values.  We have obtained third-partyvaluations, and the values of certain assets and liabilities are based on thesevaluations, but they are subject to adjustment as additional information isobtained. Such additional information includes, but is not limited to, changesin transaction costs and working capital. The following table summarizes theestimated fair value of assets acquired and liabilities assumed at the date ofthe acquisition (in thousands):

 
| ** **                    | ** ** | **Fire Quest** | ** ** | **PDI** | ** ** | **Com-Tec** | ** ** | **Total** | ** ** |
|-------------------------------|------------|---------------------|------------|---------|------------|-------------|------------|-----------|------------|
| Current assets                |       | $                   | 140        |    | $          | 2,210       |       | $         | 4,638      |   | $ | 6,988 |   |
| Property and  equipment       |       | 37                  |       | 1,126   |       | 72          |       | 1,235     |       |
| Goodwill (net of  impairment) |       | —              |       | —  |       | 1,473       |       | 1,473     |       |
| Customer  relationships       |       | 90                  |       | 470     |       | 730         |       | 1,290     |       |
| Customer backlog              |       | 84                  |       | 1,240   |       | 590         |       | 1,914     |       |
| Trade name                    |       | —              |       | —  |       | 1,080       |       | 1,080     |       |
| Software                      |       | —              |       | —  |       | 240         |       | 240       |       |
| Non-compete  agreements       |       | 70                  |       | 200     |       | 180         |       | 450       |       |
| Total assets  acquired        |       | 421                 |       | 5,246   |       | 9,003       |       | 14,670    |       |
|                          |       |                |       |    |       |        |       |      |       |
| Current  liabilities          |       | (19                 | )          | (739    | )          | (2,630      | )          | (3,388    | )          |
| Debt                          |       | —              |       | (1,110  | )          | (860        | )          | (1,970    | )          |
| Total  liabilities assumed    |       | (19                 | )          | (1,849  | )          | (3,490      | )          | (5,358    | )          |
|                          |       |                |       |    |       |        |       |      |       |
| Carrying value                |       | $                   | 402        |    | $          | 3,397       |       | $         | 5,513      |   | $ | 9,312 |   |
| Goodwill  impairment          |       | 733                 |       | 1,416   |       | 1,201       |       | 3,350     |       |
| Net purchase  price           |       | $                   | 1,135      |    | $          | 4,813       |       | $         | 6,714      |   | $ | 12,662 |   |

 

We have not identifiedany material unrecorded pre-acquisition contingencies where the related asset,liability or impairment is probable and the amount can be reasonably estimated.Prior to the end of the one-year purchase price allocation period, ifinformation becomes available that would indicate it is probable that suchevents had occurred and the amounts can be reasonably estimated, such itemswill be included in the final purchase price allocation and has resulted anadjustment in goodwill. See Note 2 regarding the Non-Cash Goodwill ImpairmentCharge.

 

**Note4 — Contract Receivables**

** **

Contract receivablesconsist of the following (in thousands):

** **
| ** **                                                        | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Completed  contracts and contracts in progress (net of allowance) |       | $                      | 23,323     |                  | $          | 12,126 |   |
| Retainage                                                         |       | 5,592                  |       | 2,333                 |       |
| Completed  contracts and contracts in progress - related parties  |       | 5,795                  |       | 8,468                 |       |
| Retainage -  related parties                                      |       | 1,557                  |       | 2,419                 |       |
| Contract  receivables                                             |       | $                      | 36,267     |                  | $          | 25,346 |   |

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**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**         | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                  | ** ** | **September 30,** | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                  | ** ** | **2008**               | ** ** | **2008**               | ** ** | **2008**               | ** ** |
| Amended contract  amount                                                    |       | $                      | 268,822    |                   | $          | 201,644                |       | $ | 67,178 |   |
| Revenues  recognized to date                                                |       | 212,675                |       | 160,129                |       | 52,546                 |       |
| Unearned  contract amount - backlog                                         |       | $                      | 56,147     |                   | $          | 41,515                 |       | $ | 14,632 |   |
| Costs incurred  to date                                                     |       | $                      | 177,426    |                   | $          | 136,329                |       | $ | 41,098 |   |
| Estimated costs  to complete                                                |       | 43,873                 |       | 32,441                 |       | 11,432                 |       |
| Estimated total  cost                                                       |       | $                      | 221,299    |                   | $          | 168,770                |       | $ | 52,530 |   |
| Billings to date                                                            |       | $                      | 213,519    |                   | $          | 161,621                |       | $ | 51,898 |   |
| Costs and  estimated earnings in excess of billings on incomplete contracts |       | $                      | 7,485      |                   | $          | 4,850                  |       | $ | 2,635 |   |
| Billing in excess  of costs and estimated earnings on incomplete contracts  |       | $                      | 6,794      |                   | $          | 5,013                  |       | $ | 1,781 |   |

 
| ** **                                                                  | ** ** | **Total**             | ** ** | **Corrections**       | ** ** | **Commercial**        | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                  | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                  | ** ** | **2007**              | ** ** | **2007**              | ** ** | **2007**              | ** ** |
| Amended contract  amount                                                    |       | $                     | 196,030    |                  | $          | 147,996               |       | $ | 48,034 |   |
| Revenues  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 withPDI is not included in the table above for Total Company and CorrectionsSegment as the associated Revenues are not accounted for under the Percentageof Completion Method as defined in 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 —Argyle Corrections and Argyle Commercial Security (see Note 1 and Note 20).Since then the Company has determined that the most valid indicator of the nextyear’s performance will be more closely tied to the Argyle Corrections backlogversus the Argyle Commercial Security backlog which is more volatile, given theshorter period typically required to complete 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 result ofthe aggregate contract amount less Revenues recognized to date usingpercentage-of-completion accounting (as described in Note 2 of theseconsolidated financial statements). The Company recognizes as backlog onlythose contracts for which it has received signed contracts and executed lettersof intent to award a contract from its customers.  As of the quarter ended September 30,2008 backlog from 26 letters of intent amounted to $14.4 million. The Companyalso verifies that funding is in place on the contracts prior to inclusion inbacklog.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note 6 —Property and Equipment**

** **

Property and equipmentconsists of the following (in thousands):

 
| ** **                         | ** ** | **Estimated**         | ** ** | ** **             | ** ** | ** **            | ** ** |
|------------------------------------|------------|-----------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **Useful Lives** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                         | ** ** | **In Years**     | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Buildings                          |       | 10 - 40               |       | $                      | 3,622      |                  | $          | 1,888 |   |
| Leasehold  improvements            |       | 12                    |       | 1,319                  |       | 593                   |       |
| Furniture,  fixtures and equipment |       | 3 - 10                |       | 3,409                  |       | 1,254                 |       |
| Vehicles                           |       | 3 - 7                 |       | 2,957                  |       | 2,189                 |       |
| Website costs                      |       | 3                     |       | 55                     |       | 39                    |       |
|                               |       |                  |       | 11,362                 |       | 5,963                 |       |
| Less -  accumulated depreciation   |       |                  |       | 2,377                  |       | 736                   |       |
| Property and  equipment, net       |       |                  |       | $                      | 8,985      |                  | $          | 5,227 |   |

 

Depreciation expenserelating to property and equipment was $0.5 million and $285,000 for threemonths ended September 30, 2008 and 2007, respectively, and $1.6 millionand $286,000 for nine months ended September 30, 2008 and 2007,respectively. Depreciation expense was $8,000 and $475,000 for the Predecessorfor the one and seven months ended July 31, 2007, respectively.

 

**Note 7 —Intangible Assets and Other Assets**

** **

At September 30,2008, intangible assets consisted of the following (in thousands):

 
| ** **                                   | ** ** | **Gross Carrying** | ** ** | **Accumulated**  | ** ** | **Net Carrying** | ** ** | **Weighted Average**    | ** ** |
|----------------------------------------------|------------|-------------------------|------------|------------------|------------|-----------------------|------------|------------------------------|------------|
| **Amortizable Intangible Assets:** | ** ** | **Amount**              | ** ** | **Amortization** | ** ** | **Amount**            | ** ** | **Amortization Period** | ** ** |
| Customer  relationships                      |       | $                       | 12,915     |             | $          | 1,539                 |       | $                            | 11,376     |   | 113 months |   |
| Customer backlog                             |       | 6,273                   |       | 5,148            |       | 1,125                 |       | 15 months                    |       |
| Software                                     |       | 540                     |       | 170              |       | 370                   |       | 36 months                    |       |
| Non-compete                                  |       | 450                     |       | 128              |       | 322                   |       | 30 months                    |       |
|                                         |       | $                       | 20,178     |             | $          | 6,985                 |       | $                            | 13,193     |   |   |   |
| **Unamortizable  Intangible Assets:**        |       |                    |       |             |       |                  |       |                         |       |
| Trade name                                   |       | $                       | 4,856      |             | $          | —                |       | $                            | 4,856      |   |   |   |

 

Amortization expense was$1.7 and $5.0 million for the three and nine months ended September 30,2008, respectively. As of September 30, 2008 and December 31, 2007,intangible assets not subject to amortization included trade names of $4.9million and $3.8 million, respectively. Estimated amortization expense for thenext five years and thereafter is as follows (in thousands):

** **
| **Years ending December 31:** |   |   |   |   |   |   |
|----------------------------------------------|--------|--------|--------|--------|--------|--------|
| 2008 (remaining  three months)               |   |   |   |   |   | $      | 1,375 |   |   |   |   |
| 2009                                         |   |   |   |   |   | 1,920  |   |   |   |   |
| 2010                                         |   |   |   |   |   | 1,611  |   |   |   |   |
| 2011                                         |   |   |   |   |   | 1,382  |   |   |   |   |
| 2012                                         |   |   |   |   |   | 1,375  |   |   |   |   |
| Thereafter                                   |   |   |   |   |   | 5,530  |   |   |   |   |
|                                         |   |   |   |   |   | $      | 13,193 |   |   |   |   |

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

**Note8 — Long-Term Debt**

** **

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

 
| ** **                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **Collateral**                             | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Notes payable:                             |       |                   |       |                  |       |
| Vehicles and  equipment                    |       | $                      | 144        |                  | $          | 190 |   |
| Unsecured debt -  related party            |       | 11,279                 |       | 5,952                 |       |
| Unsecured  convertible debt - stockholders |       | 1,925                  |       | 1,925                 |       |
| Seller notes                               |       | 6,549                  |       | —                |       |
| Line of credit  and senior term debt       |       | 13,114                 |       | 7,979                 |       |
|                                       |       | $                      | 33,011     |                  | $          | 16,046 |   |
| Less - current  maturities                 |       | 2,656                  |       | 81                    |       |
| Long term debt                             |       | $                      | 30,355     |                  | $          | 15,965 |   |

 

***Vehicles and Equipment***

*** ***

Amounts of long-term debtattributed to vehicles and equipment include notes related to Company vehiclesand various equipment lines. Vehicle and equipment notes are staggered withregard to their maturities, each amortizing over 36 to 48 monthperiods. Interest rates on the individual notes range from fixed rate of 6% upto prime plus 1.0%. The weighted average interest rate for these borrowings was8.4% and 8.2% at September 30, 2008 and December 31, 2007,respectively. Argyle has agreed to guaranty the obligations of AUSA under thenotes up to $1 million.

 

***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 at December 31, 2007. Allnotes are unsecured and subordinated to the line of credit facility. Theunsecured note agreements contain prepayment options with prepayment penalties.Interest accrues at 11.58% per annum and is payable quarterly in arrears,deferred interest at the rate of 8.42% per annum and default interest of anadditional 2% per annum. The total debt of $11.0 million plus accrued andunpaid interest is due and payable in one single payment on January 31,2010. Argyle has agreed to guaranty payment of up to $5 million of the outstandingunsecured debt. There are both financial and restrictive covenants associatedwith the note agreements.  As of September 30,2008, the Company was in compliance with all covenants.

 

On September 30, 2008,Argyle provided an unsecured, subordinated loan of $2 million to AUSA. The termof the loan was one month with the payment of all outstanding principal andaccrued and unpaid interest due on October 31, 2008. The rate of interest was6% per annum. The loan was repaid in full upon the closing of the senior creditfacility on October 3, 2008 (See Note 22 “Subsequent Events”).

 

***Unsecured Convertible Debt — Stockholders***

*** ***

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

 

In April 2007,Argyle’s officers and directors, an affiliate of Argyle’s Chairman and Co-ChiefExecutive Officer, and certain of Argyle’s consultants, pursuant to a note andwarrant acquisition agreement, loaned Argyle an aggregate of $300,000, and inexchange received promissory notes in the aggregate principal amount of$300,000 and warrants to purchase an aggregate of up to 37,500 shares of Argyle’scommon stock. The warrants are exercisable at $5.50 per share of common stockand expire on January 24, 2011.

 

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

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

** **

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

** **

***Seller Notes***

*** ***

In connection with the Fire Quest acquisition, the Company issued apromissory note in the aggregate principal amount of $250,000 (the “Fire QuestPromissory Note”). The Fire Quest Promissory Note is guaranteed by and securedby the assets of AUSA and Argyle Security, Inc bears interest at the rateof 7.25% per year and will become due and payable on January 1, 2009.  The Company has agreed to pay quarterlypayments of accrued and unpaid interest of $4,531.25 until the maturity dateand a final payment on the maturity date equal to the unpaid principal amounttogether with any then unpaid and accrued interest and other amounts payablethereunder.

 

In connection with thePDI acquisition, the Company issued convertible promissory notes (the “PDIPromissory Notes”) in the aggregate principal amount of $3.0 million. Theaggregate principal amount of the PDI Promissory Notes may be reduced dependingon the occurrence of certain events described in the Asset Purchase Agreement.The payment of the PDI Promissory Notes is guaranteed by and secured by theassets of AUSA and they bear interest at 6% paid quarterly through December 2009. After December 2009, principal and interest payments of $133,000 are duemonthly with final payment occurring on December 31, 2012.  From June 1,2009 through November 15, 2009, the Company has the option to (i) convert$500,000 of the outstanding principal into common stock of the Company based on95% of the closing price of the Company’s common stock for a 20 day tradingperiod preceding notice of the Company’s intent to convert; or (ii) extendthe $500,000 principal due in 2010 to January 3, 2011 for an additionalpayment of $15,000 plus accrued interest.  The aforementioned options toconvert or extend the PDI Promissory Notes resulted in the creation of compoundembedded derivatives for which the Company has performed valuations as of September 30,2008.  The Company will mark to market the derivatives, for which anychanges in fair value will be recognized in the statement of operations, in allthe subsequent quarters until they are exercised or have expired.  Thevaluation of these derivatives held a value of $20,000 as of September 30,2008.

 

In connection with the Com-Tec acquisition, the Company issued asecured subordinated promissory note in the aggregate principal amount of $3.5million (the “Com-Tec Promissory Note”). The Com-Tec Promissory Note isguaranteed by and secured by the assets of AUSA and Argyle Security, Inc.,bears interest at 7% per year and have a maturity date of April 1,2011.  Interest only payments were madefor each three-month period beginning on May 2008 and August 2008;  a single principal payment of $100,000 is dueand payable on December 15, 2008; and level principal and interestpayments in the cumulative amount of $128,058 are due monthly beginning on August 1,2008 and continuing monthly thereafter on the first day of each month forconsecutive months through December 2008 then level principal and interestpayments in the cumulative amount of $123,748 due monthly beginning on January 1,2009 and continuing monthly thereafter on the first day of each month through December 2008,then for 25 consecutive months until the maturity date.

 

Collectively, the FireQuest Promissory Note, the PDI Promissory Notes and the Com-Tec Promissory Noteare hereinafter collectively referred to as the “Seller Notes”.

 

***Line of Credit Facility***

*** ***

At September 30,2008, 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 September 30, 2008 was $8.9 million, due January 23,2010, and $4.2 million, with quarterly payments of $250,000 and the remainingbalance due June 30, 2011, respectively.  Interest is payablequarterly at prime plus 0.75% for the 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 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 byAUSA. At September 30, 2008, the Company was in compliance with allcovenants.

 

The Company agreed to payan annual commitment fee of 0.5% per year on the unused borrowing capacity,which was $3.2 million and $1.0 million at September 30, 2008 and December 31,2007, respectively.

 

See Note 22 regarding thenew senior loan facility entered into on October 3, 2008. Such new facilityreplaced the aforementioned line of credit and acquisition loan facility.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

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

 

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

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining  three months)              |       | $          | 682        |   |
| 2009                                        |       | 2,528      |       |
| 2010                                        |       | 25,866     |       |
| 2011                                        |       | 3,935      |       |
| 2012                                        |       | —     |       |
| Thereafter                                  |       | —     |       |
|                                        |       | $          | 33,011     |   |

 

Under the terms of thenew credit facility established with a new senior lender on October 3,2008 (See Note 22), the Company is indebted for $10.0 million in term debt and$7.0 million through the line of credit. As a result of the repayment terms under the new credit facility, theshort term portion (payable in less than one year) of the scheduled debt hasincreased from $2.3 million to $3.7 million. The amount payable in the nextthree months has increased from $0.7 million to $1.0 million.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**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. AUSA entered into a third lease on another property owned by the samepartnership in June 2008. All three leases are triple net leases. A triplenet lease is a lease agreement on a property where the tenant or lessee agreesto pay 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 twoaforementioned leases entered into prior to 2008 were modified on July 31,2007 to extend the expiration date from 2018 to 2019. The modification did notmaterially affect the carrying value of the assets or related liabilitiesrecorded in the accompanying consolidated balance sheet. The Company reassessedthese leases for proper classification under SFAS No. 13,*Accounting for Leases*, and determinedthey remain properly classified as capital leases.

 

The following is asummary of leased property, included in property and equipment, in theaccompanying consolidated financial statements (in thousands):

 
| ** **                       | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------|------------|------------------------|------------|-----------------------|------------|
| **Collateral**                   | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Buildings                        |       | $                      | 3,622      |                  | $          | 1,888 |   |
| Less -  accumulated amortization |       | 246                    |       | 69                    |       |
| Net                              |       | $                      | 3,376      |                  | $          | 1,819 |   |

 

The following is aschedule by years of future minimum lease payments under capital leases,together with the present value of net minimum lease payments at September 30,2008 (in thousands):

 
| **Year Ending December 31:**                       | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|
| 2008 (remaining  three months)                                    |       | $          | 123        |   |
| 2009                                                              |       | 493        |       |
| 2010                                                              |       | 493        |       |
| 2011                                                              |       | 493        |       |
| 2012                                                              |       | 493        |       |
| Thereafter                                                        |       | 3,338      |       |
| Future minimum  lease payments                                    |       | $          | 5,433      |   |
| Less - amount of  minimum lease payments attributable to interest |       | 1,813      |       |
| Present value of  net minimum lease payments                      |       | $          | 3,620      |   |
| Current portion  of capitalized lease obligations                 |       | 216        |       |
| Long-term  portion of capitalized lease obligations               |       | 3,404      |       |
|                                                              |       | $          | 3,620      |   |

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**Note10 — Commitments**

 

AUSA leases office spaceand equipment under operating leases expiring through 2012. Argyle’s corporateoffice lease space expired as of July 31, 2007, and Argyle operated undera month-to-month lease arrangement until it was renewed in January 2008.The new lease expands the space from approximately 2,500 square feet to 5,500square feet for a total expense in 2008 of $121,000.

 

Aspart of the acquisition of PDI on January 4, 2008, AUSA assumed PDI’sexisting leases in California and Arizona. On September 5, 2008, AUSA entered into a lease relating toapproximately 29,709 square- feet of property located at 577 and 583 NorthBatavia Street, Orange, California. The term of the new lease is for two years,commencing September 1, 2008 and ending August 31, 2010. Theaggregate monthly base rent is $16,934.  In connection with the lease,on September 5, 2008, Argyle Security, Inc. entered into a guarantydated July 21, 2008, pursuant to which Argyle has agreed to guaranty thepayment and performance obligations of ISI Detention under the Lease. ThePDI lease in Arizona is a four year lease. The three facilities occupy a totalof 55,709 square-feet (26,000 square-foot facility in Arizona and the 29,709square-foot facilities in California) with aggregate monthly payments of$32,934.

 

As part of the Com-Tecacquisition that occurred at January 31, 2008 the Company signed a newlease for the existing facility. The Com-Tec lease is a five-year lease, forthe 33,000 square foot facility, with aggregate monthly payments of $14,000beginning in year three with the total rent expense being recognized on astraight line basis over the life of the lease.

 

Rental expense was$298,000 and $17,000 for the three months ended September 30, 2008 and2007, respectively, and $838,000 and $50,000 for the nine months ended September 30,2008 and 2007, respectively. Rental expense was $103,000 and $266,000 for theone and seven months ended July 31, 2007 (Predecessor), respectively.

 

Minimum rentalcommitments at September 30, 2008 are as follows (in thousands):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining  three months)              |       | $          | 283        |   |
| 2009                                        |       | 546        |       |
| 2010                                        |       | 649        |       |
| 2011                                        |       | 552        |       |
| 2012                                        |       | 445        |       |
| Thereafter                                  |       | 200        |       |
| Total commitment  outstanding               |       | $          | 2,675      |   |

 

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.

 

In May 2008 theCompany entered into a letter of credit facility (secured by $2.5 million ofRestricted Cash shown on the financial statements) with a financialinstitution. The letter of credit may not exceed $2.5 million. The facilitydoes not have a fee on the unused portion of the letter of credit facility.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**Note11 — Self Insurance**

 

AUSA and Com-Tec areself-insured to certain limits under their respective group health and dentalplans. Stop-loss coverage is provided for claims above $75,000 per employee upto a maximum $3 million for AUSA and above $30,000 per employee up to a maximumof $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 $0.4 million at September 30,2008 and $0.3 million at December 31, 2007. AUSA has had one individualwho has met the stop-loss limit of $75,000 for 2008. Com-Tec has not had anyonemeet the stop-loss limit for 2008.

 

**Note12 — Pre-initial Public Offering Financing and Public Offering**

 

***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 until theirexpiration date of January 24, 2011. The warrants are redeemable by theCompany at a price of $.01 per warrant upon 30 days’ notice, but only in theevent that the last sale price of the common stock is at least $11.50 per sharefor any 20 trading days within a 30-trading-day period ending three businessdays before a notice of redemption is delivered.

 

***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 September 30,2008, 4,200,046 shares of common stock were reserved for issuance upon exerciseof redeemable warrants and options, 375,000 shares of common stock werereserved for issuance pursuant to the underwriters’ unit purchase optiondescribed in Note 17, and 1,875,000 shares of common stock were reserved forissuance pursuant to the preferred stock conversion option described in Note15. This includes the warrants that were issued in connection with the April 2007notes to stockholders which entitled the holder to exercise the warrants for atotal of 37,500 shares of stock. In 2007, the Company granted certain employeesincentive stock options (ISOs) and non-qualified stock options entitling theholders to exercise options for a total of 125,000 shares of stock and 130,000shares of restricted stock (see Note 17). In 2008, the Company granted certainemployees incentive stock options (ISOs) and non-qualified stock optionsentitling the holders to exercise options for a total of 100,000 shares ofstock and 85,000 shares of restricted stock (see Note 17). Lastly, in April 2008,the Company issued warrants for a total of up to 112,500 shares of stockexercisable at $8.00 per share to Rodman & Renshaw as partialconsideration in connection with the $15.0 million Preferred Stock issuancecompleted in April 2008 (see Note 15).

 

**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 stockholdersin August 2007. The 211,965 shares of common stock were cancelled as of August 2007.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**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. 18,750 shares of preferred stock are currently issued andoutstanding.

 

In April 2008, theCompany issued 18,750 shares of $0.0001 par value Series A ConvertiblePreferred Stock pursuant to a $15.0 million private placement. Each share ofthe Series A Convertible Preferred Stock accrues dividends at a rategreater of the declared dividend of the Company’s common stock or 3% per annumsuch shares are convertible into 100 shares of the Company’s common stock atany time at the option of the holder at a conversion price of $8.00 pershare.  Upon liquidation (voluntary or otherwise), dissolution, winding upor a change of control of the Company (to the extent approved by the Company’sBoard of Directors), holders of the Series A Preferred Stock will beentitle to receive, from the assets of the Company available for distribution,the greater of the original issue price plus accrued but unpaid dividends orthe amount the holder would receive if all the Series A Preferred Stockwere converted into shares of Common Stock.  Series A ConvertiblePreferred Stock holders have no voting rights.

 

**Note16 — Agreement with Underwriters**

 

In March 2007, theunderwriters of the Public Offering agreed to forfeit any and all rights orclaims to a pro-rata portion of the deferred underwriting costs and associatedaccrued interest with respect to any shares of common stock that are redeemedin connection with the proposed acquisition. This fee was charged againstadditional paid-in capital and was payable upon a successful businesscombination. Based on the redemption of 211,965 shares, $80,000 related tothese waived underwriter fees were paid to redemptive stockholders. Uponclosing of the purchase of ISI, Argyle paid approximately $1.4 million forservices performed related to the Public Offering.

 

**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) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values.Following is a description of the various grants made and the impact on thefinancial 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.

 

27

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

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

 

***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 andexpire January 24, 2011. The options to purchase up to 187,500 Units andthe Securities underlying such units were deemed to be compensation by theNational Association of Securities Dealers (“NASD”) and, therefore, weresubject to a 180-day lock-up pursuant to Rule 2710(g) (1) of theNASD Conduct Rules.

 

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 then available tomanagement. The volatility estimate was derived using historical data ofcomparable public companies in the proposed industry. Argyle believes thevolatility estimate calculated from such comparable companies was a reasonablebenchmark to use in estimating the expected volatility of our Units; however, theuse of an index to estimate volatility may not necessarily be representative ofthe volatility of the underlying securities.

 

***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 the participant’sguardian or legal representative. Each award agreement will specify, amongother things, the effect on an award of the disability, death, retirement,authorized leave of absence or other termination of employment of theparticipant. Argyle may require a participant to pay Argyle the amount of anyrequired 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, 2008and August 25, 2008, the Company granted an aggregate of 85,000 shares and5,000 shares, respectively, of the Company’s restricted common stock to certainof its executive officers and directors. Shares granted to the directors vestedimmediately and shares granted to the executive officers vest in three equaltranches on each of December 31, 2008, 2009 and 2010.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

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

 

**RestrictedStock (continued)**

 

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  January 2008                                                                      |       | 85,000             |       | 7.55                  |       |          |       |
| Granted  August 2008                                                                       |       | 5,000              |       | 4.46                  |       |          |       |
| Vested                                                                                          |       | 30,000             |       | 7.55                  |       |          |       |
| Forfeited                                                                                       |       | —             |       | —                |       |          |       |
| Nonvested at  September 30, 2008                                                           |       | 170,000            |       | $                     | 7.36       |          | 2.25       |   |
| Expected to vest  according to their respective vesting schedules as of September 30, 2008 |       | 170,000            |       | $                     | 7.36       |          | 2.25       |   |

 

During the three and ninemonths ended September 30, 2008, the Company recognized $163,000 and $0.8million, respectively, in compensation expense, net of tax benefit of $55,000and $281,000, respectively, related to the Company’s issuance of restrictedstock. As of September 30, 2008, there was $0.6 million of unrecognizedcompensation costs, net of estimated forfeitures, related to the Company’snon-vested restricted stock, which is expected to be recognized over a weightedaverage period of 2.25 years.

 

**PerformanceUnit Awards**

 

On January 25, 2008,the Company granted an aggregate of 55,000 performance unit awards to certainof its officers, subject to terms and conditions to be set forth in aperformance unit award agreement and in accordance with the Company’s 2007Incentive Plan. These awards vest on December 31, 2010 and a cash paymentis made to the holders only if certain performance goals to be determined bythe Board of Directors are achieved. The Company recognizes compensationexpense on the performance unit awards based on the fair value of the Company’sunderlying common stock at the end of each quarter over the remaining vestingperiod. The final plan metrics for determination of the award was not approvedby the Board of Directors until March 25, 2008. As a result, during thethree and nine months ended September 30, 2008, the Company recognized$20,000 and $90,000, respectively, of compensation expense related to theperformance unit awards.  Additionally,no compensation expense was recognized during the year ended December 31,2007.

 

The following tablesummarizes the performance unit activity under the 2007 Incentive Plan:

 
| ** **                                                                                      | ** ** | ** **         | ** ** | ** **            | ** ** | **Average**   | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------|------------|
| ** **                                                                                      | ** ** | ** **         | ** ** | **Weighted**          | ** ** | **Remaining** | ** ** |
| ** **                                                                                      | ** ** | ** **         | ** ** | **Average Fair** | ** ** | **Vesting**   | ** ** |
| ** **                                                                                      | ** ** | **Number of** | ** ** | **Value**             | ** ** | **Term**      | ** ** |
| **Performance Units**                                                                      | ** ** | **Units**          | ** ** | **Per Unit**     | ** ** | **(Years)**   | ** ** |
| Nonvested at  December 31, 2007                                                            |       | 115,000            |       | $                     | —     |          |       |   |
| Granted  January 2008                                                                      |       | 55,000             |       | —                |       |          |       |
| Granted  August 2008                                                                       |       | 5,000              |       | —                |       |          |       |
| Vested                                                                                          |       | —             |       | —                |       |          |       |
| Forfeited                                                                                       |       | —             |       | —                |       |          |       |
| Nonvested at  September 30, 2008                                                           |       | 175,000            |       | $                     | —     |          | 2.25       |   |
| Expected to vest  according to their respective vesting schedules as of September 30, 2008 |       | 175,000            |       | $                     | —     |          | 2.25       |   |

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

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

 

**Incentiveand Nonqualified Stock Options**

 

On January 25, 2008,the Company granted stock options to purchase an aggregate of 100,000 shares ofthe Company’s common stock to various employees, of which all were ISO. Theoptions have a strike price of $7.55 and vest in three equal tranches on eachof December 31, 2008, 2009 and 2010.

 

The following tablesummarizes the stock option activity under the 2007 Incentive Plan:

 
| ** **                                                                                                  | ** ** | ** **         | ** ** | ** **                | ** ** | **Average**   | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------------|------------|---------------|------------|
| ** **                                                                                                  | ** ** | ** **         | ** ** | **Weighted**              | ** ** | **Remaining** | ** ** |
| ** **                                                                                                  | ** ** | ** **         | ** ** | **Average Exercise** | ** ** | **Vesting**   | ** ** |
| ** **                                                                                                  | ** ** | **Number of** | ** ** | **Price**                 | ** ** | **Term**      | ** ** |
| **Stock Options**                                                                                      | ** ** | **Shares**         | ** ** | **Per Share**        | ** ** | **(Years)**   | ** ** |
| Outstanding at  December 31, 2007                                                                      |       | 125,000            |       | $                         | 7.89       |          |       |   |
| Granted                                                                                                     |       | 100,000            |       | 7.55                      |       |          |       |
| Exercised                                                                                                   |       | —             |       | —                    |       |          |       |
| Forfeited                                                                                                   |       | —             |       | —                    |       |          |       |
| Outstanding at  September 30, 2008                                                                     |       | 225,000            |       | $                         | 7.74       |          | 2.25       |   |
| Vested and  expected to vest according to their respective vesting schedules as of  September 30, 2008 |       | 225,000            |       | $                         | 7.74       |          | 2.25       |   |
| Exercisable at  September 30, 2008                                                                     |       | —             |       | $                         | —     |          | —     |   |

 

The Company hasestimated, based upon a Black-Scholes model, that the fair value of the stockoptions granted on January 25, 2008 was approximately $1.78 per option, (atotal value of approximately $178,000), using an expected life of three years,volatility of 40%, and a risk-free rate of 2.5%. However, because the sharesdid not have a trading history, the volatility assumption was based on informationthen available to management. The volatility estimate was derived usinghistorical data of public companies in the related industry. The Companybelieves that 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.

 

During the three and ninemonths ended September 30, 2008, the Company recognized $63,000 and$149,000, respectively, in compensation expense, net of tax benefit of $21,000and $51,000, respectively, related to the Company’s stock options. As of September 30,2008, there was $244,000 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 2.25 years.

 

**Note18 — Income Taxes**

 

The provision for incometaxes decreased $2.9 million and $3.8 million in the three months and ninemonths ended September 30, 2008 compared to the same period in 2007. Thedecrease in income taxes was primarily due to the decrease in income beforeincome taxes of $21.1 million and $23.9 million.  Our effective tax rate (benefit rate) was 15.8%in the nine months ended September 30, 2008 and 131.9% for the same periodin 2007.  The decrease in our effective taxrate was primarily due to a decrease in income before income taxes and thenon-deductibility for tax purposes of certain goodwill impairments recordedduring the third quarter 2008.

 

**Note19 — Related-Party Transactions**

 

During the first quarterof 2008, the Company entered into a Board-approved agreement with Sec-TecGlobal, Inc. (“Sec-Tec”) to share certain expenses related to common officespace in New York, New York as well as administrative related expenses in theNew York office. These expenses are being borne by the Company to reflectrealistic expenses associated with the Company’s conduct of business in New York.The Company has agreed to share expenses totaling $175,000 on an annual basisthat are to be paid in quarterly payments of $43,750. During the three and ninemonths ended September 30, 2008, the Company recognized $44,000 and$132,000, respectively, in expenses related to this agreement. Sec-Tec is awholly-owned subsidiary of Electronics Line 3000 of which the Company’s co-CEOsare stockholders and board members.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**Note19 — Related-Party Transactions (continued)**

 

At September 30,2008 and December 31, 2007, other receivables include $5,000 and $42,000,respectively, of receivables from related parties, all of which is attributableto AUSA. Amounts represent monies or other assets advanced to employees.Amounts have been paid on these receivables, and management believes they arefully collectible.

 

The Company leasesvarious properties from Green Wing Management, Ltd., an entity owned andcontrolled by the Chief Executive Officer and President of AUSA under capitalleases. The leases on these properties include two that were amended as part ofthe acquisition of ISI to reflect a term of 12 years ending in 2019 and a newlease executed in June 2008. All leases require that an appraisal becompleted by a qualified appraiser to determine the market rate of the leases.The rental rate to be paid on these properties, after the acquisition of ISI,is limited to no more than 90% of the market rate determined by the third-partyappraiser. Additional appraisals by a third-party appraiser are to be conductedevery three years during the 12-year terms, and the annual lease rate in theleases can increase at the time of these appraisals, but only to a level thatdoes not to exceed 90% of the market rate determined by the third-partyappraiser. Argyle has the right to purchase these three properties at any time,at the then current market value; however, the purchase price cannot be lessthan the value determined in the last appraisal preceding the effective date ofthe acquisition of ISI. During the three and nine months ended September 30,2008, the Company made lease payments of $123,000 and $284,000, respectivelyunder these leases. See Note 9 for the remaining payments due under theseleases.

 

In conjunction with themajor refinancing of ISI in 2004, the majority stockholders formed a newcompany in 2004 (ISI*MCS, Ltd.) which was used as the contracting entity on allfuture bonded contracts. ISI transferred certain existing bonded contracts attheir remaining contract values, and no gain or loss was recognized on thetransfers to ISI*MCS, Ltd. at the time of its formation. All contracts ofISI*MCS, Ltd. were subcontracted to ISI for the full contract amount, less a 2%fee. AUSA recorded Contract Revenue based on the ISI*MCS, Ltd.’s contractamount, net of the 2% fee. Contract receivables from ISI*MCS, Ltd. at September 30,2008 and December 31, 2007 totaled $7.4 million and $10.9 million,respectively, which is disclosed as contract receivables - related party on theface of the consolidated balance sheet since ISI*MCS, Ltd. is not consolidatedin the balance sheet. Contract Revenues reported by the Company from ISI*MCS,Ltd. were $2.9 million and $15.1 million for the three and nine months ended September 30,2008. ISI*MCS, Ltd. Revenues reported by the predecessor (ISI) were $3.6 millionand $16.7 million for the three and nine months ended September 30, 2007.Argyle has agreed to indemnify the shareholders of ISI*MCS, Ltd. from claimsbrought by the bonding company against their personal guarantees for thosecontracts that have not been paid in full as of the closing of the mergerbetween Argyle and ISI. The merger agreement setting forth the agreements ofArgyle and ISI provides that these indemnification obligations will survive fora period of four years after the closing date of the merger and the obligationsare not subject to cap, or maximum amount.

 

AUSA will receive 100% ofthe remaining contract amounts, and ISI*MCS, Ltd. will forego its 2% fee.Remaining amounts to be billed on these contracts as of September 30, 2008totaled $3.6 million. Beginning July 31, 2007 all future contracts, bonded andun-bonded, will be contracted directly by AUSA without involvement by ISI*MCS,Ltd.

 

**UnsecuredDebt — Related Party**

 

As part of the merger ofArgyle and ISI, debt totaling $16.0 million was owed to a shareholder of ISI,of which $10.0 million was paid prior to its scheduled payment terms. As a partof the merger, the shareholder of ISI became a shareholder of Argyle, holding486,237 shares of Argyle common stock as of July 31, 2007 and as such,also becoming a related party. At September 30, 2008 and December 31,2007, the remaining debt to the shareholder (see Note 8) totaled $11.2 millionand $6.0 million, respectively.

 

On September 30, 2008, Argyle provided anunsecured, subordinated loan of $2 million to AUSA. The term of the loan wasone month with the payment of all outstanding principal and accrued and unpaidinterest due on October 31, 2008. The rate of interest was 6% per annum. The loan was repaid in full upon theclosing of the senior credit facility on October 3, 2008 (See Note 22“Subsequent Events”).

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**Note20 — Segment Information**

 

AUSA is a detention andcommercial equipment contractor that specializes in turnkey installationsincluding 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 a contract varies but is typically less than twoyears. AUSA also provides turnkey installations covering the full spectrum ofelectronic security and low voltage systems, including fire alarm, accesscontrol, closed circuit television, intercom, sound/paging, and other customdesigned systems.

 

The Company’s segmentsare strategic business units that offer different products and services and aremanaged accordingly. Under GAAP segment reporting rules, management analyzesthe various operating segments based on segment income before income taxes. TheCompany changed its segment reporting to better align the Company’s recentlyacquired companies as business units within its existing business segments as apart of the Company’s global and strategic direction.  In February 2008,we reorganized 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 tworeporting segments: “Argyle Corrections” and “Argyle Commercial Security”. Thischange resulted in ISI Detention and MCS Detention combining into the ArgyleCorrections reporting segment and MCS Commercial into the Argyle CommercialSecurity reporting segment.  Segment information for the Predecessor forthe three and nine months ended September 30, 2007 has been restated toconform to current-year presentation. The customers and long-lived assets ofthe reportable segments are in the United States.

 

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

 

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

 

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

 

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

 

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

 

Argyle Correctionsspecializes 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. ArgyleCorrections offers a complete array of electronic security system solutionsrevolving around access control including: electronic locking systems andhardware, security doors and frames. Argyle Corrections also includes the saleand design of jail furniture, security glazing, and other security-basedsystems. It also provides the above goods and services to detention marketintegrators, electrical contractors, and competitors of AUSA that lack theirown in-house electronic solutions. Whether acting as prime contractor or as asubcontractor for projects spanning all levels of security, Argyle Corrections’product offerings include security locking systems, security hollow metal doorsand wall panels, security windows, security glass and glazing, securityfurnishings and accessories, design support and full installation capabilities.

 

Argyle CommercialSecurity has built a parallel business to Argyle Corrections targetingcommercial and industrial facilities. Argyle Commercial Security focuses on thecommercial security sector and provides turnkey, electronic security systems tothe commercial market. Currently, MCS Commercial Fire & Security isthe only active member of this business segment and is referred to historicallyas MCS-Commercial. Commercial currently operates out of its own San Antonioheadquarters and five regional offices. The offices in Austin, Houston, andDenver resulted from acquisitions made by ISI after it was acquired by Argyle.

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**Note20 — Segment Information (continued)**

 

**SummarySegment Information**

(in thousands)

 
| ** **                                         | ** ** | ** **                       | ** ** | ** **                       | ** ** | **Predecessor (ISI)**    | ** ** | ** **                      | ** ** | ** **                      | ** ** | **Predecessor (ISI)**       | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|-------------------------------|------------|---------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** | **One Month Ended** | ** ** | **Nine Months Ended** | ** ** | **Nine Months Ended** | ** ** | **Seven Months Ended** | ** ** |
| ** **                                         | ** ** | **September 30,**           | ** ** | **September 30,**           | ** ** | **July 31,**             | ** ** | **September 30,**          | ** ** | **September 30,**          | ** ** | **July 31,**                | ** ** |
| **Industry Segment (in thousands)** | ** ** | **2008**                         | ** ** | **2007**                         | ** ** | **2007**                      | ** ** | **2008**                        | ** ** | **2007**                        | ** ** | **2007**                         | ** ** |
| Revenues:                                          |       |                             |       |                             |       |                          |       |                            |       |                            |       |                             |       |
| Corrections                                        |       | $                                | 22,551     |                             | $          | 11,639                        |       | $                               | 3,893      |                            | $          | 81,432                           |       | $ | 11,639 |   | $ | 24,887 |   |
| Commercial                                         |       | 9,149                            |       | 5,454                            |       | 2,601                         |       | 24,371                          |       | 5,454                           |       | 18,246                           |       |
| Corporate                                          |       | —                           |       | —                           |       | —                        |       | —                          |       | —                          |       | —                           |       |
| Eliminations                                       |       | —                           |       | —                           |       | —                        |       | —                          |       | —                          |       | —                           |       |
| Total                                              |       | $                                | 31,700     |                             | $          | 17,093                        |       | $                               | 6,494      |                            | $          | 105,803                          |       | $ | 17,093 |   | $ | 43,133 |   |
| Operating income  (loss):                          |       |                             |       |                             |       |                          |       |                            |       |                            |       |                             |       |
| Corrections                                        |       | $                                | (12,638    | )                                | $          | 780                           |       | $                               | (362       | )                               | $          | (10,925                          | )          | $ | 780 |   | $ | 540 |   |
| Commercial                                         |       | (6,552                           | )          | 156                              |       | (291                          | )          | (6,165                          | )          | 156                             |       | 1,281                            |       |
| Corporate                                          |       | (1,126                           | )          | (890                             | )          | —                        |       | (4,283                          | )          | (1,411                          | )          | —                           |       |
| Eliminations                                       |       | —                           |       | —                           |       | —                        |       | —                          |       | —                          |       | —                           |       |
| Total                                              |       | $                                | (20,316    | )                                | $          | 46                            |       | $                               | (653       | )                               | $          | (21,373                          | )          | $ | (475 | ) | $ | 1,821 |   |
| Capital  expenditures:                             |       |                             |       |                             |       |                          |       |                            |       |                            |       |                             |       |
| Corrections                                        |       | $                                | 605        |                             | $          | 173                           |       | $                               | 73         |                            | $          | 3,611                            |       | $ | 173 |   | $ | 775 |   |
| Commercial                                         |       | 237                              |       | 42                               |       | —                        |       | 549                             |       | 42                              |       | 229                              |       |
| Corporate                                          |       | 55                               |       | —                           |       | —                        |       | 142                             |       | —                          |       | —                           |       |
| Total                                              |       | $                                | 897        |                             | $          | 215                           |       | $                               | 73         |                            | $          | 4,302                            |       | $ | 215 |   | $ | 1,004 |   |
| Total assets:                                      |       |                             |       |                             |       |                          |       |                            |       |                            |       |                             |       |
| Corrections                                        |       | $                                | 85,530     |                             | $          | 77,995                        |       | $                               | 20,295     |                            | $          | 85,530                           |       | $ | 77,995 |   | $ | 20,295 |   |
| Commercial                                         |       | 494                              |       | 6,811                            |       | 12,484                        |       | 494                             |       | 6,811                           |       | 12,484                           |       |
| Corporate                                          |       | 48,126                           |       | 5,363                            |       | —                        |       | 48,126                          |       | 5,363                           |       | —                           |       |
| Eliminations                                       |       | (35,755                          | )          | (8,753                           | )          | —                        |       | (35,755                         | )          | (8,753                          | )          | —                           |       |
| Total                                              |       | $                                | 98,395     |                             | $          | 81,416                        |       | $                               | 32,779     |                            | $          | 98,395                           |       | $ | 81,416 |   | $ | 32,779 |   |

 

**Note21 — Supplemental Disclosures of Cash Flow Information****(in thousands)**

 
| ** **                                                              | ** ** | ** **                      | ** ** | ** **                       | ** ** | **Predecessor (ISI)** | ** ** |
|-------------------------------------------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|----------------------------|------------|
| ** **                                                              | ** ** | **Nine Months Ended** | ** ** | **Seven Months Ended** | ** ** |
| ** **                                                              | ** ** | **September 30,**          | ** ** | **September 30,**           | ** ** | **July 31,**          | ** ** |
| ** **                                                              | ** ** | **2008**                        | ** ** | **2007**                         | ** ** | **2007**                   | ** ** |
| Cash paid for interest                                                  |       | $                               | 2,175      |                             | $          | 4                          |       | $ | 1,846 |   |
| Cash paid for income taxes                                              |       | 544                             |       | —                           |       | —                     |       |
| **Supplemental schedule of non-cash investing activities:**             |       |                            |       |                             |       |                       |       |
| Financed purchases of property and equipment                            |       | $                               | —     |                             | $          | 161                        |       | $ | 416 |   |
| Accrual for transaction costs                                           |       | —                          |       | —                           |       | 45                         |       |
| Issuance of warrants associated with notes to related parties           |       | —                          |       | 93                               |       | —                     |       |
| Goodwill and identified net intangible assets from push down accounting |       | —                          |       | —                           |       | 38,210                     |       |
| Reallocation of acquisition costs to goodwill                           |       | —                          |       | —                           |       | 110                        |       |
| **Supplemental schedule of non-cash financing activities:**             |       |                            |       |                             |       |                       |       |
| Notes issued for acquisitions                                           |       | $                               | 6,765      |                             | $          | —                     |       | $ | — |   |
| Dividends accrued                                                       |       | 201                             |       | —                           |       | —                     |       |
| Reduction in deferred interest liability                                |       | —                          |       | 101                              |       | —                     |       |
| Reduction in deferred underwriter liability                             |       | —                          |       | 185                              |       | —                     |       |
| Reduction in common stock subject to redemption                         |       | —                          |       | 5,736                            |       | —                     |       |
| Write-off of deferred transaction costs                                 |       | —                          |       | —                           |       | 732                        |       |
| Conversion of warrants to common stock                                  |       | —                          |       | —                           |       | 6,033                      |       |
| Settlement of debt and related accretion                                |       | —                          |       | —                           |       | 7,822                      |       |

 

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**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**SEPTEMBER 30,2008**

 

**Note22— Subsequent Events**

 

On October 3, 2008,AUSA entered into a loan agreement providing for (i) a secured revolvingline of credit in the maximum amount of $10.0 million with a $5.0 millionsublimit for the issuance of letters of credit, (ii) a secured revolvingline of credit in the maximum amount of $5.0 million, to be used solely for theissuance of letters of credit and (iii) a term loan in the maximum amountof $10.0 million (collectively, the “Loans”). The Loans have a three-year maturity and, upon closing, the proceedswere used to pay off existing indebtedness, with the remaining availability tobe used for working capital and other general corporate purposes. The Loanswill be secured by liens on and security interests in the personal property ofAUSA and guaranteed by the subsidiaries of AUSA. The Company is not a guarantorto the Loans.

 

The interest rates of theLoans are, at the AUSA’s option from time to time, (i) a floating perannum rate of interest equal to the prime rate plus the Applicable Margin, or (ii) theLIBOR Rate plus the Applicable Margin. The “Applicable Margin” means the rateper annum added to the prime rate and LIBOR as determined by the ratio of totaldebt to EBITDA of AUSA for the prior fiscal quarter, as set forth in the LoanAgreement. The intercompany loan, with a principal amount of $2.0 millionadvanced on September 30, 2008, was repaid in full upon the closing of theLoans with the Bank on October 3, 2008.

 

In connection with theLoans, the holders of each Seller Note agreed to be subordinated to the lenderwith respect to payment and perfection. In addition, the maturity dates of eachSeller Note was effectively extended to be no earlier than the date on whichall of the outstanding obligations of AUSA to repay the outstanding principaland accrued and unpaid interest relating to the Loans are satisfied.

 

The agreement containsboth financial and restrictive covenants, including a restriction on thepayment of dividends by AUSA.

 

Under the terms of thenew credit facility, as of October 3, 2008, the Company is indebted for$10 million in term debt and $7.0 million through the line of credit.  As a result of the repayment terms under thenew credit facility, the short term portion of the scheduled debt has increasedfrom $2.3 million to $3.7 million.

 

As a result of a reviewof anticipated capital expenditures for the remainder of the 2008 fiscal year,on November 12, 2008, the Company discovered that it was in excess of thelimit of $2.5 million provided for in its loan agreement with its subordinateddebt lender and accordingly on November 12, 2008, the Company requestedand received a waiver to increase the limit to $3 million in exchange for a$25,000 fee.

 

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS**

 

**ForwardLooking Statements**

 

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

 

**Overview**

 

Argyle Security, Inc.(“Argyle”) is a Delaware corporation that was incorporated on June 22,2005 in order to serve as a vehicle for the acquisition of an operatingbusiness through a merger, capital stock exchange, asset acquisition or othersimilar business combination.  Argyle completed its initial publicoffering 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.

 

On July 31, 2007,pursuant to the terms of a merger agreement, dated December 8, 2006, asamended on June 29, 2007 and July 11, 2007 (the “Merger Agreement”),Argyle acquired all of the assets and liabilities of ISI Security Group, Inc.(f/k/a ISI-Detention Contracting Group, Inc.)(“ISI”), currently referredto as Argyle Security USA (“AUSA”).  As a result of the merger, ISI becamea wholly owned subsidiary of Argyle.

 

On January 1, 2008,MCFSA, Ltd. (“MCS Commercial”) and all of the partnership interests of whichare directly or indirectly wholly owned by AUSA, acquired substantially all ofthe business assets and liabilities of Fire Quest Inc. (“Fire Quest”). FireQuest is engaged in the business of alarm system sales and service.

 

On January 4, 2008,AUSA acquired substantially all of the business assets and liabilities ofPeterson Detention, Inc. (“PDI”).  PDI is a full-service, turnkey solutionsprovider that manufactures high security metal barriers, high securityobservation window systems, detention furniture and accessories.

 

On January 31, 2008,ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of AUSA, whichin turn is a wholly owned subsidiary of the Company, closed a transaction,pursuant to which ISI-Controls acquired 100% of the outstanding limitedliability company units of Com-Tec Security LLC (“Com-Tec”), resulting inCom-Tec becoming a wholly owned subsidiary of ISI-Controls. Com-Tec is engagedin the business of custom design, manufacture and installation of electronicsecurity and communications systems.

 

AUSA is a detention andcommercial equipment contractor that specializes designing and integratingsecurity solutions, including turnkey installations, design, engineering,supply, and installation of various detention, surveillance and access controlequipment for correctional facilities and institutions. The work is performedunder fixed-price contracts. The projects are located in various citiesthroughout 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.

 

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 tworeporting segments: “Argyle Corrections” and “Argyle Commercial Security”.

 

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Argyle Correctionsconsists of all of our businesses in the corrections sector, including ISI,Metroplex Control Systems, Inc. (“MCS”) as well as Com-Tec. and PDI. Com-Tec and PDI were acquired in January 2008.  The ArgyleCorrections segment includes:

 

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

 

· MCS (also referred to historically asMCS-Detention) which designs, engineers, supplies, installs and maintainscomplex, customized security, access control, video and electronic securitycontrol system solutions at correctional and government facilities;

 

· PDI which is a full-service, turnkeysolutions provider that manufactures high security metal barriers, highsecurity observation window systems, detention furniture and accessories; and

 

· Com-Tec which is an industry leader inthe custom design and manufacture of electronic security and communicationssystems.

 

Argyle Correctionsspecializes 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. ArgyleCorrections offers a complete array of electronic security system solutionsrevolving around access control including: electronic locking systems andhardware and security doors and frames. Argyle Corrections also includes thesale and design of jail furniture, security glazing and other security-basedsystems. It also provides the above goods and services to detention marketintegrators, electrical contractors and competitors of AUSA that lack their ownin-house electronic solutions. Whether acting as prime contractor or as asubcontractor for projects spanning all levels of security, Argyle Corrections’product offerings include security locking systems, security hollow metal doorsand wall panels, security windows, security glass and glazing, securityfurnishings and accessories, design support and full installation capabilities.

 

Argyle CommercialSecurity has built a parallel business to Argyle Corrections, targetingcommercial and industrial facilities. Argyle Commercial Security focuses on thecommercial security sector and provides turnkey, electronic security systems tothe commercial market. Currently, MCS Commercial Fire & Security isthe only active member of this business segment and is referred to historicallyas MCS-Commercial. Argyle Federal Systems is currently an inactive businessunit. Argyle Commercial Security currently operates out of its own San Antonioheadquarters and five regional offices. The offices in Austin, Houston, andDenver resulted from acquisitions made by ISI before it was acquired by Argyle.

 

The following is anillustration of our business segments and business units.

 

 

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**CriticalAccounting Policies**

 

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

 

*Percentage-of-CompletionEstimates* — Otherthan for PDI, AUSA and its business units each uses percentage-of-completionaccounting to determine Revenue and Gross Margin earned on projects. Estimatingthe percentage completion on a project is a critical estimate used by AUSA whenbudgeting for its projects. This estimate is determined as follows:

 
| · |   | 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 differ, then adjustments are made. If the  costs are in excess of the estimate used in the prior month, then a decrease  in the percentage complete on the project through the current month in the  accounting period is made. If the costs are less than the estimate used in  the prior accounting period, then the new estimate increases the percentage  complete on the project. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| · |   | Revenues from  construction contracts are recognized on the percentage-of-completion method  in accordance with SOP 81-1. AUSA recognizes revenues on signed contracts and  change orders. AUSA generally recognizes revenues on unsigned change orders  where it has written notices to proceed from the customer and where  collection is deemed probable. Percentage-of-completion for construction  contracts is measured principally by the percentage of costs incurred and  accrued to date for each contract to the estimated total costs for each  contract at completion. AUSA generally considers contracts to be  substantially complete upon departure from the work site and acceptance by  the customer. If any jobs are identified during the review process which are  estimated to be a loss job (where estimated costs exceed contract price), the  entire estimated loss is recorded in full, without regard to the computed  percentage-of-completion.                                                                                             |

 

These estimates ofproject percentage-of-completion of a project determine the amounts of Revenuesand Gross Margin that are earned to date on a project. For example, if acontract is $100,000 with a 20% Gross Margin of $20,000, then a project that isestimated to be 50% complete accrues $50,000 in Revenues and $10,000 in GrossMargin. If the percentage completed is adjusted to 25%, then the Revenues onthe 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 accrualof the Revenues and Gross Margin earned on this project would be reduced in thecurrent month.

 

During the nine monthsended September 30, 2008, the Company conducted regular reviews and evaluationsfor the cost estimates associated with all of the approximately 1,500 activeConstruction Contracts in the Company’s Work–in-Process.  As a result of the review, the cost estimatesfor the in-process Construction Contracts (that existed as of year-endedDecember 31, 2007) increased by a net $4.4 million. In a few cases, the reviewsresulted in a total of $0.5 million ($0.08 basic and diluted earnings pershare) in contract loss accruals that have been have been computed asCost-of-Sales for the nine months ended September 30, 2008.    Of the aforementioned net estimated costincreases of $4.4 million, 37 contracts had cost estimate changes ofapproximately $100,000 or greater resulting in $4.9 million of the netincrease.  26 of the 37 contractsresulted in cost estimate increases totaling $7.4 million while 11 contractshad estimated cost decreases totaling $2.5 million.  Approximately 1,450 of the remainingcontracts with variances of less than $100,000 resulted in a net decrease incost estimates of $0.5 million.

 

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

 

Costs incurred prior tothe award of contracts are expensed as incurred. The balances billed but notpaid by customers pursuant to retainage provisions in construction contractswill be due upon completion of the contracts and acceptance by the customer.Based on the Company’s experience with similar contracts in recent years, theretention balance at each balance sheet date will be collected within thesubsequent fiscal year.

 

The current asset “Costsand Estimated Earnings in Excess of Billings on Incomplete Contracts”represents revenues recognized in excess of amounts billed which managementbelieves will be billed and collected within the subsequent year. The currentliability “Billings in Excess of Costs and Estimated Earnings on IncompleteContracts” represents billings in excess of revenues recognized.

 

*Revenue Recognition for ShippedProducts* -Revenue is recognized by PDI when the product is received by the customer inaccordance with the contractual shipping terms. All of the shipping of productsto PDI’s customers is FOB Destination whereby title passes to the purchase whenthe product reaches its destination. When delivery to the customer’s deliverysite has occurred, the customer takes title and assumes the risks and rewardsof ownership.

 

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

 

*IBNREstimates for Health Insurance* - On a quarterly basis, Argyle estimates its HealthInsurance Cost, for its self-insured employee base at the acquired companiesAUSA and Com-Tec, based upon expected health insurance claims for the currentyear. 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 12 months as its basis for accruing health care cost.

 

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

 

*Allowancefor Doubtful Accounts* - Argyle provides an allowance for bad debt through an analysis inwhich the bad debts that had been written off over previous periods arecompared on a percentage basis to the aggregate sales for the same periods. Theresulting percentage is applied to the year-to-date sales and a monthly reserveis accrued 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).

 

*Goodwill* - Represents the excess of the purchaseprice over the fair value of net assets acquired, including the amount assignedto identifiable intangible assets. Goodwill is reviewed for impairment annually or more frequently ifimpairment indicators arise.  Our annualimpairment review requires extensive use of accounting judgment and financialestimates.   The analysis of potentialimpairment of goodwill requires a two-step process. The first step is theestimation of fair value. If step one indicates that impairment potentiallyexists, the second step is performed to measure the amount of impairment, ifany. Goodwill impairment exists when the estimated fair value of goodwill isless than its carrying value.

 

During our quarter ended September 30,2008, the Company began an analysis of Goodwill Impairment in accordance withSFAS 142, *Goodwill and Other IntangibleAssets,* for the ISI acquisition completed July 31, 2007, theacquisition of Fire Quest on January 1, 2008, the acquisition of PDI on January 4,2008 and the acquisition of Com-Tec on January 31, 2008.   The initial analysis (first step) wasperformed by the Company’s management team and a valuation firm after theconclusion of the quarter.  Based on acombination of factors, including the current economic environment, ouroperating results and a sustained decline in our market capitalization, weconcluded that there were a number of indicators which require us to perform agoodwill impairment analysis as of September 30, 2008. For the purposes ofthis analysis, our estimates of fair value are based on a combination of theincome approach, which estimates the fair value of our reporting units based onthe future discounted cash flows, and the market approach, which estimates thefair value of our reporting units based on comparable market prices.

 

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As of the filing of thisQuarterly Report on Form 10-Q for the third quarter of fiscal 2008, we hadnot completed the entire two-step analysis due to the complexities involved indetermining the implied fair value of the goodwill of each business unit.However, based on the work performed to date, we have concluded that animpairment loss is probable and can be reasonably estimated. Accordingly, wehave recorded a $16.9 million non-cash goodwill impairment charge, representingour best estimate of the impairment loss, during the third quarter of fiscal2008.  We expect to finalize our goodwillimpairment analysis during the fourth quarter of fiscal 2008. There is alikelihood that adjustments to the goodwill impairment charge would need to bemade when the goodwill impairment test is completed. Any adjustments to ourpreliminary estimates as a result of completing this evaluation will berecorded in our financial statements for the quarter and fiscal year ended December 31,2008.

 

*NonCash Compensation Expense* - On January 1, 2006, Argyle adopted SFAS No. 123 (revised2004),*Share Based Payment*. SFAS No. 123(R) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues.

 

Purchase options (ISO /non-qualified) grants:

 

Argyle computes the valueof newly-issued purchase options (ISO and non-qualified) on the date of grantby utilizing the Black-Scholes valuation model based upon their expected lifevesting period, industry comparables for volatility and the risk-free rate onUS Government securities with matching maturities. The value of the purchaseoptions are then straight-line expensed over the life of the purchase options.

 

Restricted stock andperformance unit award grants:

 

Argyle computes the valueof newly issued stock grants on the date of grant based on the share price asof the award date. The values of the common shares are then straight-lineexpensed over the life of the corresponding vesting period.

 

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

 

**ProForma and Adjusted Pro Forma Financial Information; Non-GAAP Presentation**

 

Because we acquired ISIin July 2007, and Fire Quest, PDI and Com-Tec in January 2008, we donot believe a comparison of the results of operations and cash flows forthe three and nine months ended September 30, 2008 versus September 30,2007 is beneficial to our stockholders. In order to assist investors in betterunderstanding the changes in our business between the three and nine monthsended September 30, 2007 and September 30, 2008, we are presenting inthis Management’s Discussion and Analysis section, the Pro Forma and AdjustedPro Forma results of operations for the Company and the acquisitions for thethree and nine months ended September 30, 2008 and September 30, 2007as if the acquisitions occurred on January 1, 2008 and January 1,2007, respectively. We derived the pro forma results and adjusted pro formaresults of operations from (i) the unaudited consolidated financial statementsof ISI for the one and seven months ended July 31, 2007, (ii) theunaudited consolidated financial statements of Com-Tec for the one month ended January 31,2008 and the three and nine months ended September 30, 2007, (iii) theunaudited financial statements of PDI for the three and nine months ended September 30,2007, (iv) the unaudited financial statements of Fire Quest for the threeand nine months ended September 30, 2007 and (v) the unauditedconsolidated financial statements of the Company for the three and nine monthsended September 30, 2008 and 2007. We are presenting the pro forma and theadjusted pro forma information in order to provide, what we believe to be, amore meaningful comparison of our operating results with prior periods.

 

Adjusted Pro Forma NetIncome is an alternative view of performance used by management, and we believethat investors’ understanding of our performance is enhanced by disclosing thisperformance measure. We report Adjusted Pro Forma Net Income in order to presentthe results of our major operations, the construction, installation, marketingand sale of various electronic security systems for commercial accounts, anddetention hardware (including security doors and frames, jail furniture,security glazing, and other security-based systems) and electronic controlsystems for correctional facilities, prior to considering certain incomestatement elements, principally amortization of intangible assets.**  We havedefined Adjusted Pro Forma Net Income as Net Income before the impact ofpurchase accounting for acquisitions, acquisition-related costs, amortizationof intangibles, discontinued operations and certain significant items includingone-time expenses associated with stock appreciation rights. The Adjusted Pro FormaNet Income measure is not, and should not be viewed as, a substitute for U.S.GAAP Net Income.**

 

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The Adjusted Pro FormaNet Income measure is an important internal measurement for us. We measure theperformance of the overall Company on this basis. The following are examples ofhow the Adjusted Pro Forma Net Income measure is being utilized:

 
| · |   | Senior management  receives a monthly analysis of our operating results that is prepared on an  Adjusted Pro Forma Net Income basis;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| · |   | Our annual budgets are  prepared on an Adjusted Pro Forma Net Income basis; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| · |   | Annual and long-term  compensation, including annual cash bonuses, merit-based salary adjustments,  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 an objective may vary by level of management and job  responsibility and may be considered in the determination of certain  long-term compensation plans. |

 

**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.**

 

**Wealso recognize that, as an internal measure of performance, the Adjusted ProForma Net Income and the associated earnings per share measure has limitationswhich is the reason we do not restrict our performance-management processsolely to this metric. A limitation of the Adjusted Pro Forma Net Incomemeasure is that it provides a view of our operations without including allevents during a period such as the effects of an acquisition or amortization ofpurchased intangibles and does not provide a comparable view of our performanceto other companies in the security detention and construction industries.**

 

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

 

Adjusted Pro Forma EBITDAis used by management as a performance measure for benchmarking against theCompany’s peers and competitors. The Company believes that EBITDA is useful toinvestors because it is frequently used by securities analysts, investors andother interested parties to evaluate companies in the security industry.Additionally, we use Adjusted Pro Forma EBITDA for internal performance measurements.EBITDA is not a recognized term under GAAP. Argyle and AUSA compute EBITDAusing the same consistent method from quarter to quarter. EBITDA includes NetIncome before interest, taxes, depreciation and amortization. The presentationof EBITDA is not intended to be considered in isolation or as a substitute forthe financial information prepared and presented in accordance with GAAP.

 

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

 

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Below is a table showingArgyle’s Adjusted Pro Forma Consolidated Statements of Operations.  ThePro Forma Consolidated Statements of Operations are included in the Notes tothe Financial Statements included elsewhere in this report.

 

**ArgyleSecurity, Inc**

**AdjustedPro Forma Consolidated Statements of Operations**

**(unaudited)**

 

(in thousandsexcept share data)

 
| ** **                                                                                                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                                                            | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues:                                                                                                                             |       |                             |       |                            |       |   |   |   |   |
| Contract  revenues                                                                                                                    |       | $                                | 22,583     |                            | $          | 15,383 |   | $ | 74,200 |   | $ | 37,919 |   |
| Contract  revenues - related party                                                                                                    |       | 2,906                            |       | 8,132                           |       | 15,131 |   | 21,299 |   |
| Service and  other revenues                                                                                                           |       | 6,211                            |       | 4,520                           |       | 18,191 |   | 13,923 |   |
| Total revenues                                                                                                                        |       | 31,700                           |       | 28,035                          |       | 107,522 |   | 73,141 |   |
| Cost of  revenues:                                                                                                                    |       |                             |       |                            |       |   |   |   |   |
| Contract costs                                                                                                                        |       | 21,951                           |       | 18,311                          |       | 73,415 |   | 45,589 |   |
| Service and  other costs, excluding amortization of intangibles                                                                       |       | 5,013                            |       | 3,219                           |       | 14,025 |   | 10,162 |   |
| Total cost of  revenues                                                                                                               |       | 26,964                           |       | 21,530                          |       | 87,440 |   | 55,751 |   |
| Gross profit                                                                                                                          |       | 4,736                            |       | 6,505                           |       | 20,082 |   | 17,390 |   |
| Operating  expenses:                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Salaries and  related expense, including stock-based compensation of $226 and $975 for the  three and nine months 2008, respectively. |       | 3,068                            |       | 2,185                           |       | 10,056 |   | 6,968 |   |
| Consulting fees  and outside services                                                                                                 |       | 916                              |       | 445                             |       | 2,501 |   | 1,052 |   |
| Depreciation                                                                                                                          |       | 523                              |       | 340                             |       | 1,583 |   | 932 |   |
| Other general and  administrative expenses                                                                                            |       | 1,965                            |       | 1,822                           |       | 5,304 |   | 4,568 |   |
| Goodwill  impairment                                                                                                                  |       | 16,928                           |       | —                          |       | 16,928 |   | — |   |
| Amortization of  intangible assets                                                                                                    |       | —                           |       | —                          |       | — |   | — |   |
| Total operating  expenses                                                                                                             |       | 23,400                           |       | 4,792                           |       | 36,372 |   | 13,520 |   |
| Operating loss                                                                                                                        |       | (18,664                          | )          | 1,713                           |       | (16,290 | ) | 3,870 |   |
| Other income  (expense):                                                                                                              |       |                             |       |                            |       |   |   |   |   |
| Interest income                                                                                                                       |       | 58                               |       | 60                              |       | 136 |   | 171 |   |
| Interest expense                                                                                                                      |       | (997                             | )          | (479                            | )          | (2,695 | ) | (2,235 | ) |
| Total other  income (expense)                                                                                                         |       | (939                             | )          | (419                            | )          | (2,559 | ) | (2,064 | ) |
| Income (loss)  before provision for income taxes                                                                                      |       | (19,603                          | )          | 1,294                           |       | (18,849 | ) | 1,806 |   |
| Provision  (benefit) for income taxes                                                                                                 |       | (2,260                           | )          | (936                            | )          | (1,867 | ) | (610 | ) |
| Net income  (loss)                                                                                                                    |       | $                                | (17,343    | )                               | $          | 2,230 |   | $ | (16,982 | ) | $ | 2,416 |   |
| Deferred  interest, net of taxes, subject to possible redemption                                                                      |       | —                           |       | —                          |       | — |   | — |   |
| Dividends on  convertible preferred stockholders                                                                                      |       | 115                              |       | —                          |       | 201 |   | — |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                                                |       | $                                | (17,458    | )                               | $          | 2,230 |   | $ | (17,183 | ) | $ | 2,416 |   |
|                                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| EBITDA  Calculation:                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Interest, net                                                                                                                         |       | 939                              |       | 419                             |       | 2,559 |   | 2,064 |   |
| Depreciation                                                                                                                          |       | 543                              |       | 384                             |       | 1,659 |   | 1,064 |   |
| Taxes, net                                                                                                                            |       | (2,260                           | )          | (936                            | )          | (1,867 | ) | (610 | ) |
| EBITDA                                                                                                                                |       | $                                | (18,121    | )                               | $          | 2,097 |   | $ | (14,631 | ) | $ | 4,934 |   |
|                                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Weighted-average  number of shares of commomn stock outstanding exclusive of shares subject to  possible redemption:                  |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                                                                                 |       | 5,799,342                        |       | 5,466,200                       |       | 5,796,605 |   | 5,002,003 |   |
| Diluted                                                                                                                               |       | 5,799,342                        |       | 6,843,646                       |       | 5,796,605 |   | 6,358,007 |   |
| Net income  (loss) per share allocable to holders of non-redeemable common stock:                                                     |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                                                                                 |       | $                                | (3.01      | )                               | $          | 0.41 |   | $ | (2.96 | ) | $ | 0.48 |   |
| Diluted                                                                                                                               |       | $                                | (3.01      | )                               | $          | 0.33 |   | $ | (2.96 | ) | $ | 0.38 |   |

 

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Below is a reconciliationof GAAP Net Income (Loss) to Pro Forma Net Income (Loss), Adjusted Pro FormaNet Income (Loss) and to Pro Forma EBITDA.**  The presentation of EBITDA is not intended tobe considered in isolation or as a substitute for the financial informationprepared and presented in accordance with GAAP.**

 

**Reconciliationof GAAP Net Income to Pro Forma Net Income,**

**AdjustedPro Forma Net Income and Pro Forma EBITDA**

**(unaudited)**

 

(in thousands)

 
| ** **                                                                                  | ** ** | **Three Months Ended** | ** **  | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|---------------------------------|------------|
| ** **                                                                                  | ** ** | **September 30,**           | ** **  | **September 30,**          | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                                                  | ** ** | **2008**                         | ** **  | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| **GAAP  net income (loss)**                                                                 | ** ** | **$**                            | **(18,367** | **)**                           | **$**      | **(116** | **)** | **$** | **(20,121** | **)** | **$** | **(15** | **)** |
| Pro forma  adjustments - addbacks (reductions)                                              |       |                             |        |                            |       |   |   |   |   |
| Argyle salary  expense (increase) for management team in 2007                               |       | —                           |        | (74                             | )          | — |   | (518 | ) |
| SARS expense  reduction for 2007                                                            |       | —                           |        | 1,363                           |       | — |   | 1,363 |   |
| Non-cash  compensation expense (increase) for 2007                                          |       | —                           |        | (141                            | )          | — |   | (424 | ) |
| Depreciation  expense (increase) on revalued assets in 2007                                 |       | —                           |        | (56                             | )          | — |   | (214 | ) |
| Amortization of  intangible expense (increase) in cost of goods sold for 2008 and 2007      |       | —                           |        | (721                            | )          | (37 | ) | (3,285 | ) |
| Amortization of  intangible expense (increase) in operating expenses for 2008 and 2007      |       | —                           |        | (211                            | )          | (20 | ) | (1,079 | ) |
| Reduction in  rent expense for 2008 and 2007                                                |       | —                           |        | 34                              |       | 6 |   | 104 |   |
| Interest income  increase / (reduction) for 2008 and 2007                                   |       | —                           |        | (109                            | )          | — |   | (763 | ) |
| Interest expense  (increase) / reduction for 2008 and 2007                                  |       | —                           |        | 56                              |       | (39 | ) | 1,454 |   |
| Income / (loss)  from predecessor - Argyle Security USA for 2007                            |       | —                           |        | 946                             |       | — |   | 450 |   |
| Income / (loss)  from predecessor - Firequest for 2007                                      |       | —                           |        | 79                              |       | — |   | 239 |   |
| Income / (loss)  from predecessor - PDI for 2007                                            |       | —                           |        | 112                             |       | — |   | 425 |   |
| Income / (loss)  from predecessor - Com-Tec for January 2008 and 2007                  |       | —                           |        | 136                             |       | 44 |   | 288 |   |
| Provision  (benefit) for income taxes on pro forma adjustments for 2008 and 2007            |       | —                           |        | (430                            | )          | 33 |   | 902 |   |
| **Pro  forma net income (loss)**                                                            | ** ** | **$**                            | **(18,367** | **)**                           | **$**      | **868** | ** ** | **$** | **(20,134** | **)** | **$** | **(1,073** | **)** |
| Amortization of  intangible expense in cost of goods sold for 2008 and 2007                 |       | 1,218                            |        | 1,282                           |       | 3,784 |   | 3,846 |   |
| Amortization of  intangible expense in operating expenses for 2008 and 2007                 |       | 434                              |        | 434                             |       | 1,301 |   | 1,301 |   |
| Provision  (benefit) for income taxes on pro forma adjustments for 2008 and 2007            |       | (628                             | )           | (354                            | )          | (1,933 | ) | (1,658 | ) |
| **Adjusted  pro forma net income (loss)**                                                   | ** ** | **$**                            | **(17,343** | **)**                           | **$**      | **2,230** | ** ** | **$** | **(16,982** | **)** | **$** | **2,416** | ** ** |
| Interest, net                                                                               |       | 939                              |        | 419                             |       | 2,559 |   | 2,064 |   |
| Depreciation  expense                                                                       |       | 543                              |        | 384                             |       | 1,659 |   | 1,064 |   |
| Taxes, net                                                                                  |       | (2,260                           | )           | (936                            | )          | (1,867 | ) | (610 | ) |
| **Pro  forma EBITDA**                                                                       | ** ** | **$**                            | **(18,121** | **)**                           | **$**      | **2,097** | ** ** | **$** | **(14,631** | **)** | **$** | **4,934** | ** ** |
|                                                                                        |       |                             |        |                            |       |   |   |   |   |
| **GAAP  weighted average common shares outstanding - basic**                                | ** ** | **5,799,342**                    | ** **  | **5,436,200**                   | ** ** | **5,796,605** | ** ** | **5,002,003** | ** ** |
| Restricted stock                                                                            |       | —                           |        | 30,000                          |       | — |   | — |   |
| **Pro  forma and adjusted pro forma weighted average common shares outstanding - basic**    | ** ** | **5,799,342**                    | ** **  | **5,466,200**                   | ** ** | **5,796,605** | ** ** | **5,002,003** | ** ** |
|                                                                                        |       |                             |        |                            |       |   |   |   |   |
| **GAAP  weighted average common shares outstanding - diluted**                              | ** ** | **5,799,342**                    | ** **  | **5,436,200**                   | ** ** | **5,796,605** | ** ** | **5,002,003** | ** ** |
| Restricted stock                                                                            |       | —                           |        | 125,000                         |       | — |   | 95,000 |   |
| Stock warrants                                                                              |       | —                           |        | 1,089,946                       |       | — |   | 1,068,504 |   |
| Convertible debt                                                                            |       | —                           |        | 192,500                         |       | — |   | 192,500 |   |
| **Pro  forma and adjusted pro forma weighted average common shares outstanding -  diluted** | ** ** | **5,799,342**                    | ** **  | **6,843,646**                   | ** ** | **5,796,605** | ** ** | **6,358,007** | ** ** |

 

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Below is a table ofAdjusted Pro Forma Revenues, Cost of Sales, and Gross Margins for the threemonths ended September 30, 2008 and 2007.

 

**AdjustedPro Forma Segment P&L**

**(unaudited)**

** **

(in thousands)

 
| ** **                                             | ** ** | **Three Months September 30, 2008** | ** ** | **Three Months September 30, 2007** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **Corrections**                                         | ** ** | **Commercial**                                          | ** ** | **Total**                                 | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
| Net revenues                                           |       |                                                    |       |                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | $                                                       | 18,731     |                                                    | $          | 6,758                                     |       | $ | 25,489 |   | $ | 17,588 |   | $ | 5,927 |   | $ | 23,515 |   | 6.5 | % | 14.0 | % | 8.4 | % |
| Service and other  revenues                            |       | 3,820                                                   |       | 2,391                                                   |       | 6,211                                     |       | 2,145 |   | 2,375 |   | 4,520 |   | 78.1 | % | 0.7 | % | 37.4 | % |
| Total net  revenues                                    |       | $                                                       | 22,551     |                                                    | $          | 9,149                                     |       | $ | 31,700 |   | $ | 19,733 |   | $ | 8,302 |   | $ | 28,035 |   | 14.3 | % | 10.2 | % | 13.1 | % |
| *% of  total*                                          | * *   | *71.1*                                                  | *%*        | *28.9*                                                  | *%*        | * *                                  | * *   | *70.4* | *%* | *29.6* | % |   |   |   |   |   |   |   |   |
| Cost of revenues                                       |       |                                                    |       |                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract costs /  contract costs - related party       |       | $                                                       | 16,742     |                                                    | $          | 5,209                                     |       | $ | 21,951 |   | $ | 13,671 |   | $ | 4,640 |   | $ | 18,311 |   | 22.5 | % | 12.3 | % | 19.9 | % |
| Service and other  costs                               |       | 3,366                                                   |       | 1,647                                                   |       | 5,013                                     |       | 1,590 |   | 1,629 |   | 3,219 |   | 111.7 | % | 1.1 | % | 55.7 | % |
| Total cost of  revenues                                |       | $                                                       | 20,108     |                                                    | $          | 6,856                                     |       | $ | 26,964 |   | $ | 15,261 |   | $ | 6,269 |   | $ | 21,530 |   | 31.8 | % | 9.4 | % | 25.2 | % |
| Gross margin                                           |       |                                                    |       |                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract margins  / contract margins - related party   |       | $                                                       | 1,989      |                                                    | $          | 1,549                                     |       | $ | 3,538 |   | $ | 3,917 |   | $ | 1,287 |   | $ | 5,204 |   | (49.2 | )% | 20.4 | % | (32.0 | )% |
| Service and other  margins                             |       | 454                                                     |       | 744                                                     |       | 1,198                                     |       | 555 |   | 746 |   | 1,301 |   | 18.2 | % | (0.3 | )% | (7.9 | )% |
| Total gross  margin                                    |       | $                                                       | 2,443      |                                                    | $          | 2,293                                     |       | $ | 4,736 |   | $ | 4,472 |   | $ | 2,033 |   | $ | 6,505 |   | (45.4 | )% | 12.8 | % | (27.2 | )% |
| Gross margin  percentage                               |       |                                                    |       |                                                    |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | 10.6                                                    | %          | 22.9                                                    | %          | 13.9                                      | %          | 22.3 | % | 21.7 | % | 22.1 | % | (52.5 | )% | 5.5 | % | (37.1 | )% |
| Service and other  revenues                            |       | 11.9                                                    | %          | 31.1                                                    | %          | 19.3                                      | %          | 25.9 | % | 31.4 | % | 28.8 | % | 54.1 | % | (1.0 | )% | (33.0 | )% |
| Total gross  margin percentage                         |       | 10.8                                                    | %          | 25.1                                                    | %          | 14.9                                      | %          | 22.7 | % | 24.5 | % | 23.2 | % | (52.4 | )% | 2.4 | % | (35.8 | )% |

 

Below is a table ofAdjusted Pro Forma Revenues, Cost of Sales, and Gross Margins for the ninemonths ended September 30, 2008 and 2007.

 

**AdjustedPro Forma Segment P&L**

**(unaudited)**

** **

(in thousands)

 
| ** **                                             | ** ** | **Nine Months September 30, 2008** | ** ** | **Nine Months September 30, 2007** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **Corrections**                                        | ** ** | **Commercial**                                         | ** ** | **Total**                                 | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
| Net revenues                                           |       |                                                   |       |                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | $                                                      | 71,492     |                                                   | $          | 17,839                                    |       | $ | 89,331 |   | $ | 42,666 |   | $ | 16,552 |   | $ | 59,218 |   | 67.6 | % | 7.8 | % | 50.9 | % |
| Service and other  revenues                            |       | 11,659                                                 |       | 6,532                                                  |       | 18,191                                    |       | 5,974 |   | 7,949 |   | 13,923 |   | 95.2 | % | (17.8 | )% | 30.7 | % |
| Total net  revenues                                    |       | $                                                      | 83,151     |                                                   | $          | 24,371                                    |       | $ | 107,522 |   | $ | 48,640 |   | $ | 24,501 |   | $ | 73,141 |   | 71.0 | % | (0.5 | )% | 47.0 | % |
| *% of  total*                                          | * *   | *77.3*                                                 | *%*        | *22.7*                                                 | *%*        | * *                                  | * *   | *66.5* | *%* | *33.5* | % |   |   |   |   |   |   |   |   |
| Cost of revenues                                       |       |                                                   |       |                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract costs /  contract costs - related party       |       | $                                                      | 59,568     |                                                   | $          | 13,847                                    |       | $ | 73,415 |   | $ | 32,400 |   | $ | 13,189 |   | $ | 45,589 |   | 83.9 | % | 5.0 | % | 61.0 | % |
| Service and other  costs                               |       | 9,322                                                  |       | 4,703                                                  |       | 14,025                                    |       | 4,279 |   | 5,883 |   | 10,162 |   | 117.9 | % | (20.1 | )% | 38.0 | % |
| Total cost of  revenues                                |       | $                                                      | 68,890     |                                                   | $          | 18,550                                    |       | $ | 87,440 |   | $ | 36,679 |   | $ | 19,072 |   | $ | 55,751 |   | 87.8 | % | (2.7 | )% | 56.8 | % |
| Gross margin                                           |       |                                                   |       |                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract margins  / contract margins - related party   |       | $                                                      | 11,924     |                                                   | $          | 3,992                                     |       | $ | 15,916 |   | $ | 10,266 |   | $ | 3,363 |   | $ | 13,629 |   | 16.2 | % | 18.7 | % | 16.8 | % |
| Service and other  margins                             |       | 2,337                                                  |       | 1,829                                                  |       | 4,166                                     |       | 1,695 |   | 2,066 |   | 3,761 |   | (37.9 | )% | (11.5 | )% | 10.8 | % |
| Total gross  margin                                    |       | $                                                      | 14,261     |                                                   | $          | 5,821                                     |       | $ | 20,082 |   | $ | 11,961 |   | $ | 5,429 |   | $ | 17,390 |   | 19.2 | % | 7.2 | % | 15.5 | % |
| Gross margin  percentage                               |       |                                                   |       |                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues  / contract revenues - related party |       | 16.7                                                   | %          | 22.4                                                   | %          | 17.8                                      | %          | 24.1 | % | 20.3 | % | 23.0 | % | (30.7 | )% | 10.3 | % | (22.6 | )% |
| Service and other  revenues                            |       | 20.0                                                   | %          | 28.0                                                   | %          | 22.9                                      | %          | 28.4 | % | 26.0 | % | 27.0 | % | 29.6 | % | 7.7 | % | (15.2 | )% |
| Total gross  margin percentage                         |       | 17.2                                                   | %          | 23.9                                                   | %          | 18.7                                      | %          | 24.6 | % | 22.2 | % | 23.8 | % | (30.1 | )% | 7.7 | % | (21.4 | )% |

 

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**Discussion of Financial Results**

** **

For the three monthsended September 30, 2008, Argyle Corrections Revenues increased by 14.3%of total Company revenues from the same period in 2007.  Argyle Commercial Security’s Revenues rose by10.2%.  The total Company Margin decrease from 23.2% to 14.9% was directlyattributable to the decreased margins in Argyle Corrections (which decreased52.4%) while the Argyle Commercial Security’s Gross Margins increased by 2.4%over the same period.  For the ninemonths ended September 30, 2008, Argyle Corrections revenues increased by71.0% of total Company revenues from the same period in 2007.  The totalCompany Gross Margin decrease from 23.8% to 18.7% was directly attributable tothe decreased Gross Margins in the Argyle Corrections which decreased 30.1%while Argyle Commercial Security’s Gross Margins increased by 7.7% over thesame period.

 

Argyle Correctionscaptured additional market share due to its repeat customers.  Thiscapture rate enabled Argyle Corrections to enjoy Revenue growth. Althoughthe Argyle Corrections enjoyed an increase in Revenues during the three monthsended September 30, 2008, Gross Margins eroded largely as a result of theinability to control job related expenses and efficiently staff a number ofprojects booked in during 2007.  Initially, a lack of experience (of ourexisting workforce and newly hired workforce) resulted in a large learning curveto become efficient and effective in our operations. The need to properly trainour workforce resulted in a high level of inefficiencies that caused greaterlabor hours to be utilized which were not initially accounted for in theprojected project budget.

 

**Effect of New Sales Bookings**

** **

Typically, new bookingsresult in Revenue within six to twelve months. Despite an increase in marketshare, shortfalls in anticipated new sales bookings in the fourth quarter of2007 and the first half of 2008 have directly caused an estimated $1.2 millionnegative impact on Gross Margin 2008. This shortfall is primarily due to a dramatic slowdown in the activityof private prison developers. Based on discussions with industry professionalsand municipal buyers, it appears that this slowdown has been caused by twofactors: (i) the turbulent economy, which is reducing State and MunicipalTax Revenues and (ii) the fact that 2008 was an presidential electionyear, when historically many politicians have waited until after the electionsto decide or vote on things, such as jail and prison funding.

 

We have, however,recently seen that the number of new projects has increased and that the volumeof pending work (which is quoted work, waiting on a customer’s final decisionto buy) has increased over the past few months. We believe that this means that the projects did not start as soon inthe year as we had originally forecasted.

 

*Revenues*

* *

More than 92% aregenerated by fixed-price contracts (both “hard bid” and design build contracts).The success of a fixed-price contract is based in large part upon the qualityof the process utilized when estimating the costs that will be incurred inperforming the contract. The larger the project and the longer the term ofcompletion of the contract, the greater the number of variable factors thereare to be considered and evaluated in estimating costs. A successful estimatingprocess requires substantial experience and judgment. Management is aware ofthe significant need for experienced and qualified estimating personnel andregularly monitors the estimating process and its results.

 

The most obviousbenchmark that management considers in evaluating the estimating process iswhether the amount estimated, and submitted as a bid, was reasonably similar tothe amount bid by AUSA’s competitors on the same project. If possible,management evaluates the bids that were submitted in competition with AUSA’sbid, based on their knowledge of each competitor’s history and character (forexample, some typically bid high, some typically bid low), the condition of themarket, the complexity of the project, the type of construction and otherfactors. This review provides management with an ongoing general basis forevaluating 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.

 

AUSA also generatesService Revenues from one-time or recurring contracts. These are generallyshort-term projects which are evidenced by signed service agreements, customerwork orders 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 AUSA. ServiceRevenues are recognized when the services have been delivered to and acceptedby the customer.

 

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*Cost ofRevenues*

* *

Cost of Revenues consistsof the direct costs to complete a fixed-price contract (both bid and designbuild contracts) and includes variable costs related to the project, such asmaterial, direct labor, project management costs, travel related expenses tothe projects, 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 andAdministrative Expenses consist primarily of salaries, commissions and benefitsfor sales, labor and administrative personnel, including human resources,executive, accounting and legal personnel. These expenses also include fees forprofessional services and other administrative expenses.

 

*Goodwill Impairment*

* *

In accordance with SFAS142, “*Goodwill and Other Intangible Assets*” (“SFAS142”), we apply a fair value based impairment test to the net book value ofgoodwill and indefinite-lived intangible assets on an annual basis and, ifcertain events or circumstances indicate that an impairment loss may have beenincurred, on an interim basis. The analysis of potential impairment of goodwillrequires a two-step process. The first step is the estimation of fair value. Ifstep one indicates that impairment potentially exists, the second step isperformed to measure the amount of impairment, if any. Goodwill impairmentexists when the estimated fair value of goodwill is less than its carryingvalue.

 

During our quarter ended September 30,2008, based on a combination of factors, including the current economicenvironment, our operating results and a sustained decline in our marketcapitalization, we concluded that there were a number of indicators whichrequire us to perform a goodwill impairment analysis as of September 30,2008. For the purposes of this analysis, our estimates of fair value are basedon a combination of the income approach, which estimates the fair value of ourreporting units based on the future discounted cash flows, and the marketapproach, which estimates the fair value of our reporting units based oncomparable market prices. As of the filing of this Quarterly Report on Form 10-Qfor the third quarter of fiscal 2008, we had not completed the entire two-stepanalysis due to the complexities involved in determining the implied fair valueof the goodwill of each business unit. However, based on the work performed todate, we have concluded that an impairment loss is probable and can bereasonably estimated.

 

Accordingly, we haverecorded a $16.9 million non-cash goodwill impairment charge, representing ourbest estimate of the impairment loss, during the third quarter of fiscal2008.  We expect to finalize our goodwillimpairment analysis during the fourth quarter of fiscal 2008. There is alikelihood that adjustments to the goodwill impairment charge would need to bemade when the goodwill impairment test is completed. Any adjustments to ourpreliminary estimates as a result of completing this evaluation will berecorded in our financial statements for the quarter and fiscal year ended December 31,2008.  Management believes that the $16.9million adjustment and any subsequent adjustments did not and will not have anyimpact to the Company’s tangible net book value, liquidity or debt covenantmeasurements.

 

**Resultsof Operations for the Three Months Ended September 30, 2008 and 2007**

** **

**Revenues**

** **

Priorto our acquisition of AUSA in the third quarter of 2007, we had no Revenues.Because of the timing of the acquisition, a comparison of the three monthsended September 2007 versus 2008 would not be a meaningful comparison. Asa result, weare presenting the pro forma and the adjusted pro forma information below inorder to provide, what we believe to be, a more meaningful comparison of ourRevenues for the three months ended September 30, 2008 to the 2007 period.

 

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*ProForma Net Revenues*

* *

The following tablepresents Pro Forma Net Revenues for the three months ended September 30,2008 and 2007 (in thousands):

 
| ** **                             | ** ** | **Pro Forma Revenues** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|----------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                             | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                             | ** ** | ** **                       | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amount**                       | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract  revenues**                 |       | $                                | 22,583     |                             | 71.2       | %                            | $          | 15,383 |   | 54.9 | % | $ | 7,200 |   | 46.8 | % |
| **Contract  revenues - related party** |       | 2,906                            |       | 9.2                              | %          | 8,132                        |       | 29.0 | % | (5,226 | ) | (64.3 | )% |
| **Service  and other revenues**        |       | 6,211                            |       | 19.6                             | %          | 4,520                        |       | 16.1 | % | 1,691 |   | 37.4 | % |
| **Total  revenues**                    |       | $                                | 31,700     |                             | 100.0      | %                            | $          | 28,035 |   | 100.0 | % | $ | 3,665 |   | 13.1 | % |

 

In the last three yearsthe corrections and commercial security markets have been growing, which hasbeen a factor in our increased Revenues.  We have seen an increase inRevenues as a result of an increase in the sale of prison furniture by PDI, anincrease in the sales made by Com-Tec and a substantial increase in the numberof sales and service calls by Argyle Commercial Security. ISI and MCS Detentionalso saw growth due to an increase in the number of projects performed duringthe period.  On a pro forma basis, we hadRevenues of $31.7 million (including Related Party Revenue of $2.9million) and $28.0 million (including Related Party Revenue of $8.1million) for the three months ended September 30, 2008 and 2007,respectively, representing an increase of $3.7 million or 13.1%. The increasein Revenues is also due to an increase in Contract Revenues in our ArgyleCorrections business segment. The increase in the number of contracts isprimarily due to several major factors including, but not limited to, thedevelopment and integration of new product solutions through the development ofinternal software applications that has allowed us to capture a larger part ofthe market in the Argyle Corrections business segment. Year-over-year ServiceRevenues (when excluding Other Revenues from manufacturing) have increased by $0.8million for the three months ended September 30, 2008 versus 2007.  On a pro forma basis, Other Revenues from theArgyle Commercial Security business segment were $2.4 million and $2.3 millionfor the three months ended September 30, 2008 and 2007, respectively. The Company has focused on building its Service Revenues base by adding salespeople and improving performance to retain more customers and to increaseService Revenues.

 

The Pro Forma Revenue mixwas 80.4% Contract Revenues and 19.6% Service and Other Revenues for the threemonths ended September 30, 2008 compared to 83.9% and 16.1%, respectively,for the corresponding period in 2007.

 

As used in this analysis,“Related Party Revenues” are revenues which are generated by work subcontractedfrom ISI*MCS (an entity owned by Sam Youngblood, President of AUSA, and by DonCarr, President of AUSA – Corrections).  Messrs. Youngblood and Carrcreated ISI*MCS in 2004 to provide bonding on contracts that required bonding.The performance of those contracts was subcontracted to ISI as a subcontractorto ISI*MCS.  The subcontracted work was for third party customers ofISI*MCS that required bonded contracts.  Since the acquisition of ISI byArgyle, ISI*MCS no longer provides bonding and subcontract work to ISI (nowreferred to AUSA).  AUSA has secured its own bonding capacity and will usethat bonding capacity to directly enter into bonded contracts with third partycustomers.  As a result, the amount of Related Party Revenues willcontinue to decrease as the contracts with ISI*MCS outstanding at the time ofthe merger are completed.

 

**Cost ofRevenues**

** **

Priorto our acquisition of AUSA in the third quarter of 2007, we had no Cost ofRevenues. Because of the timing of the acquisition, a comparison of the threemonths ended September 2007 versus 2008 would not be a meaningfulcomparison. As a result, we are presenting the pro forma and the adjusted proforma information below in order to provide, what we believe to be, a moremeaningful comparison of our Cost of Revenues for the three months ended September 30,2008 to the 2007 period.

 

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*AdjustedPro Forma Cost of Revenues*

* *

The following tablereconciles Adjusted Pro Forma Cost of Revenues to Pro Forma Cost of Revenuesfor the three months ended September 30, 2008 and 2007 (in thousands):

 
| ** **                                                             | ** ** | **Adjusted Pro Forma Cost of Revenues** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **Three Months Ended**                                 | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                                                             | ** ** | **September 30, 2008**                                 | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                                             | ** ** | ** **                                                       | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                                                             | ** ** | **Amount**                                                       | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract  costs**                                                    |       | $                                                                | 21,951     |                             | 69.2       | %                            | $          | 18,311 |   | 65.3 | % | $ | 3,640 |   | 19.9 | % |
| **Service  and other costs, excluding amortization of intangibles**    |       | 5,013                                                            |       | 15.8                             | %          | 3,219                        |       | 11.5 | % | 1,794 |   | 55.7 | % |
| **Adjusted  pro forma total cost of revenues**                         |       | 26,964                                                           |       | 85.1                             | %          | 21,530                       |       | 76.8 | % | 5,434 |   | 25.2 | % |
| **Amortization  of intangibles**                                       |       | 1,218                                                            |       | 3.8                              | %          | 1,282                        |       | 4.6 | % | — |   | 0.0 | % |
| **Pro  forma cost of revenues, including amortization of intangibles** |       | $                                                                | 28,182     |                             | 88.9       | %                            | $          | 22,812 |   | 81.4 | % | $ | 5,434 |   | 23.8 | % |

 

On a pro forma basis,Cost of Revenues increased by $5.4 million, or 23.8%, to $28.2 million for thethree months ended September 30, 2008, compared to $22.8 million for thecorresponding period in 2007. On an adjusted pro forma basis, Cost of Revenuesincreased by $5.4 million, or 25.2%, to $26.9 million for the three monthsended September 30, 2008, compared to $21.5 million for the correspondingperiod in 2007. The amortization of acquired backlog has been allocated to Costof Revenues. The impact of this amortization (which was excluded from AdjustedPro Forma Cost of Revenues) for the three months ended September 30, 2008was $1.2 million. The increase in Cost of Revenues resulted from AUSA workingon a greater number of projects in 2008 than in 2007.  The percentage ofCost of Revenues has increased in 2008, due primarily to numerous projects thatran over budget. In order to timely complete projects and service the customer,we incurred higher travel, overtime and contracting expenses to complete thework. In addition, on certain projects there were costs which weresubstantially higher than anticipated, and such costs were not recovered.

 

The hiring and trainingprocess for the critical role of project managers (“PM” or “PMs”) haddiminished significantly as management responded to the dramatic growth insales.  This resulted in a quick hiringprocess with minimal vetting to meet demand. Subsequently, newly hired PMsmanaged substantial projects with very little oversight and without followingestablished operational controls and systems. A significant factor contributing to the reduced margins at ISI and MCSDetention was the poor handling of several projects, including a single projectat ISI and MCS Detention that had cost overruns of approximately $2.6 millionto date.  However, without the effect ofthe single job, ISI has had sufficient other jobs that were/are in a netunder-run position such that ISI was expected to be in an acceptable “small-slip”condition for the year.

 

Anothermajor impact on the Cost of Revenues was the escalation of steel prices whichbegan to rise toward the end of the second quarter. Domestic material costincreases of approximately 40% have increased our Cost of Sales on U.S.manufactured product by approximately $150,000 per month.  Pricing climbed from an average of $0.40 perpound to $0.56 per pound.  Although PDIwas able to renegotiate some contracts, and others had existing pricing thatwas high enough to absorb the higher steel prices, we were unable to recoverabout $50,000 per month from smaller contracts and contracts that we wereunable to renegotiate. Indicators, such as reductions in scrap prices (the basematerial in the production of steel) and very low demand, have been puttingdownward pressure on the price of steel.

 

During the later part ofthe quarter, we accelerated a plan to reduce costs and improveefficiencies. We have negotiated reduced salaries with certain employees,and we unfortunately had to terminate several employees (some because theirpositions were eliminated and others because of performance reasons). Inaddition, we have implemented plans to reduce expenditures for items such ascellular phones, computers and tools. Further, we have implemented aCompany-wide plan to review cost-to-complete estimates and man-loadingefficiencies.  We have also implemented acomprehensive training program intended to increase the effectiveness of ourlabor force (particularly in all aspects of project management) and createredundancies which should reduce the higher-than-expected cost for overtime andrework.

 

Another reason for theincrease in expenses involved the direct and indirect expenses related torework on product that did not meet our customer’s specifications. The laborthat PDI has used in order to affect the rework repairs was taken from PDI’sregular work force and, therefore, reduced the amount of labor available toproduce customer orders, thereby reducing the material markup that would havereduced Cost of Sales.  PDI was not ableto recapture the expenses by charging customers more for products.

 

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The amortization ofacquired backlog in the Cost of Sales section has been allocated to Cost ofRevenues and represents the only difference between Pro Forma Gross Margins andAdjusted Pro Forma Gross Margins for the three months ended September 30,2008 and 2007 period.

 

**GrossMargin**

** **

Priorto our acquisition of AUSA in the third quarter of 2007, we had no GrossMargin. Because of the timing of the acquisition, a comparison of the threemonths ended September 2007 versus 2008 would not be a meaningfulcomparison. As a result, we are presenting the pro forma and the adjusted proforma information below in order to provide, what we believe to be, a moremeaningful comparison of our Gross Margin for the three months ended September 30,2008 to the 2007 period.

 

*AdjustedPro Forma Gross Margin*

* *

The following tablereconciles Adjusted Pro Forma Gross Margin to Pro Forma Gross Margin for thethree months ended September 30, 2008 and 2007 (in thousands):

 
| ** **                           | ** ** | **Adjusted Pro Forma Gross Margin** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **Three Months Ended**                        | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                           | ** ** | **September 30, 2008**                        | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | ** **                                              | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                           | ** ** | **Amount**                                              | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma gross margin** |       | $                                                       | 4,736      |                             | 14.9       | %                            | $          | 6,505 |   | 23.2 | % | $ | (1,769 | ) | (27.2 | )% |
| **Amortization  of intangibles**     |       | (1,218                                                  | )          | -3.8                             | %          | (1,282                       | )          | -4.6 | % | 64 |   | (5.0 | )% |
| **Pro  forma gross margin**          |       | $                                                       | 3,518      |                             | 11.1       | %                            | $          | 5,223 |   | 18.6 | % | $ | (1,705 | ) | (32.6 | )% |

 

On a pro forma basis forthe three months ended September 30, 2008, there was Gross Margin of $3.5million compared to a Gross Margin of $5.2 million for the corresponding periodin 2007. On an adjusted pro forma basis for the three months ended September 30,2008, there was Gross Margin of $4.7 million compared to a Gross Margin of $6.5million for the corresponding period in 2007.  The Pro Forma Gross Marginfell from 18.6% to 11.1%, and the Adjusted Pro Forma Gross Margin fell from23.2% to 14.9% because of the increase in expenses described above.

 

In general, AUSA realizedGross Margin erosion primarily as a result of net job costs exceeding estimatesat MCS Detention, cost control issues at ISI (including cost overruns at asingle job), as well as increases in the cost of raw materials and single-sourcesupplier cost increases at PDI. As noted previously, the major issue causingISI margin erosion is related to a single project that is currently beingfinished. Margin erosion in MCS largely relates to issues similar to thoseexperienced by ISI. Additionally, we did not have a system in place at MCS thatprevented overselling to potential customers based on our capacity to performtheir work.  In order to meet customerexpectations, excessive overtime and additional manpower was required withtight delivery deadlines, which added unexpected costs to certain projects.

 

Margin erosion at PDI wasattributable to various reasons, including the impact of several issuesoccurring simultaneously. One of the main issues involved inefficient jobscheduling.  When PDI provides a quotefor its customers, PDI does not typically know the schedule for when the workwill need to be performed once a quote is accepted. PDI had historically onlybeen concerned with the overall size of its backlog and not the timing forproduction and delivery.  Despite thefact that PDI had been growing, there was always excess capacity whichhistorically had never been a significant issue.  However, as the third quarter of 2008progressed, PDI was faced with delivery demands by multiple customers withinthe same time frame.

 

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**OperatingExpenses**

** **

Operating Expensesincreased to $23.8 million for the three months ended September 30, 2008,compared to $3.6 million for the corresponding period in 2007.  A significant factor contributing to theseexpense increases were $16.9 million in Goodwill impairment charges, $1.0million in legal and accounting fees and $226,000 in non-cash compensationexpenses resulting from SFAS 123(R). Absent non-cash charges, Operating Expenses typically consist ofsalaries and benefits for selling and administrative personnel, including humanresources, executive, finance and legal. These expenses also include fees forprofessional services and other administrative expenses as well as amortizationof intangible assets.  In addition, we saw an increase in operatingexpenses as a result of the hiring of new personnel and the associatedrecruiting costs and purchasing of systems required to transition formerprivately held companies into becoming fully integrated business segments of apublic reporting company.  To assist usin reducing operating expenses in the future Argyle has implemented costreduction initiatives to reduce overhead and discretionary spending. Also,Argyle has hired an in-house general counsel which is anticipated to reducelegal costs. Also, the Co-Chief Executive Officers and Chief Financial Officerhave agreed to forego agreed upon cash bonus compensation and the Co-ChiefExecutive Officers have agreed to not request reimbursement for travel andentertainment expenses.  Over the pastseveral months, steps have been taken to reduce total operating expenses byapproximately $1.5 million (annualized) at AUSA. In order to achieve thisreduction, AUSA has eliminated its bonus plan for the last half of 2008,reduced the base salaries of several management employees and has terminatedboth direct and indirect employees.

 

*AdjustedPro Forma Operating Expenses*

* *

The following tablereconciles Adjusted Pro Forma Operating Expenses to Pro Forma OperatingExpenses for the three months ended September 30, 2008 and 2007 (inthousands):

 
| ** **                                       | ** ** | **Adjusted Pro Forma Operating Expenses** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **Three Months Ended**                              | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                                       | ** ** | **September 30, 2008**                              | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                       | ** ** | ** **                                                    | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **Amount**                                                    | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma total operating expenses** |       | $                                                             | 23,400     |                             | 73.8       | %                            | $          | 4,792 |   | 17.1 | % | $ | 18,608 |   | 388.3 | % |
| **Amortization  of intangible assets**           |       | 434                                                           |       | 1.4                              | %          | 434                          |       | 1.5 | % | — |   | 0.0 | % |
| **Pro  forma total operating expenses**          |       | $                                                             | 23,834     |                             | 75.2       | %                            | $          | 5,226 |   | 18.6 | % | $ | 18,608 |   | 356.1 | % |

 

On a pro forma basis,Operating Expenses increased $18.6 million, or 356.1% to $23.8 million for thethree months ended September 30, 2008, from $5.2 million for thecorresponding period in 2007. On an adjusted pro forma basis, OperatingExpenses increased $18.6 million, or 388.3% to $23.4 million for the threemonths ended September 30, 2008 from $4.8 million for the correspondingperiod in 2007. The increase is primarily due to the impact of a Non-CashGoodwill Impairment Charge and additional expenses needed to support theincreased number of projects on which AUSA is working, increased sales andmarketing efforts to promote future growth, and corporate services expensesassociated with the parent company entity.  The increase in OperatingExpenses is also attributable to the increase in accounting personnel requiredto migrate several of our subsidiaries from privately held companies to becomeintegrated into a public company.  In addition to the reportingrequirements of a public company, the growth in Revenues and correspondingincrease in projects also required additional personnel and the relatedrecruiting cost.  Other increased costs associated with a public companyincluded legal fees along with external accounting and consulting fees.

 

As discussed in Note 2 ofthe unaudited consolidated financial statements, $16.9 million in Non-CashGoodwill Impairment Charges were recognized in the three months ended September 30,2008.  This increase accounted for 90.9%of the $18.6 million increase for the three months ended September 30,2008 versus the same period in 2007. Operating Expenses excluding the Non-CashGoodwill Impairment increased $1.7 million or 32.7% over the same period in2007.

 

Additionally, $226,000 inNon-Cash Compensation Expense related to restricted stock grants and employeestock options was included in the Operating Expenses for the quarter ended September 30,2008, compared to $192,000 for the same period in 2007. The amortization ofcustomer base and software has been allocated to Operating Expenses andprimarily relates to the acquisition of ISI on July 31, 2007 and Com-Tec,PDI, and Fire Quest during the quarter ended March 31, 2008.  Theimpact of this amortization, which was excluded from Pro Forma OperatingExpenses, was $0.4 million.

 

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**OtherIncome / Expense**

** **

Prior to July 2007,Total Other Income/Expense represented interest earned on the net proceeds ofour initial public offering and the private placement held in trust through thedate of the acquisition of ISI.  Interest Expense represents interest onour line of credit, unsecured subordinated debt and notes issued during January 2008in connection with the acquisition of Com-Tec, PDI, and Fire Quest. Total otherincome/expense for the three months ended September 30, 2008 was ($0.9)million, compared to expense of ($0.2) million for the corresponding period in2007.

 

*ProForma Other Income / Expense*

* *

The following tablepresents Pro Forma Interest and other income for the three months ended September 30,2008 and 2007 (in thousands):

 
| ** **                        | ** ** | **Pro Forma Other Income (Expense)** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **Three Months Ended**                         | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                        | ** ** | **September 30, 2008**                         | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | ** **                                               | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **Amount**                                               | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Interest  income**              |       | $                                                        | 58         |                             | 0.2        | %                            | $          | 60 |   | 0.2 | % | $ | (2 | ) | (3.3 | )% |
| **Interest  expense**             |       | (997                                                     | )          | -3.1                             | %          | (479                         | )          | -1.7 | % | (518 | ) | 108.1 | % |
| **Total  other income (expense)** |       | $                                                        | (939       | )                                | -3.0       | %                            | $          | (419 | ) | -1.5 | % | $ | (520 | ) | 124.1 | % |

 

Pro Forma Interest Incomefor the three months ended September 30, 2008 mainly represents interestearned on the excess cash from the net proceeds of our preferred stockoffering.  Pro forma Interest Expense for the three months ended September 30,2008 and 2007 mainly represents interest on our line of credit, unsecuredsubordinated debt, and our notes issued during January 2008 for theacquisitions of Com-Tec, PDI and Fire Quest. Pro Forma Other Income /Expenseincreased to ($0.9) million for the three months ended September 30, 2008from ($0.4) million for the corresponding period in 2007.

 

**NetIncome / (Loss)**

** **

For the three monthsended September 30, 2008, we had Net Loss of ($18.4) million, compared toa net loss of ($116,000) for the corresponding period in 2007.  Our onlysource of income prior to the consummation of our initial business combinationwith ISI was interest earned on the funds held in the trust account. Asignificant impact on the Net Loss for the 2008 period was the $17.9 million inNon-Cash Goodwill Impairment Charges and Non-Cash Compensation Charges.

 

*AdjustedPro Forma Net Income/(Loss)*

* *

The following tablereconciles Adjusted Pro Forma Net Income/(Loss) to Pro Forma Net Income /(Loss)for the three months ended September 30, 2008 and 2007 (in thousands):

 
| ** **                                | ** ** | **Pro Forma Net Income/(Loss)** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-------------------------------------------|------------|------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **Three Months Ended**               | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **                                | ** ** | **September 30, 2008**               | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                | ** ** | ** **                                     | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Amount**                                     | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma net income (loss)** |       | $                                              | (17,343    | )                                | -54.7      | %                            | $          | 2,230 |   | 8.0 | % | $ | (19,573 | ) | (877.7 | )% |
| **Amortization  of intangible assets**    |       | (1,652                                         | )          | -5.2                             | %          | (1,716                       | )          | -6.1 | % | 64 |   | (3.7 | )% |
| **Taxes,  net**                           |       | 628                                            |       | 2.0                              | %          | 354                          |       | 1.3 | % | 274 |   | 77.4 | % |
| **Total  pro forma net income (loss)**    |       | $                                              | (18,367    | )                                | -57.9      | %                            | $          | 868 |   | 3.1 | % | $ | (19,235 | ) | (2216.0 | )% |

 

For the three monthsended September 30, 2008, we had Pro Forma Net Loss of ($18.4) millioncompared to a Pro Forma Net Income of $0.9 million for the corresponding periodin 2007.  For the three months ended September 30, 2008, we had anAdjusted Pro Forma Net Loss of ($17.3) million compared to an Adjusted ProForma Net Income of $2.2 million for the corresponding period in 2007. Our onlysource of income prior to the consummation of our initial business combinationwith AUSA was interest earned on the funds raised by Argyle in connection withits initial public offering and held in a trust account for use in a businesscombination.

 

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

** **

The following tablepresents Pro Forma EBITDA for the three months ended September 30, 2008and 2007 (in thousands):

 
| ** **            | ** ** | **Pro Forma EBITDA**   | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-----------------------|------------|----------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **            | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** | **Year to Year**   | ** ** |
| ** **            | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | ** **                       | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **            | ** ** | **Amount**                       | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Pro  Forma EBITDA** |       | $                                | (18,121    | )                                | -57.2      | %                            | $          | 2,097 |   | 7.5 | % | $ | (20,218 | ) | (964.1 | )% |
|                       |            |                                  |            |                                  |            |                              |            |  |  |  |  |  |  |  |  |  |

 

Pro Forma EBITDAdecreased by $20.2 million to ($18.1) million in the three months ended September 30,2008, compared to $2.1 million in the corresponding period in 2007.  The EBITDA Margin decreased to (57.2%) from7.5% in the corresponding period in 2007.   The September 30,2008 EBITDA includes $16.9 million in Non-Cash Goodwill Impairment Chargescompared to $0 in the same period in 2007. Additionally, the September 30, 2008 EBITDA includes $226,000 inNon-Cash Compensation Expense related to restricted stock grants and employeestock options for that period compared to $192,000 for the same period in 2007.

 

**Resultsof Operations for the Nine Months Ended September 30, 2008 and 2007**

** **

**Revenues**

** **

Priorto our acquisition of AUSA in the third quarter of 2007, we had no Revenues.Because of the timing of the acquisition, a comparison of the nine months endedSeptember 2007 versus 2008 would not be a meaningful comparison. As aresult, we arepresenting the pro forma and the adjusted pro forma information below in orderto provide, what we believe to be, a more meaningful comparison of our Revenuesfor the nine months ended September 30, 2008 to the 2007 period.

 

*ProForma Net Revenues*

* *

The following tablepresents Pro Forma Net Revenues for the nine months ended September 30,2008 and 2007 (in thousands):

 
| ** **                             | ** ** | **Pro Forma Revenues** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|----------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **Nine Months Ended**  | ** ** | **Nine Months Ended**  | ** ** | **Year to Year**   | ** ** |
| ** **                             | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                             | ** ** | ** **                       | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amount**                       | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract  revenues**                 |       | $                                | 74,200     |                             | 69.0       | %                            | $          | 37,919 |   | 51.8 | % | $ | 36,281 |   | 95.7 | % |
| **Contract  revenues - related party** |       | 15,131                           |       | 14.1                             | %          | 21,299                       |       | 29.1 | % | (6,168 | ) | (29.0 | )% |
| **Service  and other revenues**        |       | 18,191                           |       | 16.9                             | %          | 13,923                       |       | 19.0 | % | 4,268 |   | 30.7 | % |
| **Total  revenues**                    |       | $                                | 107,522    |                             | 100.0      | %                            | $          | 73,141 |   | 100.0 | % | $ | 34,381 |   | 47.0 | % |

 

On a pro forma basis, wehad Revenues of $107.5 million (including Related Party Revenues of $15.1million) and $73.1 million (including Related Party Revenues of $21.3million) for the nine months ended September 30, 2008 and 2007,respectively, representing an increase of $34.4 million, or 47.0%. We have seenan increase in Revenues as a result of an increase in the sale of prisonfurniture by PDI, an increase in the sales made by Com-Tec and a substantialincrease in the number of sales and service calls by Argyle CommercialSecurity. ISI and MCS Detention also saw growth due to an increase in thenumber of projects performed during the period. The increase is also a result of the significant increase in ContractRevenues and is primarily due to several major factors including, but notlimited to, the addition of new products through the development of internalsoftware applications that has allowed the company to capture a larger part ofthe market in the Argyle Corrections Segment. The Company has focused onbuilding its Service Revenue base by increasing the number of employed servicepeople and improving performance to retain more customers and to the increaserecurring Service Revenues. Year-over-year Service Revenues (when excludingOther Revenues from manufacturing) have increased by $0.1 million for the ninemonths ended September 30, 2008 versus 2007.  We had an unusuallylarge $1.8-million service contract recognized in the same period 2007. When excluding the $1.8 million opportunity in the quarter-ended September 30,2007, Service Revenue and Other Sales Revenues actually increased by $1.9million or 29.2% over the same period.  On a pro forma basis, OtherRevenues from manufacturing were $10.1 million and $5.6 million, respectively,for the nine months ended September 30, 2008 and 2007.

 

The Pro Forma Revenue mixwas 83.1% Contract Revenues and 16.9% Service and Other Revenues for the ninemonths ended September 30, 2008 compared to 81.0% and 19.0%, respectively,for the corresponding period in 2007.

 

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In the last three years,the corrections and commercial security markets have been growing, which hasbeen a factor in our increased Revenues.  We have seen an increase inRevenues as a result of an increase in the sale of prison furniture by PDI, anincrease in the sales made by Com-Tec and a substantial increase in the numberof sales and service calls by Argyle Commercial Security. ISI and MCS Detentionalso saw substantial growth due to an increase in the number of projectsperformed during 2008.

 

As used in this analysis,“Related Party Revenues” are revenues which are generated by work subcontractedfrom ISI*MCS (an entity owned by Sam Youngblood, President of AUSA, and by DonCarr, President of AUSA — Corrections).  Messrs. Youngblood and Carrcreated ISI*MCS in 2004 to provide bonding on contracts that required bonding.The performance of those contracts was subcontracted to ISI as a subcontractorto ISI*MCS.  The subcontracted work was for third-party customers ofISI*MCS that required bonded contracts.  After the acquisition of ISI byArgyle, ISI*MCS no longer provided bonding and subcontract work to ISI nowreferred to AUSA in 2008.  AUSA has secured its own bonding capacity andwill use that bonding capacity to directly enter into bonded contracts withthird party customers.  As a result, the amount of Related Party Revenueswill continue to decrease as the contracts with ISI*MCS, outstanding at thetime of the merger, are completed.

 

**Cost ofRevenues**

 

Priorto our acquisition of AUSA in the third quarter of 2007, we had no Cost ofRevenues. Because of the timing of the acquisition, a comparison of the ninemonths ended September 2007 versus 2008 would not be a meaningfulcomparison. As a result, we are presenting the pro forma and the adjusted proforma information below in order to provide, what we believe to be, a moremeaningful comparison of our Cost of Revenues for the nine months ended September 30,2008 to the 2007 period.

 

*AdjustedPro Forma Cost of Revenues*

* *

The following tablereconciles Adjusted Pro Forma Cost of Revenues to Pro Forma Cost of Revenuesfor the nine months ended September 30, 2008 and 2007 (in thousands):

 
| ** **                                                             | ** ** | **Adjusted Pro Forma Cost of Revenue** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **Nine Months Ended**                                 | ** ** | **Nine Months Ended**  | ** ** | **Year to Year**   | ** ** |
| ** **                                                             | ** ** | **September 30, 2008**                                | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                                             | ** ** | ** **                                                      | ** ** | **% of**                    | ** ** | ** **                   | ** ** | **% of** | ** ** | ** ** | ** ** |
| ** **                                                             | ** ** | **Amount**                                                      | ** ** | **Revenues**                     | ** ** | **Amount**                   | ** ** | **Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract  costs**                                                    |       | $                                                               | 73,415     |                             | 68.3       | %                            | $          | 45,589 |   | 62.3 | % | $ | 27,826 |   | 61.0 | % |
| **Service  and other costs, excluding amortization of intangibles**    |       | 14,025                                                          |       | 13.0                             | %          | 10,162                       |       | 13.9 | % | 3,863 |   | 0.0  38.0 | %  % |
| **Adjusted  pro forma total cost of revenues**                         |       | 87,440                                                          |       | 81.3                             | %          | 55,751                       |       | 76.2 | % | 31,689 |   | 56.8 | % |
| **Amortization  of intangibles**                                       |       | 3,784                                                           |       | 3.5                              | %          | 3,846                        |       | 5.3 | % | — |   | 0.0 | % |
| **Pro  forma cost of revenues, including amortization of intangibles** |       | $                                                               | 91,224     |                             | 84.8       | %                            | $          | 59,597 |   | 81.5 | % | $ | 31,689 |   | 53.2 | % |

 

On a pro forma basis,Cost of Revenues increased by $31.7 million, or 53.2%, to $91.2 million for thenine months ended September 30, 2008, compared to $59.5 million for thecorresponding period in 2007.  On an adjusted pro forma basis, Cost ofRevenues increased by $31.7 million, or 56.8%, to $87.4 million for the ninemonths ended September 30, 2008, compared to $55.7 million for thecorresponding period in 2007. The amortization of acquired backlog has beenallocated to the Cost of Revenues. The impact of this amortization (which wasexcluded from Adjusted Pro Forma Cost of Revenues) for the nine months ended September 30,2008 was $3.8 million. The increase in Cost of Revenues resulted from AUSAworking on a greater number of projects in 2008 than in 2007. The percentage ofCost of Revenues has increased in 2008 due primarily to numerous projects thatwere completed during the final month of the quarter.  Due to limitedresources and the inability to delay the work until the following quartermonth, the Company incurred higher travel, overtime and contracting expenses tocomplete the work. The increase in costs is also attributable to the increase inaccounting personnel required to migrate several of our subsidiaries fromprivately held companies to become integrated into a public company.  Inaddition to the reporting requirements of a public company, the growth inRevenues and corresponding increase in projects also required additionalpersonnel and the related recruiting cost.  Other increased costsassociated with a public company included legal fees, along with externalaccounting and consulting fees. Also, as mentioned above, the escalation of steelprices had a major impact on the Cost of Revenues.

 

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The hiring and trainingprocess for the critical role of project managers (“PM” or “PMs”) haddiminished significantly as management responded to the dramatic growth insales.  This resulted in a quick hiringprocess with minimal vetting to meet demand. Subsequently, newly hired PMsmanaged substantial projects with very little oversight and without followingestablished operational controls and systems. A significant factor contributing to the reduced margins at ISI and MCSwas the poor handling of several projects, including a single project at MCSthat had cost overruns of approximately $2.6 million.  However, without the effect of the singlejob, ISI has had sufficient other jobs that were/are in a net under-runposition such that ISI was expected to be in an acceptable “small-slip”condition for the year.  Also, asmentioned above, another major impact on the Cost of Revenues was theescalation of raw material prices which began to rise toward the end of thesecond quarter.

 

As mentioned above,during the later part of the quarter ended September 30, 2008, weaccelerated a plan to reduce costs and improve efficiencies. In additionto the reduction in non-personnel related costs, we have negotiated reducedsalaries for certain employees, and we unfortunately had to terminate severalemployees (some because their positions were eliminated and others because ofperformance reasons).

 

**GrossMargin**

 

 Prior to our acquisition of AUSA in the third quarter of 2007, wehad no Gross Margin. Because of the timing of the acquisition, a comparison ofthe nine months ended September 2007 versus 2008 would not be a meaningfulcomparison. As a result, we are presenting the pro forma and theadjusted pro forma information below in order to provide, what we believe tobe, a more meaningful comparison of our Gross Margin for the nine months ended September 30,2008 to the 2007 period.

 

*AdjustedPro Forma Gross Margin*

 

The following tablereconciles Adjusted Pro Forma Gross Margin to Pro Forma Gross Margin for thenine months ended September 30, 2008 and 2007 (in thousands):

 
| ** **                           | ** ** | **Adjusted Pro Forma Gross Margin** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **Nine Months Ended**                         | ** ** | **Nine Months Ended**  | ** ** | **Year to Year**   | ** ** |
| ** **                           | ** ** | **September 30, 2008**                        | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Amount**                                              | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma gross margin** |       | $                                                       | 20,082     |                             | 18.7       | %                            | $          | 17,390 |   | 23.8 | % | $ | 2,692 |   | 15.5 | % |
| **Amortization of intangibles**      |       | (3,784                                                  | )          | -3.5                             | %          | (3,846                       | )          | -5.3 | % | 62 |   | (1.6 | )% |
| **Pro forma gross margin**           |       | $                                                       | 16,298     |                             | 15.2       | %                            | $          | 13,544 |   | 18.5 | % | $ | 2,754 |   | 20.3 | % |

 

On a pro forma basis forthe nine months ended September 30, 2008, there was Gross Margin of $16.3million, compared to a Gross Margin of $13.5 million for the correspondingperiod in 2007. On an adjusted pro forma basis for the nine months ended September 30,2008, there was Gross Margin of $20.1 million compared to a Gross Margin of$17.4 million for the corresponding period in 2007. The Pro Forma Gross Marginfell from 18.5% to 15.2%, and the Adjusted Pro Forma Gross Margin fell from23.8% to 18.7%, respectively, due to Cost of Sales increases as previouslynoted in our discussion of our three months ended September 30, 2008 and2007.  The amortization of acquiredbacklog in the Cost of Sales section has been allocated to Cost of Revenues andrepresents the only difference between Pro Forma Gross Margins and Adjusted ProForma Gross Margins for the nine months ended September 30, 2008 and 2007.

 

In general, AUSA realizedGross Margin erosion primarily as a result of net job costs exceeding estimatesat MCS Detention, cost control issues at ISI (including cost overruns at asingle job), as well as increases in the cost of raw materials andsingle-source supplier cost increases at PDI. As noted previously, the majorissue causing ISI margin erosion is related to a single project that iscurrently being finished. Margin erosion in MCS largely relates to issuessimilar to those experienced by ISI. Additionally, we did not have a system inplace at MCS that prevented overselling to potential customers based on ourcapacity to perform their work.  In orderto meet customer expectations, excessive overtime and additional manpower was requiredwith tight delivery deadlines, which added unexpected costs to certainprojects.

 

Margin erosion at PDI wasattributable to various reasons, including the impact of several issuesoccurring simultaneously. One of the main issues involved inefficient jobscheduling.  When PDI provides a quotefor its customers, PDI does not typically know the schedule for when the workwill need to be performed once a quote is accepted. PDI had historically onlybeen concerned with the overall size of its backlog and not the timing forproduction and delivery.  Despite thefact that PDI had been growing, there was always excess capacity whichhistorically had never been a significant issue.  However, as the third quarter of 2008 progressed,PDI was faced with delivery demands by customers within the same time frame.

 

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**OperatingExpenses**

 

Operating Expensesincreased to $37.4 million for the nine months ended September 30, 2008,compared to $4.1 million for the corresponding period in 2007. A significantfactor contributing to these expense increases were $16.9 million in Goodwillimpairment charges, $1.0 million in legal and accounting fees and $226,000 innon-cash compensation expenses resulting from SFAS 123(R).  Absent non-cash charges, Operating Expensestypically consist of salaries and benefits for selling and administrativepersonnel, including human resources, executive, finance and legal. Theseexpenses also include fees for professional services and other administrativeexpenses, as well as amortization of intangible assets.  In addition tothe items discussed above, we saw an increase in Operating Expenses as a resultof the hiring of new personnel and purchasing of systems required to transitionformer privately held companies into becoming fully integrated businesssegments of a public reporting company. Further, as discussed above, we have implemented a significant number ofoperating cost reduction initiatives, as well as reducing headcount andcompensation to selected employees.

 

*AdjustedPro Forma Operating Expenses*

 

The following tablereconciles Adjusted Pro Forma Operating Expenses to Pro Forma OperatingExpenses for the nine months ended September 30, 2008 and 2007 (inthousands):

 
| ** **                                       | ** ** | **Adjusted Pro Forma Operating Expenses** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **Nine Months Ended**                               | ** ** | **Nine Months Ended**  | ** ** | **Year to Year**   | ** ** |
| ** **                                       | ** ** | **September 30, 2008**                              | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                       | ** ** | **Amount**                                                    | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma total operating expenses** |       | $                                                             | 36,372     |                             | 33.8       | %                            | $          | 13,520 |   | 18.5 | % | $ | 22,852 |   | 169.0 | % |
| **Amortization  of intangible assets**           |       | 1,301                                                         |       | 1.2                              | %          | 1,301                        |       | 1.8 | % | — |   | 0.0 | % |
| **Pro  forma total operating expenses**          |       | $                                                             | 37,673     |                             | 35.0       | %                            | $          | 14,821 |   | 20.3 | % | $ | 22,852 |   | 154.2 | % |

 

On a pro forma basis,Operating Expenses increased $22.9 million, or 154.2% to $37.7 million for thenine months ended September 30, 2008, from $14.8 million for thecorresponding period in 2007. On an adjusted pro forma basis, Operating Expensesincreased $22.9 million, or 154.2% to $36.4 million for the nine months ended September 30,2008, from $13.5 million for the corresponding period in 2007. A significantfactor contributing to these expense increases were Non-Cash Goodwill ImpairmentCharges and Non-Cash Compensation Expenses resulting from SFAS 123(R).  The increase is also 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. The increase in Operating Expenses is further attributable to the increase inaccounting personnel required in migrating from a privately held company to apublic company.  In addition to the reporting requirements of a publiccompany, the growth in revenue and corresponding increase in projects alsorequired additional personnel and the related recruiting cost.  Otherincreased cost associated with a public company included legal fees, along withexternal accounting and consulting fees.

 

As discussed in Note 2 tothe unaudited consolidated financial statements, $16.9 million in Non-CashGoodwill Impairment Charges were recognized in the nine months ended September 30,2008.  This increase accounted for 73.8%of the $22.9 million increase for the nine months ended September 30, 2008versus the same period in 2007. Operating Expenses excluding the Non-CashGoodwill Impairment Charges increased $6.0 million or 40.5% compared to thesame period in 2007.

 

Additionally, $1.0million in Non-Cash Compensation Expense related to restricted stock grants andemployee stock options was included in the Operating Expenses for the ninemonths ended September 30, 2008, and $0.5 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 during the quarter ended March 31,2008.  The impact of this amortization, which was excluded from pro formaoperating expenses, was $1.3 million.

 

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**OtherIncome / Expense**

 

Prior to July 2007,Total Other Income/Expense represented interest earned on the net proceeds ofour initial public offering and the private placement held in trust through thedate of the acquisition of ISI.  Interest Expense represents interest onour line 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 nine months ended September 30, 2008 was an expenseof ($2.5) million compared to income of $0.5 million for the correspondingperiod in 2007.

 

*ProForma Other Income / Expense*

 

The following tablepresents Pro Forma Interest and Other Income for the nine months ended September 30,2008 and 2007 (in thousands):

 
| ** **                        | ** ** | **Pro Forma Other Income (Expense)** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **Nine Months Ended**                          | ** ** | **Nine Months Ended**  | ** ** | **Year to Year**   | ** ** |
| ** **                        | ** ** | **September 30, 2008**                         | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Amount**                                               | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Interest income**               |       | $                                                        | 136        |                             | 0.1        | %                            | $          | 171 |   | 0.2 | % | $ | (35 | ) | (20.5 | )% |
| **Interest expense**              |       | (2,695                                                   | )          | -2.5                             | %          | (2,235                       | )          | -3.1 | % | (460 | ) | 20.6 | % |
| **Total  other income (expense)** |       | $                                                        | (2,559     | )                                | -2.4       | %                            | $          | (2,064 | ) | -2.8 | % | $ | (495 | ) | 24.0 | % |

 

Pro Forma Interest Incomefor the nine months ended September 30, 2008 mainly represents interestearned on the excess cash from the net proceeds of our preferred stockoffering.  Pro Forma Interest Expense decreased to ($2.6) million for thenine months ended September 30, 2008 from ($2.1) million for thecorresponding period in 2007.  Pro Forma Interest Expense for the ninemonths ended September 30, 2008 and 2007 mainly represents interest on ourline of credit, unsecured subordinated debt and our notes issued in January 2008for the acquisitions of Com-Tec, PDI and Fire Quest.

 

**Net Income/ (Loss)**

 

For the nine months endedSeptember 30, 2008, we had a Net Loss of ($20.1) million, compared to aNet Loss of ($15,000) for the corresponding period in 2007. The results ofoperations for the nine months ended September 30, 2008 include the resultsof operations for AUSA, Fire Quest and PDI from January 1, 2008, and theresults of operations of Com-Tec from February 1, 2008. Our only source ofincome prior to the consummation of our initial business combination with ISIwas interest earned on the funds held in the trust account. A significantimpact on the Net Loss for the 2008 period was the $17.9 million in Non-CashGoodwill Impairment Charges and the Non-Cash Compensation Charges.

 

*AdjustedPro Forma Net Income/(Loss)*

 

The following table reconcilesAdjusted Pro Forma Net Income/(Loss) to Pro Forma Net Income /(Loss) for thenine months ended September 30, 2008 and 2007 (in thousands):

 
| ** **                                | ** ** | **Pro Forma Net Income/(Loss)** | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-------------------------------------------|------------|------------------------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **Nine Months Ended**                | ** ** | **Nine Months Ended**  | ** ** | **Year to Year**   | ** ** |
| ** **                                | ** ** | **September 30, 2008**               | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                | ** ** | **Amount**                                     | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma net income (loss)** |       | $                                              | (16,982    | )                                | -15.8      | %                            | $          | 2,416 |   | 3.3 | % | $ | (19,398 | ) | (802.9 | )% |
| **Amortization of intangible assets**     |       | (5,085                                         | )          | -4.7                             | %          | (5,147                       | )          | -7.0 | % | 62 |   | (1.2 | )% |
| **Taxes, net**                            |       | 1,933                                          |       | 1.8                              | %          | 1,658                        |       | 2.3 | % | 275 |   | 16.6 | % |
| **Total  pro forma net income (loss)**    |       | $                                              | (20,134    | )                                | -18.7      | %                            | $          | (1,073 | ) | -1.5 | % | $ | (19,061 | ) | 1776.4 | % |

 

For the nine months endedSeptember 30, 2008, we had a Pro Forma Net Loss of ($20.1) million,compared to a Pro Forma Net Loss of ($1.1) million for the corresponding periodin 2007. For the nine months ended September 30, 2008, we had an AdjustedPro Forma Net Loss of ($17.0) million, compared to Adjusted Pro Forma NetIncome of $2.4 for the corresponding period in 2007. Our only source of incomeprior to the consummation of our initial business combination with AUSA wasinterest earned on the funds raised by Argyle in connection with its initialpublic offering and held in a trust account for use in a business combination.

 

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

 

 The following tablepresents Pro Forma EBITDA for the nine months ended September 30, 2008 and2007 (in thousands):

 
| ** **            | ** ** | **Pro Forma EBITDA**   | ** ** | ** **                       | ** ** | ** **                   | ** ** |
|-----------------------|------------|----------------------------------|------------|----------------------------------|------------|------------------------------|------------|
| ** **            | ** ** | **Nine Months Ended**  | ** ** | **Nine Months Ended**  | ** ** | **Year to Year**   | ** ** |
| ** **            | ** ** | **September 30, 2008** | ** ** | **September 30, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Amount**                       | ** ** | **% of  Revenues**          | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Pro  forma EBITDA** |       | $                                | (14,631    | )                                | -13.6      | %                            | $          | 4,934 |   | 6.7 | % | $ | (19,565 | ) | (396.5 | )% |
|                       |            |                                  |            |                                  |            |                              |            |  |  |  |  |  |  |  |  |  |

 

Pro Forma EBITDAdecreased by ($19.5) million to ($14.6) million in the nine months ended September 30,2008, compared to $4.9 million in the corresponding period in 2007. The EBITDAMargin decreased to -13.6% from 6.7% in the corresponding period in2007.   The September 30, 2008 EBITDA includes $1.0 million inNon-Cash Compensation Expense related to restricted stock grants and employeestock options for that period, compared to $0.5 million for the same period in2007. Additionally, the September 30, 2008 EBITDA includes $16.9 millionin Goodwill Impairment Charges compared to $0 in the same period in 2007.

 

**Liquidityand Capital Resources**

 

As of September 30,2008, we had $14.5 million in cash and cash equivalents, including $2.5 millionof restricted cash which is invested in a certificate of deposit earninginterest of 2.5% per year and $10.6 million of cash which is deposited in aninterest bearing money market account earning interest at a variable rate ofreturn. The remaining $1.4 million is deposited in several non-interest bearingoperating bank accounts.  The Companybelieves that it has enough cash available and expects to have enough incomefrom operations to operate for the next 12 months.

 

In January 2006,Argyle completed a private placement of 125,000 units to its executive officersand their affiliates and received net proceeds of approximately $0.9 million(the “Private Placement”). On January 30, 2006, Argyle consummated itsinitial public offering of 3,700,046 units (which included 75,046 units sold aspart of the underwriter’s over-allotment option) (the “Public Offering”). Eachunit in both the Private Placement and the Public Offering consisted of oneshare of common stock and one redeemable common stock purchase warrant. Eachwarrant entitles the holder to purchase from Argyle one share of Argyle’scommon stock at an exercise price of $5.50 per share.

 

Net proceeds from thesale of Argyle’s units, after deducting certain offering expenses ofapproximately $2.4 million (including underwriting discounts of approximately$1.8 million) were approximately $28.2 million. Approximately $27.3 million ofthe proceeds from our Public Offering and the Private Placement, each occurringprior to the acquisition of ISI, were placed in a trust account for Argyle’sbenefit. Except for $0.6 million in interest that was earned on the fundscontained in the trust account and that was released to Argyle to be used asworking capital, and the amounts released to Argyle for the payment of taxes,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 on July 31, 2007 tofund the ISI acquisition.

 

In connection with the PublicOffering and the Private Placement, Argyle’s officers and directors placed allthe shares owned by them before the Private Placement and the Public Offeringinto an escrow account. Except in certain circumstances, the shares held inescrow may not be released prior to January 24, 2009.  The only circumstance, other than thedate which would trigger release of shares, would be a liquidation of theCompany or the consummation of a merger, stock exchange or other similartransaction which results in all of our stockholders having the right toexchange their shares of common stock for cash, securities or other property.

 

On April 16, 2007,Argyle’s officers and directors, an affiliate of Bob Marbut, Argyle’s Chairmanand Co-Chief Executive Officer, and certain of Argyle’s consultants, pursuantto a note and warrant acquisition agreement, loaned Argyle an aggregate of $0.3million and in exchange received promissory notes in the aggregate principalamount of $0.3 million and warrants to purchase an aggregate of up to 37,500shares of Argyle’s common stock at an exercise price of $5.50 per share. Thepromissory notes were repaid in full, plus accrued interest, in August 2007.

 

On July 31, 2007,Argyle consummated a business combination, acquiring 100% of the outstandingcapital stock of ISI Detention Contracting Group, Inc. and itssubsidiaries, the value of which the Board of Directors of Argyle (the “Board”)determined was greater than 80% of Argyle’s assets at the time of the merger.Prior to the acquisition of ISI, Argyle had no operations and was considered adevelopmental stage enterprise. ISI is deemed to be a ‘‘predecessor’’ to thecombined company. The accompanying consolidated balance sheet includes theassets and liabilities related to the acquisition of ISI, adjusted to fairvalue pursuant to Statement of Financial Accounting Standards (SFAS) No. 141,*  BusinessCombinations* .

 

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Argyle used an estimated$20.5 million (excluding Argyle and AUSA transaction costs) of the net proceedsof the initial public offering to acquire ISI. At the closing of the merger,the following consideration was paid by the Company to the stockholders anddebt holders 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.

 

Additionally, Argyleincurred total transaction costs of approximately $1.7 million, including legalcosts paid to Loeb & Loeb LLP of $0.5 million, $0.6 million related tocertain Macquarie Securities (USA) Inc.’s (formerly Giuliani Capital Advisors)advisory fees and fairness opinion, $0.3 million paid in M&A fees to WFGInvestments and additional costs of $0.3 million related to accountants,consultants, printer fees and other miscellaneous expenses. Such costs do notinclude transaction costs of approximately $1.0 million incurred by ISI(related primarily to attorney, brokerage and accounting fees).

 

As part of the ISImerger, public stockholders holding 211,965 of the aggregate number of sharessold in the Public Offering elected to redeem such shares. The per-shareredemption price was equal to $7.80 per share, including interest earnedthereon in the trust account, net of taxes paid and payable, $0.6 million ofinterest income which was released from the trust account in September 2006to fund our working capital, and amounts owed to the underwriter for thePrivate Placement (approximately $0.5 million plus interest). Approximately$1.6 million was paid to redemptive shareholders in August of 2007.

 

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 accredited investors and received gross proceeds of $15.0million. Rodman & Renshaw, LLC, a wholly owned subsidiary of Rodman &Renshaw Capital Group, Inc., served as the exclusive placement agent forthe offering and received $900,000 and 112,500 warrants to purchase anaggregate of up to 112,500 shares of Argyle’s common stock; exercisable at$8.00 per share, as a placement fee.

 

 ***Working Capital***

 

Our primary liquidityneeds are for financing AUSA’s working capital (including premiums, fees andletters of credit incurred in connection with bid and performance bonds) andthe purchase of vehicles and related equipment. The nature of AUSA’s businessand operations as a detention contractor causes cash flow from operations to behighly volatile. AUSA’s large construction contracts can produce or consumecash. The production or consumption of cash is dependent on factors inherent tothe construction industry, including billing and payment terms of thecontracts. Following the closing of a new loan facility on October 3, 2008(as more specifically described below under the section below entitled “SubsequentEvents”), AUSA has in place a $25.0 million credit facility to allow it tomanage its working capital and project bonding requirements, subject toborrowing capacity based on certain financial covenants.

 

At September 30,2008, we had current assets of $63.8 million and current liabilities of $28.9million resulting in a working capital surplus of approximately $34.9 million,compared to a surplus of $20.0 million at December 31, 2007.

 

***Long-Term Debt***

 

Notes payable andLong-Term Debt consist of the following (in thousands):

 
| ** **                                 | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **Collateral**                             | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| Notes payable:                             |       |                   |       |                  |       |
| Vehicles and  equipment                    |       | $                      | 144        |                  | $          | 190 |   |
| Unsecured debt -  related party            |       | 11,279                 |       | 5,952                 |       |
| Unsecured  convertible debt - stockholders |       | 1,925                  |       | 1,925                 |       |
| Seller notes                               |       | 6,549                  |       | —                |       |
| Line of credit and  acquisition line       |       | 13,114                 |       | 7,979                 |       |
|                                       |       | $                      | 33,011     |                  | $          | 16,046 |   |
| Less - current  maturities                 |       | 2,656                  |       | 81                    |       |
| Long term debt                             |       | $                      | 30,355     |                  | $          | 15,965 |   |

 

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***Vehicles and Equipment***

 

Amounts attributed tovehicles and equipment in the above table include notes in favor of The FrostNational Bank related to AUSA’s vehicles and various equipment lines. Vehicleand equipment notes are staggered with regard to their maturities, eachamortizing over 36 – 48 month periods.  Interest rates on theindividual notes range from a fixed rate of 6% up to prime plus 1.0%. Theweighted average interest rate for these borrowings was 8.4% and 8.2% at September 30,2008 and December 31, 2007, respectively. Argyle has agreed to guarantythe obligations of AUSA under the notes up to $1 million.

 

***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 at December 31, 2007. All notes are unsecured and subordinated to the line of credit facility. Theunsecured note agreements contain prepayment options with prepayment penalties.Interest accrues at 11.58% per annum and is payable quarterly in arrears,deferred interest at the rate of 8.42% per annum, and default interest of anadditional 2% per annum. The total debt of $11.0 million plus accrued andunpaid interest is due and payable in one single payment on January 31,2010. Argyle has agreed to guaranty the payment of up to $5 million of theoutstanding unsecured debt. There are both financial and restrictive covenantsassociated with the note agreements.  As of September 30, 2008, theCompany was in compliance with all covenants.

 

On September 30, 2008,Argyle provided an unsecured, subordinated loan of $2 million to AUSA. The termof the loan was one month with the payment of all outstanding principal andaccrued and unpaid interest due on October 31, 2008. The rate of interest was6% per annum. The loan was repaid in full upon the closing of the senior creditfacility on October 3, 2008 (See the section entitled “Subsequent Events”).

 

***Unsecured Convertible Debt — Stockholders***

 

As part of the mergerconsideration paid to acquire ISI, the Company issued unsecured convertibledebt to the stockholders in the amount of $1.9 million, which bears interest at5% per annum, paid semiannually. The notes mature five years from the date ofissuance on July 31, 2012. The notes may be converted in whole or in partinto shares of the Company’s common stock at the election of the note holder ata share price of $10.00 any time after January 1, 2008. The debt may beredeemed by the Company at $10.00 per share any time after January 1,2009.

 

In April 2007,Argyle’s officers and directors, an affiliate of Argyle’s Chairman and Co-ChiefExecutive Officer, and certain of Argyle’s consultants, pursuant to a note andwarrant acquisition agreement, loaned Argyle an aggregate of $300,000 and inexchange received promissory notes in the aggregate principal amount of$300,000 and warrants to purchase an aggregate of up to 37,500 shares of Argyle’scommon stock. The warrants are exercisable at $5.50 per share of common stockand expire on January 24, 2011. The warrants also may be exercised on anet-share basis by the holders of the warrants. The Company has estimated,based upon a Black-Scholes model, that the fair value of the warrants on thedate of issue was approximately $2.48 per warrant (a total value ofapproximately $93,000, using an expected life of two years, volatility of 2.39%and a risk-free rate of 5%). However, because the Company’s warrants have alimited trading history, the volatility assumption was based on informationthen available to management. The promissory notes had an interest at a rate of4% per year and were repayable 30 days after the consummation of a businesscombination. The notes and the associated accrued interest were paid in full inAugust 2007.

 

***Seller Notes***

 

In connection with the Fire Quest acquisition, the Company issued apromissory note in the aggregate principal amount of $250,000 (the “Fire QuestPromissory Note”). The Fire Quest Promissory Note is guaranteed by and securedby the assets of AUSA and Argyle Security, Inc bears interest at the rateof 7.25% per year and will become due and payable on January 1, 2009.  The Company has agreed to pay quarterlypayments of accrued and unpaid interest of $4,531.25 until the maturity dateand a final payment on the maturity date equal to the unpaid principal amounttogether with any then unpaid and accrued interest and other amounts payablethereunder.

 

In connection with thePDI acquisition, the Company issued convertible promissory notes (the “PDIPromissory Notes”) in the aggregate principal amount of $3.0 million. Theaggregate principal amount of the PDI Promissory Notes may be reduced dependingon the occurrence of certain events described in the Asset Purchase Agreement.The payment of the PDI Promissory Notes is guaranteed by and secured by theassets of AUSA and they bear interest at 6% paid quarterly through December 2009. After December 2009, principal and interest payments of $133,000 are duemonthly with final payment occurring on December 31, 2012.  From June 1,2009 through November 15, 2009, the Company has the option to (i) convert$500,000 of the outstanding principal into common stock of the Company based on95% of the closing price of the Company’s common stock for a 20 day tradingperiod preceding notice of the Company’s intent to convert; or (ii) extendthe $500,000 principal due in 2010 to January 3, 2011 for an additionalpayment of $15,000 plus accrued interest.  The aforementioned options toconvert or extend the PDI Promissory Notes resulted in the creation of compoundembedded derivatives for which the Company has performed valuations as of September 30,2008.  The Company will mark to market the derivatives, for which anychanges in fair value will be recognized in the statement of operations, in allthe subsequent quarters until they are exercised or have expired.  Thevaluation of these derivatives held a value of $20,000 as of September 30,2008.

 

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In connection with the Com-Tec acquisition, the Company issued asecured subordinated promissory note in the aggregate principal amount of $3.5million (the “Com-Tec Promissory Note”). The Com-Tec Promissory Note isguaranteed by and secured by the assets of AUSA and Argyle Security, Inc.,bears interest at 7% per year and have a maturity date of April 1,2011.  Interest only payments were madefor each three-month period beginning on May 2008 and August 2008;  a single principal payment of $100,000 is dueand payable on December 15, 2008; and level principal and interestpayments in the cumulative amount of $128,058 are due monthly beginning on August 1,2008 and continuing monthly thereafter on the first day of each month forconsecutive months through December 2008 then level principal and interestpayments in the cumulative amount of $123,748 due monthly beginning on January 1,2009 and continuing monthly thereafter on the first day of each month through December 2008,then for 25 consecutive months until the maturity date.

 

Collectively, the FireQuest Promissory Note, the PDI Promissory Notes and the Com-Tec Promissory Noteare hereinafter collectively referred to as the “Seller Notes”.

 

***Line of Credit Facility***

 

At September 30,2008, 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 September 30, 2008 was $8.9 million, due January 23,2010, and $4.2 million, with quarterly payments of $250,000 and the remainingbalance due June 30, 2011, respectively.  Interest is payablequarterly at prime plus 0.75% for the 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 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 September 30,2008, the Company was in compliance with all covenants.

 

The Company has agreed topay an annual commitment fee of 0.5% per year on the unused borrowing capacity,which was $3.2 million and $1.0 million at September 30, 2008 and December 31,2007, respectively.

 

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

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2008 (remaining  three months)              |       | $          | 682        |   |
| 2009                                        |       | 2,528      |       |
| 2010                                        |       | 25,866     |       |
| 2011                                        |       | 3,935      |       |
| 2012                                        |       | —     |       |
| Thereafter                                  |       | —     |       |
|                                        |       | $          | 33,011     |   |

 

Assummarized below under the section entitled “Subsequent Events”, AUSA enteredinto a new loan facility on October 3, 2008. On November 12,2008, AUSA was indebted for $10.0 million in term debt and $8.0 million througha revolving line of credit.  As a resultof the repayment terms under the new credit facility, the short-term portion ofthe scheduled debt has increased from $2.3 million to $3.7 million.

 

***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. AUSA entered into a third lease on another property owned by the samepartnership in June 2008.  All three leases are triple net leases. Atriple net lease is a lease agreement on a property by where the tenant orlessee agrees to pay all real estate taxes, building insurance and maintenance(the three ‘Nets’) on the property in addition to any normal fees that areexpected under the agreement (rent, etc.). In such a lease, the tenant orlessee is responsible for all costs associated with repairs or replacement ofthe structural building elements 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.

 

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***Commitments***

 

AUSA leases office spaceand equipment under operating leases expiring through 2012.   Thecorporate office lease space of Argyle expired as of July 31, 2007, andArgyle operated under a month-to-month lease arrangement until it was renewedin January 2008.  The new lease expands the space from approximately2,500 square feet to 5,500 square feet for a total expense in 2008 of $121,000.

 

Aspart of the acquisition of PDI on January 4, 2008, AUSA assumed PDI’sexisting leases in California and Arizona. On September 5, 2008, AUSA entered into a lease relating toapproximately 29,709 square feet of property located at 577 and 583 NorthBatavia Street, Orange, California. The term of the new lease is for two yearscommencing September 1, 2008 and ending August 31, 2010. Theaggregate monthly base rent is $16,934.    In connectionwith the lease, on September 5, 2008, Argyle entered into a guarantypursuant to which Argyle has agreed to guaranty the payment and performanceobligations of AUSA under the lease. The PDI lease in Arizona is a fouryear lease. The three facilities occupy a total of 55,709 square feet (26,000square foot facility in Arizona and the 29,709 square foot facilities inCalifornia) with aggregate monthly payments of $32,934.

 

Aspart of the Com-Tec acquisition that occurred at January 31, 2008, theCompany signed a new lease for the existing facility.  The Com-Tec leaseis a five year lease, for the 33,000 square foot facility, with aggregatemonthly payments of $14,000 beginning in year three with the total rent expensebeing recognized on a straight-line basis over the life of the lease.

 

Rental expense was$298,000 and $17,000 for the three months ended September 30, 2008 and2007, respectively, and $838,000 and $50,000 for the nine months ended September 30,2008 and 2007, respectively.  Rental expense was $103,000 and $266,000 forthe three and nine months ended September 30, 2007 (Predecessor),respectively.

 

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.

 

In May 2008, theCompany entered into a letter of credit facility with a financial institution.The letter of credit may not exceed $2.5 million. The facility does not have afee on the unused portion of the letter of credit facility.

 

**OffBalance Sheet Arrangements**

 

Argyle does not have anyoff-balance sheet arrangements.

 

**ContractualObligations**

 

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

 
| ** **                               | ** ** | **Total** | ** ** | **< 1 Year** | ** ** | **1 < 3 Years** | ** ** | **3 < 5 Years** | ** ** | **> 5 Years** | ** ** |
|------------------------------------------|------------|-----------|------------|---------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|----------------------------|------------|
| Principal on  Long Term Debt Obligations |       | $         | 33,011     |                      | $          | 682                               |       | $                                 | 28,394     |                       | $          | 3,935 |   | $ | — |   |
| Capital Lease  Obligations               |       | 5,433     |       | 123                       |       | 986                               |       | 986                               |       | 3,338                      |       |
| Operating Lease  Obligations             |       | 2,675     |       | 283                       |       | 1,195                             |       | 997                               |       | 200                        |       |
| Interest on Long  Term Debt Obligations  |       | 7,765     |       | 3,037                     |       | 3,855                             |       | 873                               |       | —                     |       |
| **Total**                                | ** ** | **$**     | **48,884** | ** **                | **$**      | **4,125**                         | ** ** | **$**                             | **34,430** | ** **                 | **$**      | **6,791** | ** ** | **$** | **3,538** | ** ** |

 

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**Subsequent Events**

 

On October 3, 2008,AUSA entered into a loan agreement providing for (i) a secured revolvingline of credit in the maximum amount of $10.0 million with a $5.0 millionsublimit for the issuance of letters of credit, (ii) a secured revolvingline of credit in the maximum amount of $5.0 million, to be used solely for theissuance of letters of credit and (iii) a term loan in the maximum amountof $10.0 million (collectively, the “Loans”). The Loans have a three-year maturity and, upon closing, the proceedswere used to pay off existing indebtedness, with the remaining availability tobe used for working capital and other general corporate purposes. The Loanswill be secured by liens on and security interests in the personal property ofAUSA and guaranteed by the subsidiaries of AUSA. The Company is not a guarantorto the Loans.

 

The interest rates of theLoans are, at the AUSA’s option from time to time, (i) a floating perannum rate of interest equal to the prime rate plus the Applicable Margin, or (ii) theLIBOR Rate plus the Applicable Margin. The “Applicable Margin” means the rateper annum added to the prime rate and LIBOR as determined by the ratio of totaldebt to EBITDA of AUSA for the prior fiscal quarter. The intercompany loan,with a principal amount of $2.0 million advanced on September 30, 2008,was repaid in full upon the closing of the Loans with the Bank on October 3,2008.

 

In connection with theLoans, the holders of each Seller Note agreed to be subordinated to the lenderwith respect to payment and perfection. In addition, the maturity dates of eachSeller Note was effectively extended to be no earlier than the date on whichall of the outstanding obligations of AUSA to repay the outstanding principaland accrued and unpaid interest relating to the Loans are satisfied.

 

The agreement containsboth financial and restrictive covenants, including a restriction on thepayment of dividends by AUSA.

 

Under the terms of thenew credit facility, as of October 3, 2008, the Company is indebted for$10 million in term debt and $7.0 million through the line of credit.  As a result of the repayment terms under thenew credit facility, the short term portion of the scheduled debt has increasedfrom $2.3 million to $3.7 million.

 

On October 28, 2008,the Board approved the Company’s providing guarantees as an alternative tobonding, in an aggregate amount of up to $15.0 million, in order to allow AUSAthe ability to bid projects until the next meeting of the Board in December 2008.In order for guarantees to be provided beyond the next meeting of the Board,AUSA management was requested to provide information on the amount of aguarantee that AUSA would need from Argyle for an ongoing basis and the mannerin which the guarantees would be tracked and released.

 

As a result of a reviewof anticipated capital expenditures for the remainder of the 2008 fiscal year,on November 12, 2008, the Company discovered that it was in excess of thelimit of $2.5 million provided for in its loan agreement with its subordinateddebt lender and accordingly on November 12, 2008, the Company requestedand received a waiver to increase the limit to $3 million in exchange for a$25,000 fee.

 

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**ITEM3. QUANTITATIVE AND QUALITATIVE DISCLSOURES ABOUT MARKET RISK**

 

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

 

At September 30,2008, 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. Theoutstanding balance on the credit facility and the acquisition loan facility atSeptember 30, 2008 was $8.9 million, due January 23, 2010, and $4.3million, due June 30, 2011, respectively.  Interest is payablequarterly at prime plus 0.75% for the 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 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 interest rates of theloans in connection with the new senior credit facility entered into on October 3,2008 are, at the AUSA’s option from time to time, (i) a floating per annumrate of interest equal to the prime rate plus the Applicable Margin, or (ii) theLIBOR Rate plus the rate per annum added to the prime rate and LIBOR asdetermined by the ratio of total debt to EBITDA of AUSA for the prior fiscalquarter, as set forth in the Loan Agreement.

 

Changes in market ratesmay impact the bank’s LIBOR rate or prime rate. For instance, if either theLIBOR or prime rate were to increase or decrease by one percentage point (1.0%),our annual interest expense would change by approximately $160,000, based onthe total credit available to Argyle.

 

**ITEM4T. CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

An evaluation of theeffectiveness of our disclosure controls and procedures as of September 30,2008 was made under the supervision and with the participation of our co-ChiefExecutive Officers, Chief Financial Officer and Corporate Controller. Argyle’sdisclosure controls and procedures are designed to ensure that informationrequired to be disclosed by us in reports that we file or submit under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

 

During the third quarterof 2008, management identified certain significant deficiencies in internalcontrols related to revenue recognition, which we concluded aggregated to thelevel of a material weakness. Based upon the evaluation of our disclosurecontrols, and in light of the significant deficiencies and material weakness inour disclosure controls over financial reporting described below, managementhas concluded that the Company’s controls and procedures were not effective asof September 30, 2008. Disclosure controls and procedures are designed toensure that information required to be disclosed by us in reports that we fileor submit under the Exchange Act are recorded, processed, summarized andreported in accordance with generally accepted accounting principles and withinthe time periods specified in the U.S. Securities and Exchange Commission’s rules andforms.

 

A material weakness is adeficiency, or a combination of deficiencies, in internal control overfinancial reporting, such that there is a reasonable possibility that amaterial misstatement of the company’s annual or interim financial statementswill not be prevented or detected on a timely basis. A significant deficiencyis a control deficiency, or a combination of control deficiencies, in internalcontrol over financial reporting that is less severe than a material weakness;yet an important enough deficiency to merit attention by those responsible foroversight of the Company’s financial reporting.

 

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During the preparation ofthe Company’s financial statements for the quarter ended September 30,2008, management had concluded that certain oversight of systems at ISI and MCSDetention, such as a review of project cost estimates and work-in-process (“WIP”)reporting, was ineffective. As a result of the review by management, it wasconcluded that certain entries into accounting software were not verified priorto final financial reports being presented to management, and adjustments tosuch entries were not made in a timely manner when changes occurred.  In addition, management discovered a lack ofoversight of invoice management and revenue recognition controls at PDI.However, compensatory manual controls, such as performing physical inventoryreviews at PDI, have addressed the ongoing risks to date and management deemsthe amount of the overstatement of revenues to be immaterial.

 

This deficiency alsoextends to cost-to-complete revenue recognition for projects, which are heavilyreliant on manual processes. Two separate instances occurred which resulted inerrors in the calculation of Contract Revenue.  The first error resultedfrom an erroneous entry posted in the AUSA accounting system when a new projectwas being added.  The error was the recording of the estimated cost of aproject without consideration of an expected deductive change order.  Uponreceipt of the anticipated change order, the estimated cost was adjusted againfor the same deductive change order.  As a result of the estimated costbeing understated, the revenues recognized based on the cost to cost percentageof completion method were overstated for the period.

 

The second error was theresult of an accounting software issue which did not have a compensatingcontrol in place at the time. The error occurred when the contract value for aproject in the AUSA final cost-to-complete report was automatically reset to anearlier contract value when there was an adjustment to the schedule of valuesrelated to the project. The error resulted in the reported contract valueexceeding the actual contract value of the project.  At the time, there was no process in place formanually checking the contract values after being entered into the accountingsoftware system to ensure that the contract values reflected in the finalcost-to-complete reports are accurate.

 

In addition to staffingand procedural issues, factors contributing to this control deficiency were poorrecord keeping and lack of communication of the occurrence of changes tocertain project details. Due to the number of occurrences whereby managementidentified deficiencies in its internal controls and procedures in its reviewfor the period ended September 30, 2008, there remains a reasonablepossibility that a material misstatement of the interim and annual financialstatements would not have been prevented or detected. The Company has concludedthat controls to ensure that Revenues were appropriately recognized inaccordance with generally accepted accounting principles were not effective.

 

A system of internalcontrols over financial reporting can provide only reasonable, not absolute,assurance that the control system’s objectives will be met. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, have been detected. Over time, controls may become inadequate because ofchanges in conditions or deterioration in the degree of compliance withpolicies or procedures. Because of inherent limitations in a cost-effectivecontrol system, misstatements due to error or fraud may occur and not bedetected.

 

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**Changesin Internal Control over Financial Reporting**

 

Since the most recentlycompleted fiscal quarter, there have been a number of significant changes madein our internal control over financial reporting that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting. Management, with oversight from the Company’sAudit Committee, is working to address the material weakness disclosedabove and is committed to remediate the material weakness as soon as possible.Management is in the process of implementing its remediation plan for thesignificant deficiencies and material weakness indentified above, including thehiring of outside specialists in internal control systems, making personnelchanges, implementing additional oversight and implementing approval processesto determine that the updating of expenses are accurate. Specifically, the followinghas been implemented:

 
| · |   | Hiring of a new and reassignment of existing, more  qualified and experienced personnel to perform the month-end review and  closing processes, as well as to provide additional oversight and supervision  within the accounting departments of AUSA and the business units.                                                               |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | A number of new internal control processes have been  developed related to revenue recognition and cost of sales and such processes  are currently being implemented.                                                                                                                                                                       |
| · |   | New personnel have been appointed to take direct  operational control of ISI and MCS to effectively manage the respective teams  and implement the needed controls.                                                                                                                                                                         |
| · |   | The hiring methodology was improved to include a  consensus of input on candidates from experienced managers and rigorous  reference checking.                                                                                                                                                                                              |
| · |   | A detailed cost-to-complete summary is now generated  by project managers and then reviewed and approved monthly by the business  unit President and subject to review in a monthly operations review meeting  that is attended by the executive management of Argyle.                                                                      |
| · |   | A formalized interdepartmental WIP review has been  implemented to concentrate on the WIP with emphasis on gross margin  percentages, under-billings and any projects with potential over-runs or  challenges.                                                                                                                              |
| · |   | Monthly sales and forecast meetings have been  initiated with the participation of the business unit managers, the executive  management of AUSA and executive management of Argyle with the goal of  reporting to analyzing ongoing projects.                                                                                              |
| · |   | With respect to specifically addressing the material  weakness in our controls for revenue recognition, we are implementing systems  to improve the communications and workflow by which transactions are  evaluated for revenue recognition as well as the process for entering the  transactions in the Company’s accounting system. |
| · |   | Monthly operational review meetings have been  initiated with the participation of the business unit managers, the executive  management of AUSA and executive management of Argyle with the goal of  reporting and analyzing variances in all aspects of the Company’s operations.                                                    |
| · |   | A Sarbanes-Oxley Compliance Manager has been hired  to help establish, implement and then monitor the internal controls and  procedures at AUSA and all of its business units.                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                        |

In addition, an enhancedplanning and reporting process is being installed that includes monthly flashreports, a monthly key performance indicator analysis, a detailed man-loadingscheduling, a change-order tracking system, a monthly job expense review, adetailed accounts receivable reserve review and a purchase reporting system toidentify cost overruns.

 

Management believes that ourimplementation of changes to controls will remedy the existing significantdeficiencies and the material weakness and they will continue to evaluate theeffectiveness of these changes. Management believes these new procedures, whenfully implemented, will be effective in remediating the material weakness andsignificant deficiencies that were identified. However, the Company’s materialweakness and significant deficiencies will not be considered remediated untilthe new internal controls have been operational for a period of time, aretested and management concludes that these controls are operating effectively.

 

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**PART II - OTHER INFORMATION**

 

**ITEM1. LEGAL PROCEEDINGS**

 

From time to time, theCompany has various lawsuits, claims, and contingent liabilities arising fromthe conduct of its business; however, in the opinion of management, other thanspecifically mentioned below, they are not expected to have a material adverseeffect on the combined results of operations, cash flows, or financial positionof the Company.

 

On April 21, 2008,Metroplex Control Systems, Inc. (“MCS”) made claims in the United StatesDistrict Court for the District of Colorado for Breach of Contract and BadFaith insurance practices against Travelers and Richard E. Gash ElectricCompany (“Gash”) arising out of a Payment Bond, Bond No. 104612565 wherebythe penal sum of the Bond is $5,998,488.00 (the “Bond”), issued by Travelers assurety on behalf of Gash as principal in relation to the design andconstruction of the access control point at the Pueblo Chemical Depot inPueblo, Colorado (the “Project”). The total loss incurred by MCS as a result ofnon-payment was approximately $950,000. On September 26, 2008, the Partiesentered into a Settlement Agreement in order to provide for payment in fullsettlement and discharge of all claims against Travelers in any way relating tothe Bond and/or Civil Action and for the assignment of claims and judgmentswhich MCS has in regard to Gash’s performance on the Project (the “Settlement”).Travelers paid to MCS a settlement payment of Six Hundred Forty-Three ThousandSix Hundred Fifty-Four Dollars and Twenty Cents ($643,654.20). As a result ofthe Settlement, MCS accounted for an uncollected receivable of $238,837.33.

 

 **ITEM 1A. RISK FACTORS**

 

In addition to the otherinformation set forth in this report, you should carefully consider the factorsdiscussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2007, which could materially affect ourbusiness, financial condition or future results. The risks described in ourAnnual Report on Form 10-K are not the only risks facing our Company.Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.  In addition tothe risk factors contained in our Annual Report on form 10-K, you should alsoconsider the following:

 

***Our significantdebt could adversely affect our financial health and pose challenges forconducting our business.***

 

AUSA has and willcontinue to have a significant amount of debt and other obligations, primarilyto support our customer financing activities. As of September 30, 2008, wehad $36.6 million of total debt. Our total Cash and Cash Equivalents was $14.5million at September 30, 2008. Our substantial debt and other obligationscould have important consequences. For example, it could (i) increase ourvulnerability to general adverse economic and industry conditions; (ii) limitour ability to obtain additional financing for future working capital, capitalexpenditures, acquisitions and other general corporate requirements; (iii) increaseour vulnerability to interest rate fluctuations because a portion of our debthas variable interest rates; (iv) require us to dedicate a substantialportion of our cash flows from operations to service debt and other obligationsthereby reducing the availability of our cash flows from operations for otherpurposes; (v) limit our flexibility in planning for, or reacting to,changes in our business and the industry in which we operate; and (vi) placeus at a competitive disadvantage compared to our competitors that have lessdebt. If new debt is added to our current debt levels such as the incurrence ofdebt to partially fund acquisitions, these related risks could increase.

 

***Based on current trends in our business, in the near future,we may violate certain debt-to-EBITDA ratio requirements, capital expenditurelimits and fixed charge coverage ratio requirements set forth in the financialcovenants related to the AUSA senior and subordinated debt facilities.***

 

AUSA’s ability to comply with the financial and othercovenants contained in its senior and subordinated debt facilities may beaffected by our own operating performance changes in economic or businessconditions or other events beyond our control. If we do not comply with thesecovenants and restrictions, we could be in default and the debt, together withaccrued interest, could be declared immediately payable. If we are unable torepay any borrowings when due, the lenders could proceed to take action tosatisfy the obligations by taking possession of their collateral, whichincludes most of AUSA’s assets. If any of our debt is accelerated, we may nothave sufficient assets to repay amounts due. The senior debt facility enteredinto by AUSA contains covenants that require we maintain certain total andsenior debt to EBITDA and fixed charge coverage ratios. Based on the currentprojected calculations of EBITDA and considering the factors causing thelower-than-anticipated EBITDA calculation during the third quarter of 2008, itis possible that AUSA may violate the financial covenants in its senior debtfacility at some point in the future. As a result of a review of anticipatedcapital expenditures for the remainder of the 2008 fiscal year, on November 12,2008, we discovered that we were in excess of the limit of $2.5 millionprovided for in our loan agreement with our subordinated debt lender andaccordingly on November 12, 2008, we requested and received a waiver toincrease the limit to $3 million. There can be no assurance that we will beable to obtain waivers in the future in the event another violation occurs.

 

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***Itmay become necessary for us to take an additional non-cash amortization chargeas a result of the conclusion of our tests for an impairment of goodwill.***

 

In accordance with the *Statement of Financial Accounting Standards 142 (SFAS142),”Goodwill and Other Intangible Assets”* goodwill is no longeramortized, but is instead tested for impairment annually using a “goodwillimpairment test”. Under the impairment test, the recorded shareholders’ equityof the Company is compared to its market capitalization. If the marketcapitalization of the Company is less than its shareholders’ equity, theCompany could be required to take a non-cash amortization charge of up to the fullamount of its current goodwill. As a result of recent volatility in thequotation price of our common stock, our market capitalization has become lessthan our shareholder equity.  We haveperformed the first step of the test for impairment and concluded that agoodwill impairment loss is probable.  Weestimate that, based on our initial impairment testing, we have taken anon-cash impairment charge of approximately $16.9 million. Because of thetiming of the discovery of the impairment, we have not performed the secondstep of the goodwill impairment test and note the above amount may change uponthe completion of our testing.  Any adjustment to the estimated loss basedon the completion of the measurement of the impairment loss will be recognized inthe financial statements for the fourth quarter and fiscal year ended December 31,2008 and such amount may be greater than the initial amount of $16.9 million.

*** ***

***Our ability to obtain payment and/or performance bonds iscritical to our ability to conduct business.***

 

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

 

We believe that we havesufficient bonding capacity to address the total expected business for theremainder of 2008 and 2009. However, there can be no assurance that suchbonding capacity will be increased or whether it will always be available. Ifwe are unable to secure bonding, then we may not be able to enter intocontracts that require such bonds. This would significantly reduce our expectedsales and reduce the level of our future financial performance. Some of theadditional factors that might cause us to be unable to obtain such bondsinclude, but are not limited to, unacceptably high premium rates for suchbonds, the unavailability of bonding capacity at an acceptable cost from abonding company with an acceptable financial rating, or the collateral/financialrequirements of the bonding company. Such requirements are generally intendedto provide liquidity to a bonding company should it become obligated to pay aclaim. These requirements can include minimum cash reserves, letters of creditfor the benefit of the bonding company and other irrevocable commitments ofworking capital that are unacceptably high.

*** ***

***Budgetary pressure on federal, state,county and local governments may result in contract cancellation or ratechanges by prison operators, which would reduce our profitability.***

 

Our cash flow issubject to the receipt of sufficient funding of and timely payment bycontracting governmental entities. If the appropriate governmental agency doesnot receive sufficient appropriations to cover its contractual obligations, acontract may be terminated or the amounts payable to us may be deferred orreduced.

 

Federal, state, countyand local governments have encountered, and are expected to continue toencounter, significant budgetary constraints that may result in a reduction ofspending on the outsourced services that we provide. Such budgetary limitationsmay cause the contractual commitments for new construction projects to bedelayed, reduced or even eliminated. Many states, as wellas the federal government, are facing significant budget deficits and are underpressure to reduce current levels of spending or control additional spending.As a result of this increased budgetary pressure, prison operators haverecently granted a few of their customers relief from formulaic-increaseprovisions in their agreements, and some of their customers attempted to reducecontract values. Contractual rate increases are generally intended to offsetincreases in expenses and inflation. To the extent rates are not increased or arereduced for the prison operators,(*this a little unclear tome; could you clarify the introductory phrase?)* our profitabilitywill be adversely affected.  Examples of this budget pressure include theneed of the federal government to operate under a continuing resolution as aresult of its failure to pass a new 2008/2009 year budget and reported budgetpressures in various states, including Georgia and California.

 

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***We derive a significant portion of our revenues from a smallnumber of customers, and the loss of a significant customer could significantlyreduce our revenues.***

 

Our customer base andrevenues are concentrated among a limited number of customers, and the loss ofany one of these customers could significantly reduce our revenues. During the three and nine months ended September 30, 2008, Revenues fromour top three customers, which were all from the Argyle Corrections businesssegment, represented 17% and 30%, respectively, of our Total Revenues. During the three months ended September 30, 2008, we had Revenues from ourtop two customers, which were all from Argyle Corrections, which eachrepresented 6% of our total revenues.  During the nine months ended September 30,2008, we had revenues from our top two customers, which were all from ArgyleCorrections, which each represented 11% of our total revenues.  Theseconcentrations are down from the three months and six ended June 30, 2008,when the top three customers represented 33% of our Total Revenues.  Recently, management changes at one of ourlargest customers have effectively resulted in our losing much of ourexclusivity to provide certain design and build work for the customer.  We believe that there is a likelihood thatcertain future proposals by Argyle Corrections will not be accepted, that mayhave been accepted in the past. Although we have not lost the customer and webelieve that we have existing relationships and technological advantages thatcould result in our proposals being more attractive, there is no guarantee thatwe will be awarded such contracts in the future.

 

***If outstanding public warrants are exercised, the underlyingcommon shares will be eligible for future resale in the public market. ‘‘Marketoverhang’’ from the warrants results in dilution and could keep the marketprice of our stock lower than it would otherwise be.***

 

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

 

***Inabilityto effectively implement our strategy to more efficiently and effectivelyimplement our plan to reduce operating costs may have a significant impact onour cash flow.***

 

During the last severalmonths we have made significant systematic and personnel changes in order tomanage project cost increases as well as our operational expenses. We haveemployed new individuals or reassigned other individuals to implement ourplans.  Achievement of our goals tomanage costs is not assured. In the event that we do not effectively implementour plans, AUSA may see a decrease in its cash flow and we may continue to havefurther margin erosion and decline in EBITDA.

 

***Inabilityto effectively implement changes to our internal controls over our financialreporting systems to remedy existing and eliminate future significantdeficiencies and material weaknesses may have a significant impact on ourbusiness.***

 

During the last severalmonths we have made significant systematic changes in order to attempt toremedy certain organizational and financial reporting deficiencies which haveled to our discovery of significant deficiencies and a material weakness in ourinternal controls. We have employed new individuals or reassigned otherindividuals to handle the implementation of our plans.  In the event that our control system changesare not effective, we may be subject to increased scrutiny by our independentpublic accounting firm and our Board of Directors. Further, in the event thatour financial statements or business model are deemed unreliable as a result ofsignificant deficiencies or material weaknesses in our internal controls forfinancial reporting, we may become in default of our loan obligations, may notbe able to attract new investors and the price of our securities on the OTCBulletin Board may decrease.

 

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***The volatility and disruption of the capital and creditmarkets and adverse changes in the economy may negatively impact our ability toaccess financing, and to generate revenues and earnings.***

 

The capital andcredit markets have been experiencing extreme volatility and disruption formore than 12 months.  In the third and fourth quarters of 2008, suchvolatility and disruption have reached unprecedented levels.  The marketshave exerted downward pressure on availability of liquidity and credit capacityfor many issuers, including us.

 

While we intend tofinance our operations with existing cash, cash flow from operations andborrowing under our existing senior credit facility, we may require additionalfinancing to support our continued growth.  However, due to the existinguncertainty in the capital and credit markets, access to capital may be limitedon terms acceptable to us, or unavailable.  Our customers may also comeunder greater budgetary pressure as a result of economic and financial marketconditions, which could negatively impact our revenues and earnings.

 

**ITEM2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

None.

 

**ITEM3. DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**ITEM4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None.

 

**ITEM5. OTHER INFORMATION**

 

None.

 

**ITEM6. EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                       |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                 |       | Fifth Amendment and  Waiver to Note and Warrant Purchase Agreement dated November 13, 2008 by and  among ISI and William Blair Mezzanine Capital Fund III, L.P., filed herewith.      |
|                 |       |                                                                                                                                                                                  |
| 14.1                 |       | Code of Business  Conduct                                                                                                                                                             |
|                 |       |                                                                                                                                                                                  |
| 31.1                 |       | Certification of the  Co-Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a-14(a) of  the Securities Exchange Act, as amended                       |
|                 |       |                                                                                                                                                                                  |
| 31.2                 |       | Certification of the  Co-Chief Executive Officer (Principal Executive Officer) pursuant to  Rule 13a-14(a) of the Securities Exchange Act, as amended                       |
|                 |       |                                                                                                                                                                                  |
| 31.3                 |       | Certification of the  Chief Financial Officer (Principal Financial Officer) pursuant to  Rule 13a-14(a) of the Securities Exchange Act, as amended                          |
|                 |       |                                                                                                                                                                                  |
| 31.4                 |       | Certification of the  Vice President and Corporate Controller (Principal Accounting Officer)  pursuant to Rule 13a-14(a) of the Securities Exchange Act, as  amended        |
|                 |       |                                                                                                                                                                                  |
| 32.1                 |       | Certification of the  Co-Chief Executive Officers and Chief Financial Officer pursuant to 18 U.S.C.  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002 |
|                 |       |                                                                                                                                                                                  |
| 99.1                 |       | Press Release dated  November 14, 2008 announcing Argyle Security Inc.’s Third Quarter 2008  financial results.                                                             |

 

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**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 

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

 

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