**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

**ý****  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE****SECURITIESEXCHANGE ACT OF 1934**

 

**For the quarterly period ended September30, 2005**

 

**o**** TRANSITION REPORT UNDER SECTION 13 OR 15(d)OF THE EXCHANGE ACT**

 

**For the transition period from           to          **

 

**Commission file number 0-51148**

 

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**TRI-S SECURITY CORPORATION**

(Exact name of registrant asspecified in its charter)

 
| **GEORGIA**                                                     | ** ** | **30-0016962**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction                                    |       | (I.R.S. Employer Identification No.) |
| of incorporation or organization)                               |       |                                 |
|                                                            |       |                                 |
| **11675 Great Oaks Way, Suite 120, Alpharetta,  Georgia 30022** |
| (Address of principal executive offices)                        |
|                                                            |       |                                 |
| **(678) 808-1540**                                              |
| (Registrant’s telephone number, including area code)       |

 

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Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

Yesý No o.

 

Indicatedby check mark whether registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act) Yes o  No ý.

 

Indicatedby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act) Yes o  No ý.

 

Shares of the registrant’scommon stock, par value $0.001 per share, outstanding as of November 17, 2005:  3,323,700.

 

 

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**TRI-SSECURITY CORPORATION**

**QUARTERLYREPORT ON FORM 10-Q**

**For thequarter ended September 30, 2005**

 

**INDEX**

 
| **Part I    FINANCIAL  INFORMATION**                                                             | ** **                                                            |
|-----------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------|
|                                                                                                            |                                                                  |   |
| Item 1.   Financial  Statements                                                                  |                                                                  |
|                                                                                                            |                                                                  |   |
|                                                                                                            | Condensed Consolidated Balance Sheets as of  September 30, 2005 and   |   |
|                                                                                                            | December 31, 2004                                                     | 3 |
|                                                                                                            |                                                                  |   |
|                                                                                                            | Condensed Consolidated Statements of  Operations for the Three Months |   |
|                                                                                                            | Ended September 30, 2005 and  2004                                    | 4 |
|                                                                                                            |                                                                  |   |
|                                                                                                            | Condensed Consolidated Statements of Operations for  the Nine Months  |   |
|                                                                                                            | Ended September 30, 2005 and 2004 and  for the Period From January 1, |   |
|                                                                                                            | 2004 to February 27, 2004                                             | 5 |
|                                                                                                            |                                                                  |   |
|                                                                                                            | Condensed Consolidated Statements of  Cash Flows for the Nine Months  |   |
|                                                                                                            | Ended September 30, 2005 and  2004 and for the Period From January 1, |   |
|                                                                                                            | 2004 to February 27, 2004                                             | 6 |
|                                                                                                            |                                                                  |   |
|                                                                                                            | Notes to Condensed  Consolidated Financial Statements                 | 7 |
|                                                                                                            |                                                                  |   |
| Item  2.  Management’s Discussion and Analysis of Financial Condition And  Results of Operations | 15                                                                    |
|                                                                                                            |                                                                  |   |
| Item  3.  Quantitative and Qualitative Disclosures about Market Risk                                  | 19                                                                    |
|                                                                                                            |                                                                  |   |
| Item 4.  Controls and Procedures                                                                      | 19                                                                    |
|                                                                                                            |                                                                  |   |
| **PART II.  OTHER INFORMATION**                                                                            | **20**                                                                |
|                                                                                                            |                                                                  |   |
| Item 1.  Legal Proceedings                                                                                 | 20                                                                    |
|                                                                                                            |                                                                  |   |
| Item 5.  Other Information                                                                                 | 20                                                                    |
|                                                                                                            |                                                                  |   |
| Item 6.  Exhibits                                                                                          | 20                                                                    |
|                                                                                                            |                                                                  |   |
| Signature  Page                                                                                                 | 21                                                                    |
|                                                                                                            |                                                                  |   |
| Exhibit Index                                                                                                   | 22                                                                    |

 

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**Tri-S Security Corporation and Subsidiary**

**BalanceSheets**

**Unaudited**

**(In thousands, except per share data)**

 
| ** **                                                                                                                                                               | ** ** | **Sept 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **Assets**                                                                                                                                                               |       |              |       |                  |       |
| Current assets:                                                                                                                                                          |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                               |       | $                 | 2,430      |                  | $          | 313 |   |
| Trade accounts  receivable, net                                                                                                                                          |       | 5,480             |       | 5,312                 |       |
| Deferred initial  public offering costs                                                                                                                                  |       | —            |       | 633                   |       |
| Deferred income  taxes                                                                                                                                                   |       | 250               |       | 200                   |       |
| Prepaid expenses  and other assets                                                                                                                                       |       | 590               |       | 178                   |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total current  assets                                                                                                                                                    |       | 8,750             |       | 6,636                 |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Property and  equipment, less accumulated depreciation                                                                                                                   |       | 237               |       | 325                   |       |
| Note receivable  - officer                                                                                                                                               |       | 102               |       | 100                   |       |
| Investment in  joint venture                                                                                                                                             |       | 8,660             |       | 8,302                 |       |
| Intangibles                                                                                                                                                              |       | 1,596             |       | 1,508                 |       |
| Goodwill                                                                                                                                                                 |       | 7,747             |       | 7,747                 |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total assets                                                                                                                                                             |       | $                 | 27,092     |                  | $          | 24,618 |   |
|                                                                                                                                                                     |       |              |       |                  |       |
| **Liabilities and Stockholders’ Equity (Deficit)**                                                                                                                  |       |              |       |                  |       |
| Current  liabilities:                                                                                                                                                    |       |              |       |                  |       |
| Trade accounts  payable                                                                                                                                                  |       | $                 | 468        |                  | $          | 351 |   |
| Accrued expenses                                                                                                                                                         |       | 3,161             |       | 2,634                 |       |
| Accrued interest  expense                                                                                                                                                |       | 25                |       | 566                   |       |
| Note payable to  financial institution                                                                                                                                   |       | 1,673             |       | 3,092                 |       |
| Short-term notes  payable                                                                                                                                                |       | —            |       | 7,706                 |       |
| Current portion  of capital lease obligations                                                                                                                            |       | 125               |       | 91                    |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total current  liabilities                                                                                                                                               |       | 5,452             |       | 14,440                |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Other  liabilities:                                                                                                                                                      |       |              |       |                  |       |
| Capital lease  obligations, less current portion                                                                                                                         |       | 0                 |       | 103                   |       |
| Deferred income  taxes                                                                                                                                                   |       | 3,713             |       | 4,343                 |       |
| Series C  preferred stock subject to mandatory redemption                                                                                                                |       | 6,000             |       | 6,000                 |       |
| Long-term notes  payable                                                                                                                                                 |       | 1,919             |       | 0                     |       |
| Total  liabilities                                                                                                                                                       |       | 17,084            |       | 24,886                |       |
|                                                                                                                                                                     |       |              |       |                  |       |
| Stockholders’  equity (deficit):                                                                                                                                    |       |              |       |                  |       |
| Preferred stock,  $1.00 par value, 10,000,000 shares authorized                                                                                                          |       |              |       |                  |       |
| Series A  convertible preferred stock 100,000 shares issued and outstanding                                                                                              |       | —            |       | 460                   |       |
| Series B  convertible preferred stock, 40,000 shares issued and outstanding                                                                                              |       | —            |       | 196                   |       |
| Common stock,  $0.001 par value, 25,000,000 shares authorized, 3,323,700 and 827,832 shares  issued and outstanding at June 30, 2005 and December 31, 2004, respectively |       | 3                 |       | 1                     |       |
| Additional  paid-in capital                                                                                                                                              |       | 11,394            |       | 115                   |       |
| Retained  earnings (deficit)                                                                                                                                             |       | (1,389            | )          | (1,040                | )          |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total  stockholders’ equity (deficit)                                                                                                                               |       | 10,008            |       | (268                  | )          |
|                                                                                                                                                                     |       |              |       |                  |       |
| Total  liabilities and stockholders’ equity (deficit)                                                                                                               |       | $                 | 27,092     |                  | $          | 24,618 |   |

 

See accompanying notes to financial statements.

 

3

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**Tri-S Security Corporation and Subsidiary**

 

**Statementsof Operations**

**Unaudited**

**(In thousands, except per share data)**

 
| ** **                                                   | ** ** | **Three Months**  | ** ** | **Three Months**  | ** ** |
|--------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                   | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                                   | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** |
|                                                         |       |              |       |              |       |
| Revenues                                                     |       | $                 | 8,063      |              | $          | 7,682 |   |
|                                                         |       |              |       |              |       |
| Cost of revenues:                                            |       |              |       |              |       |
| Direct labor                                                 |       | 4,403             |       | 4,092             |       |
| Indirect labor  and labor related costs                      |       | 2,803             |       | 2,719             |       |
| Other contract  support costs                                |       | 393               |       | 335               |       |
| Amortization of  government contracts                        |       | 93                |       | 108               |       |
|                                                         |       | 7,692             |       | 7,254             |       |
| Gross profit                                                 |       | 371               |       | 428               |       |
|                                                         |       |              |       |              |       |
| Selling, general and administrative                          |       | 1,286             |       | 456               |       |
| Operating income  (loss)                                     |       | (915              | )          | (28               | )          |
|                                                         |       |              |       |              |       |
| Income from joint venture                                    |       | 403               |       | 1,422             |       |
| Other income (expense):                                      |       |              |       |              |       |
| Interest income                                              |       | 14                |       | —            |       |
| Interest expense                                             |       | (120              | )          | (364              | )          |
| Interest on  preferred stock subject to mandatory redemption |       | (75               | )          | (108              | )          |
|                                                         |       | (181              | )          | (472              | )          |
|                                                         |       |              |       |              |       |
| Income (loss) before income taxes                            |       | (693              | )          | 922               |       |
|                                                         |       |              |       |              |       |
| Income tax expense (benefit)                                 |       | (263              | )          | 350               |       |
|                                                         |       |              |       |              |       |
| Net income  (loss)                                           |       | $                 | (430       | )                 | $          | 572 |   |
|                                                         |       |              |       |              |       |
| Pro forma income tax expense (benefit)                       |       |              |       |              |       |
|                                                         |       |              |       |              |       |
| Proforma net income (loss)                                   |       |              |       |              |       |
|                                                         |       |              |       |              |       |
| Basic net income (loss) per common share                     |       | $                 | (0.13      | )                 | $          | 0.69 |   |
| Diluted net income (loss) per common share                   |       | $                 | (0.13      | )                 | 0.45       |   |
| Basic weighted average number of common shares               |       | 3,324             |       | 828               |       |
| Diluted weighted average number of common shares             |       | 3,324             |       | 1,276             |       |

 

Seeaccompanying notes to financial statements.

 

4

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| ** **                                                   | ** ** | ** **        | ** ** | ** **        | ** ** | **Predecessor Basis**     | ** ** |
|--------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|---------------------------|------------|
| ** **                                                   | ** ** | ** **        | ** ** | ** **        | ** ** | **Paragon Systems, Inc.** | ** ** |
| ** **                                                   | ** ** | **Nine Months**   | ** ** | **Nine Months**   | ** ** | **January 1, 2004**       | ** ** |
| ** **                                                   | ** ** | **Ended**         | ** ** | **Ended**         | ** ** | **to**                    | ** ** |
| ** **                                                   | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** | **February 27, 2004**     | ** ** |
|                                                         |       |              |       |              |       |                      |       |
| Revenues                                                     |       | $                 | 23,787     |              | $          | 17,728                    |       | $ | 4,705 |   |
|                                                         |       |              |       |              |       |                      |       |
| Cost of revenues:                                            |       |              |       |              |       |                      |       |
| Direct labor                                                 |       | 12,741            |       | 9,506             |       | 2,481                     |       |
| Indirect labor  and labor related costs                      |       | 8,307             |       | 6,074             |       | 1,892                     |       |
| Other contract  support costs                                |       | 992               |       | 718               |       | 221                       |       |
| Amortization of  government contracts                        |       | 275               |       | 252               |       | —                    |       |
|                                                         |       | 22,315            |       | 16,550            |       | 4,594                     |       |
| Gross profit                                                 |       | 1,472             |       | 1,178             |       | 111                       |       |
|                                                         |       |              |       |              |       |                      |       |
| Selling, general and administrative                          |       | 2,757             |       | 1,097             |       | 230                       |       |
| Operating income  (loss)                                     |       | (1,285            | )          | 81                |       | (119                      | )          |
|                                                         |       |              |       |              |       |                      |       |
| Income from joint venture                                    |       | 1,451             |       | 1,517             |       |                      |       |
| Other income  (expense):                                     |       |              |       |              |       |                      |       |
| Interest income                                              |       | 35                |       | 3                 |       | —                    |       |
| Interest expense                                             |       | (543              | )          | (983              | )          | (11                       | )          |
| Interest on  preferred stock subject to mandatory redemption |       | (225              | )          | (210              | )          | —                    |       |
|                                                         |       | (733              | )          | (1,190            | )          | (11                       | )          |
|                                                         |       |              |       |              |       |                      |       |
| Income (loss) before income taxes                            |       | (567              | )          | 408               |       | (130                      | )          |
|                                                         |       |              |       |              |       |                      |       |
| Income tax expense (benefit)                                 |       | (215              | )          | 155               |       | —                    |       |
|                                                         |       |              |       |              |       |                      |       |
| Net income (loss)                                            |       | $                 | (352       | )                 | $          | 253                       |       | $ | (130 | ) |
|                                                         |       |              |       |              |       |                      |       |
| Pro forma income tax expense (benefit)                       |       |              |       |              |       | (49                       | )          |
|                                                         |       |              |       |              |       |                      |       |
| Proforma net income (loss)                                   |       |              |       |              |       | $                         | (81        | ) |
|                                                         |       |              |       |              |       |                      |       |
| Basic net income (loss) per common share                     |       | $                 | (0.11      | )                 | $          | 0.31                      |       |   |   |
| Diluted net income (loss) per common share                   |       | $                 | (0.11      | )                 | 0.20       |                      |       |   |
| Basic weighted average number of common shares               |       | 3,236             |       | 828               |       |                      |       |
| Diluted weighted average number of common shares             |       | 3,236             |       | 1,276             |       |                      |       |

 

See accompanying notes to financial statements.

 

5

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**Tri-S Security Corporation andSubsidiary**

 

**Statementsof Cash Flows**

**Unaudited**

**(In thousands)**

 
| ** **                                                                                        | ** ** | **Nine Months**   | ** ** | **Nine Months**   | ** ** | **For the period**     | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                        | ** ** | **Ended**         | ** ** | **Ended**         | ** ** | **January 1, 2004 to** | ** ** |
| ** **                                                                                        | ** ** | **Sept 30, 2005** | ** ** | **Sept 30, 2004** | ** ** | **February 27, 2004**  | ** ** |
|                                                                                              |       |              |       |              |       |                   |       |
| Cash flow from  operating activities:                                                             |       |              |       |              |       |                   |       |
| Net income  (loss)                                                                                |       | $                 | (352       | )                 | $          | 253                    |       | $ | (130 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided (used) by operating  activities: |       |              |       |              |       |                   |       |
| (Income) Loss  from Investment in joint venture                                                   |       | (1,451            | )          | (1,517            | )          | 0                      |       |
| Depreciation and  amortization                                                                    |       | 481               |       | 440               |       | 28                     |       |
| Deferred income  tax benefits                                                                     |       | (1,028            | )          | 158               |       | —                 |       |
| Common shares  issued in exchange for services                                                    |       | 95                |       | —            |       | —                 |       |
| Changes in  operating assets and liabilities:                                                     |       |              |       |              |       |                   |       |
| Trade accounts  receivable, net                                                                   |       | (168              | )          | 1,413             |       | (1,161                 | )          |
| Prepaid expenses  and other assets                                                                |       | (272              | )          | 394               |       | (499                   | )          |
| Trade accounts  payable                                                                           |       | 117               |       | (57               | )          | 62                     |       |
| Accrued  liabilities                                                                              |       | 98                |       | 59                |       | 944                    |       |
| Income taxes  payable                                                                             |       | 138               |       | (224              | )          | (111                   | )          |
|                                                                                              |       |              |       |              |       |                   |       |
| Net cash  provided (used) by operating activities                                                 |       | (2,342            | )          | 919               |       | (867                   | )          |
|                                                                                              |       |              |       |              |       |                   |       |
| Cash flow from  investing activities:                                                             |       |              |       |              |       |                   |       |
| Acquisition of  subsidiary                                                                        |       | —            |       | (2,024            | )          | —                 |       |
| Proceeds from  sale of property and equipment                                                     |       | 10                |       | —            |       | —                 |       |
| Purchase of  property and equipment                                                               |       | (44               | )          | (62               | )          | —                 |       |
| Cash  Disbursements from investment in joint venture                                              |       | 1,092             |       | 330               |       | 715                    |       |
|                                                                                              |       |              |       |              |       |                   |       |
| Net cash  provided (used) by investing activities                                                 |       | 1,058             |       | (1,756            | )          | 715                    |       |
|                                                                                              |       |              |       |              |       |                   |       |
| Cash flow from  financing activities:                                                             |       |              |       |              |       |                   |       |
| Proceeds from  initial public offering                                                            |       | 11,079            |       | —            |       | —                 |       |
| Proceeds  (repayments) of short-term notes                                                        |       | (9,125            | )          | 1,517             |       | (405                   | )          |
| Proceeds  (repayments) of capital lease obligations                                               |       | (69               | )          | (43               | )          | (13                    | )          |
| Deferred initial  public offering costs                                                           |       | (245              | )          | —            |       | —                 |       |
| Proceeds from  issuance of Warrants                                                               |       | 289               |       | 0                 |       | —                 |       |
| Payments for  Intangible Assets                                                                   |       | 0                 |       | (426              | )          | —                 |       |
| Proceeds from  Notes Payable                                                                      |       | 1,919             |       | —            |       | —                 |       |
| Deferred  Financing Costs                                                                         |       | (447              | )          | —            |       | —                 |       |
|                                                                                              |       |              |       |              |       |                   |       |
| Net cash  provided (used) by financing activities                                                 |       | 3,401             |       | 1,048             |       | (418                   | )          |
|                                                                                              |       |              |       |              |       |                   |       |
| Net increase  (decrease) in cash and cash equivalents                                             |       | 2,117             |       | 211               |       | (570                   | )          |
| Cash and cash  equivalents at beginning of period                                                 |       | 313               |       | 102               |       | 846                    |       |
| Cash and cash  equivalents at end of period                                                       |       | $                 | 2,430      |              | $          | 313                    |       | $ | 276 |   |
|                                                                                              |       |              |       |              |       |                   |       |
| Supplemental  disclosures of cash flow information:                                               |       |              |       |              |       |                   |       |
| Interest paid                                                                                     |       | $                 | 1,307      |              | $          | 346                    |       | $ | 6 |   |
| Income taxes  paid                                                                                |       | $                 | 323        |              | $          | 170                    |       | $ | — |   |

 

See accompanying notes to financial statements.

 

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**TRI-SSECURITY CORPORATION AND SUBSIDIARY**

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**September30, 2005**

 

 

**1.****                                     ****Organization**

 

Tri-S Security Corporation, a Georgia corporation (“Tri-S”, the “Company”or “We”) provides contract guard services to various Federal governmentagencies through our subsidiary, Paragon Systems, Inc., an Alabama corporationwith offices located in Huntsville, Alabama (“Paragon Systems”).  We strive to provide cost-effective solutionsto ensure the safety and security of the assets and personnel of our customersand to continually improve the protection we provide for their personnel,programs, resources and facilities. Our goal is to provide demonstrablysuperior contract guard services with the highest degree of integrity andresponsiveness.

 

We were incorporated in Georgia in October 2001 under the name “DiversifiedSecurity Corporation.” We changed our name to “Tri-S Security Corporation” onAugust 16, 2004.  Our principalexecutive offices are located at 11675 Great Oaks Way, Suite 120, Alpharetta,GA 30022, and our telephone number at that address is (678) 808-1540.

 

**2.****                                     ****Basis of Presentation**

 

The accompanying financial statements have been prepared in accordancewith generally accepted accounting principles in the United States (“GAAP”).  The financial statements presented areunaudited and have been prepared by management of Tri-S in accordance with therules and regulations of the Securities and Exchange Commission (the “SEC”).  In the opinion of management, alladjustments, consisting of normal recurring accruals, necessary for the fairpresentation of the financial position, results of operations and cash flowshave been included.  For furtherinformation, see our audited financial statements and footnotes theretoincluded in our Annual Report on Form 10-K/A for the year ended December 31,2004 filed with the SEC, as amended by Amendment No. 1 thereto (the “AnnualReport”).  Disclosure that substantiallyduplicates the disclosure contained in the footnotes to the audited financialstatements included in the Annual Report has been omitted from theseNotes.  Certain balance sheet items as ofDecember 31, 2004 have been reclassified to conform to the presentation as ofSeptember 30, 2005.

 

**3.****                                     ****Summary of Significant AccountingPolicies**

 

The preparation of financial statements in conformity with GAAP requiresus to make certain estimates and judgments that affect the reported amounts ofassets, liabilities, revenues,

 

7

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expenses and related disclosure of contingent assets and liabilities.We believe the following critical accounting policies affect our moresignificant estimates and judgments. Actual results may differ from theseestimates under different assumptions or conditions.

 

**Revenue Recognition. **We record revenue monthly as guard servicesare provided to our customers under contracts with Federal government agencies.We bill guard services in arrears at hourly or monthly rates based on thenumber of hours worked under some contracts and as fixed monthly amounts under othercontracts. Hourly and monthly rates are determined as a result of our bidssubmitted in response to formal specifications included in solicitations forbids from government agencies. Hourly and monthly billing rates are developedby accumulating the estimated labor, general and administrative expenses, ourprofit objective and other costs to service a contract over a five-year period.

 

The terms of our contracts with Federal government agencies are complexand may be subject to differing interpretations. We make estimates andjudgments about terms of the contracts in providing services and in billing andrecording revenue. Differences in interpretation are generally resolved on amutual basis in discussions with the government agency involved. The resolutionof differences may result in a determination that amounts previously billed arenot in accordance with contract terms and adjustments of amounts initiallyrecorded as revenue may be material.

 

Contracts with Federal government agencies may be subject to cessationof funding. Cessation of funding may result in amounts billed and recorded asrevenue as being uncollectible. We work with the appropriate government agencyto resolve funding issues. When funding issues become known, we make estimatesand judgments about the extent of potential losses and adjust revenuesaccordingly. Actual amounts estimated could differ from amounts ultimatelycollected and these amounts could be material.

 

**Cost of Revenues. **Cost of revenues is primarily comprised oflabor, related payroll taxes, employee benefits, workers compensation andliability insurance. Labor is recorded on an accrual basis.

 

We make estimates and judgments of amounts recorded for accruals oflabor related costs. Expenses most subject to estimation and judgment areaccrued vacation and workers compensation costs. For some contracts, we assumeexisting liabilities for accrued vacation. The terms of vacation policies maybe complex and subject to interpretation. Workers compensation insurance issubject to retroactive audit. Actual amounts could differ from the amountsinitially recorded.

 

**Goodwill and Other Intangible Assets. **We account forgoodwill and other intangible assets in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 142, “Goodwill and Other IntangibleAssets” (“SFAS No. 142”), which requires goodwill and some intangibleassets to no longer be amortized. Instead, goodwill will be subject to anannual impairment test. The goodwill impairment test involves a two-step approach.The first step of the test is to compare the fair value of the reporting unit,which is the business of Paragon Systems,

 

8

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to its book value, including goodwill. The fair value of the reportingunit is measured using discounted projected future cash flows. Cash flowestimates include projections of revenues from existing contracts with Federalgovernment agencies, including projected renewals and extensions. The relatedcosts of revenues are based on our historical costs. The projections aresubject to the uncertainties of realizing contract renewals and extensions, thepricing of future contracts and reasonable estimates of future labor costs andother costs of revenues.

 

If the book value exceeds the fair value, then the second step of thegoodwill impairment test, used to measure the amount of impairment loss,compares the implied fair value of the reporting unit goodwill with the bookvalue of that goodwill. If the book value exceeds the implied fair value ofthat goodwill, then an impairment loss will be recognized to the extent of theexcess.

 

SFAS No. 142 also requires that intangible assets with definitelives be amortized over their estimated useful lives and reviewed forimpairment whenever events or changes in circumstances indicate an asset’scarrying value may not be recoverable in accordance with SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets.”  We are currently amortizing our acquiredintangible assets with definite lives over periods ranging from five to nineyears. Amortizable intangible assets consist of the government contracts weacquired in connection with our acquisition of Paragon Systems on February 27,2004 (the “Acquisition”) and the non-compete agreements with certain of ParagonSystems’ former owners. We believe that no events or changes in circumstanceshave occurred that would require an impairment test for these assets.

 

**Investment in Joint Venture.**  We account for our 10% equityin Army Fleet Support, LLC, a joint venture which provides logistics supportfor U.S. Army aviation training at Fort Rucker, Alabama (the “Joint Venture”),using the equity method of accounting.  Accordingly,the investment in the Joint Venture is increased by our share of the Joint Venture’searnings and reduced by the amortization of the investment in the Joint Ventureand the cash received from the Joint Venture.

 

**Income Taxes. **We account for our income taxes in accordancewith SFAS No. 109, “Accounting for Income Taxes.”  Deferred tax assets and liabilities arerecognized for the expected tax consequences of temporary differences betweenthe tax basis of assets and liabilities and their reported amounts and foroperating loss carry forwards.

 

**4.****                                     ****Initial Public Offering**

 

In February 2005, we completed an underwritten initial public offeringof 1,800,000 units (plus an additional 270,000 units upon the exercise of theunderwriters’ over-allotment option), with each unit (a “Unit”) consisting ofone share of our common stock, par value $0.001 per share (the “Common Stock”),and a warrant to purchase one share of Common Stock, at an initial offeringprice per Unit of $6.00 (the “Initial Public Offering”).  The Initial Public Offering closed withrespect to the initial 1,800,000 Units on February 14, 2005 and with respect tothe additional 270,000 Units on March 17, 2005. The aggregate net proceeds to us from the Initial Public

 

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Offering were approximately $11,079,000 after underwriting discountsand commissions, offering expenses and consulting fees.  As of December 31, 2004, we had accrued orpaid $633,000 in aggregate costs for the Initial Public Offering.  Since December 31, 2004, we have accrued orpaid an additional $205,000 in aggregate costs for the Initial Public Offering.

 

**5.****                                     ****Acquisition of Paragon Systems,Inc.**

 

On February 27, 2004, Tri-S acquired all of the outstanding capitalstock of Paragon Systems.  At the closingof the Acquisition, we: (i) paid $10.0 million, of which $2.3 million was paidin cash and $7.7 million was paid through the issuance of promissory notes (the“Paragon Notes”), to the former shareholders of Paragon Systems; and (ii)issued 100 shares of our Series C Redeemable Preferred Stock, par value $1.00per share (the “Series C Redeemable Preferred Stock”), with an aggregateredemption value of $6.0 million.  Afterthe completion of the Initial Public Offering, we repaid the outstandingprincipal of the Paragon Notes and paid all unpaid, accrued interestthereon.  We are obligated to redeem theoutstanding shares of the Series C Redeemable Preferred Stock no later than February27, 2007.

 

**6.****                                     ****Common and Preferred Stock**

 

On February 7, 2005, we effected an exchange and recapitalization (the “Exchangeand Recapitalization”) of all outstanding shares of our Common Stock, Series AConvertible Preferred Stock, par value $1.00 per share (the “Series AConvertible Preferred Stock”),  andSeries B Convertible Preferred Stock, par value $1.00 per share (the “Series BConvertible Preferred Stock”), and all rights to acquire our Common Stockpursuant to an Exchange and Recapitalization Agreement dated November 19, 2004,among the Company and all of the holders of the outstanding Common Stock,Series A Convertible Preferred Stock and Series B Convertible Preferred Stockand the holders of all rights to acquire Common Stock.  As a result of the Exchange andRecapitalization, all of the outstanding shares of Common Stock, Series AConvertible Preferred Stock and Series B Convertible Preferred Stock wereexchanged for an aggregate of 1,200,000 shares of Common Stock.  The Exchange and Recapitalization was givenretroactive treatment in the financial statements and related disclosures.

 

As of September 30, 2005, we are authorized to issue ten million sharesof preferred stock, par value $1.00 per share (the “Preferred Stock”).  Our Board of Directors (the “Board”) isauthorized, without further shareholder action, to divide any or all shares ofauthorized Preferred Stock into series and to fix and determine thedesignations, preferences and relative participating, optional or other specialrights, and qualifications, limitations or restrictions thereon, of any seriesso established, including voting powers, dividend rights, liquidationpreferences, redemption rights and conversion or exchange privileges.

 

As of December 31, 2004, we had outstanding 100,000 shares of Series AConvertible Preferred Stock, 40,000 shares of Series B Convertible PreferredStock and 100 shares of Series C Redeemable Preferred Stock.  In the Exchange and Recapitalization, all ofthe outstanding shares of Series A Convertible Preferred Stock were exchangedfor 242,718 shares of Common Stock and Series B Convertible Preferred Stockwere exchanged for 129,450 shares of Common

 

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Stock.  As of September 30, 2005,we did not have outstanding any shares of Series A Convertible Preferred Stockor Series B Convertible Preferred Stock, and we had outstanding 100 shares ofSeries C Redeemable Preferred Stock.

 

The Series A Convertible Preferred Stock and Series B ConvertiblePreferred Stock have no voting rights, except as otherwise required byapplicable law, and no redemption, preemptive, dividend or sinking fund rights.

 

The Series C Redeemable Preferred Stock has no voting rights, except asotherwise required by applicable law, and no preemptive, conversion or sinkingfund rights.  In the event of aliquidation, dissolution or winding up of the Company, holders of the Series CRedeemable Preferred Stock are entitled to a liquidation preference, and theholders of shares of Common Stock have a secondary liquidation right to theassets of the Company. The shares of Series C Redeemable Preferred Stock have aredemption value of $60,000 per share. We may redeem the outstanding shares of the Series C RedeemablePreferred Stock at any time, but must redeem all of the outstanding shares ofthe Series C Redeemable Preferred Stock no later than February 27, 2007.  The holders of the Series C RedeemablePreferred Stock are entitled to receive cumulative cash dividends at a rate of5% of the redemption value per annum (or $3,000 per share per annum).

 

We are authorized to issue 25 million shares of Common Stock.  The holders of Common Stock are entitled toone vote per share on all matters.  TheCommon Stock does not have cumulative voting rights.  Each share of Common Stock has an equal and ratableright to receive dividends to be paid from assets legally available when and ifdeclared by the Board.  We have neverpaid any cash dividends on the Common Stock.

 

On March 3, 2005, we issued 15,000 shares of Common Stock to DouglasBall pursuant to that certain Letter Agreement between the Company and Mr. Balldated December 7, 2004.

 

On April 26, 2005, we issued 8,700 shares of Common Stock to a publicrelations firm in exchange for services rendered by such firm to the Company.

 

On April 26, 2005, we issued: (i) an aggregate of 20,000 shares ofCommon Stock to two former shareholders of Paragon Systems pursuant to thatcertain Agreement Regarding Notes and Preferred Shares among the Company,Paragon Systems and the former shareholders of Paragon Systems dated as ofSeptember 29, 2004 and amended on October 6, 2004; (ii) 10,000 shares of CommonStock to an individual in exchange for services rendered by such individual tothe Company; and (iii) a three-year option to purchase 25,000 shares of CommonStock at an exercise price of $6.00 per share to a public relations firm in exchangefor services rendered by such firm to the Company.

 

In connection with the foregoing issuances, we recorded general andadministrative expense in the amount of $95,000 which represents the fairmarket value of the shares of Common Stock on the issue dates thereof.

 

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**7.****                                     ****Contingencies**

 

Based on currently known facts, we believe there are no claims orlitigation pending against us the disposition of which would materially affectour financial position or future operating results, although we cannot becertain as to the ultimate outcome of any such claim or litigation.  In addition, exposure to litigation isinherent in our ongoing business and may harm our business in the future.

 

**8.****                                     ****Investment in Army Fleet Support,LLC**

 

In conjunction with the Acquisition of Paragon Systems on February 27,2004, the Company acquired a 10% interest in the Joint Venture.  The value of the investment in the Joint Ventureat the acquisition date was $8,102,000 as established by an independentappraisal.  The Company amortizes thecost of the investment in excess of the net book value using a 10-year life,which approximates the anticipated life of the Joint Venture.

 

The Company accounts for its investment in the Joint Venture using theequity method.  Accordingly, theinvestment in the Joint Venture is increased by the Company’s share of the JointVenture’s earnings and reduced by the amortization of the investment in the JointVenture and the cash received from the Joint Venture.

 

The investment in the Joint Venture was effected by the followingtransactions for the three months ended September 30, 2005 and September 30,2004 and the nine months ended September 30, 2005 and September 30, 2004:

 
| ** **                                            | ** ** | **Three Months  Ended  Sept. 30, 2005** | ** ** | **Three Months  Ended  Sept. 30, 2004** | ** ** | **Nine Months  Ended  Sept. 30, 2005** | ** ** | **Nine Months  Ended  Sept. 30, 2004** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| Investment in Joint Venture – beginning          |       | $                                       | 8,495      |                                    | $          | 8,052                                  |       | $                                      | 8302       |   | $ | 8,102 |   |
| Company’s share of earnings in the Joint Venture |       | 609                                     |       | 1,628                                   |       | 2069                                   |       | 1,998                                  |       |
| Amortization of the investment in the Joint Venture   |       | (206                                    | )          | (206                                    | )          | (618                                   | )          | (481                                   | )          |
| Cash received from the Joint Venture                  |       | (238                                    | )          | (185                                    | )          | (1093                                  | )          | (330                                   | )          |
|                                                  |       |                                    |       |                                    |       |                                   |       |                                   |       |
| Investment in Joint Venture – ending             |       | $                                       | 8,660      |                                    | $          | 9,289                                  |       | $                                      | 8660       |   | $ | 9,289 |   |

 

Summarized unaudited balancesheet information for the Joint Venture as of September 30, 2005 and December31, 2004 is as follows:

 
| ** **                   | ** ** | **Sept. 30, 2005** | ** ** | **Dec. 31, 2004** | ** ** |
|------------------------------|------------|--------------------|------------|-------------------|------------|
|                         |       |               |       |              |       |
| Total assets                 |       | $                  | 53,693     |              | $          | 39,189 |   |
|                         |       |               |       |              |       |
| Total liabilities            |       | $                  | 32,940     |              | $          | 28,200 |   |
| Equity                       |       | 20,753             |       | 10,989            |       |
|                         |       |               |       |              |       |
| Total liabilities and equity |       | $                  | 53,693     |              | $          | 39,189 |   |

 

Summarized unaudited statement of operations information for the unconsolidatedJoint Venture for the three months ended September 30, 2005 and September 30, 2004and the nine

 

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months ended September 30, 2005 and the seven months ended September30, 2004 is as follows:

 
| ** **        | ** ** | **Three Months**   | ** ** | **Three Months**   | ** ** | **Nine Months**    | ** ** | **Seven Months**   | ** ** |
|-------------------|------------|--------------------|------------|--------------------|------------|--------------------|------------|--------------------|------------|
| ** **        | ** ** | **Ended**          | ** ** | **Ended**          | ** ** | **Ended**          | ** ** | **Ended**          | ** ** |
| ** **        | ** ** | **Sept. 30, 2005** | ** ** | **Sept. 30, 2004** | ** ** | **Sept. 30, 2005** | ** ** | **Sept. 30, 2004** | ** ** |
|              |       |               |       |               |       |               |       |               |       |
| Contract revenues |       | $                  | 74,008     |               | $          | 73,681             |       | $                  | 221,454    |   | $ | 151,656 |   |
| Operating income  |       | 6,299              |       | 16,343             |       | 20,852             |       | 20,065             |       |
| Net earnings      |       | 6,086              |       | 16,280             |       | 20,687             |       | 19,982             |       |
|                   |            |                    |            |                    |            |                    |            |                    |            |  |  |  |  |

 

**9.****                                     ****Debt and Other Obligations**

 

In April 2005, Paragon Systems entered into a new Factoring andSecurity Agreement with LSQ Funding Group, L.C. (“LSQ”) which amended ParagonSystems’ existing factoring agreement with LSQ to increase Paragon Systems’available credit line to $6.5 million and to decrease the effective borrowingrate on such credit line.

 

During the third quarter, the Company issued convertible promissorynotes with an aggregate principal amount at maturity of $2,115,000 and warrantsto purchase 220,312 shares of Common Stock for an aggregate purchase price of$2,115,000.  The notes were issued at adiscount and were priced to yield 14.2% per annum.  The face value of the notes is $2,115,000.  Interest is payable monthly on the face valueof the notes at a rate of 10% per annum. The remainder of the interest will accrue and be paid upon the maturityof the notes.  The notes mature threeyears after issuance in September 2008 and may be prepaid at the option of the Companybeginning in September 2006, subject to the satisfaction of certain conditions.

 

The notes are convertible by the holders thereof at an initialconversion price of $4.80 per share at any time after the Company obtainsshareholder approval of the potential issuance in connection with the offeringof notes and warrants of more than 20% of the outstanding shares of CommonStock for purposes of complying with the rules governing The Nasdaq StockMarket, Inc.  The warrants issued have anexercise price of $4.80 and expire three years from the date of issuance.

 

The Company issued warrants to purchase 66,094 shares of Common Stockto a placement agent as partial consideration for services rendered.  The terms of the warrants issued to theplacement agent are similar to the terms of the warrants issued in the offeringof the notes in connection with the offering of the notes and warrants.

 

**10.****                              ****Earnings Per Share**

 

The Company uses the treasury stock method to compute Basic and DilutedEarnings Per Share.  For the three monthsended Sept 30, 2005 and the nine months ended Sept 30 2005, the DilutedEarnings Per Share equaled the Basic Earnings Per Share because all outstandingoptions and warrants to purchase Common Stock were anti-dilutive.

 

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**11.****                              ****Subsequent Events**

 

During October 2005, the Company issued convertible promissory notesand warrants under similar terms as the notes and warrants described in Note8.  The Company issued notes with anaggregate principal amount at maturity of $5,900,000 and warrants to purchase614,583 shares of Common Stock for an aggregate price of $5,900,000.

 

The Company also issued 184,375 warrants to purchase Common Stock to a placementagent as partial consideration for services rendered in connection with theoffering of the notes and warrants.  Theterms of the warrants are similar to the terms described in Note 8.

 

On October 18, 2005, the Company and its subsidiaries entered into acredit agreement (the “Credit Agreement”) with LSQ and BRE LLC (“BRE” and,together with LSQ, the “Lender”) to borrow $5,150,000 under two termloans.  Term Loan A has a principalamount of $1,650,000, matures on October 1, 2007, and is repayable in equalquarterly installments on the first day of each quarter beginning January 1,2006.  Term Loan B has a principal amountof $3,500,000, matures on October 1, 2009, and is payable in installments of$98,612 on each of October 1, 2006, November 1, 2006 and December 1, 2006 and$295,836 on the first day of each calendar quarter commencing on April 1,2007.  Interest will accrue on both termloans at the Prime Rate as published by the Wall Street Journal plus 4%.  Interest is payable on the first day of eachmonth beginning November 1, 2005.  Theprincipal amount of the term loans is also payable upon certain events, includingthe sale of certain assets of the Company.

 

In connection with the Credit Agreement, the Company, its subsidiariesand Lender entered into a Factoring and Security Agreement (the “FactoringAgreement”), pursuant to which LSQ will purchase from the Company and itssubsidiaries certain accounts receivable at a discount of 0.7% and provide theCompany and its subsidiaries with a professional accounts receivable managementservice for a funds usage fee of the Prime Rate plus 1.0% on the funds advancedon the outstanding accounts receivable purchased. The Factoring Agreement has a$6,000,000 initial purchase limit and a four-year term which will automaticallyrenew unless the Company provides notice of its intent to terminate. TheFactoring Agreement amends and restates that certain Factoring Agreement datedas of April 1, 2005 between LSQ and Paragon.

 

On October 18, 2005, the Company acquired all of the outstandingcapital stock of The Cornwall Group, Inc. (“Cornwall”) for a total purchaseprice of $13,500,000.  After adjustingfor certain working capital items, the net purchase price was $12,753,000.  In addition, the Company repaid $1,800,000 ofthe outstanding balance on Cornwall’s line of credit.  The consideration paid for the acquisition ofCornwall and the repayment of the working capital facility was approximately$14.3 million in cash plus a $250,000 note, which matures in April 2007 andbears interest at a rate of 5% per annum.

 

In October 2005, the Company issued 15,000 shares of Common Stock to anindividual as payment for services provided to the Company.  An expense of $75,000 was recognized inSeptember 2005.

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

 

*Certain informationincluded in this Quarterly Report on Form 10-Q for the quarter ended September30, 2005 (the “Quarterly Report”) contains, and other reports or materials we have filed or will file withthe SEC (as well as information included in oral statements or other writtenstatements made or to be made by us) contain or will contain, “forward-lookingstatements” within the meaning of Section 221E of the Securities Exchange Actof 1934, as amended (the “Exchange Act”), Section 27A of the Securities Act of1933, as amended (the “Securities Act”), and pursuant to the Private Securities Litigation Reform Act of 1995(the PSLRA”).  Such forward-lookingstatements may relate to financial results and plans for future businessactivities, and are thus prospective. Such forward-looking statements are subject to risks, uncertainties, andother factors that could cause actual results to differ materially from futureresults expressed or implied by such forward-looking statements.  Among the important factors that could causeactual results to differ materially from those indicated by suchforward-looking statements include, without limitation, the loss of existing customers,failure of customers to renew or extend existing contracts for security guardservices and the other risk factors detailed from time to time in our periodicreports and registration statements filed with the SEC.  All forward-looking statements are madepursuant to the PSLRA and as such speak only as of the date made.*

 

*The results of operationspresented or discussed below are based on historical results for theCompany.  Historical amounts for the ninemonths ended September 30, 2004 and the period January 1, 2004 to February 27,2004 for Paragon Systems prior to the Acquisition are combined for presentationand discussion purposes.*

 

*Paragon Systems wasformerly a subchapter S corporation and, consequently, pro forma income taxexpense and pro forma net income are presented on the face of the historicalstatements for the period January 1, 2004 to February 27, 2004.  The adjustments include only taxes at astatutory rate of 38%.*

 

**Overview**

 

We provide contract guardservices to various Federal government agencies.  These guard services include providinguniformed and armed guards for access control, personnel protection, plantsecurity, theft prevention, surveillance, vehicular and foot patrol, crowdcontrol and prevention of sabotage, terrorist and criminal activities.  In connection with providing these services,we assume responsibility for a variety of functions, including recruiting,hiring, training and supervising security guards deployed to the Federalagencies we serve as well as paying all guards and providing them withuniforms, employee benefits and workers’ compensation insurance.  We are responsible for preventing theinterruption of guard services as a consequence of illness, vacations orresignations.

 

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***Three Months Ended September 30, 2005 Compared to Three Months EndedSeptember 30, 2004.***

 

Revenue increased $381,000to $8.1 million, or 5.0%, for the three months ended September 30, 2005compared to revenue of $7.7 million for the three months ended September 30,2004. The increase in revenue was due to (i) additional services provided to theFederal Emergency Management Agency (“FEMA”) in connection with a contract wemanage for the Department of Homeland Security, (ii) a new contract that beganservice in October 2004, and (iii) other additional billings to existing contracts.

 

Cost of revenue increased $438,000to $7.7 million, or 6.0%, for the three months ended September 30, 2005,compared to cost of revenue of $7.3 million for the three months ended September30, 2004.  Our cost of revenues increasedfor the following reasons: (i) additional man hours required to support theadditional revenue mentioned above, (ii) training of new employees to supportthe additional revenue, (iii) two new office locations to support FEMA, (iv) increasetravel due to support the FEMA contract and increase in gasoline prices.

 

Our gross profit decreasedby $57,000 for the three months ended September 30, 2005 to $371,000 comparedto gross profit for the three months ended September 30, 2004 of $428,000.  Our gross profit declined because our cost ofrevenues increased more than our revenues as mentioned above.

 

Selling, general andadministrative expenses increased $830,000 to $1,286,000, or 182%, for thethree months ended September 30, 2005 compared to $456,000 for the three monthsended September 30, 2004.  The increasein selling, general, and administrative costs is due to increased office space,public company costs, investor relation costs, and increased marketing andaccounting costs.  The Company hadapproximately $150,000 of expense related to the recruitment and severancecosts related to the change of management personnel.  Also, the Company recorded approximately$240,000 of bad debt provision for certain invoices over 120 days old.

 

Income from the JointVenture decreased $1,019,000 for the three months ended September 30, 2005 ascompared to the three months ended September 30, 2004.  For the three months ended September 30,2005, we recognized $609,000 of net earnings from the Joint Venture less$206,000 of amortization expense related to the Joint Venture, for a net resultof $403,000 of income from the Joint Venture. For the three months ended September 30, 2004, we recognized $1,422,000of income from the Joint Venture, which was comprised of $1,628,000 netearnings from Joint Venture and $206,000 of amortization expense.  

 

Net interest expensedecreased $277,000, or 58.7% to $195,000 for the three months ended September30, 2005 compared to interest expense of $472,000 for the three months ended

 

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September 30, 2004.  The primaryreasons for the decrease in interest expense was due to the repayment of theParagon Notes and lower amounts of interest paid to LSQ.  We do anticipate an increase in interestexpense for the three months ending December 31, 2005 as compared to the threemonths ended September 30, 2005.  Thisincrease is due to the interest with respect to the convertible promissory notesissued in September and October 2005.

 

Income taxes are provided at 38% of income(loss) before income taxes.  The 38% rateequals federal income taxes at 34% plus 4% for state income taxes net of the Federaleffect.  Even though the Company has a netoperating loss carry forward, the Company has recognized a deferred income taxbenefit for the net operating loss carry forward because the Companyanticipates reporting income before income taxes in future periods.  In addition, cash distributions received bythe Company with respect to its equity interest in the Joint Venture aretaxable.

 

***Nine Months Ended September 30,2005 Compared to Nine Months Ended September 30, 2004.***

 

Revenue increased $1,354,000to $23.8 million, or 6.0%, for the nine months ended September 30, 2005compared to revenue of $22.4 million for the nine months ended September 30,2004.  The increase in revenue wasgenerated primarily from: (i) additional services provided to the FederalEmergency Management Agency (“FEMA”) in connection with a contract we managefor the Department of Homeland Security, (ii) a new contract that began servicein October 2004, and (iii) other additional billings to existing contracts.

 

Cost of revenue increased $1,171,000to $22.3 million, or 5.5%, for the nine months ended September 30, 2005compared to cost of revenue of $21.1 million for the nine months ended September30, 2004.  The increase in cost ofrevenue is due to many factors.  We hadhigher amortization costs with respect to our government contracts, higherpersonnel costs to support the additional revenue mentioned above, and higherpersonnel costs to support our existing contracts.

 

Our gross profit increasedby $183,000 for the nine months ended September 30, 2005 to $1.5 millioncompared to the gross profit for nine months ended September 30, 2004 of $1.3million.  This increase was due to ourrevenue increasing more than our costs of revenue, as mentioned above.

 

Selling, general andadministrative expenses increased $1,430,000 to $2.8 million, or 107.8%, forthe nine months ended September 30, 2005 compared to $1.3 million for the ninemonths ended September 30, 2004.  Theincrease in costs for 2005 is attributable primarily to costs associated withthe additional office space, additional staff costs, legal costs, accountingcosts and other professional fees associated with being a public company.  There were no similar costs incurred for the ninemonths ended September 30, 2004.  The Companyincurred over $150,000 of costs associated with the replacement of managementpersonnel in the three months ended September 30, 2005, and $240,000 of baddebt for certain invoices over 120 days old.

 

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Income from the JointVenture decreased $66,000 for the nine months ended September 30, 2005 ascompared to the nine months ended September 30, 2004.  For the nine months ended September 30, 2005,we recognized $2,069,000 of net earnings from the Joint Venture less $618,000of amortization expense related to the Joint Venture, for a net result of$1,451,000 of income from the Joint Venture. For the nine months ended September 30, 2004, we recognized $1,517,000of income from the Joint Venture, which was comprised of $1,998,000 netearnings from Joint Venture and $481,000 of amortization expense.

 

Net interest expensedecreased $436,000 to $768,000 for the nine months ended September 30, 2005compared to interest expense of $1,204,000 for the nine months ended September30, 2004. In February 2005, the Company completed its Initial Public Offeringand received proceeds from the offering before expenses of the offering of$11.1 million.  The Company used theproceeds from the Initial Public Offering to repay the Paragon Notes and to paydown Paragon Systems’ liability to LSQ. Repayment of the Paragon Notes and the reduction of Paragon Systems’obligation to LSQ significantly reduced interest expense for the nine monthsended September 30, 2005 compared to the nine months ended September 30,2004.   The Company anticipates interest expense torise in the future due to the interest with respect to the notes issued inSeptember and October 2005.

 

Income taxes are provided at38% of income (loss) before income taxes. The 38% rate equals Federal income taxes at 34% plus 4% for state incometaxes net of the Federal effect.  ParagonSystems used the cash basis of accounting for income taxes prior to theAcquisition.  Pro forma income taxbenefit at 38% is presented for comparative purposes.  Even though Tri-S has a net operating losscarry forward, the Company has recognized a deferred income tax benefit for thenet operating loss carry forward because the Company anticipates reportingincome before income taxes in future periods.

 

**Liquidity and Capital Resources**

 

Our current financialcondition has been significantly influenced by the following factors:  (i) completion of the Initial PublicOffering; (ii) repayment of the Paragon Notes; (iii) receipt of cashdistributions with respect to the Company’s equity interest in Joint Venture; and(iv) issuance of the 10% Callable, Convertible Promissory Notes inSeptember 2005.

 

On February 9, 2005, wecompleted the Initial Public Offering, realizing proceeds of $11.1million.  After repayment of the ParagonNotes totaling $7.7 million, paying $205,000 in additional costs of the InitialPublic Offering and paying down Paragon Systems’ obligation to LSQ, we retainedapproximately $1.8 million in the business to fund working capital, to pay downother debt obligations, to expand our operations and to provide for generalcorporate purposes.

 

We received $1,093,000 incash distributions with respect to our equity investment in the Joint Venture throughSeptember 2005.  We anticipate receiving significantdistributions from the Joint Venture prior to December 31, 2005.  We intend to use these cash distributions tomake acquisitions, to meet our income tax obligations, and for other generalcorporate purposes.

 

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Cash out flow from operatingactivities was $2.3 million for the nine months ended September 30, 2005.  This resulted primarily from fourfactors:  (i) payments for interest of $1.3million; (ii) operating losses for the nine months ended September 30, 2005 of$1.3 million; (iii) payments of $323,000 for income taxes, and (iv) changes inworking capital accounts.  On April 20,2005, Paragon Systems amended its factoring facility with LSQ, whichsignificantly reduced the cost of funds provided by LSQ for working capitalpurposes.  We also repaid the ParagonNotes totaling $7.7 million on February 15, 2005.  As a result, net interest expense for the ninemonths ended September 30, 2005 was $436,000 less than interest expense for thenine months ended September 30, 2004.

 

The Company’s liquidityposition in the future will be determined by its ability to generate cash fromoperations, the cash distributions received from the Joint Venture, theavailability under the Factoring Agreement and future financings.

 

**Item 3:****                                                         ****Quantitativeand Qualitative Disclosures about Market Risk**

 

We are exposed to variousmarket risks, including changes in interest rates. Market risk is the potentialloss arising from adverse changes in market rates and prices, such as interestrates and foreign currency exchange rates. We do not enter into derivatives orother financial instruments for trading or speculative purposes. We have notentered into financial instruments to manage and reduce the impact of changesin interest rates and foreign currency exchange rates, although we may enterinto such transactions in the future.

 

Our factoring facility withLSQ has a funds usage fee which varies with the prime rate. Accordingly, if wesell our accounts receivable to LSQ and such accounts remain unpaid, then anyincrease in the prime rate will increase the funds usage fee we owe on suchunpaid accounts and, therefore, reduce our earnings.

 

The Company’s outstandingobligations under its two term loans payable to LSQ and BRE accrue interest atPrime Rate plus 4%.  Our interest expenseon these term loans will increase if the Prime Rate increases.

 

**Item 4:****                                                         ****Controls and Procedures**

 

Our Chief Executive Officer and Chief FinancialOfficer have evaluated our disclosure controls and procedures (as such term isdefined in Rules 13a-15(e) or 15d-15(e) of the Exchange Act), as of the end ofthe period covered by this Quarterly Report, as required by paragraph (b) ofRules 13a-15 or 15d-15 of the Exchange Act. Based on such evaluation, suchofficers have concluded that, as of the end of the period covered by thisQuarterly Report, our disclosure controls and procedures are effective.

 

During the quarter ended September 30, 2005, there wasnot any change in our internal control over financial reporting identified inconnection with the evaluation required by

 

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paragraph (d) of Rules 13a-15 or 15d-15 of the Exchange Act that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

**PART II -OTHER INFORMATION**

 

**Item 1.****                                                          ****Legal Proceedings**

 

Except as set fourth below, we believe that, based oncurrently known facts, there are no claims or litigation pending against us thedisposition of which would materially affect our financial position or futureoperating results, although we cannot be certain as to the ultimate outcome ofany such claim or litigation. In addition, exposure to litigation is inherentin our ongoing business and may harm our business in the future.

 

On or about October 5,2005, Robert Luther and Charles Keathley, former officers of Paragon Systemsand former shareholders of Paragon Systems prior to the Company’s acquisitionthereof,  filed a compliant againstParagon Systems in the Circuit Court for Madison County, Alabama claimingbreach of contract and seeking recovery of unspecified damages.  Messrs. Keathley and Luther allege thatParagon Systems owes to them unpaid compensation for accrued, vested benefitsearned pursuant to their employment agreements with Paragon Systems and certainamounts as reimbursement for taxes incurred by them in 2003. The Company doesnot expect the outcome of this proceeding to have a materially adverse effecton the Company’s financial position or results of operations.

 

**Item 5.****                                                          ****Other Information**

 

In June 2005, the Company entered into a lease for2,675 square feet of office space in Alpharetta, Georgia which commenced onSeptember 1, 2005 and expires on November 30, 2008.  The Company’s obligations under the leaseinclude rent ranging up to $4,507.38 per month plus a share of operating expenses,among other things.  The Company usesthis space to house its corporate offices.

 

**Item 6.****                                                          ****Exhibits**

 

The exhibits required to be filed with this QuarterlyReport are set forth on the Exhibit Index attached hereto.

 

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**SIGNATURE**

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934 the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                          | **TRI-S  SECURITY CORPORATION** |
|-------------------------------|---------------------------------|
|                          |                            |
|                          |                            |
| Date: November  21, 2005 | /s/  Ronald G. Farrell          |   |
|                          | Ronald G. Farrell               |
|                          | Chief Executive Officer         |
|                          | (duly authorized signatory and  |
|                          | Principal Executive Officer)    |

 

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**EXHIBITINDEX**

 
| **Exhibit No.** | ** ** | **Exhibit**                                                                                                                                                                                                                                                                                                                                                                                                                      | ** ** | **Method  of Filing**                                                                                                                            |
|----------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                       | ** ** | ** **                                                                                                                                       |
| 2.1                  |       | Stock Purchase Agreement dated as of  August 30, 2005, among the Company and the shareholders of The Cornwall  Group, Inc. (The schedules to the Stock Purchase Agreement have been  omitted from this Current Report pursuant to Item 601(b)(2) of  Regulation S-K, and the Company agrees to furnish copies of such omitted  schedules supplementally to the Securities and Exchange Commission upon  request.) |       | Incorporated by reference to Exhibit 99.1 to  the Company’s Current Report on Form 8-K filed on September 2,  2005.          |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 2.2                  |       | Amendment No. 1 to Stock Purchase Agreement  dated as of October 18, 2005, among the Company and the shareholders of  The Cornwall Group, Inc.                                                                                                                                                                                                                                                                    |       | Incorporated by reference to Exhibit 2.2 to  the Company’s Current Report on Form 8-K filed on October 24, 2005.             |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 3.1                  |       | Amended and Restated Articles of Incorporation.                                                                                                                                                                                                                                                                                                                                                                                  |       | Incorporated  by reference to Exhibit 3.1 to the Company’s Registration Statement on  Form S-1, as amended (No. 333-119737). |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 3.2                  |       | Amended and Restated Bylaws.                                                                                                                                                                                                                                                                                                                                                                                                     |       | Incorporated  by reference to Exhibit 3.2 to the Company’s Registration Statement on  Form S-1, as amended (No. 333-119737). |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 4.1                  |       | Form of 10% Callable Convertible Promissory  Note issued by the Company in connection with the private placement of  securities conducted on September 2, 2005.                                                                                                                                                                                                                                                        |       | Filed herewith.                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 4.2                  |       | Form of Warrant to purchase shares of the  Company’s common stock issued by the Company in connection with the private  placement of securities conducted on September 2, 2005.                                                                                                                                                                                                                                   |       | Filed herewith.                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 4.3                  |       | Form of Registration Rights Agreement entered  into by the Company and the investors signatory thereto in connection with  the private placement of securities conducted on September 2, 2005.                                                                                                                                                                                                                         |       | Filed herewith.                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 4.4                  |       | Form of 10% Callable Convertible Promissory  Note issued by the Company in connection with the private placement of  securities conducted on September 30, 2005, October 12, 2005 and  October 14, 2005.                                                                                                                                                                                                     |       | Filed herewith.                                                                                                                                  |
|                 |       |                                                                                                                                                                                                                                                                                                                                                                                                                             |       |                                                                                                                                             |
| 4.5                  |       | Form of Warrant to purchase shares of the  Company’s common stock issued by the Company in connection with the private  placement of securities conducted on September 30, 2005, October 12,  2005 and October 14,                                                                                                                                                                                      |       | Filed herewith.                                                                                                                                  |

 

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|   |   | 2005.                                                                                                                                                                                                                                                       |   |                                                                                                                                               |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 4.6    |   | Form of Registration Rights Agreement entered  into by the Company and the investors signatory thereto in connection with  the private placement of securities conducted on September 30, 2005,  October 12, 2005 and October 14, 2005. |   | Filed herewith.                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.1   |   | Employment Agreement between Paragon  Systems, Inc. and Leslie Kaciban dated July 29, 2005.                                                                                                                                                       |   | Incorporated by reference to Exhibit 99.1 to  the Company’s Current Report on Form 8-K filed on August 4, 2005.                |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.2   |   | Tri-S Security Corporation 2004 Stock Incentive  Plan.                                                                                                                                                                                                      |   | Incorporated  by reference to Exhibit 10.42 to the Company’s Registration Statement on  Form S-1, as amended (No. 333-119737). |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.3   |   | Form of Qualified Stock Option Agreement.                                                                                                                                                                                                              |   | Incorporated  by reference to Exhibit 4.2 to the Company’s Registration Statement on  Form S-8 (No. 333-129097).               |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.4   |   | Form of Non-Qualified Stock Option Agreement.                                                                                                                                                                                                          |   | Incorporated  by reference to Exhibit 4.3 to the Company’s Registration Statement on  Form S-8 (No. 333-129097).               |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.5   |   | Employment Agreement between Paragon  Systems, Inc. and Mark Machi dated July 29, 2005.                                                                                                                                                           |   | Incorporated by reference to Exhibit 99.2 to  the Company’s Current Report on Form 8-K filed on August 4, 2005.                |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.6   |   | Lease Agreement between the Company and V.V.  Georgia, L.P. dated June 2005.                                                                                                                                                                      |   | Incorporated by reference to Exhibit 10.2 to  the Company’s Quarterly Report for the quarter ended June 30, 2005.                   |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.7   |   | Letter Agreement dated August 10, 2005  between the Company and Ronald G. Farrell. Represents an executive  compensation arrangement or plan.                                                                                                          |   | Incorporated by reference to Exhibit 10.3 to  the Company’s Quarterly Report for the quarter ended June 30, 2005.                   |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.8   |   | Letter Agreement between the Company and E. Wayne  Stallings dated August 12, 2005.                                                                                                                                                                    |   | Incorporated by reference to Exhibit 99.1 to  the Company’s Current Report on Form 8-K filed on August 18, 2005.               |
|   |   |                                                                                                                                                                                                                                                        |   |                                                                                                                                               |
| 10.9   |   | Earnest Money Escrow Agreement dated as of  August 30, 2005, among the Company, The Cornwall Group, Inc., the  Shareholder Representative and Berman Renert Vogl & Mandler, P.A.                                                         |   | Incorporated by reference to Exhibit 99.2 to  the Company’s Current Report on Form 8-K                                              |

 

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|   |   |                                                                                                                                          |   | filed on September 2, 2005.                                                                                                      |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.10  |   | Promissory Note dated October 18, 2005 in  principal amount of $250,000 made by the Company in favor of the Shareholder  Representative. |   | Incorporated by reference to Exhibit 99.2 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.11  |   | Credit Agreement dated as of October 18, 2005  among the Company, its subsidiaries, LSQ Funding Group, L.C. and BRE LLC.                 |   | Incorporated by reference to Exhibit 99.3 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.12  |   | Factoring and Security Agreement dated as of  October 18, 2005 among the Company, its subsidiaries and LSQ Funding  Group, L.C           |   | Incorporated by reference to Exhibit 99.4 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.13  |   | Security Agreement dated as of October 18,  2005 among the Company, its subsidiaries, LSQ Funding Group, L.C. and BRE LLC                |   | Incorporated by reference to Exhibit 99.5 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.14  |   | Pledge Agreement dated as of October 18, 2005  among the Company, LSQ Funding Group, L.C. and BRE LLC                                    |   | Incorporated by reference to Exhibit 99.6 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.15  |   | Guaranty Agreement dated as of October 18,  2005 among the Company, its subsidiaries, LSQ Funding Group, L.C. and BRE LLC                |   | Incorporated by reference to Exhibit 99.7 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.16  |   | Employment Agreement between The Cornwall  Group, Inc. and David H. Shopay dated October 18, 2005                                   |   | Incorporated by reference to Exhibit 99.8 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |
|   |   |                                                                                                                                          |   |                                                                                                                                  |
| 10.17  |   | Escrow Agreement dated as of October 18, 2005  among the Company, SunTrust Bank and the Shareholder Representative.                      |   | Incorporated by reference to Exhibit 99.9 to  the Company’s Current Report on Form 8-K filed on October 24, 2005. |

 

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| 31.1   | Rule  13a-14(a)/15d-14(a) Certification by the Company’s Chief Executive Officer. |
|--------|----------------------------------------------------------------------------------------|
|   |                                                                                   |
| 31.2   | Rule  13a-14(a)/15d-14(a) Certification by the Company’s Chief Financial Officer. |
|   |                                                                                   |
| 32.1   | Section  1350 Certification by the Company’s Chief Executive Officer.             |
|   |                                                                                   |
| 32.2   | Section  1350 Certification by the Company’s Chief Financial Officer.             |

 

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