##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON, D.C. 20549
 FORM 10-QSB
 þ
    
    QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
   o
    
    TRANSITION REPORT UNDER SECTION 13 or 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
  SUNAIR SERVICES CORPORATION
  FLORIDA
    
    59-0780772(STATE OR OTHER JURISDICTION OF INCORPORATION
OR ORGANIZATION)
    
    (I.R.S. EMPLOYER IDENTIFICATION NO.)
 3005 SW THIRD AVE., FT. LAUDERDALE, FL.
    
    33315(ADDRESS OR PRINCIPAL EXECUTIVE OFFICE)
    
    (ZIP CODE)
 ISSUERS TELEPHONE NUMBER (INCLUDING AREA CODE)
    
    (954) 525-1505
 
   x o
  o x
  o x




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PAGE NO.PART I. FINANCIAL INFORMATION:ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
    
    
    3CONSOLIDATED CONDENSED BALANCE SHEETS  MARCH 31, 2006 AND SEPTEMBER 30, 2005
    
    
    3CONSOLIDATED
CONDENSED STATEMENTS OF INCOME   SIX MONTHS ENDED MARCH 31, 2006 AND 2005
    
    
    5CONSOLIDATED
CONDENSED STATEMENTS OF INCOME  THREE MONTHS ENDED MARCH 31, 2006 AND 2005
    
    
    6CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS  SIX MONTHS ENDED MARCH 31, 2006 AND 2005
    
    
    7NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
    
    
    9ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
    
    
    16ITEM 3. CONTROLS AND PROCEDURES
    
    
    18PART II. OTHER INFORMATION
    
    
    19ITEM 1. LEGAL PROCEEDINGS
    
    
    19ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
    
    
    19ITEM 3. DEFAULTS UPON SENIOR SECURITIES
    
    
    19ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    19ITEM 5. OTHER INFORMATION
    
    
    19ITEM 6. EXHIBITS
    
    
    19SIGNATURES
    
    
    20
 -2-




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SUNAIR SERVICES CORPORATION AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS
(UNAUDITED)
 ASSETS
 March 31, 2006
    
    
    September 30, 2005CURRENT ASSETS:Cash and cash equivalents
    
    $
    3,476,320
    
    
    $
    3,220,699Accounts receivable, net
    
    
    5,320,284
    
    
    
    4,983,714Interest receivable
    
    
    12,707
    
    
    
    14,488Inventories, net
    
    
    7,616,168
    
    
    
    7,609,727Deferred tax asset
    
    
    424,859
    
    
    
    315,837Prepaid and other current assets
    
    
    2,034,421
    
    
    
    1,435,146Total Current Assets
    
    
    18,884,759
    
    
    
    17,579,611NOTE RECEIVABLE
    
    
    334,986
    
    
    
    334,986PROPERTY, PLANT, AND EQUIPMENT, net
    
    
    2,792,398
    
    
    
    2,321,008DEFERRED TAX ASSET
    
    
    168,635
    
    
    
    OTHER ASSETSSoftware costs, net
    
    
    3,904,638
    
    
    
    3,938,402Customer list, net
    
    
    12,071,788
    
    
    
    10,262,250Goodwill
    
    
    53,725,987
    
    
    
    43,599,379Other assets
    
    
    211,232
    
    
    
    80,393Total Other Assets
    
    
    69,913,645
    
    
    
    57,880,424TOTAL ASSETS
    
    $
    92,094,423
    
    
    $
    78,116,029
  -3-




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SUNAIR SERVICES CORPORATION AND SUBSIDIARIES
CONSOLIDATED CONDENSED BALANCE SHEETS

(UNAUDITED)
 LIABILITIES AND STOCKHOLDERS EQUITY
 March 31, 2006
    
    
    September 30, 2005CURRENT LIABILITIES:Accounts payable
    
    $
    2,935,906
    
    
    $
    4,630,304Accrued expenses
    
    
    4,469,200
    
    
    
    2,274,312Unearned revenues
    
    
    489,417
    
    
    
    181,216Customer deposits
    
    
    2,224,123
    
    
    
    1,490,677Capital lease obligations, current portion
    
    
    11,933
    
    
    
    41,561Notes payable, current portion
    
    
    114,028
    
    
    
    90,645Total Current Liabilities
    
    
    10,244,607
    
    
    
    8,708,715LONG TERM LIABILITIESCapital lease obligations, net of current
portion
    
    
    
    
    
    
    6,712Notes payable, net of current portion
    
    
    1,844,739
    
    
    
    287,549Notes payable related party
    
    
    5,000,000
    
    
    
    5,000,000Revolving line of credit
    
    
    10,500,000
    
    
    
    12,000,000Deferred tax liability
    
    
    
    
    
    
    188,400Total Long Term Liabilities
    
    
    17,344,739
    
    
    
    17,482,661Total Liabilities
    
    
    27,589,346
    
    
    
    26,191,376STOCKHOLDERS EQUITY:Preferred stock, no par value, 2,000,000
shares authorized, none issued and
outstandingCommon
stock, $.10 par value, 25,000,000 shares authorized, 13,060,559, and
10,186,377 shares issued and outstanding at
March 31, 2006 and September 30, 2005
respectively
    
    
    1,306,056
    
    
    
    1,018,638Additional paid-in-capital
    
    
    51,252,133
    
    
    
    37,759,670Retained earnings
    
    
    12,008,342
    
    
    
    13,170,774Translation adjustment
    
    
    (61,454
    )
    
    
    (24,429
    )Total Stockholders Equity
    
    
    64,505,077
    
    
    
    51,924,653TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    92,094,423
    
    
    $
    78,116,029
  -4-




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SUNAIR SERVICES CORPORATION AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(UNAUDITED)
 Six Months EndedMarch 31, 2006
    
    
    March 31, 2005SALES
    
    $
    27,651,312
    
    
    $
    9,940,320COST OF SALES
    
    
    11,933,476
    
    
    
    5,537,526GROSS PROFIT
    
    
    15,717,836
    
    
    
    4,402,794SELLING, GENERAL AND ADMINISTRATIVE
EXPENSES
    
    
    16,713,752
    
    
    
    3,419,467INCOME (LOSS) FROM OPERATIONS
    
    
    (995,916
    )
    
    
    983,327OTHER INCOME (EXPENSES):Interest income
    
    
    30,872
    
    
    
    150,426Interest expense
    
    
    (668,445
    )
    
    
    (32,140
    )Other income (expenses)
    
    
    5,000
    
    
    
    (18,306
    )Total Other Income (Expenses)
    
    
    (632,573
    )
    
    
    99,980INCOME (LOSS) BEFORE BENEFIT (PROVISION)
FOR INCOME TAXES
    
    
    (1,628,489
    )
    
    
    1,083,307BENEFIT (PROVISION) FOR INCOME TAXES
    
    
    466,057
    
    
    
    (347,800
    )NET INCOME (LOSS)
    
    $
    (1,162,432
    )
    
    $
    735,507NET INCOME (LOSS) PER COMMON SHARE:BASIC
    
    $
    (0.10
    )
    
    $
    0.14DILUTED
    
    $
    (0.10
    )
    
    $
    0.11WEIGHTED AVERAGE SHARES OUTSTANDING:BASIC
    
    
    11,646,412
    
    
    
    5,412,524DILUTED
    
    
    11,661,482
    
    
    
    6,667,402
  -5-




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SUNAIR SERVICES CORPORATION AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(UNAUDITED)
 Three Months EndedMarch 31, 2006
    
    
    March 31, 2005SALES
    
    $
    14,685,322
    
    
    $
    4,846,332COST OF SALES
    
    
    6,661,181
    
    
    
    2,736,727GROSS PROFIT
    
    
    8,024,141
    
    
    
    2,109,605SELLING, GENERAL AND ADMINISTRATIVE
EXPENSES
    
    
    8,734,587
    
    
    
    1,628,952INCOME (LOSS) FROM OPERATIONS
    
    
    (710,446
    )
    
    
    480,653OTHER INCOME (EXPENSES):Interest income
    
    
    14,204
    
    
    
    114,650Interest expense
    
    
    (257,270
    )
    
    
    (12,258
    )Other income (expenses)
    
    
    9,789
    
    
    
    (11,460
    )Total Other Income (Expenses)
    
    
    (233,277
    )
    
    
    90,932INCOME (LOSS) BEFORE BENEFIT (PROVISION)
FOR INCOME TAXES
    
    
    (943,723
    )
    
    
    571,585BENEFIT (PROVISION) FOR INCOME TAXES
    
    
    145,834
    
    
    
    (208,483
    )NET INCOME (LOSS)
    
    $
    (797,889
    )
    
    $
    363,102NET INCOME (LOSS) PER COMMON SHARE:BASIC
    
    $
    (0.06
    )
    
    $
    0.05DILUTED
    
    $
    (0.06
    )
    
    $
    0.04WEIGHTED AVERAGE SHARES OUTSTANDING:BASIC
    
    
    12,805,558
    
    
    
    6,848,203DILUTED
    
    
    12,813,702
    
    
    
    9,993,921
  -6-




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SUNAIR SERVICES CORPORATION AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 Six Months EndedMarch 31, 2006
    
    
    March 31, 2005CASH FLOWS FROM OPERATING ACTIVITIES:Net income (loss)
    
    $
    (1,162,432
    )
    
    $
    735,507Adjustments to reconcile net income
(loss) to
net cash provided by operating activities:Depreciation
    
    
    435,919
    
    
    
    96,249Amortization
    
    
    944,946
    
    
    
    159,437Deferred taxes
    
    
    (466,057
    )
    
    
    119,725Bad debt reserve
    
    
    303,026
    
    
    
    Equity based compensation
    
    
    123,409
    
    
    
    Inventories reserve
    
    
    29,698
    
    
    
    52,571(Increase) decrease in Assets:Accounts receivable
    
    
    (164,628
    )
    
    
    40,788Interest receivable
    
    
    1,781
    
    
    
    97,138Inventories
    
    
    120,822
    
    
    
    100,085Prepaid and other current assets
    
    
    (599,275
    )
    
    
    (458,366
    )Other assets
    
    
    (130,839
    )
    
    
    Increase (decrease) in Liabilities:Accounts payable and accrued expenses
    
    
    175,458
    
    
    
    (710,953
    )Unearned revenue
    
    
    234,631
    
    
    
    (15,168
    )Income taxes payable
    
    
    
    
    
    
    235,544Customer deposits
    
    
    419,995
    
    
    
    Net Cash Provided By Operating Activities
    
    
    266,454
    
    
    
    452,557CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of property, plant, and equipment
    
    
    (250,177
    )
    
    
    (67,410
    )Software development costs
    
    
    (229,692
    )
    
    
    (226,971
    )Cash paid for business acquisitions
    
    
    (11,578,687
    )
    
    
    (1,500,000
    )Proceeds from redemption of held-to-maturity investments
    
    
    
    
    
    
    2,913,601Net Cash (Used In) Provided By Investing Activities
    
    $
    (12,058,556
    )
    
    $
    1,119,220
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SUNAIR SERVICES CORPORATION AND SUBSIDIARIES
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)
 Six Months EndedMarch 31, 2006
    
    
    March 31, 2005CASH FLOWS FROM FINANCING ACTIVITIES:Principal repayment of line of credit
    
    $
    (1,500,000
    )
    
    $
    (2,000,000
    )Proceeds from exercise of stock options
    
    
    
    
    
    
    18,563Proceeds from the sale of common stock
    
    
    13,656,472
    
    
    
    24,242,420Principal on capital leases
    
    
    (36,340
    )
    
    
    Principal repayment of notes payable
    
    
    (35,384
    )
    
    
    (10,557
    )Net Cash Provided By (Used In) Financing Activities
    
    
    12,084,748
    
    
    
    22,250,426Effect of Exchange Rate Fluctuations on Cash
    
    
    (37,025
    )
    
    
    50,625NET INCREASE IN CASH
AND CASH EQUIVALENTS
    
    
    255,621
    
    
    
    23,872,828CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    3,220,699
    
    
    
    3,872,224CASH AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    3,476,320
    
    
    $
    27,745,052SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:Cash paid during the period for income taxes
    
    $
    
    
    
    $
    125,000Cash paid during the period for interest
    
    $
    553,389
    
    
    $
    32,140
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1.
    
    Basis Of Consolidated Financial Statement PresentationThe accompanying unaudited consolidated condensed financial statements have been prepared by the
Company pursuant to the rules and regulations of the Securities and Exchange Commission
and in accordance with the instructions to Form 10-QSB and do not include all the
information and footnote disclosures normally included in consolidated financial
statements prepared in accordance with accounting principles generally accepted in the
United States of America. The information furnished in the interim financial statements
includes normal recurring adjustments and reflects all adjustments, which, in the
opinion of management, are necessary for a fair presentation of such financial
statements. For further information refer to the consolidated financial statements and
footnotes thereto included in the Companys most recent audited consolidated financial
statements and notes thereto included in its September 30, 2005 annual report on Form
10-KSB. Operating results for the three and six months ended March 31, 2006 and 2005 are
not necessarily indicative of the results that may be expected for the year ending
September 30, 2006.2.
    
    Significant Accounting PoliciesUse Of Estimates
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 in the consolidated financial
statements and accompanying notes. Actual results could differ from those estimates.Accounts Receivable
Accounts receivable consist of balances due from sales. The Company monitors accounts
receivable and provides allowances when considered necessary. As of March 31, 2006 and
September 30, 2005, the Company established an allowance of $601,722 and $144,194
respectively.Investments
Certain investments that management has the intent and ability to hold to maturity are
reported at cost, adjusted for amortization of premiums and accretion of discounts that
are recognized in interest income using the interest method over the period to maturity.Marketable and debt securities which management has classified as trading are carried at
fair value with net unrealized gains and losses reported in operations. Realized gains
and losses on marketable equity and debt securities are recognized upon sale using the
specific identification method.Inventories
Inventories, which consist of raw materials, work-in-process, and finished goods, are
stated at the lower of cost or market value, cost being determined using the first in,
first out method. Fixed and variable manufacturing costs and overhead are included in
the carrying values of finished goods and work-in-process. The Company records reserves
for inventory shrinkage and obsolescence, when considered necessary. As of March 31,
2006 inventory shrinkage and obsolescence reserves increased $29,698 from September 30,
2005.
 -9-




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Property, Plant, And Equipment
Property, plant and equipment are carried at cost. Depreciation is provided over the
estimated useful lives of the assets using both the straight-line and accelerated
methods. The estimated useful lives used to compute depreciation are as follows:
 Buildings and improvements
    
    10 to 30 yearsMachinery and equipment
    
    4 to 10 years
 The cost of maintenance and repairs is charged to expense as incurred; renewals and
betterments are capitalized. When properties are retired or otherwise disposed of, the
cost of such properties and the related accumulated depreciation are removed from the
accounts. Any profit or loss is credited, or charged to income.Software Costs
The Company capitalizes certain costs associated with software development in accordance
with statement of Financial Accounting Standard #86 (FASB No.86) Accounting for the
costs of computer software to be sold, leased, or otherwise marketed. The Company
amortizes costs over 10 years, the estimated useful life of the asset.Customer List
Pursuant to the acquisition of Middleton Pest Control, Inc.
(Middleton), the Company recorded
Customer List as an intangible asset in the amount of $10,500,000, which amount was
determined pursuant to an independent third-party appraisal. The Company is amortizing
the Customer List over its estimated economic life of 8 years.Pursuant to the acquisition of Four Seasons Lawn and Pest Control, Inc. by Middleton, the Company recorded Customer
List as an intangible asset in the amount of $204,000. The Company is amortizing the
Customer List over its estimated economic life of 8 years.Pursuant to the acquisition of Spa Creek Services, LLC, D/B/A
Pest Environmental Services, Inc. (Spa Creek)
 by Middleton, the Company recorded
Customer List as an intangible asset in the amount of $262,000. The Company is
amortizing the Customer List over its estimated economic life of 8 years.Pursuant to the acquisition of Par Pest Control, Inc. D/B/A
Paragon Termite & Pest Control (Paragon) by Middleton, the Company recorded Customer List
as an intangible asset in the amount of $562,400. The Company is amortizing the
Customer List over its estimated economic life of 8 years.Pursuant to the acquisition of Pestec Pest Control, Inc.
(Pestec) by Middleton, the Company recorded Customer List
as an intangible asset in the amount of $112,628. The Company is amortizing the
Customer List over its estimated economic life of 8 years.Pursuant to the acquisition of Ron Fee, Inc. by Middleton, we recorded Customer List as
an intangible asset in the amount of $1,554,000. The Company is amortizintg the Customer
List over its estimated economic life of 8 years.
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Impairment Of Long-Lived Assets And Long-Lived Assets To Be Disposed OfThe Company reviews long-lived assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison of the carrying
amount of an asset to future undiscounted cash flows expected to be generated by the
asset. If such assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the assets exceeds the fair value. Assets to be
disposed of are reported at the lower of the carrying amount or fair value less costs to
sell. There were no assets impaired during the six months ended March 31, 2006 and
2005.Income (Loss) Per ShareBasic earnings per share amounts are computed by dividing the net income by the weighted
average number of common shares outstanding. Diluted earnings per share amounts are
computed by dividing net income by the weighted average number of shares of common
stock, common stock equivalents, and stock options outstanding during the period.Revenue RecognitionSales revenues are recorded when products are shipped and title has passed to
unaffiliated customers. Installation revenues are considered earned at the time the
project is completed. Maintenance contracts are recorded as unearned revenues at the
time of collection and are recognized as income monthly over the term of the contract.
Interest and dividends earned on investments are recorded when earned.Advertising Costs
The Company expenses advertising costs as incurred.Research And Development
Expenditures for research and development are charged to operations as incurred.Foreign Currency Translation
Telecoms functional currency is the British Pound Sterling, its local currency.
Accordingly, balance sheet accounts are translated at exchange rates in effect at the
end of the year and income statement accounts are translated at average exchange rates
for the year. Translation gains and losses are included as a separate component of
stockholders equity as cumulative translation adjustments. Foreign currency
transaction gains and losses are included in other income and expenses.Comprehensive Income
Comprehensive income is comprised of net income and other comprehensive income. Other
comprehensive income includes certain changes in equity that are excluded from net
income. At March 31, 2006 and September 30, 2005, accumulated other comprehensive
income was comprised of cumulative foreign currency translation adjustments.Stock-Based CompensationEffective January 1, 2006, the Company adopted the provisions of SFAS No. 123 (revised 2004),
Share-Based Payment (SFAS No. 123R), using the modified prospective method (with the
Black-Scholes fair value model), which requires the Company to recognize expense related to the
fair value of stock-based compensation awards. Under the modified prospective method, stock-based
compensation expense for the three months ended March 31, 2006 includes compensation expense for
all stock-based compensation awards granted prior to, but not yet vested as of, January 1, 2006,
based on grant date fair value estimated in accordance with the original provisions of SFAS No.
123, Accounting for Stock-Based Compensation (SFAS No. 123), and compensation expense for all
stock-based compensation awards granted subsequent to January 1, 2006, based on the grant date fair
values estimated in accordance with the provisions of SFAS No. 123R. In addition, stock options
granted to certain members of the Board of Directors (Board) as payment for services rendered as
board members (Board Services) recorded in accordance with SFAS No. 123R are also included in
stock-based compensation for the three months ended March 31, 2006. Accordingly, prior period
amounts presented herein have not been restated to reflect the adoption of SFAS No. 123R.Prior to January 1, 2006, the Company accounted for its stock-based compensation plan as
permitted by SFAS No. 123, using the intrinsic value method prescribed in Accounting Principles
Board Opinion No. 25, Accounting for Stock Issued to Employees (APB No. 25), and made the pro
forma disclosures required by SFAS No. 148, Accounting for Stock-Based CompensationTransition
and Disclosure (SFAS No. 148) for the three months ended March 31, 2005. All options granted under the Plan
(discussed in Note 7) and Prior Plan (discussed in Note 7) had exercise prices equal to the fair
market value of the underlying Common Stock on the date of grant. Accordingly, for the three months
ended March 31, 2005, stock-based compensation is related to options granted to certain members of
the Board for Board Services recorded in accordance with APB No. 25.3.
    
    AcquisitionsAcquisition of Middleton Pest Control, Inc.On June 7, 2005, the Company, Sunair Southeast Pest Holdings, Inc., a wholly owned
subsidiary of the Company (Pest Holdings), and the selling shareholders (collectively,
the Sellers) of Middleton,
entered into a Stock Purchase Agreement (the Stock Purchase Agreement) pursuant to
which, on the same date, Pest Holdings acquired from the Sellers 100% of the issued and
outstanding shares of capital stock of Middleton. The aggregate purchase price for the
outstanding capital stock of Middleton was $50,000,000, which was comprised of: (i)
$35,000,000 in cash; (ii) $5,000,000 in the form of a subordinated promissory note; and
(iii) 1,028,807 shares of the Companys common stock. The Company also incurred closing
costs of $1,610,541 and a charge of $1,400,000 for Middletons built-in capital gains
tax for a total purchase price of $53,010,541.
 -11-




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The following table sets forth the preliminary allocation of the purchase price to
Middletons tangible and intangible assets acquired and liabilities assumed as of May
31, 2005:
 Cash
    
    $
    1,377,035Accounts receivable
    
    
    1,504,821Inventory
    
    
    546,129Prepaid assets
    
    
    662,565Fixed assets
    
    
    1,587,781Other assets
    
    
    63,762Customer List
    
    
    10,500,000Goodwill
    
    
    40,297,345Accounts payable
    
    
    (590,377
    )Accrued liabilities
    
    
    (930,739
    )Customer deposits
    
    
    (1,550,611
    )Notes payable
    
    
    (457,170
    )Total
    
    $
    53,010,541
 Acquisition of Four Seasons Lawn and Pest Control, Inc.On July 29, 2005, Middleton entered into an Asset Purchase Agreement to acquire
substantially all of the assets of Four Seasons Lawn and Pest Control, Inc. for
$1,423,760.Acquisition of Spa Creek, LLC.On December 16, 2005, Middleton entered into a definitive Asset Purchase Agreement by
and among Middleton and Spa Creek Services, LLC, D/B/A Pest Environmental Services,
Inc., a Delaware limited liability company (Spa Creek), to acquire substantially all
the assets and assumed certain liabilities of Spa Creek for $5,500,000.In addition, the Company incurred $233,419 of transaction costs consisting of legal and
accounting fees.The following table sets forth the preliminary allocation of the purchase price to Spa
Creek tangible and intangible assets acquired and liabilities assumed as of December 16,
2005:
 Goodwill
    
    $
    5,521,932Customer List
    
    
    262,000AR
    
    
    132,929Inventory
    
    
    66,475PPE
    
    
    30,000Customer deposits
    
    
    (279,917
    )Total
    
    $
    5,733,419
 Acquisition of Pestec Pest Control, Inc.On February 28, 2006 Middleton, entered into an Asset Purchase Agreement to
acquire substantially all of the assets of Pestec for approximately $800,000 consisting of $775,000 cash and $25,000 in transaction costs.
 -12-




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##### 



Acquisition of Par Pest Control, Inc.On January 9, 2006, Middleton entered into an Asset Purchase Agreement to acquire
substantially all of the assets of Paragon for approximately $1,050,000 consisting of
$800,000 cash,
$100,000 in the form of a subordinated note, $50,000 in transaction costs and 17,036 shares
of common stock.Acquisition of Ron Fee, Inc.On March 31, 2006 the Company, through Middleton, entered into a definitive Asset
Purchase Agreement to acquire substantially all of the assets and certain liabilities of
Ron Fee, Inc., a Florida corporation, for $5,200,000 consisting of
$4 million cash and $1.2 million in the form of a subordinated promissory note.In addition, the Company incurred approximately $325,000 of transaction costs consisting
of legal and accounting fees.The following table sets forth the preliminary allocation of the purchase price to Ron
Fee, Inc. tangible and intangible assets acquired and liabilities
assumed as of March 31, 2006:
 Goodwill
    
    $
    3,330,000Customer List
    
    
    1,554,000Accounts receivable
    
    
    235,000Inventory
    
    
    91,000PPE
    
    
    440,000Accounts payable
    
    
    (74,000
    )Customer deposits
    
    
    (22,000
    )Notes payable
    
    
    (29,000
    )Total
    
    $
    5,525,000
 Pro-Forma Results of OperationsThe following sets forth the Companys results of operations for the Six Months ended
March 31, 2006 as if the acquisitions had taken place on October 1, 2004.
 Six Months Ended March 31,2006
    
    
    2005Revenues
    
    $
    30,951,059
    
    
    $
    29,939,733Net income
    
    $
    (918,387
    )
    
    $
    1,150,531Earnings per shareBasic
    
    $
    (.08
    )
    
    $
    .21Diluted
    
    $
    (.08
    )
    
    $
    .17
 -13-




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##### 



4.
    
    InventoriesInventories consist of the following:
 March 31,2006
    
    
    September 30, 2005Materials
    
    $
    1,737,072
    
    
    $
    2,942,827Work In Progress
    
    
    4,261,712
    
    
    
    3,533,734Finished Goods
    
    
    1,617,384
    
    
    
    1,133,166$
    7,616,168
    
    
    $
    7,609,727
 5.
    
    Earnings Per Common ShareBasic earnings per share amounts are computed by dividing the net income by the weighted
average number of common shares outstanding. Diluted earnings per share amounts are
computed by dividing net income by the weighted average number of shares of common
stock, common stock equivalents, and stock options outstanding during the period.6.
    
    Preferred StockAt March 31, 2006, the Company had 8,000,000 authorized shares of preferred stock,
no par value, that may be issued at such terms and provisions as determined by the board
of directors. None are outstanding.7.
    
    Stock-Based Compensation 
Summary of plansDuring the fiscal year ended September 30, 2005, the shareholders approved the 2004 Stock
Incentive Plan with an aggregate of 800,000 shares of the Companys unissued common
stock to be reserved for issuance to key employees as non-qualified stock options.The
option price, numbers of shares and grant date are determined at the discretion of the
Companys board of directors.During the quarter ended December 31, 2005, 105,000 stock options were granted at a
price of $5.60 per share.During the quarter ended March 31, 2006, 20,000 stock options were granted at a
price of $5.35 per share and 17,500 stock options were granted at a price of $6.09 per
share. 13,244 stock options at a price of $11.40 per share and 5,000 stock options at a
price of $5.60 per share were cancelled.Fair ValueOn January 1, 2006, the Company adopted the provisions of SFAS No. 123R which requires the
Company to recognize expense related to the fair value of stock-based compensation awards. The
Company elected the modified perspective transition method as permitted by SFAS No. 123R and
therefore has not restated the financial results for prior periods. Under the modified prospective
method, stock-based compensation expense for the three months ended March 31, 2006 includes
compensation expense for all stock-based compensation awards granted prior to, but not yet vested
as of, January 1, 2006, based on grant date fair value estimated in accordance with the provisions
of SFAS No. 123 and compensation expense for all stock-based compensation awards granted subsequent
to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions
of SFAS No. 123R. In addition, options granted to certain members of the Board of Directors as
payment for services rendered as board members (Board Services) recorded in accordance with SFAS
No. 123R and the issuance of restricted stock awards and stock units are also included in
stock-based compensation for the three months ended March 31, 2006. The Company recognizes
compensation expense for restricted stock awards and restricted stock units on a straight-line
basis over the requisite service period of the award. For the three months ended March 31, 2006,
the Company expensed $123,409 compensation expense and is being reflected as selling, general and
administrative expenses.Prior to January 1, 2006, the Company accounted for its stock-based compensation plan as permitted
by SFAS No. 123, using the intrinsic value method prescribed in APB No. 25, and made the pro forma
disclosures required by SFAS No. 148 for the three months ended March 31, 2005. All options granted
under the Plan and Prior Plan had exercise prices equal to the fair market value of the underlying
Common Stock on the date of grant. Accordingly, for the three months ended March 31, 2005,
stock-based compensation was recorded in accordance with APB No. 25.The following table illustrates the effect on net income and net income per share of Common Stock
as if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based
compensation during the three months ended March 31, 2005:
 For the ThreeMonths EndedMarch 31, 2005Net income:As reported
    
    $
    363,102Add: Stock-based compensation expense, as
reported
    
    
    Deduct: Stock-based compensation expense, pro forma
    
    
    (63,287
    )Net income, pro forma
    
    $
    299,815Net income per share, basic:Basic, as reported
    
    $
    0.05Stock-based compensation expense, pro forma
    
    
    (0.01
    )Net income per share, basic, pro forma
    
    $
    0.04Net income per share, diluted:Diluted, as reported
    
    $
    0.04Stock-based compensation expense, pro forma
    
    
    (0.01
    )Net income per share, diluted, pro forma
    
    $
    0.03
 The fair value of stock-based awards was estimated using the Black-Scholes model with the
following weighted-average assumptions for the three months ended March 31, 2006:
 For the Three Months EndedMarch 31,2006
    
    
    2005Expected term (in years)
    
    
    8
    
    
    
    8Volatility
    
    
    31
    %
    
    
    31
    %Interest rate
    
    
    4.14
    %
    
    
    3.86
    %Dividend yield
    
    
    
    
    
    
    Weighted average fair value at grant
date
    
    $
    4.43
    
    
    
    6.33
 The Companys computation of the expected volatility for the three months ended March 31, 2006 is
based primarily upon historical volatility and the expected term of the option. The expected term
is based on the historical exercise experience under the share-based plans of the underlying award
(including post-vesting employment termination behavior) and represents the period of time the
share-based awards are expected to be outstanding. The interest rate is based on the U.S. Treasury
yield in effect at the time of grant for a period commensurate with the estimated expected life.As of March 31, 2006, approximately $1.8 million of total unrecognized compensation costs related
to non-vested stock options is expected to be recognized over a weighted average period of 2 years.8.
    
    Sale of Securities  Private PlacementOn January 27, 2006, the Company completed the sale of its securities to investors in a
private placement pursuant to purchase agreements, dated December 15, 2005, by and among
the Company and the investors of the common stock named therein (the Purchase
Agreements). Pursuant to the Purchase Agreements, the Company agreed to sell up to an
aggregate of 2,857,146 shares of its common stock at a price per share of $5.25 and
warrants to purchase 1,000,000 shares of its common stock (the Private Placement) at
an exercise price of $6.30 (subject to adjustment) with total gross proceeds (before
fees and expenses) to the Company of approximately $15 million and net proceeds to the
Company of approximately $13.7 million.
 -14-




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##### 



9.
    
    Segment Information:Certain financial information for each segment is provided below as of March 31:
 2006
    
    
    2005Net revenues:Pest control
    
    $
    20,375,094
    
    
    $
    Transmission equipment
    
    
    3,372,202
    
    
    
    5,297,028Telephone systems
    
    
    3,904,016
    
    
    
    4,643,292Total net revenues
    
    $
    27,651,312
    
    
    $
    9,940,320Income (loss) before taxes:Pest control
    
    $
    1,523,151
    
    
    $
    Transmission equipment
    
    
    736,716
    
    
    
    904,425Telephone systems
    
    
    (533,962
    )
    
    
    178,882Unallocated home office expenses
    
    
    (3,354,394
    )
    
    
    Total operating income (loss)
    
    $
    (1,628,489
    )
    
    $
    1,083,307
 10.
    
    Recent Accounting Pronouncements:In November 2004 the FASB issued SFAS No. 151, Inventory Costs. SFAS No. 151 amends the
guidance in Accounting Research Bulletin 43, Inventory Pricing, to clarify the
accounting for abnormal amounts of idle facility expenses, freight, handling costs and
wasted material (spoilage) cost. SFAS No. 151 requires those items to be excluded from
the cost of inventory and expensed when incurred. It also requires that the allocation
of fixed production overheads to the costs of conversion be based on the normal capacity
of the production facilities. SFAS No. 151 is effective for fiscal years beginning after
June 15, 2005. The Company is still evaluating the impact of adopting SFAS No 151, but
the Company does not expect it to have a material impact on its consolidated results of
operations or financial position.In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement
of APB Opinion No. 20 and FASB Statement No. 3. This Statement provides guidance on
accounting for reporting of accounting changes and error corrections. This statement is
effective for accounting changes and corrections of errors made in fiscal years
beginning after December 15, 2005. The Company does not expect the statement to have a
material effect on its financial statements.
 -15-




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##### 



Item 2. Managements Discussion and Analysis or Plan of Operation
   General:
 4
 The Lawn and Pest Control Services Segment
    -16-




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##### 



Liquidity:
       -17-




---



##### 



Capital Resources:
   Results of Operations:
       
 Item 3. Controls And Procedures
   -18-




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##### 



Director
    
    Affirmative Votes
    
    
    Withheld VotesJoseph S. DiMartino
    
    
    6,801,681
    
    
    
        3,206Mario B. Ferrari
    
    
    6,801,181
    
    
    
        3,706Arnold Heggestad, Ph.D.
    
    
    6,792,781
    
    
    
        12,106Steven P. Oppenheim
    
    
    6,801,181
    
    
    
        3,706Richard C. Rochon
    
    
    6,801,181
    
    
    
        3,706Charles P. Steinmetz
    
    
    6,801,381
    
    
    
        3,506
  
   
  10.20
    
    Amendment No. 1 to Management Services Agreement.31.1
    
    Certification by Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.31.2
    
    Certification by Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.32.1
    
    Certification by Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.32.2
    
    Certification by Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002.
 -19-




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##### 



SIGNATURES
  SUNAIR SERVICES CORPORATIONDate: May 15, 2006
    /s/ John J. HayesJohn J. Hayes, Presidentand Chief Executive OfficerDate: May 15, 2006
    /s/ Synnott B. DurhamSynnott B. Durham,Chief Financial Officer -20-