UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q


(Mark
One)





x
            QUARTERLY REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934





For
the quarterly period ended September 30, 2010





OR





 ̈
            TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
      OF 1934





For
the transition period
from                             to





Commission
File Number 000-52247





Cyalume Technologies
Holdings, Inc.


(Exact
name of registrant as specified in its charter)





Delaware
              
              20-3200738(State
      or other jurisdiction of
                incorporation
      or organization)
              
              (I.R.S.
      Employer
                Identification
      No.)





96
      Windsor Street, West Springfield, Massachusetts
            
            01089(Address
      of principal executive offices)
            
            (Zip
      Code)





(413)
858-2500


(Registrant's
telephone number, including area code)





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





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).  Yes  ̈    No  ̈





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





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





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





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date: As of October 26, 2010, there were
outstanding 15,749,070 shares of the registrant’s Common Stock, par value $.001
per share.











Cyalume Technologies
Holdings, Inc.





FORM
10-Q





INDEX





PART
      I—FINANCIAL INFORMATIONItem 1.
                
                Financial
      StatementsCondensed
      Consolidated Statements of Operations (unaudited) for the three months
      ended September 30, 2010 and 2009
                
                4Condensed
      Consolidated Statements of Operations (unaudited) for the nine months
      ended September 30, 2010 and 2009
                
                5Condensed
      Consolidated Balance Sheets as of September 30, 2010 (unaudited) and
      December 31, 2009
                
                6Condensed
      Consolidated Statements of Changes in Stockholders' Equity and
      Comprehensive Income for the nine months ended September 30, 2010
      (unaudited)
                
                7Condensed
      Consolidated Statements of Cash Flows (unaudited) for the nine months
      ended September 30, 2010 and 2009
                
                8Notes
      to Condensed Consolidated Financial Statements (unaudited)
                
                9Item 2.
                
                Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                
                16Item 3.
                
                Quantitative
      and Qualitative Disclosures About Market Risk
                
                19Item 4.
                
                Controls
      and Procedures
                
                19PART
      II—OTHER INFORMATIONItem 1.
                
                Legal
      Proceedings
                
                20Item 1A.
                
                Risk
      Factors
                
                20Item 2.
                
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                
                20Item 3.
                
                Defaults
      Upon Senior Securities
                
                20Item 4.
                
                [Removed
      and Reserved]
                
                20Item 5.
                
                Other
      Information
                
                20Item 6.
                
                Exhibits
                
                21Signatures
                
                22


2





PART I—FINANCIAL INFORMATION





The
statements contained in this quarterly report on Form 10-Q, including under
the section titled "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and other sections of this quarterly report, include
forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended, including, without limitation, statements
regarding our or our management's expectations, hopes, beliefs, intentions or
strategies regarding the future. The words "believe," "may," "will," "estimate,"
"continue," "anticipate," "intend," "expect," "plan" and similar expressions may
identify forward-looking statements, but the absence of these words does not
mean that a statement is not forward-looking. The forward-looking statements
contained in this quarterly report are based on our current expectations and
beliefs concerning future developments and their potential effects on us. There
can be no assurance that future developments affecting us will be those that we
have anticipated. These forward-looking statements involve a number of risks,
uncertainties (some of which are beyond our control) or other assumptions that
may cause actual results or performance to be materially different from those
expressed or implied by these forward-looking statements. Should one or more of
these risks or uncertainties materialize, or should any of our assumptions prove
incorrect, actual results may vary in material respects from those projected in
these forward-looking statements. We undertake no obligation to update or revise
any forward-looking statements, whether as a result of new information, future
events or otherwise, except as may be required under applicable securities
laws.Unless the content
otherwise requires, all references to "we", "us", the “Company" or “Cyalume" in
this quarterly report on Form 10-Q refers to Cyalume Technologies Holdings,
Inc.


3


ITEM 1.
            Financial
      Statements





Cyalume
Technologies Holdings, Inc.


Condensed
Consolidated Statements of Operations


(in
thousands, except shares and per share information)


(Unaudited)





For
      the Three
                  
                  
                  For
      the ThreeMonths
      Ended
                  
                  
                  Months
      EndedSeptember
      30,
                  
                  
                  September
      30,2010
                  
                  
                  2009Revenues
                  
                  $
                  11,570
                  
                  
                  $
                  9,860Cost
      of goods sold
                  
                  
                  5,483
                  
                  
                  
                  5,938Gross
      profit
                  
                  
                  6,087
                  
                  
                  
                  3,922Other
      expenses:Sales
      and marketing
                  
                  
                  917
                  
                  
                  
                  791General
      and administrative
                  
                  
                  1,343
                  
                  
                  
                  887Research
      and development
                  
                  
                  402
                  
                  
                  
                  487Interest,
      net
                  
                  
                  631
                  
                  
                  
                  673Interest
      – related party
                  
                  
                  17
                  
                  
                  
                  16Amortization
      of intangible assets
                  
                  
                  441
                  
                  
                  
                  878Other,
      net
                  
                  
                  91
                  
                  
                  
                  16Total
      other expenses
                  
                  
                  3,842
                  
                  
                  
                  3,748Income
      before income taxes
                  
                  
                  2,245
                  
                  
                  
                  174Provision
      for (benefit from) income taxes
                  
                  
                  916
                  
                  
                  
                  (151
                  )Net
      income
                  
                  $
                  1,329
                  
                  
                  $
                  325Income
      available to common stockholders for diluted net income per common
      share
                  
                  $
                  1,034
                  
                  
                  $
                  325Net
      income per common share:Basic
                  
                  $
                  .09
                  
                  
                  $
                  .02Diluted
                  
                  $
                  .06
                  
                  
                  $
                  .02Weighted
      average shares used to compute net income per common
share:Basic
                  
                  
                  15,511,183
                  
                  
                  
                  15,352,478Diluted
                  
                  
                  17,524,995
                  
                  
                  
                  15,418,949





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


4




Cyalume
Technologies Holdings, Inc.


Condensed
Consolidated Statements of Operations


(in
thousands, except shares and per share information)


(Unaudited)





For
      the Nine
                  
                  
                  For the
      NineMonths
      Ended
                  
                  
                  Months
      EndedSeptember
      30,
                  
                  
                  September
      30,2010
                  
                  
                  2009Revenues
                  
                  $
                  29,859
                  
                  
                  $
                  24,443Cost
      of goods sold
                  
                  
                  14,695
                  
                  
                  
                  14,374Gross
      profit
                  
                  
                  15,164
                  
                  
                  
                  10,069Other
      expenses:Sales
      and marketing
                  
                  
                  2,481
                  
                  
                  
                  2,322General
      and administrative
                  
                  
                  4,109
                  
                  
                  
                  3,489Research
      and development
                  
                  
                  1,135
                  
                  
                  
                  1,295Interest,
      net
                  
                  
                  1,931
                  
                  
                  
                  1,925Interest
      – related party
                  
                  
                  49
                  
                  
                  
                  45Amortization
      of intangible assets
                  
                  
                  1,353
                  
                  
                  
                  2,612Other,
      net
                  
                  
                  —
                  
                  
                  
                  79Total
      other expenses
                  
                  
                  11,058
                  
                  
                  
                  11,767Income
      (loss) before income taxes
                  
                  
                  4,106
                  
                  
                  
                  (1,698
                  )Provision
      for (benefit from) income taxes
                  
                  
                  1,585
                  
                  
                  
                  (755
                  )Net
      income (loss)
                  
                  $
                  2,521
                  
                  
                  $
                  (943
                  )Income
      available to common stockholders for diluted net income per common
      share
                  
                  $
                  2,242
                  
                  
                  $
                  (943
                  )Net
      income (loss) per common share:Basic
                  
                  $
                  .16
                  
                  
                  $
                  (.06
                  )Diluted
                  
                  $
                  .14
                  
                  
                  $
                  (.06
                  )Weighted
      average shares used to compute net income (loss) per common
      share:Basic
                  
                  
                  15,466,133
                  
                  
                  
                  15,089,909Diluted
                  
                  
                  16,240,932
                  
                  
                  
                  15,089,909





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


5





Cyalume Technologies
Holdings, Inc.


CondensedConsolidated Balance
Sheets


(in
thousands, except shares and per share information)





September
      30,2010
                            (unaudited)
                          
                          
                          December 31,
                            2009AssetsCurrent
      assets:Cash
                          
                          $
                          2,472
                          
                          
                          $
                          2,003Accounts
      receivable, net of allowance for doubtful accounts of $26 and $239 at
      September 30, 2010 and December 31, 2009, respectively
                          
                          
                          4,202
                          
                          
                          
                          3,319Inventories,
      net
                          
                          
                          8,876
                          
                          
                          
                          9,320Income
      taxes refundable
                          
                          
                          —
                          
                          
                          
                          294Deferred
      income taxes
                          
                          
                          810
                          
                          
                          
                          682Prepaid
      expenses and other current assets
                          
                          
                          453
                          
                          
                          
                          382Total
      current assets
                          
                          
                          16,813
                          
                          
                          
                          16,000Property,
      plant and equipment, net
                          
                          
                          8,507
                          
                          
                          
                          8,384Goodwill
                          
                          
                          51,244
                          
                          
                          
                          51,244Other
      intangible assets, net
                          
                          
                          21,286
                          
                          
                          
                          22,548Other
      noncurrent assets
                          
                          
                          301
                          
                          
                          
                          67Total
      assets
                          
                          $
                          98,151
                          
                          
                          $
                          98,243Liabilities
      and Stockholders’ EquityCurrent
      liabilities:Lines
      of credit
                          
                          $
                          —
                          
                          
                          $
                          3,200Current
      portion of notes payable
                          
                          
                          1,012
                          
                          
                          
                          6,940Accounts
      payable
                          
                          
                          2,546
                          
                          
                          
                          3,222Accrued
      expenses and other current liabilities
                          
                          
                          2,413
                          
                          
                          
                          2,069Advance
      due to related parties
                          
                          
                          9
                          
                          
                          
                          9Income
      taxes payable
                          
                          
                          522
                          
                          
                          
                          —Total
      current liabilities
                          
                          
                          6,502
                          
                          
                          
                          15,440Senior
      notes payable, net of current portion
                          
                          
                          15,142
                          
                          
                          
                          18,874Convertible
      notes payable, net of discount
                          
                          
                          7,917
                          
                          
                          
                          —Notes
      payable due to related parties
                          
                          
                          1,114
                          
                          
                          
                          1,065Deferred
      income taxes
                          
                          
                          8,125
                          
                          
                          
                          7,105Derivatives
                          
                          
                          442
                          
                          
                          
                          69Asset
      retirement obligation, net of current portion
                          
                          
                          164
                          
                          
                          
                          158Total
      liabilities
                          
                          
                          39,406
                          
                          
                          
                          42,711Commitments
      and contingencies (Note 9)
                          
                          
                          —
                          
                          
                          
                          —Stockholders'
      equity:Preferred
      stock, $0.001 par value; 1,000,000 shares authorized, no shares issued or
      outstanding
                          
                          
                          —
                          
                          
                          
                          —Common
      stock, $0.001 par value; 50,000,000 shares authorized; 15,749,070 and
      15,405,570 shares issued and outstanding at September 30, 2010 and
      December 31, 2009, respectively
                          
                          
                          16
                          
                          
                          
                          15Additional
      paid-in capital
                          
                          
                          89,151
                          
                          
                          
                          87,926Accumulated
      deficit
                          
                          
                          (29,872
                          )
                          
                          
                          (32,393
                          )Accumulated
      other comprehensive loss
                          
                          
                          (550
                          )
                          
                          
                          (16
                          )Total
      stockholders’ equity
                          
                          
                          58,745
                          
                          
                          
                          55,532Total
      liabilities and stockholders' equity
                          
                          $
                          98,151
                          
                          
                          $
                          98,243





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


6




Cyalume Technologies Holdings, Inc.


Condensed
Consolidated Statements of Changes in Stockholders' Equity and Comprehensive
Income


(in
thousands, except shares)


(Unaudited)




Common Stock
                      
                      
                      Additional
                      
                      
                      
                      
                      
                      Accumulated
                        Other
                      
                      
                      TotalNumber
                        of Shares
                      
                      
                      Amount
                      
                      
                      Paid-In
                        Capital
                      
                      
                      Accumulated
                        Deficit
                      
                      
                      Comprehensive
                        Loss
                      
                      
                      Stockholders’
                        Equity
                      
                      
                      Comprehensive
                        Income (Loss)Balance
      at December 31, 2009
                      
                      
                      15,405,570
                      
                      
                      $
                      15
                      
                      
                      $
                      87,926
                      
                      
                      $
                      (32,393
                      )
                      
                      $
                      (16
                      )
                      
                      $
                      55,532
                      
                      
                      $
                      —Stock
      issued
                      
                      
                      343,500
                      
                      
                      
                      1
                      
                      
                      
                      145
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      146
                      
                      
                      
                      —Stock-based
      compensation expense
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      875
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      875
                      
                      
                      
                      —Warrants
      issued in conjunction with issuance of convertible debt
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      205
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      205
                      
                      
                      
                      —Foreign
      currency translation adjustments
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (301
                      )
                      
                      
                      (301
                      )
                      
                      
                      (301
                      )Unrealized
      loss on cash flow hedges, net of taxes of $140
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      (233
                      )
                      
                      
                      (233
                      )
                      
                      
                      (233
                      )Net
      income
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      2,521
                      
                      
                      
                      —
                      
                      
                      
                      2,521
                      
                      
                      
                      2,521Comprehensive
      income
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      
                      —
                      
                      
                      $
                      1,987Balance
      at September 30, 2010
                      
                      
                      15,749,070
                      
                      
                      $
                      16
                      
                      
                      $
                      89,151
                      
                      
                      $
                      (29,872
                      )
                      
                      $
                      (550
                      )
                      
                      $
                      58,745





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


7





Cyalume
Technologies Holdings, Inc.


Condensed
Consolidated Statements of Cash Flows


(in
thousands)


(Unaudited)





For
      the Nine
                        
                        
                        For
      the NineMonths
      Ended
                        
                        
                        Months
      EndedSeptember
      30,
                        
                        
                        September
      30,2010
                        
                        
                        2009Cash
      flows from operating activities:Net
      income (loss)
                        
                        $
                        2,521
                        
                        
                        $
                        (943
                        )Adjustments
      to reconcile net income (loss) to net cashprovided
      by operating activities:Depreciation
      of property, plant and equipment
                        
                        
                        577
                        
                        
                        
                        479Amortization
                        
                        
                        1,593
                        
                        
                        
                        3,446Provision
      for deferred income taxes
                        
                        
                        1,068
                        
                        
                        
                        (1,009
                        )Stock-based
      compensation expense
                        
                        
                        875
                        
                        
                        
                        271Other
      non-cash expenses
                        
                        
                        186
                        
                        
                        
                        357Changes
      in operating assets and liabilities:Accounts
      receivable
                        
                        
                        (920
                        )
                        
                        
                        (1,024
                        )Inventories
                        
                        
                        377
                        
                        
                        
                        953Prepaid
      expenses and other current assets
                        
                        
                        (28
                        )
                        
                        
                        (9
                        )Accounts
      payable and accrued liabilities
                        
                        
                        (169
                        )
                        
                        
                        (22
                        )Income
      taxes payable
                        
                        
                        777
                        
                        
                        
                        329Net
      cash provided by operating activities
                        
                        
                        6,857
                        
                        
                        
                        2,828Cash
      flows from investing activities:Proceeds
      from disposal of long-lived assets
                        
                        
                        207
                        
                        
                        
                        —Purchases
      of long-lived assets
                        
                        
                        (1,219
                        )
                        
                        
                        (449
                        )Net
      cash used in investing activities
                        
                        
                        (1,012
                        )
                        
                        
                        (449
                        )Cash
      flows from financing activities:Payments
      for common stock subject to redemption
                        
                        
                        —
                        
                        
                        
                        (1,123
                        )Net
      repayment of line of credit
                        
                        
                        (3,200
                        )
                        
                        
                        (200
                        )Repayment
      of long-term notes payable
                        
                        
                        (9,859
                        )
                        
                        
                        (2,633
                        )Proceeds
      from convertible notes payable
                        
                        
                        7,942
                        
                        
                        
                        —Payments
      to reacquire and retire common stock
                        
                        
                        —
                        
                        
                        
                        (263
                        )Payment
      of stock registration costs
                        
                        
                        —
                        
                        
                        
                        (279
                        )Payment
      of debt issuance costs
                        
                        
                        (250
                        )
                        
                        
                        (65
                        )Proceeds
      from exercises of warrants
                        
                        
                        —
                        
                        
                        
                        27Net
      cash used in financing activities
                        
                        
                        (5,367
                        )
                        
                        
                        (4,536
                        )Effect
      of exchange rate changes on cash
                        
                        
                        (9
                        )
                        
                        
                        36Net
      increase (decrease) in cash
                        
                        
                        469
                        
                        
                        
                        (2,121
                        )Cash,
      beginning of period
                        
                        
                        2,003
                        
                        
                        
                        3,952Cash,
      end of period
                        
                        $
                        2,472
                        
                        
                        $
                        1,831





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


8




Cyalume Technologies Holdings, Inc.


Notes
to Condensed Consolidated Financial Statements





1.
            BASIS
      OF PRESENTATION





We have
prepared the accompanying unaudited interim condensed consolidated financial
statements in accordance with accounting principles generally accepted in the
United States of America (“U.S. GAAP”) for interim financial information and the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these
interim condensed consolidated financial statements do not include all of the
information and footnotes required by accounting principles generally accepted
in the United States of America for complete financial statements.




The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the period.




These
accompanying unaudited interim condensed consolidated financial statements
recognize the effects of all subsequent events that provide additional evidence
about conditions that existed at September 30, 2010, including the estimates
inherent in the process of preparing financial statements. Additionally, all
significant intercompany accounts and transactions have been eliminated in
consolidation.




Certain
amounts in prior periods have been reclassified to conform to the 2010
presentation. These reclassifications had no effect on operating results as
previously reported.





We
believe all adjustments (consisting of normal, recurring adjustments) considered
necessary for a fair presentation have been included in these interim condensed
consolidated financial statements. Operating results for the three and
nine-month periods presented are not necessarily indicative of the results that
may be expected for any other interim period or for the full year. The
consolidated balance sheet at December 31, 2009 has been derived from the
audited consolidated financial statements at that date. We suggest that these
unaudited interim condensed consolidated financial statements be read in
conjunction with the consolidated financial statements and footnotes thereto in
our Annual Report on Form 10-K for the year ended December 31,
2009.





2.
            DESCRIPTION
      OF BUSINESS





We have
one subsidiary: Cyalume Technologies, Inc. (“CTI”), whose headquarters are also
located in West Springfield, MA. CTI has one subsidiary, Cyalume Technologies,
SAS (“CTSAS”), located in Aix-en-Provence, France. Our products are manufactured
at both the West Springfield and Aix-en-Provence locations.





We
primarily produce products based on technologies whereby light is generated
through a chemical reaction known as chemiluminescence. CTI manufactures and
sells such chemiluminescent products, in addition to reflective and
photoluminescent products, to military, commercial and public safety
markets.  Our base product is known as a ‘‘light stick’’ and is
typically 6 inches in length. A light stick is a translucent flexible plastic
tube that is partly filled with one chemical ingredient and also with a glass
container (‘‘ampoule’’) that contains a complementary reactive chemical. When
the tube is bent enough to break the glass ampoule, the chemicals contained
within the plastic tube and ampoule mix and light is generated. Additionally, we
manufacture and sell a component of 40mm training ammunition that utilizes our
light-stick technology; sales of these components have been an increasing source
of our revenues in recent years.  Also, we produce reflective
(patches) and reflective plus photoluminescent (fire tape) products. Based on
our customers’ specifications, our products are manufactured in varying shapes,
sizes and functions, and provide light in different colors, intensity and
durations.





3.
            NEW
      ACCOUNTING PRONOUNCEMENTS





In
January 2010, the Financial Accounting Standards Board (“FASB”) issued
Accounting Standards Update (“ASU”) No. 2010-06, Improving Disclosures about Fair
Value Measurements, to amend existing guidance in FASB Accounting
Standards Codification (“ASC”) 820, Fair Value Measurements and
Disclosures, to expand and clarify existing disclosures regarding
recurring and nonrecurring fair value measurements. The amendments in this ASU
were effective on January 1, 2010 for our interim and annual reporting. The
adoption of this ASU did not have an impact on these unaudited interim condensed
consolidated financial statements.


9


Cyalume
Technologies Holdings, Inc.


Notes
to Condensed Consolidated Financial Statements





In
February 2010, the FASB issued ASU No. 2010-09, Subsequent Events (Topic 855):
Amendments to Certain Recognition and Disclosure Requirements. The
amendments in this ASU remove the requirement for an SEC filer (such as us) to
disclose a date through which subsequent events have been evaluated in both
issued and revised financial statements. Revised financial statements include
financial statements revised as a result of either correction of an error or
retrospective application of U.S. GAAP. All of the amendments in this ASU were
effective for us upon the FASB’s issuance of ASU No. 2010-09.  The
only effect of our adoption of this ASU on these unaudited interim condensed
consolidated financial statements was to not disclose the date through which
subsequent events have been evaluated in preparing these consolidated financial
statements; for SEC filers, that evaluation date must be the date of issuance of
the financial statements.





4.
            INVENTORIES





Inventories
consist of the following (all amounts in thousands):


September
      30,
                    2010
                  
                  
                  December
      31,
                    2009Raw
      materials
                  
                  $
                  4,903
                  
                  
                  $
                  4,887Work-in-process
                  
                  
                  3,305
                  
                  
                  
                  3,439Finished
      goods
                  
                  
                  1,059
                  
                  
                  
                  1,9039,267
                  
                  
                  
                  10,229Less:
      Reserve for obsolescence
                  
                  
                  (391
                  )
                  
                  
                  (909
                  )$
                  8,876
                  
                  
                  $
                  9,320





5.
            NOTES
      PAYABLE





On July
29, 2010 we issued $8.5 million in convertible notes due in 2014. The
convertible notes require monthly interest payments starting on September 1,
2010 at a rate of 11% per annum and mature on March 19, 2014, unless earlier
repurchased or converted. No principal payments are required on these
convertible notes until maturity. We have the right to prepay the notes in whole
or in part at any time without penalty. The convertible notes are senior
secured obligations and rank junior to all senior debt held by TD
Bank, N.A. but senior to all other remaining long-term debt including existing
and future subordinated debt. The notes are convertible at any time into
2,666,667 shares of our common stock at a conversion price of approximately
$3.19 per share. Under certain circumstances, such a conversion feature could be
considered to be a “beneficial” conversion feature, as defined by U.S. GAAP,
requiring separate measurement and accounting. We determined that the
convertible notes’ conversion feature was not “beneficial” under U.S.
GAAP.





Simultaneous
with the issuance of the convertible notes, we issued warrants to repay certain
costs of obtaining the convertible notes. These warrants allow the holder to
purchase 160,000 shares of our common stock at $2 per share through July 29,
2015. The warrants have a five-year term. In accordance with U.S. GAAP, we
allocated the $8.5 million proceeds from the issuance of the convertible notes and the warrants based on the
relativefair values of the debt instrument without
the warrants and of the warrants themselves attime
of issuance. The portion of the proceeds so allocated to the warrants ($205,000)
was recorded as a debt discount (a decrease to convertible notes payable, net of
discount) and an increase to additional paid-in capital on our condensed
consolidated balance sheet. The $205,000 debt discount will be amortized to
interest expense over the life of the convertible notes.





On July
29, 2010, the carrying value of the convertible notes was $7.9 million, computed
as follows (all amounts in thousands):





Principal
      amount of convertible notes
                    
                    $
                    8,500Less:
      Debt issuance costs
                    
                    
                    (399
                    )Less:
      Warrants issued to convertible note lenders
                    
                    
                    (205
                    )$
                    7,896





The
convertible note principal of $8.5 million was used in the following manner (all
amounts in thousands):





Principal
      amount of convertible notes
                      
                      $
                      8,500Less:
      Debt issuance costs
                      
                      
                      (558
                      )Proceeds
      from convertible notes payable
                      
                      
                      7,942Less
      amounts paid from proceeds from convertible notes:Principal
      payment on senior debt held by TD Bank, N.A.
                      
                      
                      (7,200
                      )Principal
      payment on line of credit held by TD Bank, N.A.
                      
                      
                      (500
                      )Debt
      issuance costs
                      
                      
                      (50
                      )Cash
      retained by Cyalume Technologies Holdings, Inc.
                      
                      $
                      192


10


Cyalume
Technologies Holdings, Inc.


Notes
to Condensed Consolidated Financial Statements





As part
of this transaction, the remaining unpaid TD Bank, N.A. senior debt was modified
to have reduced principal payments and lower interest rates.  However,
because the convertible notes and the modified TD Bank, N.A. senior debt, on a
combined basis, have a higher weighted-average interest rate than the
pre-modified TD Bank, N.A. senior debt, we expect that our interest expense will
be higher than it would have been had we not partially repaid and modified the
TD Bank, N.A. senior debt. Because the convertible notes and the modified TD
Bank, N.A. senior debt require lower monthly principal payments than the
pre-modified TD Bank, N.A. senior debt, we expect our future debt levels to be
higher than they would have been had we not partially repaid and modified the TD
Bank, N.A. senior debt. We do expect the lower monthly principal payments to
significantly improve our short-term cash flows.





Simultaneous
with the repayment of a portion of the TD Bank, N.A. senior debt, our interest
rate swaps (see Note 6) were modified to incorporate this repayment since it was
not anticipated in the original swap agreement. This allows us to continue to
assume that these hedges meet the criteria for the shortcut method for assessing
hedge effectiveness; therefore, the hedge is assumed to still be 100%
effective.





Simultaneous
with the issuance of the convertible notes, we amended our management agreement
with Selway Capital, LLC (see Note 9).





6.
            DERIVATIVE
      INSTRUMENTS AND HEDGING ACTIVITIES





The
derivative liabilities as of September 30, 2010 in our condensed consolidated
balance sheet consist of the following (all amounts in thousands):




Derivative
      Instrument
                      
                      Balance
      Sheet Location
                      
                      Fair
      ValueInterest
      rate swaps
                      
                      Derivatives
      (non-current liabilities)
                      
                      $
                      (442
                      )





Interest
Rate Swaps





In
December 2008, we entered into two pay-fixed, receive-variable, interest rate
swaps to reduce exposure to changes in cash payments caused by changes in
interest rates on our notes payable with TD Bank, N.A. Both relationships are
designated as cash flow hedges and meet the criteria for the shortcut method for
assessing hedge effectiveness; therefore, the hedge is assumed to be 100%
effective and all changes in the fair value of the interest rate swaps are
recorded in comprehensive income. These unrealized gains and losses must be
reclassified in whole or in part into earnings if, and when, a comparison of the
swaps and the related hedged cash flows demonstrates that the shortcut method is
no longer applicable. We expect these hedges to meet the criteria of the
shortcut method for the duration of the hedging relationship and therefore we do
not expect to reclassify any portion of these unrealized losses from
comprehensive income to earnings in the future. The fair values of the swaps are
determined by discounting the estimated cash flows to be received and paid due
to the swaps over the swap’s contractual lives using an estimated risk-free
interest rate for each swap settlement date.





Currency
Forward Contracts





CTSAS’
functional currency is the Euro. Periodically, CTSAS purchases inventory from
CTI, which requires payment in U.S. dollars. Beginning in 2009 and only under
certain circumstances, we use currency forward contracts to mitigate CTSAS’
exposure to changes in the Euro-to-U.S.-dollar exchange rate upon CTSAS’ payment
to CTI for these inventory purchases.  Such currency forward contracts
typically have durations of less than six months. We report these currency
forward contracts at their fair value. This relationship has not been designated
as a hedge and therefore all changes in these currency forward contracts’ fair
value are recorded in other, net on our condensed consolidated statement of
operations. The fair
value of these contracts are determined by taking the difference between (a) the
U.S. dollar amount due on the contract at maturity and (b) the present value of
estimated cash flows developed using, among other data, expectations of future
currency exchange rates over the remaining term of the contract discounted at an
estimated risk-free interest rate.At September 30, 2010, we held no such
currency forward contracts.


11


Cyalume
Technologies Holdings, Inc.


Notes
to Condensed Consolidated Financial Statements





Effect
of Derivatives on Statement of Operations





The
effect of derivative instruments (a) designated as cash flow hedges and (b) not
designated as hedging instruments on our condensed consolidated statement of
operations for the three months ended September 30, 2010 was as follows (all
amounts in thousands):




Gain (Loss)
                  
                  
                  Gain (Loss)
                  
                  
                  Gain (Loss)in
      AOCL (1)
                  
                  
                  Reclassified
      (2)
                  
                  
                  in
      Earnings (3)Derivatives
      in cash flow hedging relationships:Interest
      rate swaps
                  
                  $
                  (82
                  )
                  
                  $
                  —
                  
                  
                  $
                  —Derivatives
      not designated as hedging instruments:Forward
      currency contracts
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  —





(1)
            Amount
      recognized in accumulated other comprehensive loss (AOCL) (effective
      portion and net of taxes) during the three months ended September 30,
      2010.


(2)
            Amount
      of gain (loss) originally recorded in AOCL but reclassified from AOCL into
      earnings during the three months ended September 30,
  2010.


(3)
            Amount
      of gain (loss) recognized in earnings on the derivative (ineffective
      portion and amount excluded from effectiveness testing) reported in other,
      net on the condensed consolidated statement of operations for the three
      months ended September 30, 2010.





The
effect of derivative instruments (a) designated as cash flow hedges and (b) not
designated as hedging instruments on our condensed consolidated statement of
operations for the nine months ended September 30, 2010 was as follows (all
amounts in thousands):




Gain (Loss)
                  
                  
                  Gain (Loss)
                  
                  
                  Gain (Loss)in AOCL (1)
                  
                  
                  Reclassified (2)
                  
                  
                  in Earnings (3)Derivatives
      in cash flow hedging relationships:Interest
      rate swaps
                  
                  $
                  (233
                  )
                  
                  $
                  —
                  
                  
                  $
                  —Derivatives
      not designated as hedging instruments:Forward
      currency contracts
                  
                  $
                  —
                  
                  
                  $
                  —
                  
                  
                  $
                  (22
                  )





(1)
            Amount
      recognized in accumulated other comprehensive loss (AOCL) (effective
      portion and net of taxes) during the nine months ended September 30,
      2010.


(2)
            Amount
      of gain (loss) originally recorded in AOCL but reclassified from AOCL into
      earnings during the nine months ended September 30,
  2010.


(3)
            Amount
      of gain (loss) recognized in earnings on the derivative (ineffective
      portion and amount excluded from effectiveness testing) reported in other,
      net on the condensed consolidated statement of operations for the nine
      months ended September 30, 2010.





7.
            INCOME
      TAXES





For the
three months ended September 30, 2010, the effective tax rate of 41% differed
from the statutory rate of 34% due to state taxes and prior year true-ups. For
the three months ended September 30, 2009, the effective tax rate of (87)%
differed from the statutory rate of 34% due to state and foreign
taxes.





For the
nine months ended September 30, 2010, the effective tax rate of 39% differed
from the statutory rate of 34% primarily due to state and foreign taxes and
prior year true-ups including changes in the valuation allowance. For the nine
months ended September 30, 2009, the effective tax rate of 44% differed from the
statutory rate of 34% due to state and foreign taxes.





8.
            NET
      INCOME (LOSS) PER COMMON SHARE





Basic net
income (loss) per common share is computed by dividing net income (loss) by the
weighted average number of common shares outstanding. Diluted net income per
common share is computed by dividing net income by the weighted average number
of common shares and dilutive potential common share equivalents then
outstanding. Potential common shares consist of (i) shares issuable upon the
exercise of warrants and options (using the “treasury stock” method), (ii)
unvested restricted stock awards (using the “treasury stock” method) and (iii)
shares issuable upon conversion of our convertible notes (see Note 5) using the
“if-converted” method.


12


Cyalume
Technologies Holdings, Inc.


Notes
to Condensed Consolidated Financial Statements





Three Months Ended
                    September 30,
                  
                  
                  NineMonthsEnded
                    September30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Basic:Net
      income (loss) (in thousands)
                  
                  $
                  1,329
                  
                  
                  $
                  325
                  
                  
                  $
                  2,521
                  
                  
                  $
                  (943
                  )Weighted
      average shares
                  
                  
                  15,511,183
                  
                  
                  
                  15,352,478
                  
                  
                  
                  15,466,133
                  
                  
                  
                  15,089,909Basic
      income (loss) per common share
                  
                  $
                  0.09
                  
                  
                  $
                  0.02
                  
                  
                  $
                  0.16
                  
                  
                  $
                  (0.06
                  )Diluted:Net
      income (loss) (in thousands)
                  
                  $
                  1,329
                  
                  
                  $
                  325
                  
                  
                  $
                  2,521
                  
                  
                  $
                  (943
                  )Adjustments
      to net income assuming convertible notes payable are converted to common
      stock:Reversal
      of interest expense on convertible notes payable (in
      thousands)
                  
                  $
                  167
                  
                  
                  $
                  —
                  
                  
                  $
                  167
                  
                  
                  $
                  —Write
      off of unamortized costs of issuing convertible notes payable (in
      thousands)
                  
                  $
                  (889
                  )
                  
                  $
                  —
                  
                  
                  $
                  (889
                  )
                  
                  $
                  —Adjustments’
      estimated effect on provision for income taxes (in
    thousands)
                  
                  $
                  427
                  (2)
                  
                  $
                  —
                  
                  
                  $
                  443
                  (3)
                  
                  $
                  —Income
      available to common stockholders for diluted net income per common share
      (in thousands)
                  
                  $
                  1,034
                  
                  
                  $
                  325
                  
                  
                  $
                  2,242
                  
                  
                  $
                  (943
                  )Weighted
      average shares
                  
                  
                  15,511,183
                  
                  
                  
                  15,352,478
                  
                  
                  
                  15,466,133
                  
                  
                  
                  15,089,909Effect
      of dilutive securities
                  
                  
                  2,013,812
                  
                  
                  
                  66,471
                  
                  
                  
                  774,799
                  
                  
                  
                  —
                  (1)Weighted
      average shares, as adjusted
                  
                  
                  17,524,995
                  
                  
                  
                  15,418,949
                  
                  
                  
                  16,240,932
                  
                  
                  
                  15,089,909Diluted
      income (loss) per common share
                  
                  $
                  0.06
                  
                  
                  $
                  0.02
                  
                  
                  $
                  0.14
                  
                  
                  $
                  (0.06
                  )





(1)
            Since
      we experienced a loss during this period, common shares issuable upon
      exercise of convertible securities were excluded from the loss per share
      calculation because the effect would be
  antidilutive.


(2)
            Assumes
      an effective tax rate of 40.8%.


(3)
            Assumes
      an effective tax rate of 38.6%.





The
following common shares issuable upon exercise of convertible securities were
excluded from the calculation of diluted net income (loss) per common share
because their effect was antidilutive for each of the periods presented:





Three Months Ended
                        September 30,
                      
                      NineMonthsEnded
                        September30,2010
                      
                      2009
                      
                      2010
                      
                      2009Options
      and warrants
                      
                      6,388,256
                      
                      
                      6,225,256
                      
                      6,495,756
                      
                      
                      6,225,256





9.
            COMMITMENTS
      AND CONTINGENCIES





Civil
Action No. 06-706 in Superior Court of the Commonwealth of
Massachusetts





On
January 23, 2006, before we owned CTI, the former owners of CTI (from whom we
purchased CTI) (the “Former Owners”) acquired all of the outstanding capital
stock of Omniglow Corporation (the “Transaction”) and changed the name of the
company to Cyalume Technologies, Inc. Prior to, or substantially simultaneously
with, the Transaction, CTI sold certain assets and liabilities related to
Omniglow Corporation’s novelty and retail business to certain former Omniglow
Corporation stockholders and management (“the Omniglow Buyers”).  This
was done because CTI sought to retain only the Omniglow Corporation assets and
current liabilities associated with its government, military and safety
business. During 2006, CTI and the Omniglow Buyers commenced litigation and
arbitration proceedings against one another. Claims include breaches of a lease
and breaches of various other agreements between CTI and the Omniglow
Buyers.  The Omniglow Buyers sought compensatory damages of $1.4
million, to be trebled, and recovery of costs and legal fees. CTI filed for
damages of $368,000 against the Omniglow Buyers.  These proceedings
are known as Civil Action No. 06-706 in Superior Court of the Commonwealth of
Massachusetts.


13


Cyalume
Technologies Holdings, Inc.


Notes
to Condensed Consolidated Financial Statements





On
December 19, 2008, while Civil Action 06-706 was still unresolved, we acquired
CTI (the “Acquisition”). According to the Acquisition’s Stock Purchase Agreement
between the Former Owners and us, the Former Owners retained the responsibility
for paying for all costs and liabilities associated with Civil Action
06-706.





On June
11, 2010, CTI received preliminary Findings of Fact, Rulings of Law and Order
for Judgment (the “Findings”) regarding Civil Action No.
06-706.  Pursuant to the Findings, the court found in favor of the
Omniglow Buyers and ruled that the Omniglow Buyers were entitled to calculable
damages of approximately $828,000 from CTI, in addition to damages for certain
lost profits that have not been calculated, costs and attorney’s fees. These
additional damages, costs and fees have not yet been calculated or determined by
the court. On August 17, 2010, the court vacated this judgment. The court will
enter a final judgment once the court issues an order on these additional
damages, costs and fees.





CTI is
considering its alternatives relating to the suit in light of the Findings. No
amounts have been reported in these interim condensed consolidated financial
statements since payment of damages or loss is not yet deemed to be probable
since all of our legal remedies have not been exhausted.





Management
Agreement with Board Member





On
October 1, 2009, we entered into a management agreement with Selway Capital, LLC
(“Selway”) that provides for (but is not limited to) the following services to
be performed by Selway on our behalf:





·
            Strategic
      development and implementation as well as consultation with our chief
      executive officer on a regular basis as per his reasonable
      requests;


·
            Identifying
      strategic partnerships with companies with which Selway has relationships
      and access, including building partnerships with companies in Israel,
      Singapore, India and Europe. The focus will be on the expansion of our
      munitions business;


·
            Advise
      and support us on our investor relations
  strategy;


·
            Advise
      and support our future fund raising, including identifying sources of
      capital in the United States; and


·
            Support
      our mergers and acquisitions strategy and play an active role in our due
      diligence and analysis.





The
management agreement stipulates that these services will be performed by Yaron
Eitan, a member of our Board of Directors and an employee of Selway, with the
assistance as needed from other employees of Selway.  The management
agreement is retroactive to August 1, 2009, expires on October 1, 2012 and can
be terminated by either us or Selway upon 30-days’ written notice or upon our
default in payment or Selway’s failure to perform services under the management
agreement. Through July 2010, Selway’s compensation for these services was
$41,667 per month. However, we were only required to pay $16,000 per month, with
the balance of $25,667 per month remaining unpaid until our senior lender
consented to such payment. We will also reimburse Selway for costs incurred
specifically on our behalf for these services. Under the management agreement,
we indemnify Selway and Selway indemnifies us against certain losses that may be
incurred while carrying out its obligations under the management
agreement.





On July
29, 2010 we amended our management agreement (the “Amended Management
Agreement”) with Selway. Pursuant to the Amended Management Agreement, (i) the
monthly compensation payable to Selway was reduced to $11,667 and (ii) we were
required to issue to Selway 45,000 shares of our common stock in full
satisfaction of all accrued and unpaid liabilities (including all management
fees) we owed to Selway pursuant to this management agreement through July 2010.
Those 45,000 shares were issued in July 2010.





10.
            FAIR
      VALUE





Under
U.S. GAAP, we are required to record certain financial assets and liabilities at
fair value and may choose to record other financial assets and financial
liabilities at fair value as well. Also under U.S. GAAP, we are required to
record nonfinancial assets and liabilities at fair value due to events that may
or may not recur in the future, such as an impairment event. When we are
required to record such assets and liabilities at fair value, that fair value is
estimated using an exit price, representing the amount that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants. That fair value is determined based on significant inputs
contained in a fair value hierarchy as follows:


14


Cyalume
Technologies Holdings, Inc.


Notes
to Condensed Consolidated Financial Statements





Level
      1
            Quoted
      prices for identical assets or liabilities in active markets to which we
      have access at the measurement date.Level
      2
            Inputs
      other than quoted prices included within Level 1 that are observable for
      the asset or liability, either directly or indirectly.Level
      3
            Unobservable
      inputs for the asset or liability.





The
determination of where assets and liabilities fall within this hierarchy is
based upon the lowest level of input that is significant to the fair value
measurement.





As of
September 30, 2010, our only assets and liabilities required to be reported at
fair value on a recurring basis were the interest rate swaps and currency
forward contracts described in Note 6, both of which are measured at fair value
using level 2 inputs.





We have
other non-derivative financial instruments, such as cash, accounts receivable,
accounts payable, accrued expenses and long-term debt whose carrying amounts
approximate fair value.





11.
            SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION





Cash Paid for Interest and Income
Taxes(all amounts in thousands):




NineMonthsEndedSeptember30,2010
                  
                  2009Interest
                  
                  $
                  1,686
                  
                  
                  $
                  1,495Income
      taxes
                  
                  
                  192
                  
                  
                  
                  608





Non-Cash Investing and Financing
Activities(all amounts in thousands):




NineMonthsEndedSeptember30,2010
                  
                  
                  2009Warrants
      issued in conjunction with issuance of convertible notes
                  
                  $
                  205
                  
                  
                  $
                  —Stock
      issued as payment for accounts payable
                  
                  
                  146
                  
                  
                  
                  —Debt
      issuance costs withheld from convertible note proceeds
                  
                  
                  558
                  
                  
                  
                  —Increase
      in the Acquisition date fair value of intangible assets (a reduction of
      goodwill)
                  
                  
                  —
                  
                  
                  
                  2,024Increase
      in the Acquisition date fair value of property, plant & equipment (a
      reduction of goodwill)
                  
                  
                  —
                  
                  
                  
                  372Accrual
      of costs directly related to the Acquisition (an increase to
      goodwill)
                  
                  
                  —
                  
                  
                  
                  435Reduction
      of goodwill resulting from subsequent recognition of deferred
      taxes
                  
                  
                  —
                  
                  
                  
                  549Remeasurement
      of asset retirement obligation
                  
                  
                  —
                  
                  
                  
                  26Extinguishment
      of notes payable due to related parties by issuing common
      stock
                  
                  
                  —
                  
                  
                  
                  82


15


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





You
should read the following discussion of our financial condition and results of
operations in conjunction with our interim condensed consolidated financial
statements and the accompanying notes to those financial statements included
elsewhere in this Quarterly Report on Form 10-Q. This discussion contains
forward-looking statements that involve risks and uncertainties. Unless the
content otherwise requires, all references to "we", "us", the “Company" or
“Cyalume" in this Quarterly Report on Form 10-Q refers to Cyalume
Technologies Holdings, Inc.





Company
Overview





We
primarily produce products based on technologies whereby light is generated
through a chemical reaction known as chemiluminescence. CTI manufactures and
sells such chemiluminescent products, in addition to reflective and
photoluminescent products, to military, commercial and public safety
markets.  Our base product is known as a ‘‘light stick’’ and is
typically 6 inches in length. A light stick is a translucent flexible plastic
tube that is partly filled with one chemical ingredient and also with a glass
container (‘‘ampoule’’) that contains a complementary reactive chemical. When
the tube is bent enough to break the glass ampoule, the chemicals contained
within the plastic tube mix and light is generated. Additionally, we manufacture
and sell a component of 40mm training ammunition that uses our light-stick
technology; sales of these components have been an increasing source of our
revenues in recent years.  Also, we produce reflective (patches) and
reflective plus photoluminescent (fire tape) products. Based on our customers’
specifications, our products are manufactured in varying shapes, sizes and
functions, and provide light in different colors, intensity and
durations.





We have
one subsidiary: Cyalume Technologies, Inc. (“CTI”), whose headquarters are also
located in West Springfield, MA. CTI has one subsidiary, Cyalume Technologies,
SAS (“CTSAS”), located in Aix-en-Provence, France. Our products are manufactured
at both the West Springfield and Aix-en-Provence locations.





Material
Changes in Results of Operations – Three Months Ended September 30, 2010 versus
the Three Months Ended September 30, 2009




Revenues:   For the
three-month period ended September 30, 2010, sales were higher than for the
comparable period in 2009 due primarily to the volume of units sold. Price
increases provided some of the additional revenues for the most recent 3-month
period.




Cost of goods sold: For the
three-months ended September 30, 2010, cost of goods sold was lower than for the
comparable period in 2009 despite the increase in sales discussed in the
previous paragraph.  Gross margin for the quarter was 52.6% compared
to a 39.8% gross margin for the comparable prior-year period. 2010 margin
improved primarily due to (i) a product mix resulting in improved sales levels
of higher margin products, (ii) price increases and (iii) the impact of the
amortization of inventory step-up to fair market value arising from our
acquisition of CTI in December 2008, which depressed 2009 gross margin.
..




Expenses: Selling expenses
increased 15.9% primarily due to payroll costs of additional hires that was
incurred in the three-month period ended September 30, 2010 but not incurred in
the three-month period ended September 30, 2009. General and administrative
expenses increased 51.4% primarily due to increases in expenses related to (i)
share-based award accruals, (ii) depreciation expense and  (iii)
employee bonus accruals.  The increase in the share-based expenses is
primarily due to awards issued in 2010. The increase in depreciation expense is
primarily due to our new enterprise resource planning (“ERP”) computer system,
which began depreciating in 2010. Accruals for employee bonuses have increased
in 2010 due to our increased profitability in 2010




Research
and development expenses decreased primarily due to lower patent maintenance and
defense costs.




Amortization
of intangible assets: In December 2009, we recorded impairments on our trademark
and customer relationship intangible assets that significantly reduced our
intangible assets to be amortized in the three months ended September 30, 2010
compared to same period in the prior year.




Provision
for (benefit from) income taxes increased significantly for the three months
ended September 30, 2010 as compared to the three months ended September
30, 2009 due to our generation of net income in 2010 and operating losses in
2009.





Other,
net consists primarily of the effects of changes in foreign exchange
rates.





Material
Changes in Results of Operations – Nine Months Ended September 30, 2010 versus
the Nine Months Ended September 30, 2009




Revenues:   For the
nine-month period ended September 30, 2010, sales were higher than for the
comparable period in 2009 due primarily to the volume of units sold. Price
increases provided approximately 12% of the additional revenues for the 2010
period, with the higher number of units sold comprising the rest of the
increase.


16




Cost of goods sold: For the
nine-months ended September 30, 2010, cost of goods sold was 2.2% higher than
the comparable period in 2009 due to the increase in units sold discussed
above.  Gross margin for the period was 50.8% compared to a 41.1%
gross margin for the comparable prior-year period. 2010 margin improved
partially due to price increases as discussed in the previous paragraph. Gross
margin in the nine months ended September 30, 2009 was depressed by the
amortization of the inventory step-up to fair market value arising from our
acquisition of CTI in December 2008.




Expenses: Selling expenses
increased 6.8% primarily due to (i) 2010 payroll costs of additional hires, (ii)
increased bonuses accrued for sales staff due to our increased profitability in
2010 and (iii) other expenses that typically increase when sales increase, such
as commissions and freight on sales.  General and administrative
expenses increased 17.8% primarily due to increases in expenses related to (i)
share-based award accruals, (ii) depreciation expense, (iii) employee bonus
accruals and (iv) consultants.  The increase in the share-based
expenses is primarily due to awards issued in 2010. The increase in depreciation
expense is primarily due to our new ERP computer system, which began
depreciating in 2010. Accruals for employee bonuses have increased in 2010 due
to our increased profitability in 2010.




Research
and development expenses decreased primarily due to lower patent maintenance and
defense costs.




Amortization
of intangible assets: In December 2009, we recorded impairments on our trademark
and customer relationship intangible assets that significantly reduced our
intangible assets to be amortized in the nine months ended September 30, 2010
compared to same period in the prior year.




Provision
for (benefit from) income taxes increased significantly for the nine months
ended September 30, 2010 as compared to the nine months ended September 30,
2009 due to our generation of net income in 2010 and operating losses in
2009.





Other,
net consists primarily of the effects of changes in foreign exchange
rates.





Material
Changes in Financial Condition – September 30, 2010 versus December 31,
2009





Assets, other than cash:
Assets, other than cash, were $95.7 million at September 30, 2010 compared to
$96.2 million at December 31, 2009. The decrease is primarily due to intangible
assets amortization, fixed asset depreciation and a decrease in inventories.
Those decreases were partially offset by the purchase and installation of our
new ERP computer system, an increase in accounts receivable resulting from
increased sales activity during 2010 and an increase in capitalized debt
issuance costs incurred when we incurred new convertible debt in July 2010. The
remaining changes in asset values are the result of normal business
activities.





Liabilities: Liabilities were
$39.4 million at September 30, 2010, compared to $42.7 million at December 31,
2009. The decrease is due primarily to scheduled payments made on our notes
payable and complete repayment of our line of credit. The December 31, 2009 line
of credit balance of $3.2 million was repaid by $500,000 of the proceeds of our
July 2010 convertible debt issuance and by $2.7 million of operating cash flows.
Our derivatives liability increased since December 31, 2009 primarily due to a
decrease in estimated future LIBOR rates used to estimate the fair value of our
pay fixed/receive LIBOR interest rate swaps. Also, our income tax liability
increased in 2010 due to our being profitable in 2010. The remaining changes are
the result of normal business activities.





Liquidity
and Capital Resources





Cash on
hand was $2.5 million at September 30, 2010 and $2.0 million at December 31,
2009. The increase since December 31, 2009 resulted primarily improved sales
levels offset by payments on debt and related debt issuance costs and payments
for property, plant and equipment.





During
the nine months ended September 30, 2010, we did not sell any shares of our
common stock. However 298,500 common shares were issued for stock-based
compensation awards and 45,000 common shares were issued to Selway Capital, LLC
in full satisfaction of all accrued and unpaid liabilities (including all
management fees) we owed to Selway pursuant to this management agreement through
July 2010.





On July
29, 2010 we issued $8.5 million in convertible notes due in 2014. The
convertible notes require monthly interest payments that started on September 1,
2010 at a rate of 11% per annum and will mature on March 19, 2014, unless
earlier repurchased or converted. No principal payments are required on these
convertible notes until maturity. We have the right to prepay the notes in whole
or in part at any time without penalty. The notes are convertible at any
time into 2,666,667 shares of our common stock at a conversion price of
approximately $3.19 per share.  In addition, the lenders received 160,000
warrants for our common stock, exercisable at the lenders’ option for $2.00 per
share. The warrants have a five-year term. The convertible notes are senior
secured obligations and rank junior to all senior debt held by TD
Bank, N.A. but senior to all other remaining long-term debt including existing
and future subordinated debt.


17


We used
$7.2 million of the net proceeds of the convertible notes to reduce, but not
eliminate, the outstanding principal balance on our senior debt held by TD Bank,
N.A. Also, we used $500,000 of the net proceeds of the convertible notes to
reduce the outstanding principal balance on our line of credit with TD Bank,
N.A. As part of this transaction, the remaining unpaid TD Bank, N.A. senior debt
was modified to have reduced principal payments and lower interest
rates.  However, because the convertible notes and the modified TD
Bank, N.A. senior debt, on a combined basis, have a higher weighted-average
interest rate than the pre-modified TD Bank, N.A. senior debt, we expect that
our interest expense will be higher than it would have been had we not partially
repaid and modified the TD Bank, N.A. senior debt. Because the convertible notes
and the modified TD Bank, N.A. senior debt require lower monthly principal
payments than the pre-modified TD Bank, N.A. senior debt, we expect our future
debt levels to be higher than they would have been had we not partially repaid
and modified the TD Bank, N.A. senior debt. We do expect the lower monthly
principal payments to significantly improve our short-term cash
flows.





In
addition to the $500,000 reduction of our line of credit described in the
preceding paragraph, the December 31, 2009 line of credit balance of $3.2
million was reduced to $0 by $2.7 million in cash payments obtained from
operating cash flows. We have the ability to access this line of credit for up
to a maximum of $5 million (not including a $1million reserve for pending legal
issues).





We own
interest rate swaps on a majority of our senior debt with TD Bank, N.A. in order
to minimize the effect of variable interest rates charged on that TD Bank, N.A.
debt.





Forecasted
principal and interest payments on debt for the next 12 months are $3.2 million
and are expected to be funded from operating cash flows. All other operating and
capital expenditures are also expected to be funded completely from operating
cash flows.





Off-Balance
Sheet Arrangements





Other
than immaterial operating leases, we did not have any off-balance sheet
arrangements during 2010 or 2009.





Critical
Accounting Policies





Use
of Estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires us to make estimates
and assumptions that affect the reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of the consolidated
financial statements and the reported amounts of revenues and expenses during
the reporting periods.  Estimates are used when accounting for certain
items such as reserves for inventory, accounts receivable and deferred tax
assets; assessing the carrying value of intangible assets including goodwill;
determining the useful lives of property, plant and equipment and intangible
assets; and in determining asset retirement obligations.  Estimates
are based on historical experience, where applicable, and assumptions that we
believe are reasonable under the circumstances.  Due to the inherent
uncertainty involved with estimates, actual results may differ.





Revenue
Recognition





Revenue
from the sale of products is recognized when the earnings process is complete
and the risks and rewards of ownership have transferred to the customer. Costs
and related expenses to manufacture the products are recorded as costs of goods
sold when the related revenue is recognized.





We have
several significant contracts providing for the sale of indefinite quantities of
items at fixed per unit prices, subject to adjustment for certain economic
factors. Revenue under these contracts is recognized when goods ordered under
the contracts are received by the customer. Whenever costs change, we review the
pricing under these contracts to determine whether they require the sale of
products at a loss. To date, we have no loss contracts which would require the
accrual of future losses in the current financial statements.





Income
Taxes





Deferred
tax assets and liabilities are determined based on differences between financial
reporting and tax bases of assets and liabilities and are measured using enacted
tax rates and laws that will be in effect when the differences are expected to
reverse.  Deferred tax assets are recognized when, based upon
available evidence, realization of the assets is more likely than
not.


18


When tax
returns are filed, it is highly certain that some positions taken would be
sustained upon examination by the taxing authorities, while others are subject
to uncertainty about the merits of the position taken or the amount of the
position that would be ultimately sustained. The benefit of a tax position is
recognized in the financial statements in the period during which, based on all
available evidence, it is more likely than not that the position will be
sustained upon examination, including the resolution of appeals or litigation
processes, if any. Tax positions taken are not offset or aggregated with other
positions. Tax positions that meet the more-likely-than-not recognition
threshold are measured as the largest amount of tax benefit that is more than
50 percent likely of being realized upon settlement with the applicable
taxing authority. The portion of the benefit associated with tax positions taken
that exceeds the amount measured as described above is reflected as a liability
for unrecognized tax benefits in the accompanying balance sheet along with any
associated interest and penalties that would be payable to the taxing
authorities upon examination.





We
classify interest on tax deficiencies as interest expense and income tax
penalties as other miscellaneous expenses.





Goodwill





Goodwill
is deemed to have an indefinite life and accordingly, is not subject to
amortization.  Goodwill is subject to an annual impairment review,
and, if conditions warrant, an interim impairment review.  Impairment
charges, if any, are recorded in the period in which the impairment is
determined. Our annual impairment review was performed as of August 31, 2010 and
we determined that no impairment of goodwill has occurred.





Intangible
Assets





Intangible
assets include developed technologies and patents, customer relationships and
non-compete agreements, which are amortized over their estimated useful lives,
and trademarks and trade names, which are considered to have indefinite useful
lives and therefore are not amortized. The carrying amounts of intangible assets
are reviewed for impairment whenever events or changes in circumstances indicate
that those carrying amounts may not be recoverable.





Costs
incurred to renew or extend the term of our intangible assets are expensed when
incurred. Costs to third parties that are related to internally developing or
successfully defending an intangible asset are capitalized as part of the
intangible asset developed or defended and amortized over that asset’s remaining
useful life. Such costs to third parties that are related to patent applications
that are ultimately rejected by the relevant government authority are expensed
upon rejection.





Inventories





Inventories
are stated at the lower of cost (on a first-in first-out (“FIFO”) method) or net
realizable value.  We periodically review the realizability of our
inventory. Provisions are recorded and reserves are established for potential
obsolescence. Determining adequate reserves for inventory obsolescence requires
management’s judgment. Conditions impacting the realizability of our inventory
could cause actual write-offs to be materially different than reported inventory
reserve balances.





Foreign
Operations and Currency





Accounts
of our foreign subsidiary are recorded using its local currency (the euro) as
the functional currency. For consolidation purposes, our foreign subsidiary’s
(i) income statement accounts are converted to U.S. dollars using the average
exchange rate for the monthly period being reported, (ii) assets and liabilities
are converted to U.S. dollars using the exchange rate in effect as of the
balance sheet date and (iii) equity transactions are converted to U.S. dollars
using the exchange rate in effect as of the date of the transaction. The
resulting translation gains and losses are reported as a component of
accumulated other comprehensive income or loss. Gains and losses resulting from
transactions which are denominated in other than the functional currencies are
reported as other, net in the statement of operations in the period the gain or
loss occurred.





ITEM 3.
            QUANTITATIVE
      AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





As a
smaller reporting company, we are not required to provide information typically
disclosed under this item.





ITEM 4.
            CONTROLS
      AND PROCEDURES





Evaluation
of Disclosure Controls and Procedures





Disclosure
controls and procedures are designed to ensure that information required to be
disclosed by us in reports filed or submitted under the Securities Exchange Act
of 1934 (“Exchange Act”) is recorded, processed, summarized and reported within
the time periods specified in the SEC’s rules and forms. Disclosure controls
include, without limitation, controls and procedures designed to ensure that
information required to be disclosed under the Exchange Act is accumulated and
communicated to management, including principal executive and financial
officers, as appropriate to allow timely decisions regarding required
disclosure. There are inherent limitations to the effectiveness of any system of
disclosure controls and procedures, including the possibility of human error and
the circumvention or overriding of the controls and procedures. Accordingly,
even effective disclosure controls and procedures can only provide reasonable
assurance of achieving their control objectives.


19


Our
management carried out an evaluation, under the supervision of our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of our
disclosure controls and procedures as of September 30, 2010. Based upon that
evaluation, our management, including our Chief Executive Officer and Chief
Financial Officer, concluded that the design and operation of our disclosure
controls and procedures were effective as of September 30, 2010.





Changes
in Internal Control over Financial Reporting





There
were no changes in our internal control over financial reporting that occurred
during the three months ended September 30, 2010 that materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting.





PART II
– OTHER INFORMATION




ITEM 1.
            LEGAL
      PROCEEDINGS





Cyalume
is not currently a named party in any legal proceedings.





There
have been no material developments in the proceedings known as
Civil Action No. 06-706 in Superior Court of the Commonwealth of Massachusetts
since the developments described in our Form 10-Q filed August 11, 2010. For
full details in this matter, see Note 8 of the condensed consolidated financial
statements in Part 1, Item 1 of this Form 10-Q





ITEM 1A.
            RISK
      FACTORS





As a
smaller reporting company, we are not required to provide information typically
disclosed under this item.





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





Recent
Sales of Unregistered Securities and Use of Proceeds from Registered
Securities





None.





Purchases
of Equity Securities by the Company and Affiliated Purchasers





None.





ITEM 3.
            DEFAULTS
      UPON SENIOR SECURITIES





None.





ITEM 4.
            [REMOVED
      AND RESERVED]





ITEM 5.
            OTHER
      INFORMATION





There
were no changes to the procedures by which security holders may recommend
nominees to our Board of Directors during the three months ended September 30,
2010.





There is
no information to report under this Item in lieu of reporting that information
on Form 8-K.


20


ITEM 6.
            EXHIBITS





Exhibit
                  Number
                
                Description10.1
                
                Extension
      of deadline contained in the Second Amendment to the Credit Agreement and
      Limited Waiver with TD Bank, N.A. (1)10.2
                
                Subordinated
      Loan Agreement dated as of July 29, 2010 among Cyalume Technologies, Inc.,
      Cyalume Technologies Holdings, Inc., the Lenders and other financial
      institutions or other entities from time to time parties thereto and
      Granite Creek Partners Agent, LLC as Agent. (2)10.3
                
                Subordinated
      Security and Pledge Agreement dated as of July 29, 2010 between Cyalume
      Technologies, Inc. and Granite Creek Partners Agent, LLC.
    (2)10.4
                
                Subordinated
      Guaranty Agreement dated as of July 29, 2010 entered into by Cyalume
      Technologies Holdings, Inc. for the benefit of Granite Creek Partners
      Agent, LLC. (2)10.5
                
                Subordinated
      Stock Pledge Agreement dated as of July 29, 2010 entered into by Cyalume
      Technologies Holdings, Inc.  (2)10.6
                
                Amended
      and Restated Revolving Credit and Term Loan Agreement dated as of July 29,
      2010 among Cyalume Technologies, Inc., Cyalume Technologies Holdings,
      Inc., the Lenders and the other financial institutions or other entities
      from time to time parties thereto and TD Bank, N.A., a national banking
      association, as Agent and as Lender. (2)10.7
                
                Form
      of Warrant issued to Granite Creek FlexCap I, L.P. (2)10.8
                
                Form
      of Warrant issued to Patriot Capital II, LP. (2)10.9
                
                Registration
      Rights Agreement between CTHI and Granite Creek FlexCap I, L.P.
      (2)10.10
                
                Registration
      Rights Agreement between CTHI and Patriot Capital II, LP.
    (2)10.11
                
                Amended
      Management Agreement with Selway Capital, LLC. (2)11.1
                
                Statement
      Regarding Computation of Per Share Earnings. (3)31.1
                *
                Certification
      of Principal Executive Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.31.2
                *
                Certification
      of Principal Financial Officer pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.32.1
                *
                Certification
      of Principal Executive Officer and Principal Financial Officer pursuant to
      Section 906 of the Sarbanes-Oxley Act of
2002.


*
              Filed
      herewith.


(1)
            Incorporated
      by reference to the Current Report on Form 8-K dated June 30, 2010 and
      filed with the Commission July 8,
2010.


(2)
            Incorporated
      by reference to the Current Report on Form 8-K dated July 29, 2010 and
      filed with the Commission August 3,
2010.


(3)
            Incorporated
      by reference to Note 8 of the condensed consolidated financial statements
      in Part 1, Item 1 of this Form
10-Q.


21


SIGNATURES





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





Cyalume
      Technologies Holdings, Inc.Date:
      November 1, 2010
                    By:
                    /s/  DEREK
  DUNAWAYDerek
      Dunaway, Chief Executive Officer(Principal
      Executive Officer)Date:
      November 1, 2010
                    By:
                    /s/  MICHAEL
    BIELONKOMichael
      Bielonko, Chief Financial Officer(Principal
      Financial Officer and Principal Accounting
                      Officer)


22