10-K 1 a5110929.txt COMPUDYNE CORPORATION, 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended DECEMBER 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to ________ Commission File Number 0-29798 CompuDyne Corporation (Exact name of registrant as specified in its charter) Nevada 23-1408659 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 2530 Riva Road, Suite 201, Annapolis, Maryland 21401 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (410) 224-4415 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: Common Stock $.75 par value Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes |_| NO |X| Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes |_| NO |X| Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| NO |_| Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X| Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes |_| NO |X| As of March 23, 2006, a total of 8,119,404 shares of Common Stock, $.75 par value, were outstanding. The aggregate market value of common equity held by non-affiliates of the Registrant, based upon the price the common equity was last sold on the Nasdaq National Market on June 30, 2005 was approximately $45.7 million. (see ITEM 5) Documents incorporated by reference: Portions of the Proxy Statement relating to the 2006 Annual Meeting of Shareholders are incorporated in Part III. 1 PART I ITEM 1. BUSINESS CompuDyne Corporation (the "Company") was reincorporated in Nevada in 1996. We were originally incorporated in 1952. We believe that we are a leading provider of products and services to the public security markets. We operate in four distinct segments: Institutional Security Systems ("ISS"); Attack Protection ("AP"); Integrated Electronic Systems ("IES"); and Public Safety and Justice ("PS&J"). Revenues from external clients, gross profit, pre-tax income and total assets for each segment for the last three years are discussed in footnote 19 to the consolidated financial statements. Four Business Segments ---------------------- Institutional Security Systems The Institutional Security Systems segment is headquartered in Montgomery, Alabama and operates under the trade name Norment Security Group ("Norment"). The clients this segment serves consist primarily of state and local governmental units. This segment provides physical and electronic security products and services to the corrections industry (prisons and jails) and to the courthouse, municipal and commercial markets. ISS, through a network of regional offices, provides field level design, installation and maintenance of both physical and electronic security products. Key products and services of the Institutional Security Systems segment include: o MaxWall: a modular steel, concrete-filled, prefabricated jail cell. o Airteq: a complete line of pneumatic and electro-mechanical operating devices, locks and hardware. o Integrated Security Systems: integrated central control and monitoring products for locking, paging, audio, closed circuit television cameras, nurse call and duress signals. o Hardline products and construction services. Attack Protection The Attack Protection segment is one of the country's largest manufacturers of bullet, blast and attack resistant windows and doors. The ultimate clients this segment serves consist primarily of units of the Federal Government. These products are designed for high security applications such as embassies, courthouses and Federal buildings. We also provide our products and services to corporate headquarters and other facilities requiring the highest level of protection currently available. We believe that we are a premier provider of Underwriters Laboratory ballistic standard UL-752 Level 8 security windows and doors, the highest rating level of commercial ballistic security windows and doors. Additionally, this segment designs and installs both fixed and pop-up bollards and barrier security systems. Key products of the Attack Protection segment include: o Bullet and Blast Protection: integrated and structurally secure bullet, blast and attack resistant windows and doors. o Vehicle Intrusion Barriers: fixed, removable, semi-automatic and automatic vehicle bollards and wedge barrier security systems. o Fiber SenSys: a sophisticated fiber optic monitoring system used to detect physical intrusion. o SecurLAN: integrated security management system designed to detect intrusion attempts aimed at secure and classified communications networks. 2 Integrated Electronic Systems The Integrated Electronic Systems segment consists of our subsidiary, CompuDyne-Integrated Electronics Division, LLP. Our IES segment provides turnkey design, production, installation, and integration of public security and safety systems. The ultimate clients this segment serves consist primarily of units of the Federal Government. This segment is a security systems integrator, specializing in a wide range of customized systems, including: o Access Control and Biometric o Asset Tracking o Badging and Identification o Barriers and Turnstiles o Command, Control, and Communications o Computer Aided Dispatch (CAD)/ Records Management o Electronic Article Surveillance o Fencing, Lighting, Uninterrupted Power o Fire/Life Safety o Information Technology o Intrusion Detection (Exterior, Interior, and Duress) o Fiber Optic Network o Perimeter Security o Smart Card o Surveillance and Assessment Our IES segment provides central station oversight and control of multiple and separate facilities as well as security and public life safety systems and equipment. Key products and services of the IES segment include: o Regionalization Systems: Command and control centers that consolidate the operation and management of 911 emergency services (fire, rescue, and police), radio frequency communications, intrusion detection systems, access control systems, and video surveillance systems for multitudes of buildings at diverse geographical locations. This system centralizes monitoring and dispatch functions, maximizing utility and efficiency of all resources. o Waterside Sentry Systems: Multi-functional security systems designed to detect, alert, monitor, track, and record water-based and shoreline attack threats. o Flightline Sentry Systems: An integration of surveillance, intrusion detection, access control, and other electro/mechanical systems in a comprehensive, "layered" approach to security, which begins inside operations centers and extends beyond base perimeters, providing protection against both overt and covert acts of aggression. o Signals Intelligence+ (SigInt) Systems: Signal gathering and analysis products and systems used for field-based collections and monitoring, providing the U.S. intelligence community and U.S. allies with real time intelligence for strategic and tactical decision making. Public Safety and Justice The Public Safety and Justice segment consists of CompuDyne-Public Safety and Justice, Inc. (formerly Tiburon, Inc. ("Tiburon")), CorrLogic, LLC, the recently acquired subsidiary Xanalys Corporation and the acquired assets of 90 Degrees, Inc. ("90 Degrees") and Copperfire Software Solutions, Inc. ("Copperfire"). The clients this segment serves consist primarily of state and local governmental units. This segment provides a fully integrated suite of products including computer-assisted dispatch, records management and court and probation software systems for the law enforcement, fire and rescue, corrections and justice environments. We believe that we are a worldwide market leader in the development, implementation and support of public safety and justice automation systems. Tiburon, acquired by us in 2002, has been in business since 1980. Key products and services of the Public Safety and Justice segment include: 3 o Dispatch Systems: computer-assisted dispatch systems designed for first responders such as police, fire and emergency medical personnel that feature peer-to-peer technology that is less vulnerable to server and database failures. o Records Management Systems: integrated software modules to automate today's law enforcement and fire protection agencies, from initial incident entry to final disposition and related state reporting. o Mobile Computing Systems: solutions that provide instant access to computer assisted dispatch and records management systems by law enforcement and emergency personnel in the field. o Inmate Management Systems: development, implementation and support of complex, integrated inmate management software systems. o Investigative analysis software systems. Substantially all of the Company's research and development expenditures occur in the PS&J segment. The PS&J segment incurred $7.8 million, $7.1 million and $7.1 million of research and development expenses in the years ended December 31, 2005, 2004 and 2003, respectively. The Market ---------- The market opportunity for jail and prison security systems is related to new facility construction, existing facility renovations, and the trend towards outsourcing government services. We believe approximately $3.0-$3.5 billion will be spent in 2006 on correctional facility construction, of which typically between 10% and 15% relates to security equipment and security electronics, the markets that we currently serve. Our modular cell product, Maxwall, generally constitutes an additional 10% to 15% of the overall facility construction budget. Other larger security markets we serve include state and local government facilities, federal government facilities and large commercial installations. In all four segments of our business, we face considerable competition from large and small companies. We compete primarily on a price basis with our competitors. While we are one of the largest suppliers of physical and electronic security to the corrections industry, we have one significant competitor and many small competitors. Most of our business occurs on a bid or request for proposal basis. Because of the bid and request for proposal process, we do not generally have access to the underlying assumptions that resulted in our competitors' bids and therefore, other than price, we cannot determine why our bid was successful or unsuccessful for particular contracts. Much of the Integrated Electronic Systems work is on a cost recoverable basis and is subject to audit by the Defense Contract Audit Agency. The Public Safety and Justice segment competes in a market where the annual new solution spending is approximately $2 billion. Solution spending represents resources dedicated to implement predefined information systems through the mix of hardware, software and services and excludes existing warranty and maintenance agreements. Most of the competitors in this market are smaller than us, providing best of breed solutions as opposed to our broad solution capability. Our large competitors include divisions of Motorola, Intergraph and Northrop Grumman. Business Strategy ----------------- We continually strive to position the Company to meet the expanding requirements of the public security market. We believe that we have market-leading positions in key areas of high-end security systems integration, security electronics, advanced security technology products and first responder support software. We consider ourselves to be a one-stop shop and therefore serve as a single supplier resource for the most difficult and complex public security and first responder requirements. Not all of our competitors have this capability. In order to enhance our position in the public security market, our current strategy is to: Pursue our existing business through internal growth. We believe that we have market-leading positions in many product and service categories, which provide us a leverageable and ready-made growth platform. Expand our client base to encompass high-end commercial clients. Our products are now being marketed to banks, corporate headquarters, private estates and other facilities. 4 Utilize our Institutional Security capabilities in other markets. Many of our products and technologies, and the applications of those products and technologies, were designed to keep offenders confined to certain areas and to keep inmates from "breaking out." These same products and technologies can be adapted to keep people from "breaking in." We are currently working towards adapting our products to this new market. Make selective acquisitions to complement and enhance our current technological capabilities and market access. Our acquisitions of Norment and Tiburon greatly expanded our product offerings and solidified our position within the Institutional Security Systems and Public Safety and Justice segments. We believe other acquisition opportunities exist which if successfully consummated could further enhance our current product and service offerings. Develop strategic alliances with large defense contractors and teaming agreements with other integrators, which may put us in a position to participate in large blanket procurement projects from the Department of Homeland Security in response to homeland security requirements. Improve our cost structure, quality, and client and employee satisfaction, and re-engineer our business model to generate a greater degree of recurring revenue. In addition, we are continually evaluating our structure to determine if another organizational structure would be more advantageous to the Company in light of the current operating environment. Corporate Information --------------------- We were reincorporated in Nevada in 1996 and our predecessor corporation was incorporated in Pennsylvania in 1952. Our principal executive offices are located at 2530 Riva Road, Suite 201, Annapolis, Maryland 21401. Our telephone number is (410) 224-4415. General Information ------------------- The Company purchases most of the parts and raw materials used in its products from various suppliers. The primary raw materials used in the manufacturing of its products are electronic components and steel or aluminum sheets, stampings and castings. These materials are generally available from a number of different suppliers. While the bulk of such raw material is purchased from relatively few sources of supply, the Company believes that alternative sources are readily available. There is no significant seasonality in CompuDyne's business. The Company's construction related business, ISS, however, has historically been a very cyclical business in line with the cycle of prison construction in the United States. See the Management Outlook located in Item 7 for a discussion of backlogs. At December 31, 2005, the Company had approximately 766 permanent employees. Of the permanent employees, approximately 93 are subject to collective bargaining agreements. The Institutional Security Systems Segment regularly hires union personnel on a temporary basis for field projects. These personnel are subject to various collective bargaining agreements depending on their skills and locale. At December 31, 2005, there were no temporary employees covered under collective bargaining agreements. The ultimate clients through which substantially all of the sales of the Company are generated are the Federal government or state and local governments primarily in the United States of America. Risks Related to Our Businesses ------------------------------- Budget constraints of state and local governments could adversely affect our business. Contracts for which state or local governments are the ultimate customer account for approximately 69% of our business. Our Institutional Security Systems segment, our largest business segment, outfits correctional facilities and courthouses. Similarly, our Public Safety and Justice segment almost exclusively serves state and local governments. Many state and local governments operate under very tight budget constraints. Continued budget constraints on these governments could cause them to delay or cancel pending projects, which could materially adversely affect our financial results. The loss or reduction of U.S. Government contracts could adversely affect our business. Contracts where the U.S. Government is the ultimate customer accounted for approximately 25% of our revenues in the fiscal year ended December 31, 2005. The U.S. Government funds these contracts in annual increments, and the 5 contracts require subsequent authorization and appropriation, which may not occur or which may provide less than the total amount of the contract. We may not receive future contracts and the size of any contracts that we receive may vary. Fluctuations in spending by the U.S. Government for national defense could also adversely affect our ability to receive future contracts. Additionally, the U.S. Government may cancel its contracts unilaterally, at its convenience. The loss of, or a significant reduction in, this business could have an adverse effect on our business. We operate under fixed price contracts and our inability to estimate our costs may adversely affect our financial results. Much of our business is pursuant to fixed price contracts. If we do not accurately estimate our costs, we could suffer losses on these contracts. Increases in the cost of raw materials could have an adverse impact on our financial performance if we are not able to effectively forecast such increases. In addition, our revenues under these contracts are recognized under the percentage of completion method of accounting. This method requires considerable judgment and as a result the estimates derived at any point in time could differ significantly from the final results attained. Our ability to obtain payment and/or performance bonds is critical to our ability to conduct business. In the conduct of our business we are often required by our customers to obtain payment and/or performance bonds. The majority of these bonds have been needed in the ISS and PS&J segments. Recently, approximately 75% of ISS' work has come from jobs where payment and performance bonds are required and for PS&J, 19% of its work has required payment and performance bonds. The Company's recent losses have made it more challenging for the Company to obtain the bonding needed to procure certain of its projects. As of December 31, 2005, the Company was required to provide collateral for two of its projects which it did by issuing bank letters of credit as collateral in the amount of approximately $5.5 million in total. If we are unable to obtain such bonds for any reason, or if the terms, particularly collateral requirements, of the bonds are not within our financial means, it would significantly diminish our ability to secure new contracts, and consequently our financial performance and results of operations may be materially adversely affected. If we are unable to design, manufacture and market our products offerings in a timely and efficient manner, we may not remain competitive. We offer a wide variety of products. If the design, manufacturing or marketing of a product or products is not successful and we must allocate more resources to ensure the products' success, it could lower the profitability of the product or products and affect customer perceptions as to the quality of products we produce. In addition, all four segments of our business face considerable competition from large and small companies. We compete primarily on a price basis with our competitors and because of the bid and request for proposal process, we often do not have access to the underlying assumptions that resulted in our competitor's bids, and therefore, other than price we cannot determine why our bid was successful or unsuccessful for particular projects. This creates difficulty in accurately projecting the success of future bids. A decrease in the amount of successful bids and subsequent projects could have an adverse effect on our business. If we are unable to develop and market new products in a timely manner, we may not remain competitive. Some of our markets are characterized by continuing technological advancement, changes in customer requirements, and evolving product standards. In particular, our PS&J segment specializes in the development, implementation and support of complex, integrated software systems, and accordingly, PS&J devotes a substantial amount of resources to product development. To compete successfully, PS&J must develop and market new products that provide increasingly higher levels of performance and reliability. Product development is highly uncertain and there can be no assurance that we will successfully develop new products. Our inability to develop and market these products or to achieve customer acceptance of these products could have an adverse effect on our business. The failure to obtain U.S. Government contracts in connection with the Department of Homeland Security's Homeland Defense initiative could adversely affect our business. We currently do not have any U.S. Government contracts derived from the Department of Homeland Security's Homeland Defense initiative. We may not receive any contracts as a result of this initiative and the size of any contracts that we receive may vary. Our failure to secure Homeland Defense contracts could give other companies in the public security market a competitive advantage and could have an adverse effect on our business. We are subject to substantial government regulation that could cause delays in the delivery of our products and services and may subject us to audits or other similar review processes. As a contractor with agencies of the U.S. Government and various state governments, we are obligated to comply with a variety of regulations governing our operations and the workplace. These regulations include those promulgated by, among others, the various states with which we contract, the U.S. Departments of Commerce, State, Transportation and the U.S. Environmental Protection Agency, the Occupational Safety and Health Administration, and the U.S. Bureau of Alcohol, Tobacco and Firearms. Certain of our contracts give the 6 contracting agency the right to conduct audits of our facilities and operations, including a review of our compliance with the prescribed procedures established in connection with the government contract. We may be subject to investigations as a result of an audit or for other causes. Government contractors that are found to have violated the False Claims Act, or are indicted or convicted for violations of other federal laws, or are considered not to be responsible contractors, may be suspended or debarred from government contracting for some period of time. Such convictions could also result in fines. Suspension or debarment could have a material adverse effect on the Company. U.S. Government contracts may also contain specific delivery requirements, which if not met satisfactorily by us could result in penalties assessed against us and a loss of profits. In addition, changes in federal, state and local laws may impact our ability to secure new contracts and otherwise affect the operations of our business. Our inability to effectively integrate acquisitions could adversely affect our business. We have made a number of acquisitions in recent years, which require that we integrate operations and systems and personnel from those businesses into our Company. This process requires, among other things, that we must continually evaluate our operational and financial systems and controls and enhance those systems and controls as necessary. If we are unable to successfully integrate these acquisitions it could adversely effect our operating results and our ability to comply fully with laws and regulations. Our inability to or successfully complete our restructuring and simplify our structure could adversely affect our business. Our Institutional Security Systems, Attack Protection and Public Safety and Justice business segments are undergoing significant organizational expense restructuring. In addition, we are evaluating our structure and strategy to determine if any less decentralized, or other organizational structure would result in lower selling, general and administrative costs and we are evaluating our strategy to determine if we would benefit from focusing on fewer segments. If we are unable to successfully complete our current organizational expense restructuring, or if we are unable to effectively further change our structure in order to achieve lower selling, general and administrative costs, it could adversely affect our operating results and detract from future growth opportunities. If we are unable to comply with Sarbanes-Oxley Act Section 404 ("Section 404") and the requirement to maintain adequate disclosure controls and procedures, we may be adversely impacted. Section 404 requires that certain companies establish and maintain an adequate internal control structure and procedures for financial reporting and assess on an on-going basis, the design and operating effectiveness of their internal control structure and procedures for financial reporting. Although we are not required to comply with Section 404 for 2005, we were required to comply in 2004 and we previously disclosed that our internal control over financial reporting as of December 2004 had material weaknesses. Although we have remediated the material weaknesses, and currently are not required to comply with Section 404, we will be required to comply with Section 404 in 2007 and any future inability to maintain an adequate internal control structure and disclosure controls and procedures could result in our independent registered public accounting firm issuing an adverse opinion on our internal controls, increased regulatory scrutiny and possible restatement of our financial statements and delisting of our common stock on the Nasdaq market. Compliance with Section 404 will also result in substantial additional expenses. We may need additional financing for bonding requirements, working capital and capital expenditures and additional financing may not be available on terms acceptable to us. In order to operate our business, we may need to obtain additional surety bonds, maintain working capital and make significant capital expenditures and may need additional capital to do so. Our ability to operate and grow is dependent upon, and may be limited by, among other things, availability of financing arrangements. Additional funding sources may be needed, and we may not be able to obtain the additional capital necessary to pursue new projects or maintain our operations, and if we can obtain additional financing, the additional financing may not be on terms which are satisfactory to us. Our failure to remain in compliance with the terms of our credit facility could adversely affect our business. As of September 30, 2004 we were not in compliance with the "minimum fixed charge coverage ratio" and as of December 31, 2004 we were not in compliance with the "minimum EBITDA" covenant in our credit facility. The bank who is a party to our credit facility agreed to waive compliance with these covenants in connection with an amendment to our credit facility dated October 29, 2004 and March 4, 2005, respectively. On May 3, 2005, our bank confirmed in writing that there will not be any event of default under the various credit agreements, by virtue of our failure to timely file an Amendment to our Annual Report on Form 10-K for the year ended December 31, 2004. In the event that we were to breach a covenant under our credit facility in the future, there can be no guarantee that we could secure a waiver for such breach and we would be in default under the credit facility. Our failure to remain in compliance with the terms of our credit facility could have a material adverse effect on our ability to conduct our business and to fulfill our obligations under our Convertible Subordinated Notes due 2011 ("2011 Notes"). 7 Legal proceedings may adversely affect our business. We are a party to certain legal actions and inquiries for environmental and other matters resulting from the normal course of business. Some of our businesses, especially Institutional Security Systems, involve working as a subcontractor to a prime contractor. From time to time we make claims against the prime contractor, or the prime contractor makes claims against us. At any point in time we are engaged in a number of claim disputes with prime contractors, some of which may have a significant negative outcome. Although the total amount of liability with respect to these matters cannot be ascertained given the nature of the related allegations, we presently believe that any resulting liability would not have a material effect on our financial position, results of future operations or cash flows. In addition to claims with prime contractors, we may also make claims against customers and customers may make claims against us. We have been named in lawsuits involving asbestos related personal injury and death claims in which CompuDyne Corporation, individually and as an alleged successor, is a defendant. We have been named as a defendant in cases related to claims for asbestos exposure allegedly due to asbestos contained in certain of its predecessor's products. We have advised our insurers of each of these cases, and the insurers are providing a defense pursuant to agreement with us, subject to reservation of rights by the insurers. The insurers have advised that claims in such litigation for punitive damages, exemplary damages, malicious and willful and wanton behavior and intentional conduct are not covered. One of the carriers has given notice that asbestos related claims are excluded from certain of these policies. The insurers have additional coverage defenses which are reserved, including that claims may fall outside of a particular policy period of coverage. Litigation costs to date have not been significant and we have not paid any settlements from our own funds. The Company cannot ascertain the total amount of potential liability with respect to these legal matters, but does not believe that any such potential liability should have a material effect on its financial position, future operations or future cash flows. However, litigation is inherently risky and unexpected results could have a material adverse effect on us. We are exposed to potential liability to clients and others. Our involvement in the public security and justice business exposes us to potential liability claims from our clients. Our products are used in applications where their failure could result in serious personal injuries and death. We have sought ways to minimize loss to our clients by obtaining product liability and professional liability insurance policies; however, a successful claim could result in liability in excess of coverage limits or the cancellation of insurance coverage and have an adverse effect on our business and operations. We are subject to various environmental laws that could subject us to unforeseen expenditures. Our operations are subject to various environmental statutes and regulations, including laws and regulations addressing materials used in the manufacture of our products. In addition, certain of our operations are subject to federal, state and local environmental laws and regulations that impose limitations on the discharge of pollutants into the air and water and establish standards for the treatment, storage and disposal of solid and hazardous wastes. Although we believe that we have made sufficient capital expenditures to maintain compliance with existing laws and regulations, future expenditures may be necessary as compliance standards and technology change. Unforeseen significant expenditures required to maintain such compliance, including unforeseen liabilities, could have an adverse effect on our business and financial condition. Our ability to generate sufficient cash to make principal and interest payments on the 2011 Notes depends on many factors beyond our control. Our ability to make payments on and to repurchase the 2011 Notes upon maturity will depend on our ability to generate cash in the future. Our business may not generate sufficient cash flow from operations, cost savings may not be realized, and future borrowings may not be available to us under credit arrangements in an amount sufficient to enable us to make the principal and interest payments on the 2011 Notes. We may need to refinance all or a portion of our indebtedness under the 2011 Notes on or before maturity. We may not be able to refinance the 2011 Notes, if necessary, on commercially reasonable terms or at all. Cautionary Statement Regarding Forward-Looking Information ---------------------------------------------------------- Certain statements made in this Form 10-K with regard to the Company's expectations as to future revenues, expenses, financial position and industry conditions, the Company's ability to secure new contracts, its goals for future operations, implementation of business strategy and other future events constitute "forward-looking statements" within the meaning of the federal securities laws. When used in this Form 10-K, words such as "anticipate," "believe," "estimate," "expect," "intend" and similar expressions identify forward-looking statements. Although the Company makes such statements based on current information and assumptions it believes to be reasonable, there can be no assurance that actual results will not differ materially from those expressed or implied by such forward-looking statements. Actual results could differ 8 materially from those contemplated by the forward-looking statements as a result of certain important factors, including but not limited to, capital spending patterns of the security market and the demand for the Company's products, competitive factors and pricing pressures, changes in legislation, regulatory requirements, government budget problems, the Company's ability to secure new contracts, the ability to remain in compliance with its bank covenants, delays in government procurement processes, ability to obtain bid, payment and performance bonds on various of the Company's projects, technological change or difficulties, the ability to refinance debt when it becomes due, product development risks, commercialization difficulties, adverse results in litigation, the level of product returns, the amount of remedial work needed to be performed, costs of compliance with Sarbanes-Oxley requirements and the impact of the failure to comply with such requirements, risks associated with internal control weaknesses identified in complying with Section 404 of Sarbanes-Oxley, the Company's ability to realize anticipated cost savings, the Company's ability to simplify its structure and modify its strategic objectives, and general economic conditions. Risks inherent in the Company's business and with respect to future uncertainties are further described in our other filings with the Securities and Exchange Commission. Available Information --------------------- Our website is located at www.CompuDyne.com. The Company makes available free of charge all of its SEC filings (including its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to these reports) on the Company website and posts the filings as soon as reasonably practicable after electronically filing or otherwise furnishing such material to the SEC. ITEM 2. PROPERTIES The Company's principal executive offices are in Annapolis, Maryland where the Company leases approximately 4,358 square feet of office space. At December 31, 2005 the Institutional Security Systems segment leased primary facilities for engineering, assembly and administration including: Alabama - 40,250 square feet, California - 15,795 square feet, Maryland - 9,500 square feet, Arizona - 8,369 square feet and North Carolina - 5,775 square feet. At December 31, 2005 the Attack Protection segment owned primary facilities for engineering, manufacturing and administration in Alabama - 165,883 square feet. A portion of this space is used by the ISS segment for administrative purposes. These facilities are encumbered by Industrial Revenue Bonds. The Attack Protection segment also leases 31,372 square feet of office/warehouse space in Oregon. At December 31, 2005 the Integrated Electronic Systems segment leased primary facilities for engineering, assembly and administration in Maryland - 14,690 square feet. At December 31, 2005 the Public Safety and Justice segment leased primary facilities for engineering and administration including California - 34,527 square feet, Colorado - 10,432 square feet, Texas - 10,247 square feet, United Kingdom - 6,663 square feet, Oregon - 5,669 square feet, Utah - 5,422 square feet, Washington - 4,000 square feet, Massachusetts - 3,552 square feet, and Wisconsin - 1,902 square feet. The Company leases only those properties necessary to conduct its business and does not invest in real estate or interests in real estate on a speculative basis. The Public Safety and Justice segment's California office has signed a new lease agreement for 30,772 square feet of office space to replace the currently used 32,050 square feet of office space beginning on April 1, 2006. The lease has a term of six years and total future minimum rental payments under the lease are $4.2 million. The Company believes that after this relocation the current properties will be suitable and adequate for its current operations. Additional space may be required to service contracts in other areas. ITEM 3. LEGAL PROCEEDINGS The Company is party to certain legal actions and inquiries for environmental and other matters resulting from the normal course of business. Some of the businesses, especially Institutional Security Systems, involve working as a subcontractor to a prime contractor. From time to time the Company makes claims against the prime contractor, or the prime contractor makes claims against the Company. At any point in time the Company is engaged in a number of claim disputes with prime contractors, some of which may have a significant negative outcome. Although the total amount of potential liability with respect to these matters can not be ascertained given the nature of the related allegations, the Company presently believes that any resulting liability will not have a material effect on its financial position, results of future operations or cash flows. 9 In addition to claims with prime contractors, the Company may also make claims against customers and customers may make claims against the Company. The Company has learned that the National Association of Securities Dealers ("NASD") and other regulatory bodies are seeking sanctions against purchasers of the Company's common stock in its 2001 PIPE transaction. In addition, the Company has learned that the placement agent for this transaction is also being investigated by the SEC, NASD and other regulatory bodies. The Company is investigating these matters, has filed lawsuits against certain purchasers and is evaluating its other options for recovery. The Company has been named in lawsuits involving asbestos related personal injury and death claims in which CompuDyne Corporation, individually and as an alleged successor, is a defendant. The Company has been named as a defendant in cases related to claims for asbestos exposure allegedly due to asbestos contained in certain of its predecessor's products. The Company has advised its insurers of each of these cases, and the insurers are providing a defense pursuant to agreement with the Company, subject to reservation of rights by the insurers. The insurers have advised that claims in such litigation for punitive damages, exemplary damages, malicious and willful and wanton behavior and intentional conduct are not covered. One of the carriers has given notice that asbestos related claims are excluded from certain of these policies. The insurers have additional coverage defenses, which are reserved, including that claims may fall outside of a particular policy period of coverage. Litigation costs to date have not been significant and the Company has not paid any settlements from its own funds. The Company cannot ascertain the total amount of potential liability with respect to these legal matters, but does not believe that any such potential liability should have a material effect on its financial position, future operations or future cash flows. The Company, as a government contractor, is from time to time subject to U.S. Government investigations relating to its operations. Government contractors that are found to have violated the False Claims Act, or are indicted or convicted for violations of other federal laws, or are considered not to be responsible contractors, may be suspended or debarred from government contracting for some period of time. Such convictions could also result in fines. Suspension or debarment could have a material adverse effect on the Company. No such violations or conditions of debarment exist at this time. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 10 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS CompuDyne Common Stock is quoted on the Nasdaq National Market, under the symbol "CDCY." There were 1,907 common shareholders of record as of March 23, 2006. The following table sets forth the high and low sales for CompuDyne Common Stock as quoted on the Nasdaq National Market. 2005 2004 ---- ---- Quarter Ended High Low High Low ------------- ------------------- ------------------- March 31 $ 7.80 $ 4.65 $13.19 $ 8.56 June 30 $ 8.00 $ 5.03 $17.46 $ 8.55 September 30 $ 9.40 $ 5.27 $11.61 $ 7.06 December 31 $ 6.75 $ 4.74 $ 8.50 $ 6.10 The Company did not pay any dividends on its common stock during the years ended December 31, 2005 and 2004, and its bank covenants forbid paying dividends until satisfaction in full of the obligations and termination of the banking agreements. In addition, the Company's 2011 Notes restrict the Company's ability to declare or pay cash dividends. ITEM 6. SELECTED FINANCIAL DATA The following is a consolidated summary of operations of CompuDyne and its subsidiaries for the years ended December 31, 2005, 2004, 2003, 2002, and 2001. The information in the table below is based upon the audited consolidated financial statements of CompuDyne and its subsidiaries for the years indicated appearing elsewhere in this annual report or in prior annual reports on Form 10-K filed by the Company with the SEC, and should be read in conjunction therewith and the notes thereto.
(In thousands except per share data) For the years ended December 31 ----------------------------------------------------------------------- 2005(b) 2004 2003 2002(a) 2001 ------------ ------------ ------------ ------------ -------------- Net sales $ 141,650 $ 142,782 $ 193,263 $ 155,556 $ 127,394 ============ ============ ============ ============ ============== Gross profit $ 42,539 $ 37,678 $ 46,396 $ 34,816 $ 25,280 Selling, general and administrative expenses 40,567 36,219 32,305 25,785 17,378 Research and development 8,685 7,755 7,374 4,916 70 Impairment of goodwill and other intangibles - 1,826 - - - ------------ ------------ ------------ ------------ -------------- Operating (loss) income $ (6,713) $ (8,122) $ 6,717 $ 4,115 $ 7,832 ============ ============ ============ ============ ============== Interest expense, net of interest income $ 2,233 $ 2,289 $ 1,051 $ 1,394 $ 2,540 ============ ============ ============ ============ ============== Net (loss) income $ (8,691) $ (8,198) $ 3,408 $ 1,814 $ 4,092 ============ ============ ============ ============ ============== (Loss) earnings per share (c): Basic (Loss) earnings per common share $ (1.07) $ (1.01) $ .43 $ .24 $ .75 ============ ============ ============ ============ ============== Weighted average number of common shares outstanding 8,129 8,136 7,895 7,456 5,424 ============ ============ ============ ============ ============== Diluted (Loss) earnings per common share $ (1.07) $ (1.01) $ .42 $ .23 $ .67 ============ ============ ============ ============ ============== Weighted average number of common shares and equivalents 8,129 8,136 8,158 7,940 6,110 ============ ============ ============ ============ ============== Total assets $ 126,692 $ 132,891 $ 115,732 $ 120,804 $ 74,485 ============ ============ ============ ============ ============== Long-term debt $ 42,870 $ 43,123 $ 17,658 $ 27,510 $ 15,162 ============ ============ ============ ============ ============== Total shareholders' equity $ 36,422 $ 45,831 $ 52,927 $ 49,204 $ 32,637 ============ ============ ============ ============ ==============
Reclassifications - Certain prior year amounts have been reclassified to conform with the current year's presentation. Notes: (a) Includes operations of Tiburon, Inc. from May 2, 2002, the date of acquisition. (b) Includes operations of Xanalys Corporation from August 24, 2005, the date of acquisition. (c) No dividends have been paid on the Company's Common Stock during the above periods. 11 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Introduction Overview of CompuDyne Corporation CompuDyne Corporation was reincorporated in Nevada in 1996. We were originally incorporated in 1952. We believe that we are a leading provider of products and services to the public security markets. We operate in four distinct segments: Institutional Security Systems ("ISS"); Attack Protection ("AP"); Integrated Electronic Systems ("IES"); and Public Safety and Justice ("PS&J"). The Institutional Security Systems segment is headquartered in Montgomery, Alabama and operates under the trade name Norment Security Group ("Norment"). This segment provides physical and electronic security products and services to the corrections industry (prisons and jails) and to the courthouse, municipal and commercial markets. ISS typically serves as a subcontractor, responsible for their portion of the installation work on larger projects. Installations involve hard-line (steel security doors, frames, locking devices, etc.) and sophisticated electronic security systems, including software, electronics, touch-screens, closed circuit TV, perimeter alarm devices and other security monitoring controls. ISS also developed a product called MaxWall. MaxWall is a modular steel, concrete filled prefabricated jail cell. It allows for construction projects to use considerably less space and can save the project owner significant amounts of money. ISS provides field level design, installation and maintenance of both physical and electronic security products. Included in the Institutional Security Systems segment is the TrenTech line which manufactures and integrates electronic security systems. TrenTech integrates generally available products and software as well as developing its own proprietary systems. TrenTech has developed a sophisticated proprietary video badging system, with approximately 250 systems installed at more than 70 facilities, most of which are military installations. The Institutional Security Systems segment also manufactures a complete line of locks and locking devices under the brand name Airteq. Airteq is an industry leader in pneumatic and electro-mechanical locking devices used in the corrections industry. The Attack Protection segment is one of the country's largest manufacturers of bullet, blast and attack resistant windows and doors designed for high security applications such as embassies, courthouses, Federal buildings, banks, corporate headquarters and other facilities that insist on having the highest level of protection currently available. We believe that we are a premier provider of Underwriters Laboratory ballistic standard UL-752 Level 8 security windows and doors, the highest rating level of commercial ballistic security windows and doors. Our attack resistant windows and doors are integrated and structurally secure products with specifically designed frames and encasements that are integral parts of the structure in which they are installed. Existing product installations number in the thousands and range from the Middle East to the White House. AP is a significant supplier of bullet and blast resistant windows and doors to United States embassies throughout the world. AP usually works under contracts from prime contractors who have direct contracts with the United States Department of State, the segment's largest client. Attack Protection products are also sold to drug stores and convenience stores to secure drive through facilities. Other commercial applications include guard booths, tollbooths, cash drawers and other similar items. Additionally, this segment designs and installs both fixed and pop-up bollards and wedge barrier security systems. The Attack Protection segment also manufactures a sophisticated fiber optic sensor system, known as Fiber SenSys, used to detect physical intrusion. This application is designed to protect large perimeters including such applications as Federal facilities, military deployments and bases, oil fields, airport tarmacs, public utilities, nuclear reactors and water systems. In addition, it has been installed to protect the perimeters of private estates and other similar properties. The Integrated Electronic Systems (formerly known as Federal Security Systems) segment consists of CompuDyne-Integrated Electronics Division, LLC. Its customer base includes the military, governmental agencies, and state and local governmental units. IES provides turnkey system integration of public security and safety systems. This segment specializes in a wide range of customized access control and badging, intrusion detection, surveillance and assessment, communications, command and control, fire and life safety, and asset tracking systems. IES provides central station oversight and control of multiple and separate facilities as well as security and public life safety systems and equipment. This segment also designs and manufactures advanced digital signal processing products used in reconnaissance of foreign telecommunications signals designed for the United States Government and its foreign allies. 12 The Public Safety and Justice segment consists of CompuDyne-Public Safety and Justice, Inc. (formerly Tiburon, Inc.), CorrLogic, LLC, the recently completed acquisition of Xanalys Corporation and the acquired assets of 90 Degrees, Inc. ("90 Degrees") and Copperfire Software Solutions, Inc. ("Copperfire"). PS&J's software systems are used in a wide range of applications within the public safety and criminal justice sectors of governmental units, including police, fire and emergency medical services computer-aided dispatch systems, and police, fire, jail, prosecution, probation, court records and institutional medical software management systems. We also specialize in the development, implementation and support of complex, integrated inmate management software systems, including inmate medical management systems that improve the efficiency and accuracy of correctional facility operations. During the second half of 2004, we expanded our offerings in the Public Safety and Justice segment by acquiring the assets of 90 Degrees and Copperfire. 90 Degrees provides a web-based fire records management system, which is being integrated into our current PS&J product offerings. 90 Degrees' enterprise-wide records management solutions assist fire and Emergency Medical Service agencies in managing responses to emergency situations. We anticipate that as we integrate 90 Degrees' product offerings into our PS&J product offerings, the open web-based technology from 90 Degrees will advance our current fire and rescue product offerings. Copperfire provides customized report writing and forms generation software designed specifically for public safety and justice agencies. The software automates an agency's current business practices, turning hard copy forms into digital images, to create a paperless report writing system. Xanalys was acquired during the third quarter of 2005. Xanalys provides a suite of investigative management and analysis solutions that enable investigators to collect, analyze and share information to solve cases. We believe that integration of Copperfire's and Xanalys' products will enhance our total offerings in PS&J. Management Outlook We continue to find ourselves in very challenging times. We have three major areas of focus: o The first is increasing the amount of our backlog. o The second is migrating to a business model with a more predictable revenue stream. o The third is to improve our cost structure (including evaluating our strategy to determine if we would benefit from focusing on fewer segments), quality, and customer and employee satisfaction. Our backlog is a key indicator of what our future revenues will look like. Our backlog peaked at December 31, 2002, at which time it exceeded $204 million. The December 31, 2005 quarter is the third consecutive quarter in which we experienced a quarter-over-quarter increase. Backlog was approximately $148.1 million at December 31, 2005, as shown in the following table:
Institutional Integrated Public Security Attack Electronics Safety and Backlog (in thousands) Systems Protection Systems Justice Total ----------------------------------------------------------------------- December 31, 2002 $ 99,527 $ 18,478 $ 11,440 $ 74,867 $204,312 December 31, 2003 $ 57,258 $ 10,043 $ 8,326 $ 63,727 $139,354 December 31, 2004 $ 49,324 $ 20,803 $ 8,299 $ 48,434 $126,860 March 31, 2005 $ 42,700 $ 20,139 $ 8,395 $ 44,488 $115,722 June 30, 2005 $ 56,492 $ 19,466 $ 9,105 $ 46,045 $131,108 September 30, 2005 $ 52,557 $ 16,210 $ 8,146 $ 58,270 $135,183 December 31, 2005 $ 58,128 $ 28,802 $ 7,503 $ 53,705 $148,138
Historically, approximately 93% of our revenues were generated from sources where the ultimate client is a federal, state or local government unit. During the last few years, due to the general economic slowdown, state and local budgets, which we are dependent on for approximately 69% of our revenue sources, have come under intense pressure. Most states were running in a deficit situation, as were many local governments. This caused many of them to delay and in some cases cancel many infrastructure projects until such time as their economic fortunes rebound. In recent months, tax revenues have been improving resulting in increased activity preparatory to the issuance of bids and ultimately the awarding of new projects. In addition, we have increased our sales and marketing efforts with a specific objective of marketing to the commercial sector which inherently offers faster project implementation schedules. Our second area of focus is the reengineering of our business model so that it contains a greater percentage of recurring revenue. As indicated in the following table, approximately 15.4% of the revenue in 2005 was generated from recurring revenue sources (primarily maintenance revenues), and the majority of these revenues occurred in our Public Safety and Justice segment. We define one-time revenue as revenue derived from discrete projects, from which we do not expect to generate incremental revenue upon the completion of the project. We 13 define recurring revenue as sources of revenue from which we anticipate receiving revenue in the current, as well as future periods, for example annual renewable maintenance contracts.
Year Ended December 31, 2005 ---------------------------- (in thousands) One-time Revenue % Recurring Revenue % Total ------------------------------------------------------------------- Institutional Security Systems $ 56,035 39.6 $ 4,617 3.3 $ 60,652 Attack Protection 27,017 19.1 - - 27,017 Integrated Electronic Systems 7,786 5.5 2,324 1.6 10,110 Public Safety and Justice 28,987 20.4 14,884 10.5 43,871 ----------------------- --------------------- ------------- Total $ 119,825 84.6 $ 21,825 15.4 $ 141,650 ======================= ===================== =============
Since the majority of our revenues are one-time revenues and are non-recurring, we must reinvent our book of business on a continual basis. This makes it very difficult for us to project our future revenue stream and thus makes it very difficult for us to project our earnings as well as our business outlook. Over the next five years, we intend to modify our business model to rely less upon one-time sources of revenue and more on recurring sources of revenue. Our third focus area is to improve our cost structure, quality, and client and employee satisfaction. Our Institutional Security Systems and Attack Protection business segments are undergoing significant organizational and expense restructuring, including a partial consolidation of regional office efforts and an increased focus on centralized performance of the most complicated security projects. This initiative began by ensuring our organization is properly aligned with our clients' needs. Many changes have been made and initial results indicate that our cost, our quality, our clients and our employees are responding favorably to the changes implemented thus far. We have much room for improvement as we move toward a more client-oriented organization. The organization re-alignment is critical to strengthening our future as it allows us to deploy the Six Sigma and Lean Manufacturing methodologies across all our business segments more efficiently. The Six Sigma methodology focuses on defect elimination, which will have a direct impact on our cost, quality, and client satisfaction. Lean Manufacturing also focuses on reduction of costs and elimination of waste. In addition, in light of the escalating selling, general and administrative costs associated with the current heightened regulatory environment, we are evaluating our structure and strategy to determine if a less decentralized, or other organizational structure would result in lower selling, general and administrative costs and we are evaluating our strategy to determine if we would benefit from focusing on fewer segments. We believe that if we address and implement successfully the above three areas of focus, we will significantly enhance our future growth opportunities and will provide for more predictable financial results. During the second half of 2004, we expanded our offerings in the Public Safety and Justice segment by acquiring the assets of 90 Degrees and Copperfire. 90 Degrees provides a web-based fire records management system, which is being integrated into our current PS&J product offerings. 90 Degrees' enterprise-wide records management solutions assist fire and emergency medical service agencies in managing responses to emergency situations. We anticipate that as we integrate 90 Degrees' product offerings into our PS&J product offerings, the open web-based technology from 90 Degrees will advance our current fire and rescue product offerings. Copperfire provides customized report writing and forms generation software designed specifically for public safety and justice agencies. The software automates an agency's current business practices, turning hard copy forms into digital images, to create a paperless report writing system. Xanalys was acquired during the third quarter of 2005. Xanalys provides a suite of investigative management and analysis solutions that enable investigators to collect, analyze and share information to solve cases. We believe that integration of Copperfire's and Xanalys' products will enhance our total offerings in PS&J. On May 2, 2005, we filed a Form 8-K disclosing that the we failed to timely file an amendment to our Annual Report on Form 10-K for the year ended December 31, 2004 to provide management's report on internal control over financial reporting as of December 31, 2004 and the related report of our independent registered public accounting firm on management's assessment of the effectiveness of internal control over financial reporting (together, the "404 Report") required by Section 404 of the Sarbanes-Oxley Act of 2002. On May 4, 2005, we received a notice from the Listing Qualifications Department of The Nasdaq Stock Market stating that due to our failure to timely file the 404 Report, we were no longer in compliance with the requirements of Marketplace Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports required to be filed with the Securities and Exchange Commission on or before the date they are required to be filed with the SEC. 14 On June 27, 2005, the Company filed its Form 10-K/A with the SEC containing the 404 Report. On June 30, 2005, the Nasdaq Listing Qualifications Panel advised CompuDyne that CompuDyne had remedied its filing delinquency and was in full compliance with Nasdaq Market Place Rules. On December 21, 2005 the Securities and Exchange Commission issued Release No. 33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For Filing Periodic Reports" (the "Release"). The Release revised the definition of "accelerated filer" to make it simpler for accelerated filers whose public float falls below the $50 million threshold on the measurement date of June 30 to exit accelerated filer status. Under the new rules, an accelerated filer that has voting and non-voting equity held by non-affiliates of less than $50 million at the end of its second fiscal quarter is permitted to exit accelerated filer status at the end of that year and to file its annual report for that year and subsequent periodic reports on a non-accelerated basis. Accelerated filer status affects an issuer's deadlines for filing its periodic reports with the SEC and complying with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. A non-accelerated filer must begin to comply with the internal control over financial reporting requirements including the attestation report of a registered public accounting firm for its first fiscal year ending on or after July 15, 2007. The Company exited accelerated filer status as of December 31, 2005. The aggregate worldwide market value of CompuDyne Corporation's equity held by non-affiliates as of June 30, 2005, the last business day of CompuDyne's second fiscal quarter, was less than $50 million. As a result, as of December 31, 2005, CompuDyne exited accelerated filer status. Prior to the Release CompuDyne was classified as an "accelerated filer" and was required to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. In light of the Release, CompuDyne, as a non-accelerated filer as of December 31, 2005, is not required to comply with Section 404 for the year ended December 31, 2005. Results of Operations YEARS ENDED DECEMBER 31, 2005 AND 2004 Revenues. The Company had revenues of $141.6 million and $142.8 million for the years ended December 31, 2005 and December 31, 2004, respectively, representing a decrease of $1.13 million or 0.8%. As discussed below, the decrease occurred primarily from our IES and PS&J segments offset by increases from our ISS and AP segments. Revenues from the Institutional Security Systems segment were $60.7 million for the year ended December 31, 2005, an increase from $54.0 million for the year 2004 representing an increase of $6.7 million or 12.4%. The Institutional Security Systems segment is largely a construction driven business. Much of its revenue is obtained by working on new and retrofit construction projects in the corrections industry, as opposed to sources of recurring revenue. As such, the increase in revenue experienced by this segment is largely attributable to our working on more projects than we did in the previous year. Backlog for ISS had decreased from $99.5 million at December 31, 2002 to $57.3 million at December 31, 2003. Backlog was $49.3 million and $58.1 million at December 31, 2004 and December 31, 2005, respectively. The years 2003 and 2004 were slow bidding periods for the Company. Although the gross amount of construction spending in the corrections area remained relatively flat between 2003 and 2004, the types of projects that the Company solicits, namely large-scale medium to maximum security installations, declined significantly in 2003 and 2004. This situation was further compounded by the general state and local governmental budget deficits which caused these governmental units to rethink and delay many of their pending corrections projects. Beginning in early 2005, ISS is seeing significant, heightened bidding activity, particularly in the market space it serves, namely large-scale medium to maximum security prisons. This increased bidding activity is expected to result in securing more projects, which should result in increased revenue. During the last three quarters of 2005, ISS' backlog increased significantly providing the segment with a greater opportunity to generate revenue during the second half of 2005. Revenues from the Attack Protection segment were $27.0 million for the year ended December 31, 2005, an increase from $25.2 million for the same period of 2004 representing an increase of $1.9 million or 7.4%. In 2002 the Company purchased an existing 75,000 square foot factory for the Attack Protection segment on 20 acres of land in close proximity to its existing factory in Montgomery, Alabama. This capacity increase was largely driven by the Company's expectation that the demands for its products, principally its bullet and blast resistant windows and doors would accelerate significantly in the post September 11, 2001 world. Throughout 2002, 2003, and 2004 this anticipated increase in demand did not materialize leaving the segment with significant excess capacity. This segment is composed of two chief product offerings, namely Norshield, which encompasses bullet and blast resistant windows and doors and ancillary products, and Fiber SenSys, which encompasses fiber optic intrusion detection systems. For the year ended December 31, 2005 the Norshield line experienced a 14.6% increase in revenues as compared to the year ended December 31, 2004, whereas the Fiber 15 SenSys line experienced a 10.8% decrease in revenues for the comparable period. The increase in revenue of $2.6 million in the Norshield line is a direct result of the award of a major contract won in the fourth quarter of 2005. Execution on this contract began immediately upon award. Fiber SenSys' revenue decline is a result of the rollout of its next generation product, which until its testing is completed, expected in the first quarter of 2006, has and will continue to negatively impact revenues. The slow-down in the government building process experienced during 2002 and 2003 has reversed. Projects are now being released for construction, and thus the Attack Protection segment is experiencing increased bidding activity for its products. During 2003, the Company furnished bids to supply its products for eight new embassy projects. At the time, this was the largest number of embassy projects bid in a single calendar year for this segment. The Company was awarded four of these embassy projects, for a total CompuDyne contract value of $7.0 million, and lost the remaining four embassy project bids to competitors. During 2004, we bid on fifteen new embassy projects. Through December 31, 2005 the Company was awarded seven of these embassy projects for a total contract value of $9.6 million, and lost seven embassy project bids to competitors, with one project still awaiting award. In 2005, twenty-eight embassy projects were planned. We believe that this increased level of new embassy construction will continue for the next several years. Through December 31, 2005 the Company had been awarded three of these projects, one of which was for a total of $14.3 million, and lost one project and one bulk bid embassy project comprising eight embassies to competitors, with sixteen projects still awaiting award. Revenues from Integrated Electronic Systems were $10.1 million for the year ended December 31, 2005, a decrease from $14.3 million for the same period of 2004 representing a decrease of $4.2 million or 29.3%. A significant portion of this segment's revenue is backlog driven. Backlog at both December 31, 2003 and December 31, 2004 was $8.3 million. IES' revenue decline was largely due to certain government clients, for which the segment receives repeat business, having had their budgets significantly reduced. This decrease was partially offset by a new $2.0 million project. The first half of 2005 was a difficult time for IES, with a downturn in revenues and gross profit, ensuing from: a delay in a large-scale installation contract, pending the government's completion of the building to house the system's Command and Control Center; a reduction in an ongoing governmental integration program, resulting from the Department of Defense's base relocation and closure (BRAC) program; delays in several significant awards, because funding had been redirected to the war efforts in Iraq and Afghanistan; and a delay in the start-up of a 5-year, $25 million security contract, due to an award protest by the predecessor contractor. Revenues from the Public Safety and Justice segment were $43.9 million for the year ended December 31, 2005, a decrease from $49.4 million for the same period of 2004 representing a decrease of $5.5 million or 11.2%. The decline was primarily the result of lower backlogs and an increased focus on developing our next generation product which resulted in more hours worked on research and development and less hours worked on revenue-generating projects. Revenues were also impacted by relatively low contract signing rates in early 2005, low billing rates and difficult performance requirements on some contracts. The lower levels of backlog did, however, start to improve late in the year. During the fourth quarter of 2005 PS&J redeployed a portion of its technical staff, typically deployed in the research and development area, to work on projects, resulting in increased revenue. It should be noted that although we made three acquisitions in this segment, two in 2004 (90 Degrees and Copperfire) and one in August 2005 (Xanalys), these acquisitions had little impact on Public Safety and Justice's revenues due to their relatively small size. Expenses. Cost of sales of $99.1 million for the year ended December 31, 2005 were down $6.0 million or 5.7% from $105.1 million during the same period of 2004. The smaller percentage decrease in sales as compared to the percentage decrease in cost of goods sold resulted in an increased gross profit percentage of 30.0% for the year ended December 31, 2005 as compared to 26.4% in 2004. In 2004, the windows and door component of the Attack Protection segment experienced significant operating inefficiencies and difficulties. These inefficiencies and difficulties, which did not recur in 2005, reduced the 2004 gross profit percentage. Cost of goods sold in the Institutional Security Systems segment of $50.8 million for the year ended December 31, 2005 were up $3.2 million or 6.8% from $47.5 million during the same period of 2004. This increase was less than the related sales increase of this segment of 12.4%, resulting in a 4.4% increase in the gross profit percentage to 16.3% from 11.9% for the year ended December 31, 2004. This increase in gross profit percentage resulted mainly from one of this segment's customers terminating its contract for convenience, resulting in the recognition of $1.3 million in gross margin. Starting in 2002 and continuing through 2004, Institutional Security Systems' senior management identified managerial problems at its West Coast operations and determined that numerous problems existed there, including that the costs to complete its projects were going to be significantly higher than was previously projected. This resulted in significant cost overruns on many of these projects. As the work on the projects progressed, the Institutional Security Systems segment identified additional cost overruns which caused the costs to complete these projects to increase. Although the problem projects identified in 2002 are substantially all complete, the problems in the ISS West Coast operations continued into 2003, 2004 and 2005. The West Coast office continues to be affected by one final contract which requires ISS to install a proprietary duress system which has been validated through an independent consultant and the manufacturer of the equipment but will not function as required by the contract specifications. ISS has incurred 16 significant costs trying to make the equipment function as desired. The customer is working with ISS to develop a level of acceptance, and both ISS and the customer are cooperating to close out the project in an amicable manner. We believe that all future costs on these projects have been adequately accounted for through December 31, 2005. Senior management at the West Coast operations has been replaced as well as certain project management and engineering staff. It should be noted that the West Coast office has been downsized to a sales and support office, consolidating the estimating, electronics engineering and electronics fabrication functions into the Montgomery home office. The project management and hardline engineering staff has been upgraded to experienced professional personnel, and this office only manages projects specifically suited to their expertise or as required by the local marketplace. The West Coast office realized eleven consecutive months of positive gross margins on such projects in 2005. Despite these positive gross margins, the West Coast office experienced high legal and overhead costs closing out many of the old projects. While this resulted in an overall loss at the West Coast operation, the office was also able to significantly reduce aged receivables and filed multiple claims for possible future upside recovery. The office is in the process of moving its facilities to a smaller, more cost effective facility, which will further reduce overhead costs in the future. The West Coast problems, including project overruns, resulted in pre-tax losses recorded in the following periods, in thousands: Second Half of 2002 $ 2,698 Full Year 2003 4,087 Full Year 2004 6,092 First Quarter of 2005 740 Second Quarter of 2005 472 Third Quarter of 2005 399 Fourth Quarter of 2005 417 -------- Total West Coast Losses $ 14,905 ======== To address this situation, the Company has implemented more centralized controls, replaced certain personnel at its West Coast operations and its Alabama headquarters, and has reorganized the function of the West Coast office. Cost of goods sold in the Attack Protection segment of $20.9 million for the year ended December 31, 2005 decreased $2.7 million or 11.4% from $23.6 million during the same period of 2004. This decrease was not proportional when compared to the relative sales increase, resulting in a 16.4% increase in the gross profit percentage to 22.6% from 6.2% during the year ended December 31, 2004. Significant factors contributing to this increase in gross profit included the fact that in 2004, significant operating inefficiencies and difficulties were experienced by the windows and doors components of the Attack Protection segment. These inefficiencies and difficulties amounted to approximately $1.9 million, which contributed to the reduction of the 2004 gross profit percentage. They did not recur in 2005 due to new senior management hired in January 2005 that has reduced manufacturing and overhead costs. In addition, one of this segment's customers terminated its contracts for convenience during the first quarter of 2005 resulting in the recognition of $0.2 million in gross margin due to contract closeout activities. Cost of goods sold in the Integrated Electronic Systems segment of $8.5 million for the year ended December 31, 2005 decreased $3.8 million or 30.9% from $12.3 million during the same period of 2004. This decrease was consistent with the related sales decrease of this segment of 29.3%, resulting in a 2.0% increase in the gross profit percentage to 16.1% from 14.1% in the year ended December 31, 2004. Substantially all of the projects awarded in this segment are discrete projects. Cost of goods sold in the Public Safety and Justice segment of $19.0 million for the year ended December 31, 2005 was down $2.7 million or 12.7% from $21.7 million during 2004. This decrease was more than the related sales decrease of this segment of 11.2%, resulting in a 0.8% increase in the gross profit percentage to 56.8% from 56.0% in the year ended December 31, 2004. Substantially all of the projects awarded in this segment are discrete projects. Selling, general and administrative expenses were $40.6 million for the year ended December 31, 2005, an increase of $4.3 million or 12.0% from $36.2 million for the same period of 2004. Much of this increase is related to additional costs incurred by the Company related to compliance with new requirements mandated by the Sarbanes-Oxley Act and the SEC. The Company expended approximately $0.4 million to perform its 2003 audit, which did not require a SOX 404 report. This was paid to our independent registered public accounting firm for audit and audit related services. For the 2004 audit, the Company expended $3.2 million for external third party costs to complete its 2004 audit and its SOX 404 report. Of this amount, approximately $2.5 million was paid to our independent registered public accounting firm for audit and audit related services with the balance paid to various consultants and others who have assisted the Company in the 404 process. Expenses related to audit and SOX 404 of $2.1 million and $1.9 million were recorded during the years ended December 17 31, 2005 and 2004, respectively, for services provided or accrued for during these periods. In addition, AP's selling, general and administrative expenses increased by $1.2 million or 24.8% during the year ended December 31, 2005 as compared to the year ended December 31, 2004. This increase was largely the result of increased legal costs associated with ongoing claims resolutions in actions both as plaintiff and defendant and for increased selling and training costs as the segment is trying to expand its presence into new marketplaces. PS&J's selling, general and administrative expenses increased by $1.8 million or 10.3% during the year ended December 31, 2005 as compared to the year ended December 31, 2004. This increase was largely the result of increased headcount and related costs from the three acquisitions made by PS&J in 2004 and 2005. In addition, the Xanalys acquisition contributed approximately $600 thousand to this increase. In conjunction with the acquisition of the assets of 90 Degrees and Copperfire and the stock of Xanalys and in compliance with Statement of Financial Accounting Standards No. 141 (SFAS 141) Business Combinations, the Company determined the fair value of the following identifiable assets and assigned the indicated lives for the purposes of amortization and depreciation. Amount (in thousands) Life (in years) -------------- --------------- Software $ 2,434 5 Non Compete Agreements 130 3 Tradename 60 15 ------- $ 2,624 The amortization of the above assets resulted in the Company recording amortization expense related to these assets of $582 thousand and $178 thousand for the years ended December 31, 2005 and 2004, respectively, which is included in operating expenses. In an effort to further reduce costs, during 2005 the Company eliminated the position of Chief Operating Officer and had its division Presidents report directly to the Company's CEO. Research and development expenses were $8.7 million for the year ended December 31, 2005, an increase of $0.9 million or 12.0% from $7.8 million for the same period of 2004. Being a technology-driven enterprise, the Company's Public Safety and Justice segment continually updates and enhances its software offerings, thus incurring significant research and development costs. During 2005 Public Safety and Justice started investing in its Next Generation products and expended $884 thousand for this project, and is expected to spend $2.5 million and $1.0 million in 2006 and 2007, respectively. Interest expense was $3.1 million for the year ended December 31, 2005, a decrease of $0.2 million or 7.1% from $3.3 million for the same period of 2004. The following table compares the weighted average of the Company's twelve months ended December 31, 2005 and 2004 interest bearing borrowings, in thousands, and the related rates charged thereon: Monthly Weighted Monthly Weighted Average - 2005 Average - 2004 Amount Rate Amount Rate ------ ---- ------ ---- Bank borrowings $ - -% $ 617 4.2% Industrial revenue bonds $ 3,722 3.7% $ 4,162 3.1% Subordinated borrowings $ 40,250 6.2% $ 40,250 6.2% Swap hedge agreement $ 1,015 1.4% $ 3,721 3.6% In addition the Company recorded the following non-cash interest expense, in thousands: Amortization and write-off of deferred financing charges $ 283 $ 600 Taxes on Income. The effective tax rate was a benefit of 2.4% for the year ended December 31, 2005 and the effective tax benefit rate was approximately 21.4% for the year ended December 31, 2004. The Company's tax benefit of $2.2 million for the year ended December 31, 2004 was primarily a result of the Company's ability to carryback the loss incurred in 2004 to prior years, resulting in Federal and State tax receivables. Since all available tax loss prior year receivables were used via the 2004 carrybacks, no such receivables were available to offset the December 31, 2005 losses generated by the Company. The tax benefit for the year ended December 31, 2005 is primarily a result of $500 thousand previously recorded as a reserve for uncertain tax positions which is no longer needed, partially offset by state tax expenses. The Company has decided to provide a valuation allowance against its deferred tax assets, as it has determined that 18 due to the Company's recent operating losses there is uncertainty as to whether more likely than not the assets will be realized. The Company had net operating loss carryforwards for financial accounting purposes of $8.9 million at December 31, 2005. Net Loss. The Company reported a net loss of $8.7 million for the year ended December 31, 2005 and a net loss of $8.2 million for the year ended December 31, 2004. Diluted loss per share was a loss of $1.07 for the year ended December 31, 2005 and a loss of $1.01 for the year ended December 31, 2004. The weighted average number of common shares outstanding and equivalents used in computing EPS was 8.1 million in both 2005 and 2004. YEARS ENDED DECEMBER 31, 2004 AND 2003 Revenues. The Company had revenues of $142.8 million and $193.3 million for the years ended December 31, 2004 and December 31, 2003, respectively, representing a decrease of $50.5 million or 26.1%. As discussed below, most of this decline occurred in our ISS segment due to delayed projects at the state and local levels, largely caused by significant budget deficits many governmental units are currently experiencing. Revenues from the Institutional Security Systems segment were $54.0 million for the year ended December 31, 2004, a decrease from $98.7 million for the same period of 2003 representing a decrease of $44.7 million or 45.3%. The Institutional Security Systems segment is largely a construction driven business. Much of its revenue is obtained by working on new and retrofit construction projects in the corrections industry, as opposed to sources of recurring revenue. As such, the decrease in revenue experienced by this segment is largely attributable to our working on less projects than we did in the previous year. The principal reason for the decline was that its backlog had decreased from $99.5 million at December 31, 2002 to $57.3 million at December 31, 2003 thus resulting in less work available to be performed in the year ended December 31, 2004 as compared to the year ended December 31, 2003. Backlog at December 31, 2004 had declined further to $49.3 million. The years 2003 and 2004 have been slow bidding periods for the Company. Although the gross amount of construction spending in the corrections area remained relatively flat between 2002, 2003 and 2004, the types of projects that the Company solicits, namely large-scale medium to maximum security installations, declined in 2003 and 2004. This situation was further compounded by the general state and local governmental budget deficits which are causing these governmental units to rethink and delay many of their pending corrections projects. Revenues from the Attack Protection segment were $25.2 million for the year ended December 31, 2004, a decrease from $28.4 million for the same period of 2003 representing a decrease of $3.2 million or 11.3%. In 2002 the Company purchased an existing 75,000 square foot factory for the Attack Protection segment on 20 acres of land in close proximity to its existing factory in Montgomery, Alabama. This capacity increase was largely driven by the Company's expectation that the demands for its products, principally its bullet and blast resistant windows and doors would accelerate significantly in the post September 11, 2001 world. Throughout 2002, 2003 and 2004 this anticipated increase in demand did not materialize leaving the segment with significant excess capacity. This segment is composed of two chief product offerings, namely Norshield, which encompasses bullet and blast resistant windows and doors and ancillary products, and Fiber SenSys, which encompasses fiber optic intrusion detection systems. For the year ended December 31, 2004 the Norshield line experienced a 22.7% decline in revenues as compared to the year ended December 31, 2003, whereas the Fiber SenSys line experienced a 40.5% increase in revenues for the comparable period. The Company continues to see heightened interest for its Fiber SenSys products and expects sales for these items to continue to experience sustainable growth. The slow-down in the government building process experienced during 2002 and 2003 appears to have stabilized. It appears that projects are being released for construction, and thus the Attack Protection segment is experiencing increased bidding activity for its products. During 2003 the Company furnished bids to supply its products for eight new embassy projects. At the time, this was the largest number of embassy projects bid in a single calendar year for this segment. Through December 31, 2004, the Company was awarded four of these embassy projects, for a total CompuDyne contract value of $7.0 million, and lost the remaining four embassy projects. During 2004, we bid on fifteen new embassy projects. Through March 2005 the Company was awarded six of these embassy projects for a total contract value of $8.6 million, and lost seven embassy projects to competitors, with two projects still awaiting award. In 2005, preliminary indications show eighteen embassy projects will be available for bid. It appears to us that this increased level of new embassy construction will continue for the next several years. Revenues from the Integrated Electronic Systems segment were $14.3 million for the year ended December 31, 2004, a decrease from $16.4 million for the same period of 2003 representing a decrease of $2.1 million or 13.1%. A significant portion of this segment's revenue is backlog driven. The Integrated Electronic Systems segment ended 2002 with a backlog level of $11.4 million. Backlog at December 31, 2003 was $8.3 million and at December 31, 2004 was also $8.3 million. Revenues from the Public Safety and Justice segment were $49.4 million for the year ended December 31, 2004, a decrease from $49.8 million for the same period of 2003 representing a decrease of $0.4 million or 0.8%. In 2003, the Company 19 recognized approximately $5.5 million of revenue related to hardware supplied under a contract with one of its customers. Minimal margin was earned on this hardware. Although PS&J ships certain hardware components to clients on an occasional basis, shipments of this magnitude of hardware, done to accommodate our client, is an unusual and non-routine event. In addition, it should be noted that although we made two acquisitions in this segment in 2004 (90 Degrees and Copperfire), these acquisitions had little impact on Public Safety and Justice's revenues due to their relatively small size and due to their occurring in the later part of the year. Expenses. Cost of goods sold of $105.1 million for the year ended December 31, 2004 were down $41.8 million or 28.4% from $146.9 million during the same period of 2003. This decrease was a result of decreased costs of goods sold of $36.9 million at the Institutional Security Systems segment, largely attributable to the decreased sales of this segment. The smaller percentage decrease in sales as compared to the percentage decrease in cost of goods sold resulted in an increased gross profit percentage of 26.4% for the year ended December 31, 2004 as compared to 24.0% in 2003. Cost of goods sold in the Institutional Security Systems segment of $47.5 million for the year ended December 31, 2004 were down $36.9 million or 43.7% from $84.4 million during the same period of 2003. This decrease was less than the related sales decrease of this segment of 45.3%, resulting in a 2.5% decrease in the gross profit percentage to 11.9% from 14.4% in the year ended December 31, 2003. Starting in 2002 and continuing through 2004, Institutional Security Systems' senior management identified managerial problems at its West Coast operations and determined that numerous problems existed there including that the costs to complete its projects were going to be significantly higher than was previously projected. This was a result of significant cost overruns on many of these projects. As the work on the projects progressed, the Institutional Security Systems segment identified additional cost overruns which would cause the costs to complete these projects to increase as a result of the changes in the estimates to complete. Although the problem projects identified in 2002 are substantially all complete, the problems in the ISS West Coast operations continued into 2003 and 2004. We realized that the management changes made in 2002 did not adequately address the root problems identified, and as a result, projects started after 2002 continued to experience cost overruns due to a lack of appropriate oversight. Staff and management changes in ISS are ongoing. We have revised our estimates to complete these projects and believe that all future costs on these projects have been adequately considered through December 31, 2004. The West Coast problems, including project overruns, resulted in losses recorded in the following periods: (in thousands) Second Half of 2002 $ 2,698 First Half of 2003 1,674 Third Quarter of 2003 541 Fourth Quarter of 2003 1,872 First Quarter of 2004 1,271 Second Quarter of 2004 1,139 Third Quarter of 2004 1,516 Fourth Quarter of 2004 2,166 ------- Total West Coast Losses $12,877 ======= To address this situation, the Company is implementing more centralized controls, replaced certain personnel at its West Coast operations and its Alabama headquarters, and hired a Chief Operating Officer. Cost of goods sold in the Attack Protection segment of $23.6 million for the year ended December 31, 2004 increased $0.9 million or 4.1% from $22.7 million during the same period of 2003. This increase occurred in spite of a sales decrease of this segment of 11.3%, resulting in a 13.9% decrease in the gross profit percentage to 6.2% from 20.1% during the year ended December 31, 2003. We are actively working to better utilize the 75,000 square foot factory the Company purchased in Montgomery, Alabama. The Airteq manufacturing operation in Oregon was relocated in the latter part of 2003 and consolidated into this facility. This was done in an effort to enhance the utilization of our owned facilities in Alabama and thus absorb some of our excess manufacturing capacity. Although not the primary contributor, this did result in further utilization of approximately 12,000 square feet of previously unused manufacturing space in this plant in Alabama. In addition, we identified, in late 2003, a quality problem with the windows and doors being installed on a project ultimately completed in the fourth quarter of 2004. As a result of this identified problem, we took remedial action in the field to repair this defect. During the year ended December 31, 2004 we increased our estimated cost to complete this project by $2.0 million thus causing this project to become a negative margin project. Cumulative write-downs on this project amount to $2.3 million. 20 Cost of goods sold in the Integrated Electronic Systems segment of $12.3 million for the year ended December 31, 2004 decreased $1.6 million or 11.3% from $13.8 million during the same period of 2003. This decrease was less than the related sales decrease of this segment of 13.1%, resulting in a 1.8% decrease in the gross profit percentage to 14.1% from 15.9% in the year ended December 31, 2003. Substantially all of the projects awarded in this segment are discrete projects. Cost of goods sold in the Public Safety and Justice segment of $21.7 million for the year ended December 31, 2004 was down $4.2 million or 16.2% from $25.9 million during 2003. This decrease was more than the related sales decrease of this segment of 0.8%, resulting in an 8.0% increase in the gross profit percentage to 56.0% from 48.0% in the year ended December 31, 2003. During the fourth quarter of 2003, our Public Safety and Justice segment received a complaint alleging that we breached our contract to provide a public safety software system to a client. As a result, we recorded a $1.6 million pre-tax charge, of which $600 thousand was recorded as a reduction of revenue and $1.0 million was recorded as a charge to cost of sales. During the second quarter of 2004 this matter was settled, resulting in a reversal of $0.3 million of the accrued charge, which was reflected as a reduction of cost of sales. The net of this activity contributed $1.9 million of the $3.8 million gross profit improvement in 2004 compared to 2003. Selling, general and administrative expenses were $36.2 million for the year ended December 31, 2004, an increase of $3.9 million or 12.1% from $32.3 million for the same period of 2003. Much of this increase is related to additional costs incurred by the Company related to legal fees in connection with responding to and settling the complaint filed by a Public Safety and Justice segment client, expenses incurred in connection with evaluating potential acquisitions, recruiting fees incurred to fill the recently hired COO position and other senior management positions and expenses related to compliance with new requirements mandated by the Sarbanes-Oxley Act and the SEC. During the fourth quarter of 2004 the Company concluded that the continuing decline in the backlog in its ISS segment constituted a triggering event which caused the Company to conclude it was necessary to reassess and ultimately write off goodwill in the amount of $0.7 million and certain other intangibles in the amount of $1.1 million. Those amounts appear as a separate line item in the 2004 statement of operations. In conjunction with the acquisition of the assets of 90 Degrees and Copperfire and in compliance with Statement of Financial Accounting Standards No. 141 (SFAS 141) Business Combinations, the Company preliminarily determined the fair value of the following identifiable assets and assigned the indicated lives for the purposes of amortization and depreciation. Amount (in thousands) Life (in years) -------------- --------------- Software $ 2,800 5 Employment Contracts 120 1-3 -------- $ 2,920 The amortization of the above assets resulted in the Company recording amortization expense related to these assets of $178 thousand in 2004, which is included in operating expenses. Research and development expenses were $7.8 million for the year ended December 31, 2004, an increase of $0.4 million or 5.1% from $7.4 million for the same period of 2003. Being a technology-driven enterprise, the Company's Public Safety and Justice segment continually updates and enhances its software offerings, thus incurring significant research and development costs. Interest expense increased to $3.3 million for the year ended December 31, 2004 from $1.4 million for the year ended December 31, 2003 due to an increase in borrowings and overall higher interest rates. The following table compares the weighted average of the Company's years ended December 31, 2004 and December 31, 2003 interest bearing borrowings and the related rates charged thereon.
Monthly Weighted Monthly Weighted Average - 2004 Average - 2003 Amount Rate Amount Rate ---------------- -------- ---------------- -------- (in thousands) (in thousands) Bank borrowings $ 617 4.2% $ 16,208 3.6% Industrial revenue bonds $ 4,162 3.1% $ 4,675 3.7% Subordinated borrowings $ 40,250 6.3% - - Swap hedge agreement $ 3,721 3.6% $ 6,103 4.0%
21 In addition the Company recorded the following non-cash interest expense: Amortization and write-off of deferred financing charges $ 600 $ 250 Taxes on Income. The effective tax benefit was approximately 21% for the year ended December 31, 2004 and the effective tax rate was approximately 41% for the year ended December 31, 2003. The difference in rates is largely attributable to the losses experienced in 2004 and the related valuation allowance established for substantially all of the Company's net deferred tax assets as of December 31, 2004. Net (Loss) Income. The Company reported net (loss) income of ($8.2) million and $3.4 million for the years ended December 31, 2004 and 2003, respectively. The reason for the loss in 2004 was the significant decline in revenues. While the Company was able to significantly reduce its cost of goods sold, its selling, general and administrative expenses increased while its revenues significantly decreased, contributing to the loss. Diluted earnings per share decreased to a loss of ($1.01) in the year ended December 31, 2004 from a profit of $.42 in the year ended December 31, 2003. The weighted average number of common shares outstanding and equivalents used in computing EPS was 8.1 million in 2004 and 8.2 million in 2003. Liquidity and Capital Resources The Company funds its operations through cash flows generated from its operations, bank and public financings, and the sale of its common stock. The Company's liquidity requirements arise from cash necessary to carry its inventories and billed and unbilled receivables, for capital expenditures, to repurchase shares of its common stock under its share repurchase program, for payments of principal and interest on outstanding indebtedness and for acquisitions. The ultimate clients of the Company are primarily federal, state and local governmental units. In the event the funding of these governmental units is reduced for any reason, including budgetary reductions due to economic conditions, there is a risk that the demand for the Company's goods and services would decrease which would reduce the availability of funds to the Company. As of December 31, 2005, the Company had working capital of $35.3 million compared with $44.0 million as of December 31, 2004. Net cash used in operating activities was $3.6 million during the year ended December 31, 2005 versus $4.5 million provided by operating activities during the year ended December 31, 2004. This decrease was largely caused by the decline in revenues and the $8.9 million loss experienced by the Company. The largest component of cash used in operating activities was an increase in accounts receivable of $5.2 million, which was partially offset by a decrease in cost in excess of billings of $2.3 million and a decrease in prepaid expenses and other current assets of $3.0 million. Net cash provided by investing activities was $6.5 million for the year ended December 31, 2005 compared to net cash used of $26.8 million in the year ended December 31, 2004. In the year ended December 31, 2005, the net of marketable securities bought and redeemed was an increase of cash of $8.0 million. In the year ended December 31, 2004 the net purchase of marketable securities was $19.5 million. Net cash used in financing activities amounted to $1.1 million for the year ended December 31, 2005 compared with a net cash provided by financing activities of $25.6 million in the year ended December 31, 2004. The amount in 2004 was primarily provided through the issuance of the 2011 Notes, offset by the repayment of $13.7 million of bank borrowings. The following table summarizes contractual obligations consisting of total notes payable, non-cancelable operating lease obligations and related interest of the Company as of December 31, 2005 and the payments due by period, in thousands. Non-Cancelable Interest on -------------- ----------- Notes Payable Operating Leases Contractual Obligations ------------- ---------------- ----------------------- December 31: 2006 $ 440 $ 2,497 $ 2,636 2007 440 2,551 2,620 2008 440 1,885 2,604 2009 440 1,544 2,588 2010 440 1,313 2,571 Thereafter 41,615 1,120 856 ------- ---------- -------- Totals $43,815 $ 10,910 $13,875 ======= ========== ======= 22 In addition, the Company enters into purchase obligations to procure equipment and services, including subcontractor contracts, in the performance of the day-to-day operations of its business. Substantially all of these obligations are covered by our existing backlog and the revenues generated by these backlogs are expected to be sufficient to meet any payment obligations resulting from these purchase commitments. On January 22, 2004, the Company completed the offering of the 2011 Notes. The offering was for $40.25 million principal amount. The 2011 Notes bear interest at the rate of 6.25% per annum, payable semi-annually, and are convertible into shares of common stock at a conversion price of $13.89 per share. The proceeds from the 2011 Notes were used to repay substantially all of the Company's outstanding bank borrowings. During January 2004, the Company repaid substantially all of its outstanding bank borrowings from the proceeds of the issuance of its 2011 Notes. The Company did not prepay any of its Industrial Revenue Bond ("IRB") borrowings as it determined that there are certain favorable tax treatments afforded the Company when it entered into these IRBs, which it would lose in the event these borrowings were prepaid. On October 29, 2004 and March 4, 2005, the Company and its bank entered into amendments to its credit agreement pursuant to which the bank waived the Company's non-compliance with its fixed charge coverage ratio covenant as of September 30, 2004 and non-compliance with its minimum EBITDA covenant as of December 31, 2004, respectively. In addition, the Company and its bank amended the credit agreement to eliminate the $15.0 million line of credit maturing March 2005 and to require borrowings under its $10.0 million line of credit to be secured by pledged marketable securities equal to 111.11% of the value of such borrowings or cash equal to the value of such borrowings. The credit agreement was also amended to permanently eliminate the quarterly minimum EBITDA covenant effective as of the Company's first quarter ended March 31, 2005 and to provide that the minimum fixed charge coverage ratio covenant, maximum debt to EBITDA ratio covenant and the minimum consolidated tangible net worth covenant were not to become effective until March 31, 2006. On May 3, 2005, the Company's bank confirmed in writing that there will not be any event of default under the various credit agreements, by virtue of the Company's failure to timely file an amendment to its Annual Report on Form 10-K for the year ended December 31, 2004 (the "2004 10-K") to provide management's report on internal control over financial reporting as of December 31, 2004 and the related report of the Company's independent registered public accounting firm on management's assessment of the effectiveness of internal control over financial reporting (together, the "404 Report") required by Section 404 of the Sarbanes-Oxley Act of 2002. The 404 Report was filed with the SEC on Form 10-K/A on June 27, 2005. On November 17, 2005, the Company and its bank entered into an additional amendment to the credit agreement pursuant to which the bank agreed to increase its commitment to lend under the Company's revolving line of credit from $10,000,000 to $13,000,000, to increase the letter of credit subfacility from $8,000,000 to $13,000,000 and to terminate the swing line subfacility. On December 19, 2005, the Company and its bank entered into a Second Amended and Restated Revolving Credit and Security Agreement (the "Second Restated Credit Agreement"). The Second Restated Credit Agreement amended and restated the Company's Amended and Restated Credit Agreement dated March 31, 2004. In connection with the execution of the Second Restated Credit Agreement, the Company provided the bank with collateral that includes all receivables, equipment, general intangibles, inventory, investment property, real property and a security interest in subsidiary stock. The Second Restated Credit Agreement allows the Company to obtain revolving advances in a principle amount of up to $20,000,000. Revolving advances are limited by a borrowing base formula based upon the value of the Company's receivables, inventory, fixed assets, real property and issued and outstanding letters of credit. The maximum aggregate face amount of letters of credit that may be drawn under the Second Restated Credit Agreement is limited to $18,000,000. The Second Restated Credit Agreement matures on December 18, 2008. Revolving advances under the Second Restated Credit Agreement bear interest, at the election of the Company, at a variable rate equal to the alternate base rate, a prime interest based rate, or the Eurodollar rate plus two and one half percent. For letters of credit, the Company shall pay an amount equal to the average daily face amount of each outstanding letter of credit multiplied by two and one half percent per annum, and a fronting fee of one quarter of one percent per annum, together with other administrative fees and charges. The Company paid its bank a closing fee of $50,000 in connection with the execution of the Second Restated Credit Agreement. The Company is also required to pay the bank an unused fee equal to three-eighths of one percent per annum of the amount by which $20,000,000 exceeds the average daily unpaid balance of the revolving advances and undrawn amount of any outstanding letters of credit. In addition, the Company is required to pay a collateral monitoring fee equal to $1,000 per month and a collateral evaluation fee as required. The Second Restated Credit Agreement contains various affirmative and negative covenants including financial covenants. On the closing date, the Company was required to have undrawn availability of at least $10,000,000 and thereafter the 23 Company is required to maintain an unrestricted undrawn borrowing base availability of at least $5,000,000. Commencing with the fiscal quarter ending June 30, 2006, the Company is required to maintain a fixed charge coverage ratio of at least 1.1 to 1.0. The Company's total outstanding borrowings at December 31, 2005 amounted to approximately $42.9 million, net of broker's discounts in the amount of $0.9 million. The 2011 Notes accounted for $39.3 million, net of broker's discounts, of these borrowings. The remaining amount of $3.6 million resulted from borrowings at variable rates and consisted of two industrial revenue bonds outstanding in the amounts of $1.3 million and $2.3 million. The average interest rate charged to the Company at December 31, 2005 for its industrial revenue bonds was 3.7%. The variable interest rate for these borrowings fluctuated between 1.6% and 3.7% during the year ended December 31, 2005 based on weekly market conditions. These bonds are fully collateralized by bank letters of credit issued under the Company's bank agreement. The Company's bank considers letters of credit as outstanding borrowings when considering the amount of availability the Company has remaining under its line of credit. Other than the Company's letters of credit, which amounted to $15.5 million at December 31, 2005, the Company has no other material off balance sheet liabilities. At December 31, 2005 the Company had $3.6 million of unused availability. The Company anticipates that cash generated from operations and its currently available cash will enable the Company to meet its liquidity, working capital and capital expenditure requirements during the next 12 months. The Company, however, may require additional financing to pursue acquisitions, and to meet its long-term liquidity, working capital and capital expenditure requirements. If such financing is required, there are no assurances that it will be available, or if available, that it can be obtained on terms favorable to the Company. From time to time, the Company may be party to one or more non-binding letters of intent regarding material acquisitions, which, if consummated, may be paid for with cash or through the issuance of a significant number of shares of the Company's common stock. The Company has not been profitable and in fact has recorded significant losses over the previous two years. We recognize that the return to profitability is a critical objective which the Company must attain. The Company continues to have a significant amount of cash and marketable securities on its balance sheet at December 31, 2005, however, the Company must return to profitability prior to depleting its current cash and marketable securities. On May 2, 2005, we filed a Form 8-K disclosing that we failed to timely file an amendment to our Annual Report on Form 10-K for the year ended December 31, 2004 to provide management's report on internal control over financial reporting as of December 31, 2004 and the related report of our independent registered public accounting firm on management's assessment of the effectiveness of internal control over financial reporting (together, the "404 Report") required by Section 404 of the Sarbanes-Oxley Act of 2002. On May 3, 2005, the Company's bank confirmed in writing that there will not be any event of default under the various credit agreements, by virtue of the Company's failure to file its report required by Section 404 of Sarbanes-Oxley in a timely manner. On May 4, 2005, we received a notice from the Listing Qualifications Department of The Nasdaq Stock Market stating that due to our failure to timely file the 404 Report, we were no longer in compliance with the requirements of Marketplace Rule 4310(c)(14). The Rule requires us to file with Nasdaq copies of all reports required to be filed with the Securities and Exchange Commission on or before the date they are required to be filed with the SEC. On June 27, 2005, the Company filed its Form 10-K/A with the SEC containing the 404 Report. On June 30, 2005, the Nasdaq Listing Qualifications Panel advised CompuDyne that CompuDyne had remedied its filing delinquency and was in full compliance with Nasdaq Market Place Rules. Another consequence of not filing the 404 Report timely as noted above includes our inability to use a shorter form registration document for one year in the event we were to engage in an offering of our securities. This could have an adverse impact on our ability to raise capital and the cost of raising capital. Additional Considerations Bid Bonds and Payment and Performance Bonds Historically, certain of the Company's projects have required bid bonds at time of proposal submission and payment and/or performance bonds upon contract award. The majority of these bonds have been needed in the ISS and PS&J segments. Recently, approximately 75% of ISS' work has come from jobs where payment and 24 performance bonds are required and for PS&J, 19% of its work has required payment and performance bonds. The Company's recent losses have made it more challenging for the Company to attain the bonding needed to procure certain of its projects. As of December 31, 2005, the Company was required to provide collateral for two of its projects which it did by issuing bank letters of credit as collateral in the amount of approximately $5.5 million in total. In the event the Company is unable to obtain bonds, or if the terms, namely additional collateral, of the bonds are not within the financial means of the Company, the amount of work the Company is able to contract for will be negatively impacted. Cost Containment Due to current economic conditions, the Company's losses, and in light of a very strong competitive environment, the Company recognizes that its ability to increase the prices it charges its clients is limited. In addition, in light of escalating selling, general and administrative costs associated with the current heightened regulatory environment, we are evaluating our strategy to determine if a revised strategy would result in lower selling, general and administrative costs. As a result, in order to enhance our profitability, the Company will continue to seek ways to reduce its costs. Total Backlog CompuDyne's backlog amounted to $148.1 million at December 31, 2005. This was an increase of 16.8% from the Company's December 31, 2004 backlog of $126.9 million. The break down of the Company's backlog by segment is as follows, in thousands: December 31, -------------------------------- 2005 2004 ------------- ------------- Institutional Security Systems $ 58,128 $ 49,324 Attack Protection 28,802 20,803 Integrated Electronic Systems 7,503 8,299 Public Safety and Justice 53,705 48,434 ------------- ------------- Total $148,138 $126,860 ============= ============= Included in the backlog of the ISS, AP and PS&J segments at December 31, 2005 is $11.9 million, $0.8 million and $5.4 million, respectively, representing awards received by the segment for which the clients have not yet entered into signed contracts. These awards are expected to result in signed contracts over the next twelve months. Corporate Reorganization As part of the Company's efforts to better manage its costs, during the first quarter of 2005 the Company implemented a corporate reorganization whereby it converted several corporate entities into LLCs (Limited Liability Corporations). This activity was designed to improve the Company's tax reporting structure and should help better manage the Company's state income tax obligations. In conjunction with this reorganization, our Federal Security Systems group, formerly known as Quanta Systems Corporation, was re-formed as CompuDyne-Integrated Electronics Division, LLC, and our Public Safety and Justice group, formerly known as Tiburon, was renamed CompuDyne-Public Safety and Justice, Inc. In addition, CorrLogic, Inc. was converted to CorrLogic, LLC and Fiber SenSys, Inc. was converted to Fiber SenSys, LLC. The impact of this reorganization is not expected to have a material effect on operations. In addition, in light of escalating selling, general and administrative costs associated with the current heightened regulatory environment, we are evaluating our structure to determine if another organizational structure would result in lower selling, general and administrative costs. Critical Accounting Policies and Estimates Percentage of Completion Accounting and Revenue Recognition. Approximately 60% of the Company's revenues are derived from long-term contracts where revenue is recognized under the percentage of completion method of accounting. The Company's software related contracts utilize labor hours incurred to date on a project, divided by the total expected project hours to determine the completion percentage. The Company's construction contracts utilize costs incurred to date on a project, divided by the total expected project costs to determine the completion percentage. Both of these methods require considerable judgment and, as such, the estimates derived at any point in time could differ significantly from actual results. These estimates affect many of the balance sheet and statement of operations accounts including net sales, cost of goods sold, accounts receivable, contract costs in excess of billings and billings in excess of contract costs incurred. Revenues for support and maintenance contracts are deferred and recognized ratably over the life of the contract. Sales of products unrelated to contract revenue are recognized as revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the seller's price to the buyer is fixed or determinable; and collectibility is reasonably assured. 25 Provisions for estimated losses on uncompleted contracts are recognized in the period such losses are determined. Inventories are stated at the lower of cost or market, using the First-in, First-out (FIFO) method. Costs included in inventories consist of materials, labor, and manufacturing overhead, which are related to the purchase and production of inventories. Warranty reserves are estimated and made at the time products are sold or services are rendered. They are established using historical information on the nature, frequency and average cost of warranty claims. The Company warrants numerous products, the terms of which vary widely. In general, the Company warrants its products against defect and specific non-performance. Accounts receivable are expected to be substantially collected within one year except for a portion of the receivables recorded as retainage. Retainage expected to be collected in over one year is reflected as a current asset as it will be collected within the operating cycle under the related contract. Tax valuation allowances are established when the Company believes it is not "more likely than not" that the Company will be able to receive tax benefits in the future. The federal income tax benefit recorded in 2005 represents the reduction of a liability maintained for uncertain tax positions which was no longer required. Goodwill and Intangible Assets. The Company reviews the carrying value of goodwill and intangible assets not subject to amortization annually during the fourth quarter of the year or when events or changes in circumstances indicate that the carrying value may not be recoverable, utilizing a discounted cash flow model. Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the Company's reporting units' fair value and result in an impairment charge. The carrying value of goodwill and intangible assets not subject to amortization totaled approximately $26.8 million and $5.6 million, respectively, and intangible assets subject to amortization totaled approximately $2.6 million, net, at December 31, 2005. The Company cannot predict the occurrence of events that might adversely affect these values. Stock Compensation Policy. The Company accounts for its stock-based compensation using the intrinsic value method and in accordance with the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted had an exercise price equal to the fair market value of the underlying common stock on the date of the grant. Economic Conditions and the After Effect of the September 11, 2001 Terrorist Attacks Much of the work CompuDyne performs is for state and local governmental units. These entities were severely impacted by recent economic conditions and the resulting contraction of the tax bases of these governmental units. This has caused these governmental units to carefully evaluate their budgets and defer expenses and projects where possible. Much of the work of the Company's Public Safety and Justice and Institutional Security Systems segments is contracted with these state and local governmental units. As a result, these segments have seen delays in new work available to be bid and worked on. In addition, even work that had been contracted for was sometimes deferred by the customer into the future. In recent months, it appears the state and local government revenues have been improving, resulting in increased activity preparatory to the issuance of requests for new bids and ultimately, the Company expects the awarding of new projects. It appears to us that we are in the early stages of an economic recovery. After the occurrence of the tragic events of the September 11, 2001 terrorist attacks, there was a general perception that our Integrated Electronic Systems and Attack Protection segments would see a significant increase in order flow. To the contrary, in the months subsequent to the terrorist attacks these segments saw a slowing in new work opportunities as the various federal agencies and other customers that are the usual source of their business slowed their procurement processes waiting for definitive direction as to how to proceed in the post September 11 world. Now further complicated by the military action in Iraq, the Company's clients are reevaluating priorities and budgets and are funding only their most pressing demands while also making key decisions as to which projects can be deferred. As a result of the above factors, during the last four years the Company has experienced a more challenging marketplace than it experienced in the years prior to September 11, 2001. Market Risk The Company is exposed to market risk related to changes in interest rates. The Company entered into a 4.9% fixed rate interest rate swap agreement on June 26, 2001 in the initial notional amount of $11.5 million. The notional amount of 26 this swap agreement declined by $676 thousand on a quarterly basis until it matured on September 30, 2005. In January 2004 the interest rate swap ceased to be a highly-effective cash flow hedge when the related debt was repaid. Consequently, the amounts previously recorded in other comprehensive income as changes in fair value of the interest rate swap were recognized in earnings for the year ended December 31, 2004. Upon determination of the hedge ineffectiveness, the cumulative loss on the fair value of the interest rate swap was $155 thousand, which was recognized in other expense. The change in fair value of the interest rate swap for the year ended December 31, 2005 was a gain of $21 thousand. On January 22, 2004, the Company completed an offering of $40.25 million principal amount of the 2011 Notes. The 2011 Notes bear interest at the rate of 6.25% per annum, payable semi-annually, and are convertible into shares of common stock at a conversion price of $13.89 per share. The Company used a portion of the proceeds of this note offering to pay down outstanding borrowings under its variable rate bank notes. Subsequent to the pay-down of its bank notes the only variable rate borrowing remaining outstanding at December 31, 2005 is approximately $3.6 million of industrial revenue bonds. Since this borrowing bears interest at variable rates, and in the event interest rates increase dramatically, the increase in interest expense to the Company could be material to the results of operations of the Company. Recent Accounting Pronouncements In May 2005, the FASB issued SFAS 154, "Accounting Changes and Error Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting Changes" and SFAS 3, "Reporting Accounting Changes in Interim Financial Statements-An Amendment of APB Opinion No. 28." SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 is not expected to have a material impact on our consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. Statement 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. Statement 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of Statement 153 has not had a material effect on our consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued FASB Staff Position No. 109-1, Application of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (FSP 109-1). FSP 109-1 clarifies that the manufacturer's deduction provided for under the American Jobs Creation Act of 2004 (AJCA) should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. The adoption of FSP 109-1 had no impact on the Company's results of operations or financial position for fiscal year 2005 because the manufacturer's deduction is not available due to the Company's net loss carryforwards. The Company is evaluating the effect that the manufacturer's deduction will have in subsequent years. In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123R requires the Company to expense grants made under its stock option and employee stock purchase plan programs. That cost will be recognized over the vesting period of the options. SFAS No. 123R is effective for the first annual period beginning after June 15, 2005. The Company has not yet determined the method of adoption or the effect of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. The Company is evaluating the alternatives allowed under the standard, which the Company is required to adopt beginning in the first quarter of 2006. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs," an amendment to ARB No. 43, Chapter 4, "Inventory Pricing," to clarify that abnormal amounts of idle facility expenses, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges. In addition, FAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. There has been no material effect on the financial position, results of operations, or cash flows of the Company upon adoption of this statement. 27 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Interest Rate Risk CompuDyne has fixed and variable rate notes payable. These on-balance sheet financial instruments expose the Company to interest rate risk, with the primary interest rate exposure resulting from changes in the bond market used to determine the interest rate applicable to the borrowings under the Company's IRB borrowings. The following information summarizes our sensitivity to market risks associated with fluctuations in interest rates as of December 31, 2005. To the extent that the Company's financial instruments expose the Company to interest rate risk, they are presented in the table below. The table presents principal cash flows and related interest rates by year of maturity of the Company's notes payable with variable rates of interest in effect at December 31, 2005. On January 22, 2004, the Company completed an offering of $40.25 million principal amount of 6.25% Convertible Subordinated Notes due on January 15, 2011. The 2011 Notes bear interest at a rate of 6.25% per annum, payable semi-annually, and are convertible into shares of common stock at a conversion price of $13.89 per share. The Company used a portion of the proceeds of the 2011 Notes to pay down its variable bank notes payable. The pay down of its variable borrowings reduced the Company's interest rate risk. Financial Instruments by Expected Maturity Date Notes Payable Variable Fixed Year Ending Rate ($) Average Variable Rate ($) Average Fixed December 31 (in thousands) Interest Rate (in thousands) Interest Rate -------------------------------------------------------------------------------- 2006 $ 440 3.67% $ - - 2007 440 3.67% - - 2008 440 3.67% - - 2009 440 3.67% - - 2010 440 3.67% - - Thereafter 1,365 3.67% 40,250 6.25% ----------- ------------ Total $ 3,565 3.67% $ 40,250 6.25% Fair Value $ 3,565 3.67% $ 26,162 11.73% 28 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The following consolidated financial statements of the Corporation and its subsidiaries are included herein as indicated below: Report of Independent Registered Public Accounting Firm - Aronson & Company Report of Independent Registered Public Accounting Firm - PricewaterhouseCoopers LLP Report of Independent Registered Public Accounting Firm - Deloitte & Touche LLP Consolidated Balance Sheets at December 31, 2005 and 2004 Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003 Consolidated Statement of Changes in Shareholders' Equity for the years ended December 31, 2005, 2004 and 2003 Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003 Notes to Consolidated Financial Statements 29 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of CompuDyne Corporation Annapolis, Maryland We have audited the accompanying Consolidated Balance Sheet of CompuDyne Corporation and Subsidiaries as of December 31, 2005 and the related Consolidated Statements of Operations, Stockholders' Equity and Cash Flows for the year then ended. Our audit also included the financial statement schedule for the year ended December 31, 2005, listed in the index at Item 15a(2). These financial statements and financial statement schedule are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of CompuDyne Corporation and Subsidiaries as of December 31, 2005, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule for the year ended December 31, 2005, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. ARONSON & COMPANY Rockville, Maryland March 10, 2006 30 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of CompuDyne Corporation Annapolis, Maryland In our opinion, the accompanying consolidated balance sheet and the related consolidated statement of operations, changes in shareholders' equity and cash flows present fairly, in all material respects, the financial position of CompuDyne Corporation and its subsidiaries at December 31, 2004 and the results of its operations and its cash flows for the year ended December 31, 2004 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule for the year ended December 31, 2004 listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. PRICEWATERHOUSECOOPERS LLP Baltimore, Maryland March 31, 2005 31 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of CompuDyne Corporation Annapolis, Maryland We have audited the accompanying consolidated statements of operations, shareholders' equity, and cash flows of CompuDyne Corporation for the year ended December 31, 2003. Our audit also included the financial statement schedule for the year ended December 31, 2003, listed in the Index at Item 15a(2). These financial statements and financial statement schedule are the responsibility of the Corporation's management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the results of CompuDyne Corporation's operations and their cash flows for the year ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. DELOITTE & TOUCHE LLP Baltimore, Maryland March 8, 2004 32 COMPUDYNE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS
December 31, December 31, ASSETS 2005 2004 --------------- --------------- (dollars in thousands) Current Assets Cash and cash equivalents $ 6,938 $ 5,198 Marketable securities 11,429 19,577 Accounts receivable, net 39,625 34,291 Contract costs in excess of billings 13,764 16,087 Inventories 6,195 5,165 Prepaid expenses and other 2,809 5,412 --------------- --------------- Total Current Assets 80,760 85,730 Property, plant and equipment, net 9,962 12,094 Goodwill 26,846 25,894 Other intangible assets, net 8,221 8,460 Other 903 713 --------------- --------------- Total Assets $ 126,692 $ 132,891 =============== =============== LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable and accrued liabilities $ 23,030 $ 21,771 Billings in excess of contract costs incurred 13,847 13,497 Deferred revenue 8,094 5,998 Current portion of notes payable 440 440 --------------- --------------- Total Current Liabilities 45,411 41,706 Notes payable 3,125 3,565 Convertible subordinated notes payable, net 39,305 39,118 Deferred tax liabilities 2,060 2,072 Other 369 599 --------------- --------------- Total Liabilities 90,270 87,060 --------------- --------------- Commitments and Contingencies Shareholders' Equity Preferred stock, 2,000,000 shares authorized and unissued - - Common stock, par value $.75 per share: 50,000,000 shares authorized at December 31, 2005 and December 31, 2004; 8,950,356 and 8,943,856 shares issued at December 31, 2005 and December 31, 2004, respectively 6,712 6,707 Additional paid-in-capital 44,388 44,368 Accumulated deficit (8,963) (272) Accumulated other comprehensive (loss) income (39) 14 Treasury stock, at cost; 831,777 and 721,077 shares at December 31, 2005 and December 31, 2004, respectively (5,676) (4,986) --------------- --------------- Total Shareholders' Equity 36,422 45,831 --------------- --------------- Total Liabilities and Shareholders' Equity $ 126,692 $ 132,891 =============== ===============
The accompanying notes are an integral part of these financial statements. 33 COMPUDYNE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS
Year Ended December 31, 2005 2004 2003 --------------- --------------- --------------- (in thousands, except per share data) Revenues: Contract revenues earned $ 106,512 $ 114,899 $ 160,709 Other revenues 35,138 27,883 32,554 --------------- --------------- --------------- Total revenue 141,650 142,782 193,263 Cost of Sales 99,111 105,104 146,867 --------------- --------------- --------------- Gross profit 42,539 37,678 46,396 Selling, general and administrative expenses 40,567 36,219 32,305 Research and development 8,685 7,755 7,374 Impairment of goodwill and other intangibles - 1,826 - --------------- --------------- --------------- (Loss) income from operations (6,713) (8,122) 6,717 --------------- --------------- --------------- Other expense (income) Interest expense 3,065 3,298 1,389 Interest income (832) (1,009) (338) Other (income) expense (40) 19 (90) --------------- --------------- --------------- Total other expense 2,193 2,308 961 --------------- --------------- --------------- (Loss) income before income taxes (8,906) (10,430) 5,756 Income taxes (benefit) expense (215) (2,232) 2,348 --------------- --------------- --------------- Net (loss) income $ (8,691) $ (8,198) $ 3,408 =============== =============== =============== Earnings (loss) per share: Basic earnings (loss) per common share $ (1.07) $ (1.01) $ .43 =============== =============== =============== Weighted average number of common shares outstanding 8,129 8,136 7,895 =============== =============== =============== Diluted earnings (loss) per common share $ (1.07) $ (1.01) $ .42 =============== =============== =============== Weighted average number of common shares and equivalents 8,129 8,136 8,158 =============== =============== ===============
The accompanying notes are an integral part of these financial statements. 34 COMPUDYNE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (in thousands)
Accumulated Additional Retained Other Common Stock Paid-in Earnings Comprehensive Treasury Stock Shares Amount Capital (Deficit) Income (Loss) Shares Amount Total ---------- --------- ---------- ---------- ------------ ------- ---------- --------- Balance at December 31, 2002 8,392 $ 6,294 $ 42,508 $ 4,518 $ (196) 574 $ (3,920) $ 49,204 Tax benefit from the exercise of stock options 127 127 Acquisition of Tiburon Purchase price adjustment (370) (370) Stock options exercised 128 96 360 456 Warrants exercised 48 36 130 21 (166) - Purchase of treasury shares - (1) (1) ----------------------------------------------------------------- -------- -------- Subtotal 8,568 6,426 42,755 4,518 (196) 595 (4,087) 49,416 Comprehensive income: Net income 3,408 3,408 Other comprehensive income, net of tax: Gain on interest rate swap agreement 110 110 Translation adjustment (7) (7) -------- Comprehensive income (loss) 3,511 ---------------------------------------------------------------------------- -------- Balance at December 31, 2003 8,568 6,426 42,755 7,926 (93) 595 (4,087) 52,927 Common stock issued in connection with acquisition 72 54 585 639 Stock options exercised 304 227 1,028 1,255 Purchase of treasury shares 126 (899) (899) ----------------------------------------------------------------- -------- -------- Subtotal 8,944 6,707 44,368 7,926 (93) 721 (4,986) 53,922 Comprehensive income: Net loss (8,198) (8,198) Other comprehensive income, net of tax: Gain on interest rate swap agreement 93 93 Unrealized gain on available for sale marketable securities 14 14 -------- Comprehensive income (loss) (8,091) ---------------------------------------------------------------------------- -------- Balance at December 31, 2004 8,944 6,707 44,368 (272) 14 721 (4,986) 45,831 Stock options exercised 6 5 20 25 Purchase of treasury shares 111 (690) (690) ----------------------------------------------------------------- -------- -------- Subtotal 8,950 6,712 44,388 (272) 14 832 (5,676) 45,166 Comprehensive income: Net loss (8,691) (8,691) Other comprehensive loss, net of tax: Unrealized loss on available for sale marketable securities (53) (53) -------- Comprehensive loss (8,744) ---------------------------------------------------------------------------- -------- Balance at December 31, 2005 8,950 $ 6,712 $ 44,388 $ (8,963) $ (39) 832 $ (5,676) $ 36,422 ========== ======== ========= ========== ==================== ======== ========
The accompanying notes are an integral part of these financial statements. 35 COMPUDYNE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS
Year Ended December 31, 2005 2004 2003 -------------- -------------- -------------- (in thousands) Cash flows from operating activities: Net (loss) income $ (8,691) $ (8,198) $ 3,408 Adjustments to reconcile net (loss) income to net cash provided by (used in) operations: Depreciation and amortization 3,393 2,921 2,988 Deferred income tax (benefit) expense (12) (219) 245 (Gain) loss from disposition of property, plant and equipment (5) 2 - Impairment of goodwill and other intangibles - 1,826 - Amortization of debt discount 187 176 - Amortization of discounts of marketable securities 11 (18) - Unrealized loss on interest rate swap - 21 - Changes in assets and liabilities: Accounts receivable (5,244) 7,507 3,388 Contract costs in excess of billings 2,323 1,481 1,305 Inventories (1,028) 1,539 (303) Prepaid expenses and other current assets 3,018 (3,160) 188 Other assets (190) 191 (237) Accounts payable and accrued liabilities 885 616 (830) Billings in excess of contract costs incurred 350 (54) (51) Deferred revenue 1,606 (38) 224 Other liabilities (230) (66) 665 -------------- -------------- -------------- Net cash flows (used in) provided by operating activities (3,627) 4,527 10,990 -------------- -------------- -------------- Cash flows from investing activities: Purchase of marketable securities (14,610) (42,361) - Redemption of marketable securities 22,660 22,824 - Additions to property, plant and equipment (1,252) (1,784) (1,068) Proceeds from sale of property, plant and equipment 7 4 14 Cash acquired from acquisition 363 - - Net payment for acquisitions (696) (5,526) (71) -------------- -------------- -------------- Net cash flows provided by (used in) investing activities 6,472 (26,843) (1,125) -------------- -------------- -------------- Cash flows from financing activities: Warrants exercised - - 166 Stock options exercised 25 1,255 583 Purchase of treasury stock (690) (899) (167) Repayment of bank notes and lines of credit (440) (13,653) (9,852) Borrowings of convertible subordinated notes payable - 38,942 - -------------- -------------- -------------- Net cash flows (used in) provided by financing activities (1,105) 25,645 (9,270) -------------- -------------- -------------- Net change in cash and cash equivalents 1,740 3,329 595 Cash and cash equivalents at the beginning of the year 5,198 1,869 1,274 -------------- -------------- -------------- Cash and cash equivalents at the end of the year $ 6,938 $ 5,198 $ 1,869 ============== ============== ============== Supplemental disclosures of cash flow information: Cash paid during the year for: Interest $ 2,690 $ 1,573 $ 1,087 Income taxes, net of refunds $ 88 $ 771 $ 1,873 Common stock issued in connection with acquisition $ - $ 639 $ -
The accompanying notes are an integral part of these financial statements. 36 COMPUDYNE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. NATURE OF OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES Nature of Operations CompuDyne Corporation, a Nevada corporation, operates in four sectors of the security industry - Institutional Security Systems, Attack Protection, Public Safety and Justice, and Integrated Electronic Systems. The Institutional Security Systems segment provides physical and electronic security products and services to the corrections industry (jails and prisons), and to the courthouse, municipal and commercial markets. The Attack Protection segment manufactures bullet, blast and attack resistant windows and doors designed for high-end security applications, including embassies, courthouses, Federal Reserve buildings and banks; and also manufactures fiber optic systems used to detect physical intrusion, protect large perimeters and for the physical protection of data lines; and, fixed, removable, semi-automatic vehicle bollards and wedge barrier security systems. The Integrated Electronic Systems segment provides the United States military, governmental agencies and state and local units with specialty engineering and security services, often of a classified nature. The Public Safety and Justice segment provides a fully integrated suite of products including computer assisted dispatching, records management, court and probation software systems, and inmate management software for the law enforcement, fire and rescue, corrections and justice environments. Summary of Significant Accounting Policies The consolidated financial statements of CompuDyne Corporation and its subsidiaries have been prepared in accordance with accounting principles generally accepted in the United States of America. Principles of Consolidation The consolidated financial statements include the accounts of CompuDyne Corporation and its subsidiaries (collectively "CompuDyne" or "the Company"). Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These include estimates of percentage-completion on long-term contracts and valuation allowances for contracts, accounts receivable, inventories and deferred tax assets. Actual results could differ from those estimates. Revenue Recognition Much of the Company's revenues are derived from long-term contracts where revenue is recognized under the percentage of completion method of accounting. Revenues and the associated costs from software products and related hardware installations, as well as computer programming and systems engineering services delivered as part of the Company's delivery of its software products, are recognized using the percentage-of-completion method using labor hours incurred relative to total estimated contract hours as the measure of progress towards completion. The Company's construction contracts utilize costs incurred to date on a project divided by the total expected project costs to determine the completion percentage. Revenue under cost reimbursable contracts is recognized to the extent of costs incurred to date plus a proportionate amount of the fee earned. Revenue under time and materials contracts is recognized to the extent of billable rates times hours incurred plus materials expense incurred. Revenue from fixed price construction contracts is recognized under the percentage of completion method, whereby a portion of the total contract price is recognized based on the amount of costs incurred to date as a percentage of total estimated costs. Changes in revenue, costs, and profit estimates occurring during the course of a contract are recognized in the period in which the revisions are determined. Revenues for support and maintenance contracts are deferred and recognized ratably over the life of the service contract. Sales of products unrelated to contract revenue are recognized as revenue when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred or services have been rendered; the seller's price to the buyer is fixed or determinable; and collectibility is reasonably assured. Provisions for estimated losses on uncompleted contracts are recognized in the period such losses are determined. Costs and estimated earnings in excess of billings on uncompleted contracts represent the excess of contract revenues recognized to date over billings to date on certain contracts. Billings in 37 excess of costs and estimated earnings on uncompleted contracts represent the excess of billings to date over the amount of revenue recognized to date on certain contracts. Research and Development Expenditures for research and development are charged to operations as incurred. Goodwill Goodwill represents the cost in excess of the fair value of net assets acquired. In July 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 142 ("SFAS 142"), "Goodwill and Other Intangible Assets", which was effective January 1, 2002. SFAS 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the standard includes provisions for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the identification of reporting units for purposes of assessing potential future impairments of goodwill. SFAS 142 also requires the Company to complete a transitional goodwill impairment test six months from the date of adoption. The result of this impairment test identified that as of January 1, 2002 there were no impairments of goodwill or intangible assets. CompuDyne will continue to conduct impairment assessments annually as of October 1 of each fiscal year or when events indicate a triggering event has occurred. During the fourth quarter of 2004, the Company concluded that the continuing decline in the backlog in its ISS segment constituted a triggering event. The Company performed its interim impairment test of the reporting unit as of December 31, 2004 and based on its valuation concluded it was necessary to write off the value of the segment's goodwill in the amount of $739 thousand. This write-off is included in impairment of goodwill and other intangibles in the 2004 statement of operations. As of October 1 and December 31, 2005, there were no other impairments of goodwill. Cash and Cash Equivalents The Company considers all highly liquid investments with an original or remaining maturity of three months or less to be cash equivalents. The Company deposits cash and cash equivalents with high credit quality financial institutions. These deposits may exceed the federally insured limits. Marketable Securities The Company's marketable securities are categorized as available-for-sale securities, as defined by Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities," and as a result, were reported at fair value. Unrealized gains and losses are reported as a component of accumulated other comprehensive income in shareholders' equity. The amortized costs of debt securities is adjusted for accretion of discounts from the date of purchase to maturity. The accretion is included in interest income on the investments. The cost for marketable securities was determined using the specific identification method. The fair values of marketable securities are estimated based on the quoted market price for these securities. Allowance for Doubtful Accounts An allowance for doubtful accounts is estimated based on a combination of write-off history, aging analysis and any specific, known troubled accounts. Property, Plant, and Equipment Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation of plant and equipment is computed principally by the straight-line method based upon the estimated useful lives of the various classes of assets. Leasehold improvements are amortized over their useful lives or the term of the underlying lease, whichever is shorter. Maintenance and repair costs are charged to operations as incurred; major renewals and betterments are capitalized. Any gain or loss from the retirement or sale of an asset is credited or charged to operations. Inventories Inventories are stated at the lower of cost or market, using the First-in, First-out (FIFO) method. Costs included in inventories consist of materials, labor, and overhead, which are related to the purchase and production of inventories. Warranty Reserves In November 2002, the FASB issued Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"). FIN 45 requires the recognition of liabilities for guarantees that are issued or modified subsequent to December 31, 2002. The liabilities should reflect the fair value, at inception, of the guarantors' obligations to stand ready to perform, in the event that the specified triggering events or conditions occur. The adoption of this standard did not have a material effect on the financial position, results of operations or cash flows of CompuDyne. The Interpretation also requires disclosure of accounting policies and methodologies with respect to warranty accruals, as well 38 as a reconciliation of the change in these accruals for the reporting period. Refer to Note 12, "Product Warranties," in the Notes to Consolidated Financial Statements for additional information. Deferred Revenue The Company provides ongoing maintenance and service for many of its completed projects. Much of this work is performed pursuant to maintenance agreements, which typically cover such services for a twelve month period. The Company recognizes revenue under these contracts ratably over the term of the contract. Any revenue not yet earned under the contract is recorded as deferred revenue in the accompanying financial statements. Fair Value and Hedging The Company hedged the cash flows of some of its long-term debt using an interest rate swap. The Company entered into this derivative contract to manage its exposure to interest rate movements by achieving a desired proportion of fixed rate versus variable rate debt. In the interest rate swap, the Company agreed to exchange the difference between a variable interest rate and either a fixed or another variable interest rate, multiplied by a notional principal amount. The Company's hedge matured on September 30, 2005 at which time it was no longer in force. Income Taxes The Company follows Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." Under SFAS 109, deferred income taxes are recognized for the future tax consequences of differences between tax bases of assets and liabilities and financial reporting amounts, based upon enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. The Company has decided to provide a valuation allowance against its deferred tax assets, as it has determined that due to the Company's recent operating losses there is uncertainty as to whether it is more likely than not that these assets will be realized. Comprehensive Income (Loss) The following table shows the components of comprehensive income (loss), net of income taxes, for the years ended December 31, 2005 and 2004, in thousands. For the Year Ended December 31, 2005 2004 ----------- ----------- Net loss $ (8,691) $ (8,198) Unrealized (loss) gain on available-for-sale securities (53) 14 Ineffectiveness of interest rate swap agreement - 93 ----------- ----------- Comprehensive loss $ (8,744) $ (8,091) =========== =========== Stock-Based Compensation As of December 31, 2005, the Company continues to account for its stock-based compensation plans, using the intrinsic value method and in accordance with the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. No stock-based employee compensation cost is reflected in the results of operations, as all options granted had an exercise price equal to or greater than the fair market value of the underlying common stock on the date of grant. The following table illustrates, in accordance with the provisions of SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," the effect on the net loss and loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to stock-based employee compensation. For the Year Ended December 31, 2005 2004 2003 ---------- ------------ ---------- (in thousands, except per share data) Net (loss) income, as reported $ (8,691)$ (8,198) $ 3,408 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards net of related tax effects 2,678 1,040 1,117 ---------- ------------ ---------- Pro forma net (loss) income $ (11,369)$ (9,238) $ 2,291 ========== ============ ========== (Loss) earnings per share: Basic - as reported $ (1.07)$ (1.01) $ .43 Basic - pro forma $ (1.40)$ (1.14) $ .29 Diluted - as reported $ (1.07)$ (1.01) $ .42 Diluted - pro forma $ (1.40)$ (1.14) $ .28 39 On December 27, 2005 the Compensation Committee of the Company's Board of Directors approved the acceleration of option vesting terms for 166,600 unvested out of the money employee stock options, including executive officers in accordance with the provisions of the Company's 1996 and 2005 Stock Incentive Plans for Employees. Stock options which had been awarded under the Non-employee directors plans were not included in such acceleration. This accelerated vesting included all options with a grant price of $9.00 and above. The exercise prices of the affected stock options were above the Company's closing stock price on the date of acceleration. As a result of the accelerated vesting terms, approximately $954 thousand has been included in pro forma compensation expense for the twelve months ended December 31, 2005. The accelerated options have exercise prices ranging from $9.19 to $14.09 and a weighted average exercise price of $11.45. The total number of accelerated options includes 20,200 options held by executive officers of the Company, with exercise prices ranging from $9.19 to $12.21 and a weighted average exercise price of $10.11. The primary purpose of accelerating the vesting of these options is to eliminate the recognition of non-cash compensation expense associated with these options that the Company would have been required to recognize in its future consolidated statements of operations upon its adoption of Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment ("SFAS 123R"). SFAS 123R will generally require that the fair value of all share-based payments to employees, including stock option awards, be recognized as compensation expense in the Company's statements of operations. The Company will be required to adopt the expense recognition provisions of SFAS 123R effective January 1, 2006. The fair value of the Company's stock-based option awards to employees was estimated using the Black-Scholes model assuming no expected dividends and the following weighted-average assumptions: For the Year Ended December 31, 2005 2004 2003 ----- ----- ----- Expected life in years 4.8 5.4 6.6 Risk-free interest rate 4.0% 3.4% 2.9% Expected volatility 81.5% 75.3% 79.5% On May 27, 2005, the Company's shareholders approved amendments to the CompuDyne Corporation 1996 Stock Incentive Compensation Plan for Employees and the CompuDyne Corporation 1996 Stock Option Plan for Non-Employee Directors ("the 1996 Plans") to provide primarily for a definition of a change in control. The Company does not believe the amendments have a material impact on the stock awards issued under the 1996 Plans. On May 27, 2005, the Company's shareholders approved the CompuDyne Corporation 2005 Stock Incentive Compensation Plan for Employees and the CompuDyne Corporation 2005 Stock Option Plan for Non-Employee Directors ("the 2005 Plans") and authorized awards exercisable for up to 4,000,000 and 400,000 common shares, respectively, under the 2005 Plans. The 2005 Plans are intended to replace the 1996 Plans, which expire in March 2006, and contain similar provisions. The 2005 Plans permit the issuance of either incentive stock awards or non-qualified stock awards. Corporate Reorganization As part of the Company's efforts to better manage its costs, during the first quarter of 2005 the Company implemented a corporate reorganization whereby it converted several corporate entities into LLCs (Limited Liability Corporations). This activity was designed to improve the Company's tax reporting structure and should help better manage the Company's state income tax obligations. In conjunction with this reorganization, our Federal Security Systems group, formerly known as Quanta Systems Corporation, was re-formed as CompuDyne-Integrated Electronics Division, LLC, and our Public Safety and Justice group, formerly known as Tiburon, was renamed CompuDyne-Public Safety and Justice, Inc. In addition, CorrLogic, Inc. was converted to CorrLogic, LLC and Fiber SenSys, Inc. was converted to Fiber SenSys, LLC. The impact of this reorganization is not expected to have a material effect on operations. In addition, in light of the escalating selling, general and administrative costs associated with the current heightened regulatory environment, we are evaluating our structure to determine if another organizational structure would result in lower selling, general and administrative costs. Other Recently Issued Accounting Pronouncements In May 2005, the FASB issued SFAS 154, "Accounting Changes and Error Corrections" (SFAS 154) which replaces APB Opinion No. 20, "Accounting Changes" and SFAS 3, "Reporting Accounting Changes in Interim Financial Statements-An Amendment of APB Opinion No. 28." SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application, or the latest practicable date, as the required method for reporting a change in accounting principle and the reporting of a correction of an error. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 is not expected to have a material impact on our consolidated financial position, results of operations or cash flows. 40 In December 2004, the FASB issued Statement No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29. Statement 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. Statement 153 is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of Statement 153 has not had a material effect on our consolidated financial position, results of operations or cash flows. In December 2004, the FASB issued FASB Staff Position No. 109-1, Application of FASB Statement No. 109 (SFAS 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (FSP 109-1). FSP 109-1 clarifies that the manufacturer's deduction provided for under the American Jobs Creation Act of 2004 (AJCA) should be accounted for as a special deduction in accordance with SFAS 109 and not as a tax rate reduction. The adoption of FSP 109-1 had no impact on the Company's results of operations or financial position for fiscal year 2005 because the manufacturer's deduction is not available due to the Company's net loss carryforwards. The Company is evaluating the effect that the manufacturer's deduction will have in subsequent years. In December 2004, the FASB issued SFAS No. 123R, "Share-Based Payment," a revision of SFAS No. 123, "Accounting for Stock-Based Compensation" and superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123R requires the Company to expense grants made under its stock option and employee stock purchase plan programs. That cost will be recognized over the vesting period of the options. SFAS No. 123R is effective for the first annual period beginning after June 15, 2005. The Company has not yet determined the method of adoption or the effect of adopting SFAS 123R, and has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. The Company is evaluating the alternatives allowed under the standard, which the Company is required to adopt beginning in the first quarter of 2006. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs," an amendment to ARB No. 43, Chapter 4, "Inventory Pricing," to clarify that abnormal amounts of idle facility expenses, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges. In addition, FAS 151 requires that allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. SFAS No. 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. There has been no material effect on the financial position, results of operations, or cash flows of the Company upon adoption of this statement. Reclassifications - Certain prior year amounts have been reclassified to conform with the current year's presentation. 2. EARNINGS PER SHARE Earnings per share are presented in accordance with SFAS No. 128, "Earnings Per Share." This Statement requires dual presentation of basic and diluted earnings per share on the face of the statement of operations. Basic earnings per share is computed using the weighted average number of shares outstanding during the period and excludes any dilutive effects of options, warrants, or convertible securities. Diluted earnings per share is computed using the weighted average number of common and common stock equivalent shares outstanding during the period; common stock equivalent shares are excluded from the computation if their effect is antidilutive. Stock options and warrants to purchase 1,257,133 shares, 729,800 shares, and 901,770 shares for the years ended December 31, 2005, 2004 and 2003, respectively, were not dilutive and, therefore, were not included in the computation of diluted earnings per common share. Additionally, the 2,897,768 shares issuable upon conversion of the 6.25% Convertible Subordinated Notes due January 15, 2011 (the "2011 Notes") are excluded for the years ended December 31, 2005 and 2004 as the effect is antidilutive. The computations of the Company's basic and diluted earnings per common share amounts were as follows: 41
2005 2004 2003 ----------------------------------------- (in thousands, except per share data) Net (loss) income $ (8,691) $ (8,198) $ 3,408 ============ ============ ============= Weighted average common shares outstanding 8,129 8,136 7,895 Effect of dilutive stock options and warrants - - 263 ------------ ------------ ------------- Diluted weighted average common shares outstanding $ 8,129 $ 8,136 $ 8,158 ============ ============ ============= Net earnings (loss) per common share Basic $ (1.07) $ (1.01) $ .43 Diluted $ (1.07) $ (1.01) $ .42
In March 2004, the EITF reached a final consensus on Issue 03-6, "Participating Securities and the Two-Class Method under FASB Statement No. 128, Earnings Per Share" ("Issue 03-6"), effective June 30, 2004. Issue 03-6 requires the use of the two-class method to compute earnings per share for companies that have issued securities other than common stock that contractually entitle the holder to participate in dividends and earnings of the Company ("participation rights") when, and if, it declares dividends on its common stock. The 2011 Notes contain contingent participation rights. The participation rights are contingent upon the ability, based on the undistributed earnings for the period, of the Company to declare and distribute dividends per share equal to or in excess of the per share fair value of the Company's common stock. The contingency was not met for the years ended December 31, 2005 and 2004. Accordingly, no undistributed earnings have been allocated to the 2011 Notes. At each reporting period, the Company assesses whether the contingency criteria have been met and consequently if undistributed earnings should be allocated to participating securities. 3. INVESTMENTS IN MARKETABLE SECURITIES The Company's marketable securities are categorized as available-for-sale securities, as defined by SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities." At December 31, 2005 and December 31, 2004 all of the Company's investments in marketable securities were classified as available-for-sale, and as a result, were reported at fair value. Unrealized gains and losses are reported as a component of accumulated other comprehensive income in shareholders' equity. The cost for marketable securities was determined using the specific identification method and adjusted for accretion of discounts from the date of purchase to maturity. The accretion is included in interest income. The fair values of marketable securities are estimated based on the quoted market price for these securities. Marketable securities at December 31, 2005 and 2004 are summarized, in thousands, as follows:
2005 2004 ---------------------------------------------------- ----------------------------------- Gross Unrealized Gross Unrealized -------------------------- Fair --------------- Fair Cost Gains Losses Value Cost Gains Losses Value ---------------------------------------------------------------------------------------- Collateralized mortgage obligations (CMO's) consisting of securities issued by Fannie Mae and Freddie Mac $ 11,494 $ - $ 65 $ 11,429 $ 19,554 $ 23 $ - $ 19,577
The cost and estimated fair value of current marketable securities at December 31, 2005, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities have the right to repay obligations without prepayment penalties. It is the Company's policy to classify available-for-sale securities that are available for use in current operations as a current asset. Estimated (in thousands) Cost Fair Value -------- ---------- Due after one year and beyond $ 11,494 $ 11,429 -------- -------- Total debt securities $ 11,494 $ 11,429 ======== ======== 42 4. ACCOUNTS RECEIVABLE Accounts receivable consist of the following, in thousands: December 31, ----------------------------------- 2005 2004 --------------- --------------- U.S. Government Contracts Billed $ 1,926 $ 6,181 Unbilled 424 384 --------------- --------------- 2,350 6,565 --------------- --------------- Commercial Billed 33,954 23,760 Retainage 5,642 5,885 --------------- --------------- 39,596 29,645 --------------- --------------- Total accounts receivable 41,946 36,210 Less: allowance for doubtful accounts (2,321) (1,919) --------------- --------------- Accounts receivable, net $ 39,625 $ 34,291 =============== =============== The Company expects to collect substantially all receivables within one year except for a portion of the receivables recorded as retainage. Retainage expected to be collected in over one year amounts to $2.2 million, or 39% of the total retainage amount at December 31, 2005, and is reflected as a current asset as it will be collected within the operating cycle under the related contract. Substantially all of the U.S. Government billed receivables result from cost reimbursable or time-and-material contracts. Direct sales to the U.S. Government for the years ended December 31, 2005, 2004 and 2003 were approximately $9.4 million, $9.9 million and $12.6 million, respectively, or 6.7%, 7.0%, and 6.5% of the Company's total net sales for the respective years. The sales to the U.S. Government were in the Institutional Security Systems, Attack Protection and Integrated Electronic Systems segments. No single customer accounted for greater than 10% of the Company's net sales. Contract costs for services provided to the U.S. Government, including indirect expenses, are subject to audit by the Defense Contract Audit Agency ("DCAA"). All contract revenues are recorded in amounts expected to be realized upon final settlement. In the opinion of management, adequate provisions have been made for adjustments, if any, that may result from the government audits. The Company received final approval on its indirect costs billed to the U. S. Government for 2000 from DCAA in April 2004 and final approval on its indirect costs billed to the U.S. Government for 2001 from DCAA in August 2004. No significant payments or billings were made as a result of the approval of the 2000 and 2001 rates. The years 2002, 2003, 2004 and 2005 are still open and subject to audit. The Company does not expect the audit of these years to have a material effect on its financial position or results of operations. 5. CONTRACTS IN PROCESS Amounts included in the financial statements, which relate to recoverable costs and accrued profits not yet billed on contracts in process, are classified as current assets. Billings on uncompleted contracts in excess of incurred cost and accrued profits are classified as current liabilities. The Company expects to bill and collect substantially all costs in excess of billings within one year. Summarized below are the components of the amounts:
December 31, --------------------------------- 2005 2004 --------------- --------------- (in thousands) Costs and estimated earnings on uncompleted contracts $ 277,048 $ 286,041 Less customer progress payments 285,225 289,449 --------------- --------------- $ (8,177) $ (3,408) =============== =============== Included in the consolidated balance sheets: Costs and estimated earnings in excess of billings on uncompleted contracts $ 13,764 $ 16,087 Billings in excess of contract costs and estimated on uncompleted contracts (13,847) (13,497) Deferred revenue (8,094) (5,998) --------------- --------------- $ (8,177) $ (3,408) =============== ===============
43 6. INVENTORIES Inventories consist of the following, in thousands:
December 31, -------------------------------- 2005 2004 --------------- --------------- Raw materials $ 3,984 $ 4,241 Work in progress 3,342 1,890 Finished goods 240 396 --------------- --------------- Total inventory 7,566 6,527 Reserve for excess and obsolete inventory (1,371) (1,362) --------------- --------------- Inventories, net $ 6,195 $ 5,165 =============== ===============
7. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following, in thousands:
December 31, Estimated --------------------------------- Useful Life 2005 2004 In Years --------------- --------------- ------------ Land $ 435 $ 435 Buildings and leasehold improvements 4,889 4,897 7-39 Machinery and equipment 7,170 7,050 3-10 Furniture and fixtures 1,238 1,191 3-10 Automobiles 396 458 3-7 Software 8,734 9,027 3-7 Construction in progress 966 605 --------------- --------------- 23,828 23,663 Less: accumulated depreciation and amortization (13,866) (11,569) --------------- --------------- $ 9,962 $ 12,094 =============== ===============
The Company acquired software as a result of its purchase of the assets of 90 Degrees and Copperfire of $2.2 million and $0.2 million, respectively. Depreciation expense for the years ended December 31, 2005, 2004, and 2003 was $3.1 million, $2.6 million and $2.6 million, respectively. 8. GOODWILL The December 31, 2005 and December 31, 2004 consolidated financial statements include the fair market value of the assets acquired and liabilities assumed and the related allocations of the purchase price related to the acquisition of the assets of 90 Degrees on August 11, 2004. Goodwill recorded for the 90 Degrees asset acquisition was approximately $2.0 million. The December 31, 2005 and December 31, 2004 consolidated financial statements also include the fair market value of the assets acquired and liabilities assumed and the related allocations of the purchase price related to the acquisition of the assets of Copperfire on December 15, 2004. Goodwill recorded for the Copperfire asset acquisition was approximately $2.3 million. The Company reviews the carrying value of goodwill annually during the fourth quarter of the year or whenever events or changes in circumstances indicate that the carrying value may not be recoverable, utilizing a discounted cash flow model. Changes in estimates of future cash flows caused by items such as unforeseen events or changes in market conditions could negatively affect the reporting unit's fair value and result in an impairment charge. The Company cannot predict the occurrence of events that might adversely affect the reported value of goodwill of approximately $26.9 million at December 31, 2005. 44 Goodwill, by segment, consists of the following, in thousands:
Institutional Public Security Attack Safety & Systems Protection Justice Total --------------- --------------- --------------- --------------- December 21, 2003 $ 739 $ 728 $ 21,883 $ 23,350 Goodwill impairment (739) - - (739) Acquisitions - - 3,283 3,283 --------------- --------------- --------------- --------------- December 31, 2004 - 728 25,166 25,894 Acquisitions - - 952 952 --------------- --------------- --------------- --------------- December 31, 2005 $ - $ 728 $ 26,118 $ 26,846 =============== =============== =============== ===============
The change in Public Safety & Justice's goodwill balance at December 31, 2005 as compared to December 31, 2004 is primarily a result of the adjustments necessitated by recording the final appraisal of the assets received and liabilities assumed for the recent acquisitions. 9. INTANGIBLE ASSETS The December 31, 2005 and December 31, 2004 consolidated financial statements include the fair market value of the assets acquired and liabilities assumed and the related allocations of the purchase price related to the acquisition of the assets of 90 Degrees on August 11, 2004. Intangible assets for the 90 Degrees asset acquisition are approximately $60 thousand at December 31, 2005. The December 31, 2005 and December 31, 2004 consolidated financial statements include the fair market value of the assets acquired and liabilities assumed and the related allocations of the purchase price related to the acquisition of the assets of Copperfire on December 15, 2004. Intangible assets for the Copperfire asset acquisition are approximately $130 thousand at December 31, 2005. The weighted average life for purposes of amortization of identified intangible assets acquired in 2005 was three years for non compete agreements and trade names. Intangible assets include the trade name, customer relationships and backlog from the acquisition of Tiburon, Inc. in 2002. Other intangibles include trade names, Department of State Certifications, Underwriters Laboratories, Inc. listings, and patents related to the acquisition of Norment in 1998 and its other recent acquisitions. With the exception of the Norment and Tiburon trade names, which have indefinite lives, the intangible assets are being amortized using the straight-line method. Intangible assets consist of the following, in thousands: December 31, --------------------------------- Amortizable 2005 2004 Lives --------------- --------------- -------------- Cost (in years) Trade names $ 5,673 $ 5,673 15 - Indefinite Customer relationships 2,500 2,500 14 Other 1,255 1,305 1-20 --------------- --------------- 9,428 9,478 Accumulated Amortization Trade names (4) - Customer relationships (655) (476) Other (548) (542) --------------- --------------- Net Cost $ 8,221 $ 8,460 =============== =============== Amortization expense for the Company's intangible assets for the years ended December 31, 2005 and December 31, 2004 was $309 thousand and $358 thousand respectively. The following schedule lists the expected amortization expense for each of the next five years ending December 31, in thousands: 45 Year ---- 2006 $ 263 2007 254 2008 243 2009 243 2010 229 Thereafter 1,357 ------- Total $ 2,589 ======= 10. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable and accrued liabilities consist of the following, in thousands: December 31, ---------------------- 2005 2004 -------- -------- Accounts payable $ 15,461 $ 9,406 Liability for marketable security purchased - 4,336 Accrued payroll costs 3,558 3,323 Income taxes payable 206 707 Other accrued expenses 3,805 3,999 -------- -------- $ 23,030 $ 21,771 ======== ======== 11. NOTES PAYABLE AND LINE OF CREDIT
December 31, -------------------------------- 2005 2004 -------------------------------- (in thousands) Industrial revenue bond, interest payable monthly at a variable rate of 1.65% to 3.71% (3.71% at December 31, 2005) principal payable in quarterly installments of $35,000. The bond is fully collateralized by a $1.4 million letter of credit and a bond guarantee agreement. $ 1,260 $ 1,400 Industrial revenue bond, interest payable monthly at a variable rate of 1.62% to 3.65% (3.65% at December 31, 2005) principal payable in annual installments of $300,000 until 2013 when the annual installments become $100,000. The bond is fully collateralized by a $2.3 million letter of credit and a bond guarantee agreement. 2,305 2,605 6.25% Convertible Subordinated Notes due January 15, 2011. The notes bear interest at a rate of 6.25% per annum, payable semi-annually, and are convertible into shares of common stock at a conversion price of $13.89 per share. These notes are subordinated to all other liabilities of the Company. 40,250 40,250 --------------- --------------- Total notes payable 43,815 44,255 Less convertible subordinated notes discount 945 1,132 --------------- --------------- Subtotal 42,870 43,123 Less amount due within one year 440 440 --------------- --------------- $ 42,430 $ 42,683 =============== ===============
Maturities of notes payable are as follows, in thousands: Year Ending December 31, Amount ------------------------ --------- 2006 $ 440 2007 440 2008 440 2009 440 2010 440 Thereafter 41,615 --------- $ 43,815 46 On January 22, 2004, the Company completed an offering of $40.25 million principal amount of the 2011 Notes. The 2011 Notes bear interest at a rate of 6.25% per annum, payable semi-annually, and are convertible into shares of common stock at a conversion price of $13.89 per share, subject to adjustments. The 2011 Notes are subordinated to all other liabilities of the Company. The December 31, 2005 carrying value is listed below, in thousands. Face value $40,250 Underwriters discounts, net 945 ------- $39,305 ======= The 2011 Notes can be converted into the Company's common stock at the option of the holder at any time at a conversion price of $13.89 per share, subject to adjustments for stock splits, stock dividends, the issuance of certain rights or warrants to the existing holders of the Company's common stock and common stock cash dividends in excess of a stated threshold. The 2011 Notes are redeemable at the option of the Company after January 15, 2009, at a premium of two percent of the face value plus accrued interest unless a change in control event, as defined in the indenture dated as of January 15, 2004 between the Company and U.S. Bank, relating to the 2011 Notes, occurs. If such an event does occur, the Company may redeem the 2011 Notes in whole but not in part at face value plus a premium. If a change in control event occurs and the Company does not elect to redeem the 2011 Notes, the holders can require the Company to repurchase the 2011 Notes at face value plus accrued interest. The debt issuance costs for the 2011 Notes are recorded as non-current assets and are amortized on a straight-line basis to interest expense over the term of the 2011 Notes. In addition, underwriters' discounts totaled $1.3 million and are amortized on a straight-line basis to interest expense over the term of the 2011 Notes. Interest expense recorded for the total of the deferred debt issuance costs and underwriters' discounts on the 2011 Notes totaled $251 thousand and $245 thousand for the years ended December 31, 2005 and 2004, respectively. On March 31, 2004, the Company signed an Amended and Restated Credit Agreement for a $25.0 million secured working capital line of credit. This agreement provided for borrowings against eligible accounts receivable and inventories and contained various financial covenants, including among other things, a minimum fixed charge coverage ratio, maximum debt to earnings before interest, taxes, depreciation and amortization ("EBITDA") ratio, minimum EBITDA covenant, a minimum consolidated tangible net worth covenant, a maximum permitted capital expenditures covenant, and a covenant restricting the payment of dividends. Of this line of credit, $10.0 million was to mature on March 1, 2007 and $15.0 million was to mature on March 1, 2005. On October 29, 2004 and March 4, 2005, the Company and its bank entered into amendments to its credit agreement pursuant to which the bank waived the Company's non-compliance with its fixed charge coverage ratio covenant as of September 30, 2004 and non-compliance with its minimum EBITDA covenant as of December 31, 2004, respectively. In addition, the Company and its bank amended the credit agreement to eliminate the $15.0 million line of credit maturing March 2005 and to require borrowings under its $10.0 million line of credit to be secured by pledged marketable securities equal to 111.11% of the value of such borrowings or cash equal to the value of such borrowings. The credit agreement was also amended to permanently eliminate the quarterly minimum EBITDA covenant effective as of the Company's first quarter ended March 31, 2005 and to provide that the minimum fixed charge coverage ratio covenant, maximum debt to EBITDA ratio covenant and the minimum consolidated tangible net worth covenant were not to become effective until March 31, 2006. On May 3, 2005, the Company's bank confirmed in writing that there will not be any event of default under the various credit agreements, by virtue of the Company's failure to timely file an amendment to its Annual Report on Form 10-K for the year ended December 31, 2004 (the "2004 10-K") to provide management's report on internal control over financial reporting as of December 31, 2004 and the related report of the Company's independent registered public accounting firm on management's assessment of the effectiveness of internal control over financial reporting (together, the "404 Report") required by Section 404 of the Sarbanes-Oxley Act of 2002. The 404 Report was filed with the SEC on Form 10-K/A on June 27, 2005. On November 17, 2005, the Company and its bank entered into an additional amendment to the credit agreement pursuant to which the bank agreed to increase its commitment to lend under the Company's revolving line of credit from $10,000,000 to $13,000,000, to increase the letter of credit subfacility from $8,000,000 to $13,000,000 and to terminate the swing line subfacility. On December 19, 2005, the Company and its bank entered into a Second Amended and Restated Revolving Credit and Security Agreement (the "Second Restated Credit Agreement"). The Second Restated Credit Agreement amended and restated the Company's Amended and Restated Credit Agreement dated March 31, 2004. 47 In connection with the execution of the Second Restated Credit Agreement, the Company provided the bank with collateral that includes all receivables, equipment, general intangibles, inventory, investment property, real property and a security interest in subsidiary stock. The Second Restated Credit Agreement allows the Company to obtain revolving advances in a principle amount of up to $20,000,000. Revolving advances are limited by a borrowing base formula based upon the value of the Company's receivables, inventory, fixed assets, real property and issued and outstanding letters of credit. The maximum aggregate face amount of letters of credit that may be drawn under the Second Restated Credit Agreement is limited to $18,000,000. The Second Restated Credit Agreement matures on December 18, 2008. Revolving advances under the Second Restated Credit Agreement bear interest, at the election of the Company, at a variable rate equal to the alternate base rate, a prime interest based rate, or the Eurodollar rate plus two and one half percent. For letters of credit, the Company shall pay an amount equal to the average daily face amount of each outstanding letter of credit multiplied by two and one half percent per annum, and a fronting fee of one quarter of one percent per annum, together with other administrative fees and charges. The Company paid its bank a closing fee of $50,000 in connection with the execution of the Second Restated Credit Agreement. The Company is also required to pay the bank an unused fee equal to three-eighths of one percent per annum of the amount by which $20,000,000 exceeds the average daily unpaid balance of the revolving advances and undrawn amount of any outstanding letters of credit. In addition, the Company is required to pay a collateral monitoring fee equal to $1,000 per month and a collateral evaluation fee as required. The Second Restated Credit Agreement contains various affirmative and negative covenants including financial covenants. The Company is required to maintain an unrestricted undrawn borrowing base availability of at least $5,000,000. Commencing with the fiscal quarter ending June 30, 2006, the Company is required to maintain a fixed charge coverage ratio of at least 1.1 to 1.0. In January 2004, the interest rate swap ceased to be a highly-effective cash flow hedge when the related debt was repaid. Consequently, the amounts previously recorded in other comprehensive income as changes in fair value of the interest rate swap were recognized in earnings for the year ended December 31, 2004. Upon determination of the hedge ineffectiveness the cumulative loss on the fair value of the interest rate swap was $155 thousand, which was recognized in other expense. The change in fair value of the interest rate swap for the year ended December 31, 2005 was a gain of $21 thousand. The interest rate swap matured on September 30, 2005. 12. PRODUCT WARRANTIES Included in accounts payable and accrued liabilities are estimated expenses related to warranties made at the time products are sold or services are rendered. These accruals are established using historical information on the nature, frequency, and average cost of warranty claims. The Company warrants numerous products, the terms of which vary widely. In general, the Company warrants its products against defect and specific non-performance. The changes in the product warranty liability are displayed in the following table, in thousands: December 31, -------------------------------- 2005 2004 --------------- --------------- Beginning balance at January 1 $ 359 $ 517 Plus: accruals for product warranties 375 280 Less: warranty charges/claims (346) (438) --------------- --------------- Ending balance at December 31 $ 388 $ 359 =============== =============== 13. FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments: Cash and Cash Equivalents, Accounts Receivable and Accounts Payable and Accrued Expenses - The carrying amounts reported in the balance sheets for these items approximate fair value due to the short-term maturities of these assets and liabilities. Long-Term Debt - The carrying amounts reported in the balance sheet approximate fair value as the amounts are at floating rates and terms available to the Company at December 31, 2005 and 2004 for borrowings for similar transactions. The Company's 2011 Notes are at a fixed rate of 6.25%. 48 Interest Rate Swap Agreements - The Company used an interest rate swap agreement to manage exposure to fluctuations in interest rates. At December 31, 2004, the Company had an unleveraged swap agreement with a bank with a notional principal amount of $2.0 million. This agreement was placed on June 26, 2001 with a fixed rate of 4.9% and is settled in cash on a quarterly basis. The termination date was September 30, 2005. In prior years the Company hedged the cash flows of some of its long-term debt using an interest rate swap. The Company entered into this derivative contract to manage its exposure to interest rate movements by achieving a desired proportion of fixed rate versus variable rate debt. In an interest rate swap, the Company agreed to exchange the difference between a variable interest rate and either a fixed or another variable interest rate, multiplied by a notional principal amount. As of December 31, 2003, the Company recognized the cash flow hedge at its fair value of $155 thousand in accounts payable and accrued expenses on the consolidated balance sheet. As of December 31, 2003 the interest rate swap qualified for cash flow hedge accounting, therefore an unrealized loss of $155 thousand ($93 thousand net of tax), representing the effective portion of the change in its fair value, was reported in other comprehensive loss. For the year ended December 31, 2004, the interest rate swap was determined to be ineffective and the changes in fair value were recognized in earnings. 14. INCOME TAXES The components of the income tax provision (benefit) are as follows, in thousands: For the years ended December 31, ------------------------------------------------ 2005 2004 2003 -------------- -------------- --------------- Current $ (203) $ (2,013) $ 2,103 Deferred (12) (219) 245 -------------- -------------- --------------- $ (215) $ (2,232) $ 2,348 ============== ============== =============== The tax effects of the primary temporary differences giving rise to the Company's net deferred tax assets and liabilities at December 31, 2005 and 2004 are summarized as follows, in thousands:
December 31, -------------------------------- 2005 2004 --------------- ---------------- Deferred tax assets: Accrued expenses and deferred compensation $ 204 $ 566 Tax operating loss carryforward 4,349 1,064 Book reserves in excess of tax 1,762 1,093 Tax depreciation and amortization in excess of book depreciation and amortization 821 440 Other 25 84 --------------- ---------------- Total deferred tax assets 7,161 3,247 --------------- ---------------- Deferred tax liabilities: Price risk management activities (9) (9) Purchased intangibles (3,086) (3,452) --------------- ---------------- Total deferred tax liabilities (3,095) (3,461) Valuation allowance (6,126) (1,858) --------------- ---------------- Net deferred tax (liability) asset $ (2,060)$ (2,072) =============== ================
In the third quarter of 2005 the Company reversed $500 thousand previously recorded as a reserve for uncertain tax positions which was no longer needed. At December 31, 2005 and 2004 the Company established a valuation allowance to reserve substantially all of its net deferred tax assets, because the Company believes that it is not "more likely than not" that it will be able to realize the deferred tax assets in the future. Deferred tax assets at December 31, 2005 include $1.0 million of state net operating losses for which a valuation allowance has been established. This deferred tax asset and its related valuation allowance were not included in prior years as it was determined that the assets were unlikely to be realized in future years. The company completed an organizational restructuring during the year ended December 31, 2005, creating a state tax structure that may result in realization of the state net operating loss in future years if the Company returns to profitability. At December 31, 2005, the Company and its subsidiaries have Federal net operating loss carryforwards available to offset future taxable income of approximately $8.4 million, of which $500 thousand is subject to severe limitations. The limited tax loss carryforwards are limited to approximately $235 thousand each year as a result of an ownership change, which occurred in 49 1995. Approximately $7.9 million is available for use on an unlimited basis through 2025. The balance of these carryforwards expires between 2006 and 2010. At December 31, 2005, the Company and its subsidiaries have $32.5 million state net operating loss carryforwards available to offset future taxable state income. The difference between the statutory tax rate and the Company's effective tax rate is summarized as follows: For the years ended December 31, ------------------------------------ 2005 2004 2003 ------------------------------------ Statutory federal income tax rate (34.0)% (34.0)% 34.0% State income taxes, net of Federal benefit (4.6) (0.3) 6.2 Change in valuation allowance 38.7 14.8 - Tax effect of non-deductible items 0.7 0.5 1.1 Foreign income exclusion (1.4) (1.9) (2.4) Other (1.8) (0.5) 1.9 ------------------------------------ Effective tax rate (2.4)% (21.4)% 40.8% ==================================== At December 31, 2004, the Company and its subsidiaries recorded a tax receivable representing net operating losses carried back to its 2003 and 2002 Federal and State tax returns. The value of these carrybacks is approximately $2.5 million and was recorded within prepaid expenses and other current liabilities in the accompanying balance sheet as of December 31, 2004. Such amounts were received in 2005. 15. SHAREHOLDERS' EQUITY Warrants for Common Stock. In connection with a Private Investment in Public Equity ("PIPE") transaction the Company entered into in October 2001, the Company granted its underwriter an option to purchase 40,000 shares of the Company's common stock at $12.00 per share, the price at which the shares were sold in the PIPE. These options were granted on October 29, 2001 and expire on October 29, 2006. The shares underlying these warrants have piggyback registration rights. At the underwriter's option, these piggyback registration rights may either convert to demand registration rights, with any fees related to the registration of these warrants and underlying shares paid by the Company, or the Company may grant the underwriter a put option to sell the shares underlying the warrants back to the Company at a predetermined price. In connection with the Company's acquisition of Tiburon in 2002, the Company exchanged warrants and convertible securities to purchase shares of Tiburon into warrants to purchase shares of the Company. On May 2, 2002, the Company issued 90,962 warrants to purchase shares of CompuDyne common stock at prices ranging from $3.75 to $6.71 per share. During 2002, 11,909 of the warrants were exercised. During 2003, 44,417 of the warrants were exercised resulting in 34,636 of such warrants remaining outstanding at December 31, 2005. The following shows the exercise price and expiration date of the remaining warrants outstanding: Number of Warrants Exercise Price Expiration Date ------------------ -------------- --------------- 23,000 $ 5.37 December, 2006 11,636 $ 6.71 December, 2006 Stock Option Plans. The Company has various stock option plans. Under these plans, 5,778,358 options to purchase common stock may be granted until December 8, 2015. Options generally are granted at fair market value at the date of grant, typically vest over 1 to 5 years from the date of grant, and expire 10 years after the date of grant. The plans permit the issuance of either incentive stock options or non-qualified stock options. Under all plans, there were 4,325,000 shares of common stock reserved for future grants as of December 31, 2005. Transactions for stock options and warrants are summarized as follows:
Year Year Year Ended Weighted Ended Weighted Ended Weighted December 31, Average December 31, Average December 31, Average 2005 Price 2004 Price 2003 Price --------------------------------------------------------------------------------------- Outstanding, Beginning of Year 1,671,958 $ 9.418 1,414,556 $ 8.587 1,489,653 $ 8.324 Granted 287,000 $ 6.983 675,000 $ 9.145 271,500 $ 8.131 Exercised 6,500 $ 3.906 303,898 $ 4.131 172,497 $ 3.610 Expired or Cancelled 499,100 $ 10.004 113,700 $ 11.590 174,100 $ 10.554 --------------- -------------------------- ----------------------------- -------------- Outstanding, End of Year 1,453,358 $ 8.755 1,671,958 $ 9.418 1,414,556 $ 8.587 --------------- -------------------------- ----------------------------- -------------- Exercisable, End of Year 843,308 $ 9.587 492,861 $ 9.226 616,365 $ 6.625 =============== ========================== ============================= ==============
50 Summarized information about stock options and warrants outstanding as of December 31, 2005 is as follows:
Options and Warrants Outstanding Options and Warrants Exercisable ------------------------------------ -------------------------------- Weighted Average Weighted Average Remaining Average Exercise Life Exercise Exercise Price Range Number Price (In years) Number Price -------------------- -------- -------- ---------- ------ --------- $1.625 - 6.035 171,225 $5.1065 6.61 66,225 $3.8657 $6.250 - 7.125 148,836 $6.8423 7.88 33,736 $6.8247 $7.375 - 7.615 151,000 $7.5126 8.12 41,700 $7.5165 $7.640 - 8.075 267,000 $7.8950 7.03 139,800 $7.9931 $8.105 - 8.960 194,597 $8.6043 6.99 106,147 $8.5988 $9.190 - 10.420 206,700 $10.0675 7.34 141,700 $10.0278 $10.460 - 12.000 155,500 $11.2459 6.29 155,500 $11.2459 $12.070 - 13.890 145,500 $13.0218 6.22 145,500 $13.0218 $14.090 - 16.330 11,500 $14.3822 5.81 11,500 $14.3822 $16.630 - 16.630 1,500 $16.6300 5.74 1,500 $16.6300 1,453,358 $8.7550 7.05 843,308 $9.5867 ========= =======
As of December 31, 2005, the Company continues to account for its stock-based compensation plans using the intrinsic value method and in accordance with the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. No stock-based employee compensation cost is reflected in the statement of operations, as all options granted had an exercise price equal to fair market value of the underlying common stock on the date of grant. The Company has provided the additional disclosures specified in SFAS No. 123 as amended by SFAS No. 148 (see Note 1). The weighted average fair value calculated utilizing the Black-Scholes method at the date of grant for options granted during 2005, 2004 and 2003 was $4.15, $5.95, and $5.80 per option, respectively. 16. COMMITMENTS AND CONTINGENCIES Operating Leases. The Company leases office space, equipment, distribution, manufacturing and storage facilities under non-cancelable operating leases with various expiration dates through December 2012. Total rental expense for the years ended December 2005, 2004 and 2003 was $3.2 million, $3.2 million, and $3.2 million, respectively. As of December 31, 2005, future minimum rental payments required under all non-cancelable operating leases are as follows, in thousands: Year Ending December 31, Total ------------ --------- 2006 $ 2,497 2007 2,551 2008 1,885 2009 1,544 2010 1,313 Thereafter 1,120 -------- $ 10,910 Interest on Contractual Obligations. As of December 31, 2005, the Company has a $40.25 million note outstanding at a fixed rate of 6.25%. In addition it has industrial revenue bonds in the amount of $3.6 million outstanding which have variable interest rates and decreasing principal balances until maturity. Future interest on contractual obligations is as follows, in thousands: Year Ending December 31, Total ------------ --------- 2006 $ 2,636 2007 2,620 2008 2,604 2009 2,588 2010 2,571 Thereafter 856 -------- $13,875 51 Purchase Obligations. The Company enters into purchase obligations to procure equipment and services, including subcontractor contracts, in the performance of the day-to-day operations of its business. Substantially all of these obligations are covered by our existing backlog and the revenues generated by these backlogs are expected to be sufficient to meet any payment obligations resulting from these purchase commitments. Legal Matters. The Company is party to certain legal actions and inquiries for environmental and other matters resulting from the normal course of business. Some of the businesses, especially Institutional Security Systems, involve working as a subcontractor to a prime contractor. From time to time the Company makes claims against the prime contractor, or the prime contractor makes claims against the Company. At any point in time the Company is engaged in a number of claim disputes with prime contractors, some of which may have a significant negative outcome. Although the total amount of potential liability with respect to these matters can not be ascertained given the nature of the related allegations, the Company presently believes that any resulting liability will not have a material effect on its financial position, results of future operations or cash flows. In addition to claims with prime contractors, the Company may also make claims against customers and customers may make claims against the Company. The Company has learned that the National Association of Securities Dealers ("NASD") and other regulatory bodies are seeking sanctions against purchasers of the Company's common stock in its 2001 PIPE transaction. In addition, the Company has learned that the placement agent for this transaction is also being investigated by the SEC, NASD and other regulatory bodies. The Company is investigating these matters, has filed lawsuits against certain purchasers and is evaluating its other options for recovery. The Company has been named in lawsuits involving asbestos related personal injury and death claims in which CompuDyne Corporation, individually and as an alleged successor, is a defendant. The Company has been named as a defendant in cases related to claims for asbestos exposure allegedly due to asbestos contained in certain of its predecessor's products. The Company has advised its insurers of each of these cases, and the insurers are providing a defense pursuant to agreement with the Company, subject to reservation of rights by the insurers. The insurers have advised that claims in such litigation for punitive damages, exemplary damages, malicious and willful and wanton behavior and intentional conduct are not covered. One of the carriers has given notice that asbestos related claims are excluded from certain of these policies. The insurers have additional coverage defenses, which are reserved, including that claims may fall outside of a particular policy period of coverage. Litigation costs to date have not been significant and the Company has not paid any settlements from its own funds. The Company cannot ascertain the total amount of potential liability with respect to these legal matters, but does not believe that any such potential liability should have a material effect on its financial position, future operations or future cash flows. The Company, as a government contractor, is from time to time subject to U.S. Government investigations relating to its operations. Government contractors that are found to have violated the False Claims Act, or are indicted or convicted for violations of other federal laws, or are considered not to be responsible contractors, may be suspended or debarred from government contracting for some period of time. Such convictions could also result in fines. Suspension or debarment could have a material adverse effect on the Company. No such violations or conditions of debarment exist at this time. 17. RELATED PARTY TRANSACTION During 2005 and 2004 the Company's Integrated Electronic Systems unit recorded revenue of approximately $255 thousand and $200 thousand, respectively, from sales to a company of which one of CompuDyne's Directors is a senior vice president and member of its board of directors. Included in the Integrated Electronic Systems unit at December 31, 2005 and 2004 related to the company at which this Director is employed was $351 thousand and $29 thousand of accounts receivables, respectively, and $9 thousand and $171 thousand of contract costs in excess of billings, respectively. 18. EMPLOYEE BENEFIT PLANS The Company established a non-qualified Employee Stock Purchase Plan in October 1999, the terms of which allow for qualified employees (as defined) to participate in the purchase of shares of the Company's common stock. The Company matches at a rate of 15% of the employee purchase at the market value of the common stock for the monthly purchase period. The Company purchases stock on the open market and distributes the shares monthly to employees' individual accounts. Expense for matching contributions to the plan was $33 thousand, $33 thousand, and $34 thousand for 2005, 2004, and 2003 respectively. 52 The Company has 401(k) retirement savings plans covering all employees. All employees are eligible to participate in a plan after completing one year of service (as defined by the plan). Participants may make before tax contributions subject to Internal Revenue Service limitations. CompuDyne currently matches up to 2.5% of employee contributions up to a maximum of $5,000. Expense for matching contributions to the Plan was $783 thousand, $694 thousand and $712 thousand for 2005, 2004, and 2003, respectively. The Company entered into the CompuDyne Corporation Retention Plan for Selected Employees (the "Retention Plan") effective June 28, 2005 with certain employees. The Retention Plan provides for cash bonuses and acceleration of vesting of all unexercised unvested stock awards upon the occurrence of a change in control, as defined in the Retention Plan, for eligible employees. A change in control, as defined in the Retention Plan, did not occur during the year ended December 31, 2005 and therefore, the Company did not record a liability or related compensation expense for the Retention Plan. 19. OPERATING SEGMENT INFORMATION Segment information has been prepared in accordance with the Statement of Financial Accounting Standards (SFAS) No. 131, "Disclosure about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 defines "operating segments" to be those components of a business about which separate financial information is available that is regularly evaluated by management in deciding how to allocate resources and in assessing performance. SFAS No. 131 further requires that the segment information presented be consistent with the basis and manner in which management internally evaluates financial information for the purpose of assisting in making internal operating decisions. The following segment information includes operating information for CompuDyne's four operating segments, Institutional Security Systems, Attack Protection, Integrated Electronic Systems and Public Safety and Justice in addition to Corporate activities for each of the years ended December 31, 2005, 2004 and 2003. 53
Revenues Gross Profit ------------------------------------------ --------------------------------------- (in thousands) 2005 2004 2003 2005 2004 2003 ------------- ------------ ------------- ------------ ---------- ------------ Institutional Security Systems $ 60,652 $ 53,952 $ 98,653 $ 9,896 $ 6,437 $ 14,203 Attack Protection 27,017 25,161 28,375 6,105 1,551 5,694 Integrated Electronic Systems 10,110 14,293 16,441 1,625 2,019 2,606 Public Safety and Justice 43,871 49,376 49,794 24,913 27,671 23,893 CompuDyne Corporate - - - - - - ------------- ------------ ------------- ------------ ---------- ------------ $ 141,650 $ 142,782 $ 193,263 $ 42,539 $ 37,678 $ 46,396 ============= ============ ============= ============ ========== ============ Total Assets, at Year End Pre-tax Income (Loss) ------------------------------------------- --------------------------------------- 2005 2004 2003 2005 2004 2003 ------------- ------------ ------------- ------------ ---------- ------------ Institutional Security Systems $ 23,755 $ 26,895 $ 34,343 $ 629 $ (5,174) $ 3,613 Attack Protection 20,621 15,760 21,202 (2,333) (5,444) 551 Integrated Electronic Systems 4,354 3,807 6,076 431 563 953 Public Safety and Justice 57,780 56,538 49,439 (2,928) 2,364 407 CompuDyne Corporate 20,182 29,891 4,672 (4,705) (2,739) 232 ------------- ------------ ------------- ------------ ---------- ------------ $ 126,692 $ 132,891 $ 115,732 $ (8,906) $ (10,430) $ 5,756 ============= ============ ============= ============ ========== ============ Capital Expenditures Depreciation and Amortization ------------------------------------------- --------------------------------------- 2005 2004 2003 2005 2004 2003 ------------- ------------ ------------- ------------ ---------- ------------ Institutional Security Systems $ 132 $ 411 $ 312 $ 388 $ 531 $ 330 Attack Protection 264 64 215 767 644 885 Integrated Electronic Systems 8 16 72 35 41 68 Public Safety and Justice 815 1,140 451 2,145 1,664 1,679 CompuDyne Corporate 33 153 18 58 41 26 ------------- ------------ ------------- ------------ ---------- ------------ $ 1,252 $ 1,784 $ 1,068 $ 3,393 $ 2,921 $ 2,988 ============= ============ ============= ============ ========== ============
Included in the 2005 results are certain contract closeout activities in the ISS segment which resulted in the recognition of $2.0 million of gross margin and $2.0 million in losses recorded in the ISS segment related to continuing problems in its West Coast office. In addition, PS&J increased its focus on its Next Generation products, expending $884 thousand. Also included in the 2005 results are costs related to SOX 404 compliance in the amount of $2.4 million. Included in the 2004 results is a $739 thousand pre-tax charge to record the impairment of the Institutional Security Systems segment's goodwill and a $1.1 million charge to record the impairment of certain of the Institutional Security Systems segment's other intangible assets. In addition, the continuing problems in the West Coast office of ISS resulted in the Company recording additional losses of $6.1 million from the work performed in this office and an additional $2.0 million was added to a project's estimated cost to complete. Also included in 2004's results are charges of $411 thousand for terminated deal costs related to unconsummated acquisitions, and $2.6 million of interest expense incurred in connection with the 2011 Notes issued in January 2004; these expenses were recorded in CompuDyne Corporate's accounts. Included in the 2003 results is a $1.6 million pre-tax charge for a contract in litigation, which occurred in the Public Safety and Justice segment. During the second quarter of 2004 this matter was settled resulting in a reversal of $0.3 million of the accrued charge, which was reflected as a reduction of its cost of sales. During 2003, the Company increased its allowance for doubtful accounts by approximately $725 thousand in its Institutional Security Systems segment for past due receivables. Pre-tax income in the Attack Protection segment benefited by approximately $900 thousand from a successful arbitration decision related to a disputed customer receivable. During 2002, the West Coast operations of the Institutional Security Systems segment experienced significant cost overruns on many of its projects. These cost overruns were incurred and recorded during the latter half of 2002 and amounted to approximately $2.4 million. As a result, as these projects were brought to completion in 2003, the revenues generated by them resulted in little margin or in some cases losses. The Company recorded $1.9 million of additional write-downs on its West Coast projects that were either completed or neared completion in 2003. In 2004 and 2005, the West Coast operations generated pre-tax losses of $6.1 million and $2.0 million, respectively. 54 20. SELECTED QUARTERLY FINANCIAL DATA (Unaudited)
First Second Third Fourth (In thousands, except per share data) Quarter Quarter Quarter Quarter Total ------------------------------------------------------------------------------------------------------------------- Year Ended December 31, 2005 Revenues -------- Institutional Security Systems $ 15,732 $ 11,728 $ 15,548 $ 17,644 $ 60,652 Attack Protection 6,898 6,065 5,892 8,162 27,017 Integrated Electronic Systems 2,019 1,888 2,898 3,305 10,110 Public Safety and Justice 11,657 11,423 9,161 11,630 43,871 ------------- ------------ ------------- ------------- ------------ Total revenues $ 36,306 $ 31,104 $ 33,499 $ 40,741 $ 141,650 Gross Profit ------------ Institutional Security Systems $ 3,567 $ 1,581 $ 2,343 $ 2,405 $ 9,896 Attack Protection 2,368 1,380 341 2,016 6,105 Integrated Electronic Systems 282 340 473 530 1,625 Public Safety and Justice 6,166 7,126 5,360 6,261 24,913 ------------- ------------ ------------- ------------- ------------ Total gross profit $ 12,383 $ 10,427 $ 8,517 $ 11,212 $ 42,539 Pre-tax Income (loss) --------------------- Institutional Security Systems $ 1,230 $ (532) $ (170) $ 101 $ 629 Attack Protection 499 (840) (1,800) (192) (2,333) Integrated Electronic Systems (8) 16 172 251 431 Public Safety and Justice (482) 400 (3,188) 342 (2,928) Unallocated corporate expense (1,558) (1,683) (791) (673) (4,705) ------------- ------------ ------------- ------------- ------------ Pre-tax loss from operations $ (319) $ (2,639) $ (5,777) $ (171) $ (8,906) ------------- ------------ ------------- ------------- ------------ Net loss $ (319) $ (2,639) $ (5,277) $ (456) $ (8,691) ------------- ------------ ------------- ------------- ------------ Basic loss per share $ (.04) $ (.33) $ (.65) $ (.06) $ (1.07) ------------- ------------ ------------- ------------- ------------ Diluted loss per share $ (.04) $ (.33) $ (.65) $ (.06) $ (1.07) ------------- ------------ ------------- ------------- ------------ First Second Third Fourth (In thousands, except per share data) Quarter Quarter Quarter Quarter Total ------------------------------------------------------------------------------------------------------------------- Year Ended December 31, 2004 Revenues -------- Institutional Security Systems $ 16,057 $ 13,954 $ 11,783 $ 12,158 $ 53,952 Attack Protection 6,953 6,741 6,510 4,957 25,161 Integrated Electronic Systems 3,575 4,371 3,296 3,051 14,293 Public Safety and Justice 12,442 12,717 11,771 12,446 49,376 ------------- ------------ ------------- ------------- ------------ Total revenues $ 39,027 $ 37,783 $ 33,360 $ 32,612 $ 142,782 Gross Profit ------------ Institutional Security Systems $ 2,505 $ 2,244 $ 1,773 $ (85) $ 6,437 Attack Protection 919 1,082 (477) 27 1,551 Integrated Electronic Systems 490 611 501 417 2,019 Public Safety and Justice 6,284 7,210 7,011 7,166 27,671 ------------- ------------ ------------- ------------- ------------ Total gross profit $ 10,198 $ 11,147 $ 8,808 $ 7,525 $ 37,678 Pre-tax Income (loss) --------------------- Institutional Security Systems $ 207 $ (84) $ (806) $ (4,491) $ (5,174) Attack Protection (679) (456) (2,101) (2,208) (5,444) Integrated Electronic Systems 200 214 137 12 563 Public Safety and Justice 435 960 370 599 2,364 Unallocated corporate expense (674) (481) (671) (913) (2,739) ------------- ------------ ------------- ------------- ------------ Pre-tax (loss) income from operations $ (511) $ 153 $ (3,071) $ (7,001) $ (10,430) ------------- ------------ ------------- ------------- ------------ Net (loss) income $ (307) $ 90 $ (1,850) $ (6,131) $ (8,198) ------------- ------------ ------------- ------------- ------------ Basic (loss) earnings per share $ (.04) $ .01 $ (.23) $ (.74) $ (1.01) ------------- ------------ ------------- ------------- ------------ Diluted (loss) earnings per share $ (.04) $ .01 $ (.23) $ (.74) $ (1.01) ------------- ------------ ------------- ------------- ------------
55 Included in the first, second, third and fourth quarters of 2005 were approximately $0.6 million, $0.9 million, $0.5 million and $0.4 million, respectively, in costs related to SOX 404 compliance. Included in the results of the fourth quarter of 2004 is a $739 thousand pre-tax charge to record the impairment of the Institutional Security Systems segment's goodwill and a $1.1 million charge to record the impairment of certain of the Institutional Security Systems segment's other intangible assets. In addition, the continuing problems in the West Coast office of ISS resulted in the Company recording additional losses of $2.2 million from the work performed in this office. Included in the results of the fourth quarter of 2003 is a $1.6 million pre-tax charge for a contract in litigation, which occurred in the Public Safety and Justice segment. During the second quarter of 2004 this matter was settled resulting in a reversal of $0.3 million of the accrued charge, which was reflected as a reduction of its cost of sales. 56 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Changes in Accelerated Filer Status On December 21, 2005 the Securities and Exchange Commission issued Release No. 33-8644 "Revisions to Accelerated Filer Definition and Accelerated Deadlines For Filing Periodic Reports" (the "Release"). Included in the Release was an amendment to revise the definition of the term "accelerated filer" to permit an accelerated filer that has an aggregate worldwide market value of voting and non-voting common equity held by non-affiliates of less than $50 million as of the last business day of its second fiscal quarter to exit accelerated filer status at the end of the fiscal year in which the company's equity falls below $50 million as of the last business day of its second fiscal quarter and to file its annual report for that year and subsequent periodic reports on a non-accelerated basis. The aggregate worldwide market value of CompuDyne Corporation's equity held by non-affiliates as of June 30, 2005, the last business day of CompuDyne's second fiscal quarter, was less than $50 million. As a result, as of December 31, 2005, CompuDyne exited accelerated filer status. Prior to the Release, CompuDyne was classified as an "accelerated filer" and was required to comply with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. In light of the Release, CompuDyne, as a non-accelerated filer as of December 31, 2005, is not required to comply with Section 404 for the year ended December 31, 2005. Disclosure Controls and Procedures The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company's periodic Securities Exchange Act of 1934 ("Exchange Act") reports is recorded, processed, summarized, and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required financial disclosure. As of December 31, 2005, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon, and as of the date of, this evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company's disclosure controls and procedures were effective. Remediation of Material Weaknesses In the Company's 2004 Annual Report on Form 10-K for the fiscal year ended December 31, 2004 (the "Annual Report"), we disclosed three material weaknesses in our internal control over financial reporting. The following is a discussion of specific changes that we have made to our internal control over financial reporting during 2005 relating to the material weaknesses previously disclosed in the 2004 Annual Report. After consideration of the remediation efforts below and testing of the design and operating effectiveness of controls, we have concluded that as of December 31, 2005, the material weaknesses disclosed in the 2004 Annual Report have been remediated. 1. The Company did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of accounting principles generally accepted in the United States of America (GAAP) commensurate with the Company's financial reporting requirements to support the size, complexity, operating activities, and locations of the Company. This material weakness contributed to the other individual material weaknesses described below. To address this material weakness, the Company has upgraded and supplemented the talent of its accounting staff throughout the organization by hiring and promoting qualified candidates, including a number of external candidates. Through management's review of the accounting personnel and additions to the accounting staff, management has achieved a general control objective related to the material weakness. 57 2. The Company did not maintain effective controls over the accounting for income taxes, including income taxes payable, deferred income tax assets and liabilities and the related income tax provision. Specifically, the Company did not have effective controls over the reconciliation between the tax and financial reporting bases of the Company's assets and liabilities with its deferred income tax assets and liabilities. Additionally, there was a lack of oversight and review over the income taxes payable, deferred income tax assets and liabilities and the related income tax provision accounts by accounting personnel with appropriate expertise in income tax accounting. This control deficiency resulted in an audit adjustment to the fourth quarter 2004 consolidated financial statements. Additionally, this control deficiency could result in a misstatement of the income taxes payable, deferred income tax assets and liabilities and the related income tax provision accounts that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constituted a material weakness. To address this material weakness, the Company has engaged an outside tax consultant, other than from the Company's independent registered public accounting firm, and has implemented an ongoing training program to enhance the capabilities of its internal tax personnel. 3. The Company did not maintain effective controls over certain contract revenues, contract costs in excess of billings and accounts receivable. Specifically, the Company did not have effective controls over the accounting for non-routine change orders to customer contracts to ensure that change orders were accounted for in accordance with GAAP. This control deficiency resulted in an audit adjustment to the fourth quarter 2004 consolidated financial statements. Additionally, this control deficiency could result in a misstatement of the contract revenues, contract costs in excess of billings and accounts receivable accounts that would result in a material misstatement to annual or interim financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constituted a material weakness. To address this material weakness, the Company has instituted formal new procedures requiring the accounting for all significant, non-routine transactions to be documented and submitted to the Corporate Accounting Group for approval. CompuDyne management has implemented controls to achieve the control objective related to the material weakness; therefore, we have concluded that the material weakness related to Ineffective Controls over the Accounting for Non-Routine Change Orders has been fully remediated and no longer is considered to represent an internal control deficiency. ITEM 9B. OTHER INFORMATION None. 58 PART III Information required by Items 10, 11, 12, 13 and 14 about CompuDyne is incorporated herein by reference from the definitive proxy statement of CompuDyne to be filed with the SEC within 120 days following the end of the fiscal year ended December 31, 2005. PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements (1) Index to Financial Statements Report of Independent Registered Public Accounting Firm - Aronson & Company Report of Independent Registered Public Accounting Firm - PricewaterhouseCoopers LLP Report of Independent Registered Public Accounting Firm - Deloitte & Touche LLP Consolidated Balance Sheets at December 31, 2005 and 2004 Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003 Consolidated Statement of Changes in Shareholders' Equity for the years ended December 31, 2005, 2004 and 2003 Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003 Notes to Consolidated Financial Statements (2) Schedule II - Schedule of valuation and qualifying accounts (b) Exhibits The Exhibits listed on the index below are filed as a part of this Annual Report. 59 SCHEDULE II COMPUDYNE CORPORATION AND SUBSIDIARIES SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 2005, 2004, and 2003 ($ in thousands)
Balance at Charged to Balance Beginning Costs and At End Description Of Period Expenses Deduction Of Period ----------- --------- -------- --------- --------- Year Ended December 31, 2005 Reserve and allowances deducted from asset accounts: Reserve for excess and slow moving inventory $ 1,362 315 (306) $ 1,371 Reserve for accounts receivable $ 1,919 699 (297) $ 2,321 Deferred tax asset valuation allowance $ 1,858 4,268 - $ 6,126 Year Ended December 31, 2004 Reserve and allowances deducted from asset accounts: Reserve for excess and slow moving inventory $ 840 649 (127) $ 1,362 Reserve for accounts receivable $ 1,252 1,153 (486) $ 1,919 Deferred tax asset valuation allowance $ - 1,858 - $ 1,858 Year Ended December 31, 2003 Reserve and allowances deducted from asset accounts: Reserve for excess and slow moving inventory $ 642 367 (169) $ 840 Reserve for accounts receivable $ 1,173 996 (917) $ 1,252
60 COMPUDYNE CORPORATION INDEX TO EXHIBITS (Item 15(b)) 2(A). Agreement and Plan of Merger dated May 8, 1996, herein incorporated by reference to Exhibit 3(B) to Registrant's 10-K filed March 31, 1997. 3(A). Articles of Incorporation of CompuDyne Corporation filed with the Secretary of State of the State of Nevada on May 8, 1996, herein incorporated by reference to Registrant's Proxy Statement dated May 13, 1996 for its 1996 Annual Meeting of Shareholders. 3(B). Amendment to the Articles of Incorporation of CompuDyne Corporation increasing the number of authorized common shares filed with the Secretary of the State of Nevada on February 16, 2001, herein incorporated by reference to Exhibit 3(B) to the Registrant's 10-K filed March 27, 2001. 3(C). By-Laws, as amended through January 28, 1997 and as presently in effect, herein incorporated by reference to Exhibit 3(C) to Registrant's 10-K filed March 31, 1997. 10(A). CompuDyne Corporation 1996 Stock Incentive Compensation Plan for Employees, herein incorporated by reference to Registrant's Proxy Statement dated July 17, 2001 for its 2001 Annual Meeting of Shareholders. 10(B). Credit Agreement dated November 16, 2001 by and among CompuDyne Corporation, its subsidiaries, certain participating lenders and PNC Bank, National Association in its capacity as agent for the lenders, herein incorporated by reference to Exhibit 10 (b) to Registrant's 8-K filed November 21, 2001. 10(C)(1). Amended and Restated Credit Agreement dated March 31, 2004 by and among CompuDyne Corporation and its subsidiaries, certain participating lenders and PNC Bank, National Association, in its capacity as agent for the lenders, herein incorporated by reference to Exhibit 3.1 to Registrant's 10-Q filed May 7, 2004. 10(C)(2). Amendment to Amended and Restated Credit Agreement dated October 29, 2004 by and among CompuDyne Corporation, its subsidiaries, certain participating lenders and PNC Bank, National Association in its capacity as agent for the lenders, herein incorporated by reference to Exhibit 10.1 to Registrant's 8-K filed on November 1, 2004. 10(C)(3). Second Amendment to Amended and Restated Credit Agreement and Amendment to Securities Pledge Agreement dated March 4, 2005 by and among CompuDyne Corporation, its subsidiaries, certain participating lenders and PNC Bank, National Association in its capacity as agent for the lenders, herein incorporated by reference to Exhibit 10.1 to registrant's 8-K filed on March 7, 2005. 10(C)(4). Third Amendment to Amended and Restated Credit Agreement dated November 17, 2005 by and among CompuDyne Corporation and PNC Bank, National Association, and Sixth Amended and Restated Revolving Note dated November 17, 2005, herein incorporated by reference to Exhibits 10.1 and 10.2 to Registrant's 8-K filed on November 17, 2005. 10(C)(5). Second Amended and Restated Revolving Credit and Security Agreement dated December 19, 2005 by and among CompuDyne Corporation, its subsidiaries and PNC Bank, National Association, herein incorporated by reference to Exhibit 10.1 to Registrant's 8-K filed on December 19, 2005. 10(D). 2005 Employment Agreement between CompuDyne Corporation and Mr. Daniel Crawford, herein incorporated by reference, filed on Form 8-K, October 27, 2004. 10(E). Transition Agreement by and among CompuDyne Corporation, Norment Security Group, Inc., and Mr. Jon Lucynski, herein incorporated by reference, filed on Form 8-K, January 26, 2005. 10(F). 1996 Stock Non-Employee Director Plan, herein incorporated by reference to Registrant's Proxy Statement dated April 18, 1997 for its 1997 Annual Meeting of Shareholders. 61 10(G). Stock Option Agreement dated August 21, 1995 by and between Martin A. Roenigk and CompuDyne Corporation, herein incorporated by reference to Exhibit (4.5) to Registrant's Form 8-K filed September 5, 1995. 10(H).* Compensatory Arrangements. 10(I). 2005 Stock Option Plan for Non-Employee Directors, 2005 Stock Incentive Compensation Plan for Employees, Amendment to the 1996 Stock Option Plan for Non-Employee Directors, and Amendment to the 1996 Stock Incentive Compensation Plan for Employees, herein incorporated by reference to Registrant's Proxy Statement dated April 29, 2005 for its 2005 Annual Meeting of Shareholders. 10(J). CompuDyne Corporation Retention Plan for Selected Employees, herein incorporated by reference to Exhibit 10.1 to Registrant's 8-K filed July 1, 2005. 21.* Subsidiaries of the Registrant. 23.1* Consent of Independent Registered Public Accounting Firm - Aronson & Company. 23.2* Consent of Independent Registered Public Accounting Firm - PricewaterhouseCoopers LLP. 23.3* Consent of Independent Registered Public Accounting Firm - Deloitte & Touche LLP. 31.1* Certification of Chief Executive Officer pursuant to Rule 13(a)-14(a) or 15(d)-14(a). 31.2* Certification of Chief Financial Officer pursuant to Rule 13(a)-14(a) or 15(d)-14(a). 32.1* Certification Pursuant To 18 U.S.C. Section 1350 As Adopted Pursuant To Section 906 of The Sarbanes-Oxley Act Of 2002, for Mr. Martin Roenigk. 32.2* Certification Pursuant To 18 U.S.C. Section 1350 As Adopted Pursuant To Section 906 of The Sarbanes-Oxley Act Of 2002, for Mr. Geoffrey F. Feidelberg. * Filed herewith. 62 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. COMPUDYNE CORPORATION --------------------- (Registrant) By: --------------------------------------- Martin Roenigk Chief Executive Officer By: --------------------------------------- Geoffrey F. Feidelberg Dated: March 27, 2006 Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 27, 2006.
---------------------- Director, Chairman, President ------------------------- Director Martin A. Roenigk and Chief Executive Officer David W. Clark, Jr. ---------------------- Director ------------------------- Director John H. Gutfreund Ronald J. Angelone ---------------------- Director ------------------------- Director Albert R. Dowden Wade B. Houk ---------------------- Director, Chief Financial Officer ------------------------- Director Geoffrey F. Feidelberg and Treasurer John Michael McConnell
63