10-K 1 a5373277.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, 2006 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 (410) 224-4415 (Address of principal executive offices (Telephone number, including zip code) including area code) 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 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 |_| NO |X| 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. [ ] 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| 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, 2006 was approximately $42.0 million. (see ITEM 5) As of April 4, 2007, a total of 8,437,915 shares of Common Stock, $.75 par value, were outstanding. Documents incorporated by reference: Portions of the Proxy Statement relating to the 2007 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 20 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. Integrated Electronic Systems The Integrated Electronic Systems segment consists of our subsidiaries, CompuDyne-Integrated Electronics Division, LLC and Signami DCS, LLC. 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: 2 o Access Control and Biometric Applications 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 o Signals Intelligence Gathering Technology 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 collecting and monitoring, providing the U.S. intelligence community and U.S. allies with real time intelligence for strategic and tactical decision making. o Modular, One-Box, Signals Intercept and Analysis Hardware/Software o Intelligence Gathering Solutions o Monitoring/Recording/First Alerts o Worldwide Deployable: Mobile or Fixed-Station Configurations o Installation/Integration/Training Public Safety and Justice The Public Safety and Justice segment consists of Tiburon, Inc. ("Tiburon"), CorrLogic, LLC, its 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. 3 Key products and services of the Public Safety and Justice segment include: 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 Court Administrative Software 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 $6.5 million, $7.8 million and $7.1 million of research and development expenses in the years ended December 31, 2006, 2005 and 2004, 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 $4.0-$4.5 billion will be spent in 2007 on correctional facility construction, of which between 10% and 15% typically relates to security equipment and security electronics, which are the markets that we currently serve. Our modular cell product, Maxwall, generally addresses an additional 10% to 15% potential 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. We are one of the largest suppliers of physical and electronic security to the corrections industry however, we have many smaller 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. The Public Safety and Justice segment competes in a market where the annual new solution spending is approximately $2.0 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. Few 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. 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 and other Federal Agencies. 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. Our Company Code of Ethics can be found on our website at www.CompuDyne.com. 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 Management Outlook located in Item 7 for a discussion of backlogs. At December 31, 2006, the Company had approximately 707 permanent employees. Of the permanent employees, approximately 62 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, 2006, 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 accounted for approximately 60% of our business in the fiscal year ended December 31, 2006. 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. 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 30% of our revenues in the fiscal year ended December 31, 2006. The U.S. Government funds these contracts in annual increments, and the 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. 5 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 60% of ISS' revenue has come from jobs where payment and performance bonds are required and for PS&J, 19% of its revenue 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 secure certain of its projects. As of December 31, 2006, the Company was required to provide collateral to its primary bonding company which it did by placing cash, invested in a money market mutual fund, as collateral in the amount of $7.5 million. 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 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. The Company also conducts internal investigations from time to time regarding potential violations of regulations or Company Policies, and a recent investigation found violations resulting in disciplinary actions being taken by the Company. 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 would 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. 6 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 affect 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 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. 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 were not required to comply with Section 404 for 2005 and 2006, 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, the 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"). 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. 7 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 retire 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, the ability to secure payment and performance bonds, 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 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 and 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, inability 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 ("SOX"), 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. 8 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, 2006 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, North Carolina - 5,775 square feet and Arizona - 5,570 square feet. At December 31, 2006 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, 2006 the Integrated Electronic Systems segment leased primary facilities for engineering, assembly and administration in Maryland - 16,001 square feet. At December 31, 2006 the Public Safety and Justice segment leased primary facilities for engineering and administration including California - 33,249 square feet, Texas - 10,247 square feet, United Kingdom - 6,663 square feet, Oregon - 5,669 square feet, Utah - 5,422 square feet, Colorado - 4,474 square feet, Washington - 4,000 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 Company believes that the current properties are 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. In addition to claims with prime contractors, the Company may also make claims against customers and customers may make claims against the Company. During 2006 we received a letter from a client of our Public Safety and Justice segment indicating their intent to terminate their contract with us for cause. The letter alleges that we failed to complete the project under the terms of the agreement and the applications implemented failed to meet the functionality requirements of the agreement. The customer is seeking a refund of approximately $400 thousand previously paid by them. Costs in excess of billings of approximately $600 thousand related to this project remain as an asset on our books and records as of December 31, 2006. The segment disagrees with the client's views. While the ultimate outcome cannot be predicted, the Company intends to vigorously pursue this matter. The Company has established an accrual for this matter which is included in accounts payable and accrued liabilities on the balance sheet. 9 On November 21, 2006, CompuDyne Corporation ("CompuDyne") and William Blair Mezzanine Capital Fund II, L.P. ("Blair") entered into a Release and Settlement Agreement with Friedman, Billings, Ramsey Group, Inc. ("FBR"), by which FBR agreed to pay $4.5 million to CompuDyne and Blair, CompuDyne and Blair agreed to release FBR, and FBR has agreed to release CompuDyne and Blair, from any and all causes of action arising out of or relating to, among other things, an offering of CompuDyne common stock in 2001 for which FBR acted as lead underwriter and financial advisor. Blair is former shareholder of CompuDyne which also sold shares in the 2001 offering. After legal and other expenses and payment of Blair's share of the settlement, the net amount recorded by CompuDyne was approximately $2.7 million which is recorded in additional paid-in capital. The Company has learned that the National Association of Securities Dealers ("NASD") and other regulatory bodies are seeking sanctions against certain purchasers of the Company's common stock in its 2001 PIPE transaction. The Company is investigating these matters, and has filed lawsuits against certain purchasers. The Company is currently attempting to resolve these matters. 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. The Company also conducts internal investigations from time to time regarding potential violations of regulations or Company Policies; a recent investigation found violations resulting in disciplinary actions being taken by the Company. 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, debarment or fines could have a material adverse effect on the Company. In connection with the acquisition of the assets of Signami, LLC made by the Company in July 2006, the Company issued 93,334 shares to the sellers for which it guaranteed for a 2 year period that upon sale of these securities, the Company would guarantee a price of $7.50 per share for these shares. This period is extended for members precluded from selling their shares due to statutory reasons. Included in other long term liabilities at December 31, 2006 is approximately $86 thousand representing the fair value of this liability. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 10 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES CompuDyne Common Stock is quoted on the Nasdaq National Market, under the symbol "CDCY." There were 1,367 common shareholders of record as of April 4, 2007. The following table sets forth the high and low sales for CompuDyne Common Stock as quoted on the Nasdaq National Market. 2006 2005 ---- ---- Quarter Ended High Low High Low ------------- -------------------- ------------------- March 31 $ 7.60 $ 6.00 $ 7.80 $ 4.65 June 30 $ 7.44 $ 6.06 $ 8.00 $ 5.03 September 30 $ 6.78 $ 4.94 $ 9.40 $ 5.27 December 31 $ 6.98 $ 5.56 $ 6.75 $ 4.74 The Company did not pay any dividends on its common stock during the years ended December 31, 2006 and 2005, 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. Securities Authorized For Issuance Under Equity Compensation Plans See Item 12 of Part III. Comparative Stock Performance COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN* AMONG COMPUDYNE CORPORATION, THE NASDAQ STOCK MARKET (U.S.) INDEX, AND BOTH CURRENT AND PRIOR PEER GROUPS
12/01 12/02 12/03 12/04 12/05 12/06 CompuDyne Corporation 100.00 35.94 58.24 42.63 35.54 37.60 NASDAQ Composite 100.00 69.66 99.71 113.79 114.47 124.20 New Peer Group 100.00 71.00 76.77 79.59 76.28 74.36 Old Peer Group 100.00 49.66 84.18 146.82 128.78 155.79 * $100 invested on 12/31/01 in stock or index-including reinvestment of dividends Fiscal year ending December 31.
The above graph compares the cumulative total stockholder return on our common stock for the last five fiscal years with the cumulative total return on the Nasdaq Composite Index. This graph assumes the investment of $100 on December 31, 2001 in our common stock and the index listed above, and assumes dividends are reinvested. We have not paid any dividends on our common stock and no dividends are included in the representation of our performance. The stock price performance shown in the below graph is not necessarily indicative of future price performance. Measurement points are the last trading day of the fiscal years ended December 31, 2002, 2003, 2004, 2005 and 2006. 11 The graph and table above are not "soliciting material," are not deemed filed with the SEC and are not to be incorporated by reference in any filing of ours under the Securities Act of 1933, as amended, or the Exchange Act, whether made before or after the date hereof and irrespective of any general incorporation language in any such filing. The Company is using a new peer group that is more similar in market capitalization to CompuDyne than the previous peer group. Previous Peer Group New Peer Group ------------------- -------------- Armor Holdings (AH) OSI Systems Inc. (OSIS) Magal Security Systems(MAGS) Lasercard Corporation (LCRD) Henry Bros. Electronics, Inc. (HBE) ITEM 6. SELECTED FINANCIAL DATA The following is a consolidated summary of operations of CompuDyne and its subsidiaries for the years ended December 31, 2006, 2005, 2004, 2003, and 2002. 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 ------------------------------------------------------------------ 2006(a) 2005(b) 2004 2003 2002(c) ---------- ---------- ---------- ---------- ---------- Total revenues $ 147,462 $ 141,650 $ 142,782 $ 193,263 $ 155,556 ========== ========== ========== ========== ========== Gross profit $ 47,867 $ 42,539 $ 37,678 $ 46,396 $ 34,816 Selling, general and administrative expenses 38,261 40,567 36,219 32,305 25,785 Research and development 7,294 8,685 7,755 7,374 4,916 Impairment of goodwill and other intangibles 16,141 - 1,826 - - ---------- ---------- ---------- ---------- ---------- Operating (loss) income $ (13,829) $ (6,713) $ (8,122) $ 6,717 $ 4,115 ========== ========== ========== ========== ========== Interest expense, net of interest income $ 2,105 $ 2,233 $ 2,289 $ 1,051 $ 1,394 ========== ========== ========== ========== ========== Net (loss) income $ (14,993) $ (8,691) $ (8,198) $ 3,408 $ 1,814 ========== ========== ========== ========== ========== (Loss) earnings per share (d): Basic ----- (Loss) earnings per common share $ (1.82) $ (1.07) $ (1.01) $ .43 $ .24 ========== ========== ========== ========== ========== Weighted average number of common shares outstanding 8,256 8,129 8,136 7,895 7,456 ========== ========== ========== ========== ========== Diluted ------- (Loss) earnings per common share $ (1.82) $ (1.07) $ (1.01) $ .42 $ .23 ========== ========== ========== ========== ========== Weighted average number of common shares and equivalents 8,256 8,129 8,136 8,158 7,940 ========== ========== ========== ========== ========== Total assets $ 103,950 $ 126,692 $ 132,891 $ 115,732 $ 120,804 ========== ========== ========== ========== ========== Long-term debt $ 42,617 $ 42,870 $ 43,123 $ 17,658 $ 27,510 ========== ========== ========== ========== ========== Total shareholders' equity $ 26,839 $ 36,422 $ 45,831 $ 52,927 $ 49,204 ========== ========== ========== ========== ==========
Reclassifications - Certain prior year amounts have been reclassified to conform with the current year's presentation. Notes: (a) Includes operations from the acquired assets of Signami LLC, from July 20, 2006, the date of acquisition. (b) Includes operations of Xanalys Corporation from August 24, 2005, the date of acquisition. (c) Includes operations of Tiburon, Inc. from May 2, 2002, the date of acquisition. (d) No dividends have been paid on the Company's Common Stock during the above periods. 12 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 television, 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. 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 segment consists of CompuDyne-Integrated Electronics Division, LLC and the newly-formed Signami DCS, 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. In July 2006, the Company acquired the assets and certain liabilities of Signami, LLC, a producer of software and hardware systems for signals intelligence gathering. Together with the Data Control Systems ("DCS") division of IES, a new business was established and is going to market under the name Signami DCS. 13 The Public Safety and Justice segment consists of Tiburon, Inc., CorrLogic, LLC, Xanalys Corporation ("Xanalys"), 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 that improve the efficiency and accuracy of correctional facility operations. 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. Backlog was approximately $117.3 million at December 31, 2006, as shown in the following table: Public Institutional Integrated Safety Security Attack Electronic 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 December 31, 2005 $ 58,128 $ 28,802 $ 7,503 $ 53,705 $ 148,138 March 31, 2006 $ 57,030 $ 20,961 $ 6,590 $ 43,874 $ 128,455 June 30, 2006 $ 51,173 $ 13,593 $ 7,393 $ 39,351 $ 111,510 September 30, 2006 $ 65,489 $ 7,991 $ 8,137 $ 40,088 $ 121,705 December 31, 2006 $ 64,687 $ 5,686 $ 7,902 $ 39,067 $ 117,342 During the fourth quarter of 2005 the Attack Protection segment was awarded a significant contract to provide its products to a large embassy project. The execution of this contract is complete as of December 31, 2006. Since the award of this contract, the Norshield component of the Attack Protection segment has had limited success in winning new contracts due to competitive factors which has resulted in a significant decline in the backlog of this segment. We are actively pursuing non-embassy work in an effort to generate awards incremental to our embassy work. The overall decline in backlog in 2006 could lead to a potential decline in future quarterly revenues. Historically, approximately 90% of our revenues were generated from sources where the ultimate client is a federal, state or local government unit. During the last few years, state and local budgets, which we are dependent on for approximately 60% 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 certain 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 18% of our revenue in 2006 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 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. 14 Year Ended December 31, 2006 ----------------------------------------------- (in thousands) One-time Recurring Revenue % Revenue % Total ---------- ------ --------- ------ ---------- Institutional Security Systems $ 43,488 29.5 $ 4,777 3.2 $ 48,265 Attack Protection 40,241 27.3 - - 40,241 Integrated Electronic Systems 9,993 6.8 3,901 2.7 13,894 Public Safety and Justice 27,066 18.3 17,996 12.2 45,062 ---------- ------ --------- ------ ---------- Total $ 120,788 81.9 $ 26,674 18.1 $ 147,462 ========== ====== ========= ====== ========== 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 hope 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. In addition, our Public Safety and Justice segment has and is continuing to undergo expense restructuring including right sizing its organization in light of its relatively low level of backlog. The Attack Protection segment also has a very low backlog level which will necessitate us to reevaluate and reduce our expense structure. 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. 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 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. 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 for its first fiscal year ending on or after December 15, 2007. 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. CompuDyne's aggregate worldwide market value as June 30, 2006, the last business day of CompuDyne's second fiscal quarter, was also less than $50 million; as such CompuDyne continued to be classified as a non-accelerated filer for the year ended December 31, 2006. 15 Prior to the issuance of 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, was not required to comply with Section 404 for the years ended December 31, 2005 and 2006. Results of Operations YEARS ENDED DECEMBER 31, 2006 and 2005 Revenues. The Company had revenues of $147.5 million and $141.7 million for the years ended December 31, 2006 and December 31, 2005, respectively, representing an increase of $5.8 million or 4.1%. As discussed below, the increase occurred primarily due to higher revenues in our AP, IES and PS&J segments, offset in part by a decrease in revenues from our ISS segment. Revenues from the Institutional Security Systems segment were $48.3 million for the year ended December 31, 2006, a decrease from $60.7 million for the year ended December 31, 2005, representing a decrease of $12.4 million or 20.4%. 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 decrease in revenue experienced by this segment is largely attributable to our working on fewer projects than we did in the previous year and the delay in the start of some projects. Although backlog increased significantly during the second half of 2006, it was not at a significantly high enough level prior thereto to maintain its revenue levels. Backlog was $64.7 million and $58.1 million at December 31, 2006 and December 31, 2005, respectively. Several of ISS' recently won awards were delayed and/or not yet available to be worked on by us. 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. Since 2005, ISS has seen heightened bidding activity, particularly in the market space it serves, namely large-scale medium to maximum security prisons. Revenues from the Attack Protection segment were $40.2 million for the year ended December 31, 2006, an increase from $27.0 million for the same period of 2005, representing an increase of $13.2 million or 48.9%. During 2005 and 2006 factory utilization increased significantly. 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, 2006 the Norshield line experienced a 53.0% increase in revenues as compared to the year ended December 31, 2005, whereas the Fiber SenSys line experienced a 35.9% increase in revenues for the comparable period. The increase in revenue of $10.9 million in the Norshield line is a direct result of execution on an award of a major contract won in the fourth quarter of 2005. Execution on this contract began immediately upon award. Fiber SenSys' revenue increase is a result of the rollout of its next generation product, which until its testing was completed and accepted, at the end of the second quarter of 2006, negatively impacted revenues. During 2004, Norshield bid on fifteen new embassy projects. We were awarded seven of these embassy projects for a total contract value of $9.9 million, and lost eight embassy project bids to competitors. In 2005, we bid on seventeen embassy projects. The Company was awarded five of these projects, for a total contract value of $20.4 million, and lost four projects and one bulk bid embassy project comprising eight embassies to competitors. In 2006, eleven embassy projects were planned, seven of which have not been awarded yet. The Company was awarded two of these projects for a total contract value of $3.3 million and lost two of these 2006 projects. We believe that the increased level of new embassy construction will continue for the next several years. Revenues from Integrated Electronic Systems were $13.9 million for the year ended December 31, 2006, an increase from $10.1 million for the same period of 2005, representing an increase of $3.8 million or 37.4%. The first half of 2005 was a difficult time for IES, with a downturn in revenues and gross profit, ensuing from: (i) a delay in a large-scale installation contract pending the government's completion of a building to house the system's Command and Control Center; (ii) a reduction in an ongoing governmental integration program, resulting from the Department of Defense's base relocation and closure (BRAC) program; (iii) delays in several significant awards, because funding had been redirected to the war efforts in Iraq and Afghanistan; and (iv) a delay in the start-up of a 5-year, $25 million security contract with the Bureau of Engraving & Printing ("BEP"), due to an award protest by the predecessor contractor. IES is currently performing work under the BEP contract although due to the protest the BEP has decided to put the contract out for re-bid later in 2007. In addition, revenue from Signami since its acquisition in July 2006 of $1.4 million is included in IES's 2006 revenues. 16 Revenues from the Public Safety and Justice segment were $45.1 million for the year ended December 31, 2006, an increase from $43.9 million for the same period of 2005, representing an increase of $1.2 million or 2.7%. PS&J has been experiencing lower backlogs and has increased its focus on developing its next generation products. Beginning in the fourth quarter of 2005 and continuing through 2006, PS&J redeployed a portion of its technical staff, typically deployed in the research and development area, to work on projects and thus increase quarterly revenues. 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 have had little impact on Public Safety and Justice's revenues due to their relatively small size. Expenses. Cost of goods sold of $99.6 million for the year ended December 31, 2006 were up $0.5 million or 0.5% from $99.1 million during the same period of 2005. The larger percentage increase in sales as compared to the percentage increase in cost of goods sold resulted in an increased gross profit percentage of 32.5% for the year ended December 31, 2006, as compared to 30.0% for the year ended December 31, 2005. Cost of goods sold in the Institutional Security Systems segment of $40.9 million for the year ended December 31, 2006 were down $9.8 million or 19.4%, from $50.8 million during the same period of 2005. This decrease coupled with the related sales decrease of this segment of 20.4%, resulted in a 1.1% decrease in the gross profit percentage to 15.2% from 16.3% for the year ended December 31, 2005. The decrease in the gross profit percentage is largely a result of ISS' fixed costs now being absorbed by a smaller revenue base during the year of 2006. In addition, during the first quarter of 2005, one of this segment's customers terminated its contract for convenience, resulting in the recognition of $1.3 million in gross margin. Cost of goods sold in the Attack Protection segment of $27.2 million for the year ended December 31, 2006 increased $6.2 million or 29.9% from $20.9 million during the same period of 2005. This increase was less than the related sales increase of 48.9%, resulting in an 9.9% increase in the gross profit percentage to 32.5% from 22.6% during the year ended December 31, 2005. The principal reason for the increase in the gross profit percentage during the year ended December 31, 2006, as compared to the year ended December 31, 2005, was a shift in product mix and a significant increase in facility utilization as a result of the significant increase in sales of this segment. Cost of goods sold in the Integrated Electronic Systems segment of $10.9 million for the year ended December 31, 2006 increased $2.4 million or 28.6% from $8.5 million during the same period of 2005. This increase was largely the result of the acquisition of Signami in July 2006, whose gross margins tend to be higher than those of what this segment's historical margins had been. This increase was less than the related sales increase of this segment of 37.4%, resulting in a 5.4% increase in the gross profit percentage to 21.5% from 16.1% in the year ended December 31, 2005. Substantially all of the projects awarded in this segment are discrete projects. Cost of goods sold in the Public Safety and Justice segment of $20.6 million for the year ended December 31, 2006 was up $1.6 million or 8.7% from $19.0 million during 2005. This increase was greater than the related sales increase of this segment of 2.7%, resulting in a 2.5% decrease in the gross profit percentage to 54.3% from 56.8% in the year ended December 31, 2005. Selling, general and administrative expenses were $38.3 million for the year ended December 31, 2006, a decrease of $2.3 million or 5.7% from $40.6 million for the same period of 2005. Much of this decrease is related to costs incurred by the Company during 2005 related to compliance with Section 404 of SOX. The Company exited accelerated filer status as of December 31, 2005 and remained a non-accelerated filer in 2006. In conjunction with the acquisition of the assets of Signami, 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. December 31, December 31, 2006 2005 Life (in thousands) (in thousands) (in years) -------------- -------------- ---------- Software $ 3,064 $ 2,434 5 Non Compete Agreements 590 130 3-5 Customer Relationships 780 - 7 Other 60 60 15 -------- -------- $ 4,494 $ 2,624 ======== ======== The amortization of the above assets resulted in the Company recording amortization expense related to these assets of $673 thousand and $525 thousand for the years ended December 31, 2006 and 2005, respectively, which is included in operating expenses. 17 Research and development expenses were $7.3 million for the year ended December 31, 2006, a decrease of $1.4 million or 16.0% from $8.7 million for the year ended December 31, 2005. 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 September of each year, Tiburon hosts its annual users group conference which is attended by approximately 400 client personnel. During 2005, to be in a position to adequately demonstrate the segment's new Nextgen products, the Company diverted significant resources to its research and development effort to advance the demonstrability of its updated product offerings. As the Company's Nextgen product development effort advances towards completion, the need for research and development on its core products diminishes, which has resulted in a decrease in research and development expenditures during the year ended December 31, 2006 as compared to the year ended December 31, 2005. The impairment of goodwill and intangible assets totaled $16.1 million for the year ended December 31, 2006. 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. 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. During the fourth quarter of 2006 the Company concluded that an impairment occurred in its Public Safety and Justice segment. The Company performed its interim impairment test of the reporting unit as of October 1, 2006 and based on its valuation concluded it was necessary to write down the value of the segment's goodwill in the amount of $14.4 million. The Company reviews the carrying value of intangible assets when circumstances indicate that the carrying value may not be recoverable. During the fourth quarter of 2006 the Company concluded that an impairment had occurred in its Public Safety and Justice segment. The Company performed its impairment test of intangible assets as of October 1, 2006 and based on its valuation concluded it was necessary to write down the value of the intangible assets in the amount of $1.7 million. These valuations are performed by the Company with the assistance of an independent national valuation firm which considers market valuations, discounted cash flows and other factors when preparing the valuations. Pre-Tax Income. The Company had a pre-tax loss of $15.7 million for the year ended December 31, 2006 compared to a pre-tax loss of $8.9 million for the year ended December 31, 2005. As discussed below, the increased pre-tax loss occurred primarily due to the impairment of goodwill and other intangible asset charges at our Public Safety and Justice segment. This was partially offset by improved results in our Attack Protection segment. Pre-tax loss from the Institutional Security Systems segment was $1.3 million for the year ended December 31, 2006, a decrease from a pre-tax income of $629 thousand for the year ended December 31, 2005. This decrease was largely a result of this segment's sales decline. Pre-tax income from the Attack Protection segment was $4.7 million for the year ended December 31, 2006, an improvement from the $2.3 million pre-tax loss for the year ended December 31, 2005. This increase in pre-tax income for this segment is attributable to the significant increase in this segment's revenues, amplified by the fact that products with higher margins were sold during 2006 as compared to 2005. Pre-tax income from the Integrated Electronic Systems segment was $985 thousand for the year ended December 31, 2006, an increase from a $431 thousand pre-tax income for the year ended December 31, 2005. This increase in pre-tax income is a result of the increased revenue generated by this segment in 2006 as compared to 2005, which includes revenues from the new signals intercept business acquired by Integrated Electronic Systems during the third quarter of 2006, which contributed revenues with higher margins to this segment. Pre-tax loss from the Public Safety and Justice segment was $18.0 million for the year ended December 31, 2006 which included a goodwill impairment charge of $14.4 million and an intangible asset impairment charge of $1.7 million. This segment is making a significant investment in advancing its products using a Microsoft.net platform. As a result of this undertaking, which has been previously expensed, reported earnings have been adversely affected. This compares to a $2.9 million pre-tax loss for the year ended December 31, 2005. This net improvement prior to the impairment charges in this segment's pre-tax loss, is largely a result of a significant reduction in costs including headcount by this segment in its effort to return to profitability. Pre-tax loss at the Corporate level was $2.1 million for the year ended December 31, 2006 as compared to a pre-tax loss of $4.7 million for the year ended December 31, 2005. During 2005, the Company incurred significant costs to comply with Section 404 of the Sarbanes Oxley Act, which the Company was not required to incur in 2006 having exited accelerated filing status in 2005. Interest expense was $3.3 million and $3.1 million for the years ended December 31, 2006 and December 31, 2005, respectively. The following table compares the weighted average of the Company's year ended December 31, 2006 and 2005 interest bearing borrowings, which includes bank letters of credit fees for the industrial revenue bonds, and the related rates charged thereon: 18 Monthly Weighted Monthly Weighted Average - 2006 Average - 2005 Amount Amount (in thousands) Rate (in thousands) Rate -------------- ---- -------------- ---- Industrial revenue bonds $ 3,319 6.3% $ 3,722 3.7% Subordinated borrowings $ 40,250 6.3% $ 40,250 6.3% Swap hedge agreement $ - - $ 1,015 1.4% The Company also incurred letter of credit fees, in addition to those related to the industrial revenue bonds, of $141 thousand and $26 thousand for the years ended December 31, 2006 and 2005, respectively. In addition the Company recorded the following non-cash interest expense, in thousands: 2006 2005 Amortization and write-off ------ ------ of deferred financing charges $ 329 $ 283 Other income benefited during 2006 by receipt of $161 thousand in a legal settlement by the Attack Protection segment. Taxes on Income. The effective tax rate was a benefit of 4.7% for the year ended December 31, 2006 and the effective tax rate was a benefit of 2.4% for the year ended December 31, 2005. The Company has decided to provide a valuation allowance against its deferred tax assets, as it has determined that due to the Company's accumulated deficit resulting from recent prior year losses there is uncertainty as to whether it is more likely than not the assets will be realized. The Company had Federal net operating loss carry forwards for financial accounting purposes of $6.5 million at December 31, 2006. Net Income (Loss). The Company reported a net loss of $15.0 million for the year ended December 31, 2006 and a net loss of $8.7 million for the year ended December 31, 2005. Diluted loss per share was $1.82 for the year ended December 31, 2006 and a loss of $1.07 for the year ended December 31, 2005. The weighted average number of common shares outstanding and equivalents used in computing earnings per share was 8.3 million and 8.1 million for the years ended December 31, 2006 and 2005, respectively. 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 sought significant, heightened bidding activity, particularly in the market space it serves, namely large-scale medium to maximum security prisons. This increased bidding activity was 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, 19 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 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 was 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 was 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 20 not function as required by the contract specifications. ISS has incurred 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 hard line 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 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. 21 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 of 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 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. 22 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. 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 to retire its 2011 Notes. 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, 2006, the Company had working capital of $31.0 million compared with $35.3 million as of December 31, 2005. Net cash provided by operating activities was $6.3 million during the year ended December 31, 2006 versus $3.6 million used in operating activities during the year ended December 31, 2005. The largest component of cash provided by operating activities was a decrease in accounts receivable of $14.2 million, which was partially offset by a decrease in accounts payable and accrued liabilities of $8.9 million. Net cash used in investing activities was $0.3 million for the year ended December 31, 2006 compared to net cash provided of $6.5 million in the year ended December 31, 2005. In the year ended December 31, 2006, the net of marketable securities bought and redeemed was an increase of cash of $2.5 million. In the year ended December 31, 2005 the net redemption of marketable securities was $8.0 million. Net cash used in financing activities amounted to $5.2 million for the year ended December 31, 2006 compared with net cash used in financing activities of $1.1 million in the year ended December 31, 2005. The following table summarizes contractual obligations consisting of total notes payable, related interest, non-cancelable operating lease obligations and purchase obligations of the Company as of December 31, 2006 and the payments due by period, in thousands. Interest on Non-Cancelable Notes Contractual Operating Purchase Payable Obligations Leases Obligations --------- ----------- -------------- ----------- December 31: 2007 $ 440 $ 2,632 $ 3,203 $ 8,363 2008 440 2,614 2,670 - 2009 440 2,596 2,179 - 2010 440 2,578 1,747 - 2011 40,690 147 1,356 - Thereafter 925 376 381 - --------- --------- --------- -------- Totals $ 43,375 $ 10,943 $ 11,536 $ 8,363 ========= ========= ========= ======== 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. On November 21, 2006, CompuDyne Corporation ("CompuDyne") and William Blair Mezzanine Capital Fund II, L.P. ("Blair") entered into a Release and Settlement Agreement with Friedman, Billings, Ramsey Group, Inc. ("FBR"), by which FBR agreed to pay $4.5 million to CompuDyne and Blair, CompuDyne and Blair agreed to release FBR, and FBR agreed to release CompuDyne and Blair, from any and all causes of action arising out of or relating to, among other things, an offering of CompuDyne common stock in 2001 for which FBR acted as lead underwriter and financial advisor. Blair is former shareholder of CompuDyne which also sold shares in the 2001 offering. After legal and other expenses and payment of Blair's share of the settlement, the net amount recorded by CompuDyne was approximately $2.7 million which is recorded in additional paid-in capital. 23 On December 19, 2005, the Company and its bank entered into a Second Amended and Restated Revolving Credit and Security Agreement (the "Credit Agreement"). The Credit Agreement amended and restated the Company's Amended and Restated Credit Agreement dated March 31, 2004. In connection with the execution of the Credit Agreement, the Company provided the bank with collateral that includes all receivables, equipment, general intangibles, inventories, investment property, real property and a security interest in subsidiary stock. The Credit Agreement allows the Company to obtain revolving advances in a principle amount of up to $20 million. Revolving advances are limited by a borrowing base formula based upon the value of the Company's receivables, inventories, 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 Credit Agreement is limited to $18 million. The Credit Agreement matures on December 18, 2008. Revolving advances under the 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 percent. For letters of credit, the Company pays an amount equal to the average daily face amount of each outstanding letter of credit multiplied by two 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 thousand 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 million 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 thousand per month and a collateral evaluation fee as required. The 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 million. Commencing with the fiscal quarter ended June 30, 2006, the Company is required to maintain a fixed charge coverage ratio of at least 1.1 to 1.0. The Company was in compliance with this ratio during the applicable period in 2006. On July 14, 2006, the Company and its banks entered into a First Amendment to Second Amended and Restated Revolving Credit and Security Agreement (the "First Amendment"). The First Amendment amended the Credit Agreement to (i) modify the borrowing base, (ii) permit any Borrower to guaranty certain indebtedness of any other Borrower, (iii) increase the maximum limit of rental payments for non-capitalized leases from $3 million to $4 million per fiscal year, (iv) permit the Company, subject to certain conditions, to repurchase or redeem up to $2.0 million of the Company's 6.25% Convertible Subordinated Notes due January 15, 2011 and (v) consent to an acquisition by a newly formed indirect subsidiary of the Company pursuant to an asset purchase transaction. On December 5, 2006, the Company and its banks entered into a Second Amendment to Second Amended and Restated Revolving Credit Security Agreement (the "Second Amendment"). The Second Amendment amended the Credit Agreement to reduce the interest rate being charged on Eurodollar loans and the letter of credit fee by 0.5%. On March 28, 2007, the Company and its banks entered into a Third Amendment to Second Amended and Restated Revolving Credit and Security Agreement (the "Third Amendment"). The Third Amendment amended the Credit Agreement by (i) amending the definition of EBITDA to exclude from the calculation of EBITDA any non-cash impairment charges against goodwill and other intangible assets incurred by the Company's subsidiary, Tiburon, Inc., during the fiscal quarter ended December 31, 2006, (ii) increasing the aggregate maximum permissible amount of capital expenditures in any fiscal year to $2.5 million; (iii) permitting the Company, subject to certain conditions, to purchase or redeem up to $8 million of the Company's 6.25% Convertible Subordinated Notes due January 15, 2011, (iv) permitting the Company to deliver its audited financials for the fiscal year ended December 31, 2006 by no later than April 30, 2007 and (v) permitting the Company's annual projected operating budget and cash flow projections be broken down on a quarterly basis versus a monthly basis. The Company's total outstanding borrowings at December 31, 2006 amounted to approximately $43.4 million, less broker's discounts in the amount of $0.8 million. The 2011 Notes accounted for $39.5 million, net of broker's discounts, of these borrowings. The remaining amount of $3.1 million resulted from borrowings at variable rates and consisted of two industrial revenue bonds outstanding in the amounts of $1.1 million and $2.0 million. The average interest rate charged to the Company at December 31, 2006 for its industrial revenue bonds was 4.1%. The variable interest rate for these borrowings fluctuated between 3.1% and 4.2% during the year ended December 31, 2006 based on weekly market conditions. These bonds are fully collateralized by bank letters of credit issued under the Credit 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. 24 At December 31, 2006 the Company had $16.8 million of unused availability under the Second Restated Credit Agreement, subject to the availability of collateral under its line of credit. 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 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 recorded significant losses in fiscal 2004, 2005, and 2006. We recognize that sustaining profitability is a critical objective which the Company must attain. The Company continued to have a significant amount of cash and marketable securities on its balance sheet at December 31, 2006, however, the Company must sustain its 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 had an adverse impact on our ability to raise capital and the cost of raising capital. This consequence lapsed on June 27, 2006. Off-Balance Sheet Arrangements Other than the Company's letters of credit, which amounted to $3.2 million at December 31, 2006, the Company has no other material off balance sheet liabilities. Additional Considerations Bid Bonds and Payment and Performance Bonds 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 60% of ISS' revenue has come from jobs where payment and performance bonds are required and for PS&J, 19% of its revenue 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 secure certain of its projects. As of December 31, 2006, the Company was required to provide collateral to its primary bonding company which it did by placing cash, invested in a money market mutual fund, as collateral in the amount of $7.5 million. 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. 25 Cost Containment Due to current economic conditions, the Company's losses in 2004, 2005 and 2006, 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 significant 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 $117.3 million at December 31, 2006. This was a decrease of 20.8% from the Company's December 31, 2005 backlog of $148.1 million. The break down of the Company's backlog by segment is as follows, in thousands: December 31, December 31, 2006 2005 ------------ ------------ Institutional Security Systems $ 64,687 $ 58,128 Attack Protection 5,686 28,802 Integrated Electronic Systems 7,902 7,503 Public Safety and Justice 39,067 53,705 ------------ ------------ Total $ 117,342 $ 148,138 ============ ============ The decline in backlog could lead to a potential decline in future quarterly revenues. Included in the backlog of the ISS, AP and PS&J segments at December 31, 2006 is $19.6 million, $2.1 million and $3.7 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. 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. A majority 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 total revenue, cost of goods sold, accounts receivable, contract costs in excess of billings and billings in excess of contract costs incurred. Revenues from these contracts are classified as contract revenues earned on the statement of operations. Change orders are modifications of an original contract that effectively change the provisions of the contract without adding new provisions. They may be initiated by either us as the contactor, or by the customer, and include changes in specifications or design, method or manner of performance, facilities, equipment, materials, site, and period for completion of the work. Change orders approved by the customer and us regarding both scope and price are reflected as an adjustment to the revenue and costs of the contract. Costs attributable to unpriced change orders are treated as costs of contract performance in the period in which the costs are incurred if it is not probable that the costs will be recovered through a change in the contract price. When it is probable that the costs will be recovered through a change in the contract price, the costs are deferred until the parties have agreed on the change in contract price. Change orders that are in dispute or are unapproved in regard to both scope and price, are evaluated as claims. Customer termination of contracts result in the Company's ceasing of any further revenue recognition and any existing assets at that date are evaluated for collectibility under the contractual terms. 26 Revenues for support and maintenance contracts are deferred and recognized ratably over the life of the contract. Revenues for these items are classified as maintenance revenues on the statement of operations. 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. Revenues for these items are classified as other revenues on the statement of operations. 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 recorded 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 the first quarter of 2006 is primarily the result of 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 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 $13.3 million and $4.0 million, respectively, and intangible assets subject to amortization totaled approximately $3.5 million, net, at December 31, 2006. The Company cannot predict the occurrence of events that might adversely affect these values. Stock Compensation Policy. Effective January 1, 2006, we adopted SFAS No. 123(R), "Share-Based Payment." This statement requires us to expense the fair value of grants of various stock-based compensation programs over the vesting period of the awards. We elected to adopt the "Modified Prospective Application" transition method which does not require the restatement of previously issued financial statements. Compensation expense is measured and recognized beginning in 2006 as follows: Awards granted after December 31, 2005 - Awards are measured at their fair value at date of grant. The resulting compensation expense is recognized in the consolidated statement of operations ratably over the vesting period of the award. Awards granted prior to December 31, 2005 - Awards were measured at their fair value at the date of original grant. Compensation expense associated with the unvested portion of these options at January 1, 2006 is recognized in the consolidated statement of operations ratably over the remaining vesting period. For all grants issued after December 31, 2005 the amount of recognized compensation expense is adjusted based upon an estimated forfeiture rate which is derived from historical data. 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 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 as it relates to the segments of the marketplace we serve. 27 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 Afghanistan and 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 few years the Company has experienced a more challenging marketplace than it experienced in the years prior to September 11, 2001. Market Risk 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, 2006 is approximately $3.1 million of industrial revenue bonds. Since this borrowing bears interest at variable rates, 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 February 2007, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115" ("SFAS 159"). SFAS 159 permits entities to elect to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact of SFAS 159 on its consolidated financial statements. In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans -- an amendment of FASB Statements No. 87, 88, 106 and 132(R)." This statement would require a company to (a) recognize in its statement of financial position an asset for a plan's overfunded status or a liability for a plan's underfunded status (b) measure a plan's assets and its obligations that determine its funded status as of the end of the employer's fiscal year, and (c) recognize changes in the funded status of a defined postretirement plan in the year in which the changes occur (reported in comprehensive income). The adoption of this new accounting pronouncement has not had an impact on our financial position or results of operation. The Company does not have any such plans. In September 2006, the FASB issued SFAS No 157 "Fair Value Measurements". This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. The adoption of this new accounting pronouncement has not had an impact on our financial position or results of operation. In June 2006, the FASB issued Interpretation 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109. FIN 48 describes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The guidance is effective for fiscal years beginning after December 15, 2006, which we intend to adopt during our fiscal year ending December 31, 2007. We have not yet determined the impact from adoption of this new accounting pronouncement on our financial position or results of operation. 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 did not have a material impact on our financial position, results of operations or cash flows. 28 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 industrial revenue bond borrowings. The following information summarizes our sensitivity to market risks associated with fluctuations in interest rates as of December 31, 2006. 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, 2006. 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 ------------- -------------- ------------- -------------- ------------- 2007 $ 440 4.05% $ - - 2008 440 4.05% - - 2009 440 4.05% - - 2010 440 4.05% - 2011 440 4.05% 40,250 6.25% Thereafter 925 4.05% - - -------- --------- Total $ 3,125 4.05% $ 40,250 6.25% Fair Value $ 3,125 $ 36,024 9.89% 29 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 Consolidated Balance Sheets at December 31, 2006 and 2005 Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004 Consolidated Statement of Changes in Shareholders' Equity for the years ended December 31, 2006, 2005 and 2004 Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004 Notes to Consolidated Financial Statements 30 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors and Shareholders CompuDyne Corporation Annapolis, Maryland We have audited the accompanying Consolidated Balance Sheets of CompuDyne Corporation and Subsidiaries as of December 31, 2006 and 2005 and the related Consolidated Statements of Operations, Stockholders' Equity and Cash Flows for the years then ended. Our audit also included the financial statement schedules for the years ended December 31, 2006 and 2005, listed in the index at Item 15a(2). These financial statements and financial statement schedules are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits 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 audits provide 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, 2006 and 2005, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules for the years ended December 31, 2006 and 2005, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. As discussed in Note 1 to the financial statements, on January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R) Share Based Payment. Aronson & Company Rockville, Maryland April 6, 2007 31 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of CompuDyne Corporation Annapolis, Maryland In our opinion, the consolidated statements of operations, of changes in shareholders' equity and of cash flows for the year ended December 31, 2004 present fairly, in all material respects, the results of operations and cash flows of CompuDyne Corporation and its subsidiaries 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 32 COMPUDYNE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS December 31, December 31, 2006 2005 ASSETS ------------ ------------ (dollars in thousands) Current Assets Cash and cash equivalents $ 7,740 $ 6,938 Marketable securities 8,687 11,429 Accounts receivable, net 25,534 39,625 Contract costs in excess of billings 12,031 13,764 Inventories 5,577 6,195 Prepaid expenses and other 4,595 2,809 ------------ ------------ Total Current Assets 64,164 80,760 Cash equivalents pledged 7,500 - Property, plant and equipment, net 9,630 9,962 Goodwill 13,274 26,846 Other intangible assets, net 7,428 8,221 Other 1,954 903 ------------ ------------ Total Assets $ 103,950 $ 126,692 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY Current Liabilities Accounts payable and accrued liabilities $ 14,155 $ 23,030 Billings in excess of contract costs incurred 9,221 13,847 Deferred revenue 9,305 8,094 Current portion of notes payable 440 440 ------------ ------------ Total Current Liabilities 33,121 45,411 Notes payable 2,685 3,125 Convertible subordinated notes payable, net 39,492 39,305 Deferred tax liabilities 1,425 2,060 Other 388 369 ------------ ------------ Total Liabilities 77,111 90,270 ------------ ------------ 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, 2006 and December 31, 2005; 9,293,637 and 8,950,356 shares issued at December 31, 2006 and December 31, 2005, respectively 6,970 6,712 Additional paid-in-capital 50,034 44,388 Accumulated deficit (23,956) (8,963) Accumulated other comprehensive loss (331) (39) Treasury stock, at cost; 862,922 and 831,777 shares at December 31, 2006 and December 31, 2005, respectively. (5,878) (5,676) ------------ ------------ Total Shareholders' Equity 26,839 36,422 ------------ ------------ Total Liabilities and Shareholders' Equity $ 103,950 $ 126,692 ============ ============ The accompanying notes are an integral part of these financial statements. 33 COMPUDYNE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS Year Ended December 31, 2006 2005 2004 --------- --------- --------- (in thousands, except per share data) Revenues: Contract revenues earned $ 76,366 $ 89,454 $ 95,343 Maintenance revenues 26,674 21,826 19,556 Other revenues 44,422 30,370 27,883 --------- --------- --------- Total revenues 147,462 141,650 142,782 Cost of Sales 99,595 99,111 105,104 --------- --------- --------- Gross profit 47,867 42,539 37,678 Selling, general and administrative expenses 38,261 40,567 36,219 Research and development 7,294 8,685 7,755 Impairment of goodwill and other intangibles 16,141 - 1,826 --------- --------- --------- Loss from operations (13,829) (6,713) (8,122) --------- --------- --------- Other expense (income) Interest expense 3,268 3,065 3,298 Interest income (1,163) (832) (1,009) Other (income) expense (209) (40) 19 --------- --------- --------- Total other expense 1,896 2,193 2,308 --------- --------- --------- Loss before income taxes (15,725) (8,906) (10,430) Income taxes benefit (732) (215) (2,232) --------- --------- --------- Net loss $(14,993) $ (8,691) $ (8,198) ========= ========= ========= Earnings (loss) per share: ------------------------- Basic loss per common share $ (1.82) $ (1.07) $ (1.01) ========= ========= ========= Weighted average number of common shares outstanding 8,256 8,129 8,136 ========= ========= ========= Diluted loss per common share $ (1.82) $ (1.07) $ (1.01) ========= ========= ========= Weighted average number of common shares and equivalents 8,256 8,129 8,136 ========= ========= ========= 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, 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 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 Common stock issued in connection with acquisition 308 231 1,630 1,861 Settlement of prior year equity transaction 2,723 2,723 Warrants exercised in cashless exercise 35 26 176 31 (202) - Stock options exercised 1 1 4 5 Stock-based compensation 1,113 1,113 ------------------------------------------------------------------------------------- Subtotal 9,294 6,970 50,034 (8,963) (39) 863 (5,878) 42,124 Comprehensive income: Net loss (14,993) (14,993) Other comprehensive loss, net of tax: Unrealized loss on available for sale marketable securities (292) (292) ---------- Comprehensive loss (15,285) ------------------------------------------------------------------------------------- Balance at December 31, 2006 9,294 $ 6,970 $ 50,034 $ (23,956) $ (331) 863 $ (5,878) $ 26,839 ======= ======== ========== ========== =========== ======== ========= ==========
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, 2006 2005 2004 --------- --------- --------- (in thousands) Cash flows from operating activities: Net (loss) $(14,993) $ (8,691) $ (8,198) Adjustments to reconcile net income (loss) to net cash provided by (used in) operations: Depreciation and amortization 3,167 3,393 2,921 Stock-based compensation expense 1,113 -- -- Deferred income tax benefit (635) (12) (219) (Gain) loss from disposition of property, plant and equipment -- (5) 2 Impairment of goodwill and other intangibles 16,141 -- 1,826 Amortization of debt discount 187 187 176 Amortization of discounts of marketable securities (3) 11 (18) Unrealized loss on interest rate swap -- -- 21 Changes in assets and liabilities: Accounts receivable 14,177 (5,244) 7,507 Contract costs in excess of billings 1,733 2,323 1,481 Inventories 749 (1,028) 1,539 Prepaid expenses and other current assets (1,802) 3,018 (3,160) Other assets (1,050) (190) 191 Accounts payable and accrued liabilities (8,914) 885 616 Billings in excess of contract costs incurred (4,626) 350 (54) Deferred revenue 1,211 1,606 (38) Other liabilities (116) (230) (66) -------- -------- -------- Net cash flows provided by (used in) operating activities 6,339 (3,627) 4,527 -------- -------- -------- Cash flows from investing activities: Purchase of marketable securities (6,938) (14,610) (42,361) Redemption of marketable securities 9,410 22,660 22,824 Additions to property, plant and equipment (1,852) (1,252) (1,784) Proceeds from sale of property, plant and equipment -- 7 4 Cash acquired from acquisition -- 363 -- Net payment for acquisitions (945) (696) (5,526) -------- -------- -------- Net cash flows (used in) provided by investing activities (325) 6,472 (26,843) -------- -------- -------- Cash flows from financing activities: Stock options exercised 5 25 1,255 Purchase of treasury stock -- (690) (899) Restricted cash equivalents pledged to surety company (7,500) -- -- Settlement of prior year equity transaction 2,723 -- -- Repayment of bank notes and lines of credit (440) (440) (13,653) Borrowings of convertible subordinated notes payable -- -- 38,942 -------- -------- -------- Net cash flows (used in) provided by financing activities (5,212) (1,105) 25,645 -------- -------- -------- Net change in cash and cash equivalents 802 1,740 3,329 Cash and cash equivalents at the beginning of the year 6,938 5,198 1,869 -------- -------- -------- Cash and cash equivalents at the end of the year $ 7,740 $ 6,938 $ 5,198 ======== ======== ======== Supplemental disclosures of cash flow information: Cash paid during the year for: Interest $ 2,906 $ 2,690 $ 1,573 Income taxes, net of refunds $ 59 $ 88 $ 771 Common stock issued in connection with acquisition $ 1,861 $ -- $ 639 Warrants exercised $ 202 $ -- $ -- Treasury stock received with cashless exercise of warrants $ (202) $ - $ -
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. Their products include Signals Intelligence+ (SigInt) Systems: Signal gathering and analysis products and systems used for field-based collecting and monitoring, providing the U.S. intelligence community and U.S. allies with real time intelligence for strategic and tactical decision making. 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 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. 37 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. The Company elected to perform these annual assessements as of October 1 of each year. SFAS 142 requires the Company to conduct impairment assessments annually 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. During the fourth quarter of 2006, the Company concluded that an impairment occurred in its Public Safety and Justice segment. The Company performed its interim impairment test of the reporting unit as of December 31, 2006 and based on its valuation concluded it was necessary to write down a portion of the value of the segment's goodwill in the amount of $14.4 million and $1.7 million of other intangible assets. This write-down is included in impairment of goodwill and other intangibles in the 2006 statement of operations. As of October 1 and December 31, 2006, there were no other impairments of goodwill or other intangibles. These valuations are performed by the Company with the assistance of an independent national valuation firm which considers market valuations, discounted cash flows and other factors when preparing the valuations. 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 Interpretation also requires disclosure of accounting policies and methodologies with respect to warranty accruals, as well 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. 38 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 accumulated deficit resulting from recent years 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 (loss), net of income taxes, for the years ended December 31, 2006 and 2005, in thousands. For the Year Ended December 31, 2006 2005 --------- --------- Net loss $(14,993) $ (8,691) Unrealized loss on available-for-sale securities (292) (53) -------- -------- Comprehensive loss $(15,285) $ (8,744) ======== ======== Stock-Based Compensation In December 2004, the FASB issued SFAS No. 123R (revised 2004) "Share-Based Payment." This statement replaces SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." This statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. Pro forma disclosure is no longer an alternative. This statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value-based measurement method in accounting for share-based payment transactions with employees. This statement uses the terms compensation and payment in their broadest senses to refer to the consideration paid for goods or services, regardless of whether the supplier is an employee. The Company adopted SFAS No. 123R effective January 1, 2006 and is recognizing the cost of stock-based compensation, consisting of stock options, using the modified prospective application method whereby the cost of new awards and awards modified, repurchased or cancelled after January 1, 2006 and the portion of awards for which the requisite service has not been rendered (unvested awards) that are outstanding as of January 1, 2006, as the requisite service is rendered on or after the effective date, January 1, 2006. This standard has a material impact on our financial statements. 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. 39 The primary purpose of accelerating the vesting of these options was 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 generally requires 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 was 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, 2006 2005 2004 ---- ---- ---- Expected life in years 6.5 4.8 5.4 Risk-free interest rate 4.9% 4.0% 3.4% Expected volatility 77.4% 81.5% 75.3% Annual forfeiture rate 4.4% -- -- Dividend yield -- -- -- 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. For the years ended December 31, 2005 and December 31, 2004, we applied the intrinsic value based method of accounting for stock options prescribed by APB No. 25. Accordingly, no compensation expense was recognized for these stock options since all options granted had an exercise price equal to the market value of the underlying stock on the grant date. If compensation expense had been recognized based on the estimate of the fair value of each option granted in accordance with the provisions of SFAS No. 123 as amended by SFAS No. 148, our results of operations would have been reduced to the following pro forma amounts as follows, in thousands:
For the Year Ended For the Year Ended December 31, 2005 December 31, 2004 ------------------ ------------------ Net loss as reported $ (8,691) $ (8,198) Deduct: pro forma stock based employee compensation expense, net of tax 2,678 1,040 ------------------ ------------------ Pro forma net loss $ (11,369) $ (9,238) ================== ================== Earnings per common share: Basic - as reported $ (1.07) $ (1.01) Basic - pro forma $ (1.40) $ (1.14) Diluted - as reported $ (1.07) $ (1.01) Diluted - pro forma $ (1.40) $ (1.14)
Pro forma compensation expense recognized under SFAS No. 123 does not consider potential forfeitures. 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 to 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. 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. 40 Other Recently Issued Accounting Pronouncements In February 2007, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard ("SFAS") No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115" ("SFAS 159"). SFAS 159 permits entities to elect to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact of SFAS 159 on its consolidated financial statements. In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans -- an amendment of FASB Statements No. 87, 88, 106 and 132(R)." This statement would require a company to (a) recognize in its statement of financial position an asset for a plan's overfunded status or a liability for a plan's underfunded status, (b) measure a plan's assets and its obligations that determine its funded status as of the end of the employer's fiscal year, and (c) recognize changes in the funded status of a defined postretirement plan in the year in which the changes occur (reported in comprehensive income). The adoption of this new accounting pronouncement has not had an impact on our financial position or results of operation as the Company does not have any such plans. In September 2006, the FASB issued SFAS No 157 "Fair Value Measurements". This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. The adoption of this new accounting pronouncement has not had an impact on our financial position or results of operation. In June 2006, the FASB issued Interpretation 48 ("FIN 48"), Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109. FIN 48 describes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The guidance is effective for fiscal years beginning after December 15, 2006, which we intend to adopt during our fiscal year ending December 31, 2007. We have not yet determined the impact from adoption of this new accounting pronouncement on our financial position or results of operation. 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 did not have a material impact on our financial position, results of operations or cash flows. Reclassifications Certain prior year amounts have been reclassified to conform with the current year's presentation. The effect of these reclassifications is not material to the consolidated financial statements. 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 1,273,600, 1,257,133 and 729,800 shares for the years ended December 31, 2006, 2005 and 2004 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, 2006, 2005 and 2004 as the effect is antidilutive. 41 The computations of the Company's basic and diluted earnings per common share amounts were as follows:
Year Ended December 31, -------------------------------- 2006 2005 2004 -------- -------- -------- (in thousands, except per share data) Net loss $(14,993) $ (8,691) $ (8,198) ======== ======== ======== Weighted average common shares outstanding 8,256 8,129 8,136 Effect of dilutive stock options and warrants -- -- -- -------- -------- -------- Diluted weighted average number of common shares outstanding 8,256 8,129 8,136 ======== ======== ======== Net loss per common share Basic $ (1.82) $ (1.07) $ (1.01) Diluted $ (1.82) $ (1.07) $ (1.01)
In March 2004, the Emerging Issues Task Force ("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, 2006, 2005 and 2004. Accordingly, no undistributed earnings have been allocated to the 2011 Notes. The 2011 Notes provide that "if the portion of the cash so distributed applicable to one share of Common Stock is equal to or greater than the Current Market Price on the Record Date [of the dividend declared], in lieu of the foregoing adjustment [to the conversion price], adequate provision shall be made so that each Noteholder shall have the right to receive upon conversion the amount of cash such holder would have received had such holder converted each Note on the Record Date." Under EITF 03-06, the assessment as to whether the contingency criteria have been met must be made each reporting period. This determination is made without regard to the participation rights of the convertible notes. Under the consensus reached for Issue 3 of EITF 03-06, the criteria could be met even if the dividend were not declared. The consensus also permits consideration of avoiding allocation to the participating securities in certain events. 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, 2006 and December 31, 2005 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/(loss) in shareholders' equity. The cost for marketable securities was determined using the specific identification method and adjusted for accretion of discounts or amortization of premiums from the date of purchase to maturity. The accretion and amortization is included in interest income. The fair values of marketable securities are estimated based on the quoted market price for these securities. Marketable securities are summarized, in thousands, as follows:
December 31, 2006 December 31, 2005 ------------------------------------ ------------------------------------ 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 $ 9,026 $ -- $ 339 $ 8,687 $11,494 $ -- $ 65 $11,429
The cost and estimated fair value of current marketable securities at December 31, 2006, 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. 42 Estimated Cost Fair Value ------------ ----------- (in thousands) Due within one year $1,735 $1,732 Due after one year and beyond $7,291 $6,955 ------ ------ Total debt securities $9,026 $8,687 ====== ====== The following table shows the gross unrealized losses and fair value of the Company's investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2006, in thousands:
Less Than 12 Months 12 Months or Greater Total ----------------------- ----------------------- ----------------------- Fair Unrealized Fair Unrealized Fair Unrealized Value (Gains) Value Losses Value Losses ---------- ---------- ---------- ---------- ---------- ---------- Federal agency mortgage-backed securities $ 3,252 $ (2) $ 5,435 $ 341 $ 8,687 $ 339 ========== ========== ========== ========== ========== ==========
The unrealized losses on the Company's investments in federal agency mortgage-backed securities were caused by interest rate increases. The Company purchased these investments at a discount of or at their face amount, and the contractual cash flows of these investments are guaranteed by an agency of the U.S. government. Accordingly, it is expected that the securities would not be settled at a price less than the amortized cost of the Company's investment. Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability and intent to hold these investments until their expected redemption at full principal value, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2006. 4. ACCOUNTS RECEIVABLE Accounts receivable consist of the following, in thousands: December 31, ------------------------ 2006 2005 -------- -------- U.S. Government Contracts Billed $ 2,279 $ 1,926 Unbilled 369 424 -------- -------- 2,648 2,350 -------- -------- Commercial Billed 20,713 33,954 Retainage 4,291 5,642 -------- -------- 25,004 39,596 -------- -------- Total accounts receivable 27,652 41,946 Less: allowance for doubtful accounts (2,118) (2,321) -------- -------- Accounts receivable, net $ 25,534 $ 39,625 ======== ======== 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 $0.5 million, or 12.5% of the total retainage amount at December 31, 2006, 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, 2006, 2005 and 2004 were approximately $16.4 million, $9.4 million and $9.9 million, respectively, or 11.1%, 6.7%, and 7.0% of the Company's total revenue 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 2002 from DCAA in May 2006 and final approval on its indirect costs billed to the U.S. Government for 2003 from DCAA in June 2006. No significant payments or billings were made as a result of the approval of the 2002 and 2003 rates. The years 2004, 2005 and 2006 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. 43 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, ---------------------- 2006 2005 --------- --------- (in thousands) Costs and estimated earnings on uncompleted contracts $ 283,891 $ 277,048 Less customer progress payments 290,386 285,225 --------- --------- $ (6,495) $ (8,177) ========= ========= Included in the consolidated balance sheets: Costs and estimated earnings in excess of billings on uncompleted contracts $ 12,031 $ 13,764 Billings in excess of contract costs and estimated on uncompleted contracts (9,221) (13,847) Deferred revenue (9,305) (8,094) --------- --------- $ (6,495) $ (8,177) ========= =========
6. INVENTORIES Inventories consist of the following, in thousands:
December 31, ---------------------- 2006 2005 --------- --------- Raw materials $ 3,645 $ 3,984 Work in progress 2,575 3,342 Finished goods 274 240 --------- --------- Total inventories 6,494 7,566 Less: Reserve for excess and obsolete inventory (917) (1,371) --------- --------- Inventories, net $ 5,577 $ 6,195 ========= =========
7. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consist of the following, in thousands:
Estimated December 31, Useful ---------------------- Life 2006 2005 In Years --------- --------- --------- Land $ 435 $ 435 Buildings and leasehold improvements 4,924 4,889 7-39 Machinery and equipment 7,518 7,170 3-10 Furniture and fixtures 1,456 1,238 3-10 Automobiles 309 396 3-7 Software 9,408 8,734 3-7 Construction in progress 1,289 966 --------- --------- 25,339 23,828 Less: accumulated depreciation and amortization (15,709) (13,866) --------- --------- $ 9,630 $ 9,962 ========= =========
The Company acquired software as a result of its purchase of the assets of Signami in 2006, and 90 Degrees and Copperfire in 2005 of $0.6 million, $2.2 million and $0.2 million, respectively. Depreciation and amortization expense on property, plant and equipment for the years ended December 31, 2006, 2005, and 2004 was $2.8 million, $3.1 million and $2.6 million, respectively. 8. GOODWILL The December 31, 2006 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 Signami on July 20, 2006. Goodwill recorded for the Signami asset acquisition was approximately $0.8 million at December 31, 2006. 44 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. 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. During the fourth quarter of 2006, the Company concluded that an impairment occurred in its Public Safety and Justice segment. The Company performed its interim impairment test of the reporting unit as of October 1, 2006 and based on its valuation concluded it was necessary to write down the value of the segment's goodwill in the amount of $14.4 million. This write-down is included in impairment of goodwill and other intangibles in the 2006 statement of operations. The Company cannot predict the occurrence of events that might adversely affect the reported value of the remaining goodwill of approximately $13.3 million at December 31, 2006. This valuation was performed by the Company with the assistance of an independent national valuation firm which considered market valuations, discounted cash flows and other factors when preparing the valuations. Goodwill, by segment, consists of the following, in thousands:
Integrated Public Attack Electronic Safety & Protection Systems Justice Total ---------- ---------- ---------- ---------- December 31, 2004 $ 728 $ -- $ 25,166 $ 25,894 Addition from 2005 acquisitions -- -- 952 952 ---------- ---------- ---------- ---------- December 31, 2005 728 -- 26,118 26,846 Addition from 2006 acquisition -- 829 -- 829 Impairment charge -- -- (14,401) (14,401) ---------- ---------- ---------- ---------- December 31, 2006 $ 728 $ 829 $ 11,717 $ 13,274 ========== ========== ========== ==========
9. OTHER INTANGIBLE ASSETS The December 31, 2006 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 Signami on July 20, 2006. Other intangible assets for the Signami asset acquisition are approximately $1.2 million at December 31, 2006. The Company reviews the carrying value of intangible assets when circumstances indicate that the carrying value may not be recoverable, utilizing a discounted cash flow model. During the fourth quarter of 2006 the Company concluded that an impairment had occurred in its Public Safety and Justice segment. The Company performed its impairment test of intangible assets as of October 1, 2006 and based on its valuation concluded it was necessary to write down the value of the intangible assets in the amount of $1.7 million. This write-down is included in impairment of goodwill and other intangibles in the 2006 statement of operations. The Company cannot predict the occurrence of events that might adversely affect the reported value of the remaining intangible assets of approximately $7.4 million at December 31, 2006. This valuation was performed by the Company with the assistance of an independent national valuation firm which considered excess earnings method, the relief from royalty method and discounted earnings method when preparing the valuations. The weighted average life for purposes of amortization of identified intangible assets acquired in 2006 amounting to $1.2 million was six years. Other 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 other recent acquisitions. With the exception of the trade names, which have indefinite lives, the intangible assets are being amortized using the straight-line method. Other intangible assets consist of the following, in thousands: December 31, December 31, Amortizable 2006 2005 Lives ------------ ------------ ------------ Cost (in years) Trade names $ 3,952 $ 5,632 Indefinite Customer relationships 3,280 2,500 7-14 Other 1,715 1,255 2-20 ------------ ------------ 8,947 9,387 ------------ ------------ Accumulated amortization Customer relationships (883) (655) Other (636) (511) ------------ ------------ (1,519) (1,166) ------------ ------------ Other intangible assets, net $ 7,428 $ 8,221 ============ ============ 45 Amortization expense for the Company's intangible assets for the years ended December 31, 2006, 2005 and 2004 was $353 thousand, $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: Year ---- 2007 $ 459 2008 447 2009 447 2010 432 2011 390 Thereafter 1,300 ----- Total $3,475 ====== 10. ACCOUNTS PAYABLE AND ACCRUED LIABILITIES Accounts payable and accrued liabilities consist of the following, in thousands: December 31, --------------------- 2006 2005 ------- ------- Accounts payable $ 7,321 $15,461 Accrued payroll costs 3,011 3,558 Income taxes payable 32 206 Other accrued expenses 3,791 3,805 ------- ------- $14,155 $23,030 ======= ======= 11. NOTES PAYABLE AND LINE OF CREDIT
December 31, December 31, 2006 2005 ------------ ------------ (in thousands) Industrial revenue bond, interest payable monthly at a variable rate of 3.14 % to 4.19 % (4.16 % at December 31, 2006) principal payable in quarterly installments of $35,000. The bond is fully collateralized by a $1.1 million letter of credit and a bond guarantee agreement. $ 1,120 $ 1,260 Industrial revenue bond, interest payable monthly at a variable rate of 3.07 % to 4.11 % (4.05 % at December 31, 2006) principal payable in annual installments of $300,000 until 2013 when the annual installments become $100,000. The bond is fully collateralized by a $2.0 million letter of credit and a bond guarantee agreement. 2,005 2,305 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 43,375 43,815 Less convertible subordinated notes discount 758 945 ------------ ------------ Subtotal 42,617 42,870 Less amount due within one year 440 440 ------------ ------------ $ 42,177 $ 42,430 ============ ============
46 Maturities of notes payable are as follows, in thousands: Year Ending December 31, Amount 2007 $ 440 2008 440 2009 440 2010 440 2011 40,690 Thereafter 925 ------------ $ 43,375 ============ 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, 2006 carrying value is listed below, in thousands. Face value $ 40,250 Underwriters discounts, net 758 --------- $ 39,492 ========= 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 at a premium, in whole but not in part, to face. 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 a non-current asset 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. There is no material difference between the straight-line method of amortization and the effective interest method with respect to the amortization of the underwriter's discounts and debt issuance costs on 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 $251 thousand for the years ended December 31, 2006 and 2005, respectively. 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 principal amount of up to $20 million. Revolving advances are limited by a borrowing base formula based upon the value of the Company's receivables, inventories, 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 $18 million. 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 percent. For letters of credit, the Company pays an amount equal to the average daily face amount of each outstanding letter of credit multiplied by two 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 thousand 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 million 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 thousand per month and a collateral evaluation fee as required. 47 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 million. Commencing with the fiscal quarter ended June 30, 2006, the Company is required to maintain a fixed charge coverage ratio of at least 1.1 to 1.0. This Company was in compliance with this ratio during the applicable period in 2006. On July 14, 2006, the Company and its banks entered into a First Amendment to Second Amended and Restated Revolving Credit Security Agreement (the "First Amendment"). The First Amendment amended the Credit Agreement to (i) modify the borrowing base, (ii) permit any Borrower to guaranty certain indebtedness of any other Borrower, (iii) increase the maximum limit of rental payments for non-capitalized leases from $3 million to $4 million per fiscal year, (iv) permit the Company to repurchase or redeem certain of the Company's 6.25% Convertible Subordinated Notes due January 15, 2011 and (v) consent to an acquisition by a newly formed indirect subsidiary of the Company pursuant to an asset purchase transaction. On December 5, 2006, the Company and its banks entered into a Second Amendment to Second Amended and Restated Revolving Credit Security Agreement (the "Second Amendment"). The Second Amendement amended the Credit Agreement to supply a new definition for the loan agreement which reduced the interest rate being charged by 0.5%. On March 28, 2007, the Company and its banks entered into a Third Amendment to Second Amended and Restated Revolving Credit and Security Agreement (the "Third Amendment"). The Third Amendment amended the Credit Agreement by (i) amending the definition of EBITDA to exclude from the calculation of EBITDA any non-cash impairment charges against goodwill and other intangible assets incurred by the Company's subsidiary, Tiburon, Inc., during the fiscal quarter ended December 31, 2006, (ii) increasing the aggregate maximum permissible amount of capital expenditures in any fiscal year to $2.5 million; (iii) permitting the Company, subject to certain conditions, to purchase or redeem up to $8 million of the Company's 6.25% Convertible Subordinated Notes due January 15, 2011, (iv) permitting the Company to deliver its audited financials for the fiscal year ended December 31, 2006 by no later than April 30, 2007 and (v) permitting the Company's annual projected operating budget and cash flow projections be broken down on a quarterly basis versus a monthly basis. 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: 2006 2005 ----- ----- Beginning balance at January 1 $ 388 $ 359 Plus: accruals for product warranties 343 375 Less: warranty charges/claims (321) (346) ----- ----- Ending balance at December 31 $ 410 $ 388 ===== ===== 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 fair value of these Notes at December 31, 2006 was $36.0 million. 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 was 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 exchanges the difference between a variable interest rate and either a fixed or another variable interest rate, multiplied by a notional principal amount. 48 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, ----------------------------------- 2006 2005 2004 ------- ------- ------- Current $ (97) $ (203) $(2,013) Deferred (635) (12) (219) ------- ------- ------- $ (732) $ (215) $(2,232) ======= ======= ======= The tax effects of the primary temporary differences giving rise to the Company's net deferred tax assets and liabilities at December 31, 2006 and 2005 are summarized as follows, in thousands: December 31, ------------------- 2006 2005 ------- ------- Deferred tax assets: Accrued expenses and deferred compensation $ 349 $ 204 Tax operating loss carryforward 4,928 4,349 Book reserves in excess of tax 1,430 1,762 Tax depreciation and amortization in excess of book depreciation and amortization 1,423 821 Unrealized loss on marketable securities 132 25 Other 246 -- ------- ------- Total deferred tax assets 8,508 7,161 ------- ------- Deferred tax liabilities: Purchased intangibles (2,686) (3,086) Other -- (9) ------- ------- Total deferred tax liabilities (2,686) (3,095) Valuation allowance (7,247) (6,126) ------- ------- Net deferred tax (liability) asset $(1,425) $(2,060) ======= ======= 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. In the first quarter of 2006 the Company reversed $200 thousand previously recorded as a reserve for uncertain tax positions which was no longer needed. At December 31, 2006 and 2005 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, 2006 include $32.4 million of state net operating losses for which a valuation allowance has been established. 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, 2006, the Company and its subsidiaries have Federal net operating loss carryforwards available to offset future taxable income of approximately $6.5 million, of which $1.0 million is subject to limitations. The limited tax loss carryforwards are limited to approximately $235 thousand each year as a result of an ownership change, which occurred in 1995. Approximately $5.5 million is available for use on an unlimited basis through 2025. The balance of these carryforwards expires between 2006 and 2010. At December 31, 2006, the Company and its subsidiaries have $32.4 million of state net operating loss carryforwards available to offset future taxable state income. We excluded approximately $629 thousand of Federal net operating loss carryforwards from the calculation of the deferred tax asset above because it represents excess stock option deductions that did not reduce taxes payable. These unrealized excess stock option deductions, if realized in the future, will result in an increase to paid-in capital. We recognize the benefits of net operating loss carryforwards in the following order: (1) net operating losses from items other than excess stock option deductions; (2) net operating losses from excess stock option deductions accounted for under SFAS 123R. We calculated our adoption date pool of excess tax benefits previously included in paid-in capital under the long-form method outlined in SFAS 123R. 49 The difference between the statutory tax rate and the Company's effective tax rate is summarized as follows: For the years ended December 31, ---------------------- 2006 2005 2004 ---- ---- ---- Statutory federal income tax rate (34.0)% (34.0)% (34.0)% State income taxes, net of Federal benefit (0.7) (4.6) (0.3) Change in valuation allowance 0.0 38.7 14.8 Tax effect of non-deductible goodwill 31.7 -- -- Tax effect of other non-deductible items 1.5 0.7 0.5 Foreign income exclusion (1.1) (1.4) (1.9) Other (2.1) (1.8) (0.5) ---- ---- ---- Effective tax rate (4.7)% (2.4)% (21.4)% ==== ==== ==== 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 warrants were granted on October 29, 2001 and expired on October 29, 2006. 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 and during 2006 the remaining 34,636 warrants were exercised. 16. STOCK-BASED COMPENSATION Effective January 1, 2006, we adopted SFAS No. 123(R), "Share-Based Payment." This statement requires us to expense the fair value of grants of various stock-based compensation programs over the vesting period of the awards. We elected to adopt the "Modified Prospective Application" transition method which does not require the restatement of previously issued financial statements, and therefore previously issued financial statements are not directly comparable to periods after adoption. Compensation expense is measured using the Black-Scholers-Merton option pricing model which we have determined to be the most appropriate fair-value method for determining the value of our awards and we have recognized compensation costs on a straight-line basis over the awards vesting periods in accordance with the provisions of FAS 123R. We have recognized stock based compensation beginning in 2006 as follows: Awards granted after December 31, 2005 - Awards are measured at their fair value at date of grant. The resulting compensation expense is recognized in the consolidated statement of operations ratably over the vesting period of the award. Awards granted prior to December 31, 2005 - Awards were measured at their fair value at the date of original grant. Compensation expense associated with the unvested portion of these options at January 1, 2006 is recognized in the consolidated statement of operations ratably over the remaining vesting period. For all grants issued after December 31, 2005 the amount of recognized compensation expense is adjusted based upon an estimated forfeiture rate which is derived from historical data. The following table shows total stock-based compensation expense included in the Consolidated Statement of Operations, in thousands: For the Year Ended December 31, 2006 ----------------------- Cost of sales $ 60 Selling, general and administrative 995 Research and development 58 ------ Total $1,113 ====== No similar expense was charged against income in the prior periods as we had elected to apply the provisions of APB No. 25 to those periods as permitted by SFAS No. 123. 50 SFAS No. 123(R) also requires that the tax benefit from the exercise of options be reflected in the statement of cash flows as a cash inflow from financing activities. Prior to the adoption of SFAS No. 123(R), these tax benefits were reflected as a cash inflow from operations. The tax benefit from the exercise of options was $1,500 and $6,800 for the years ended December 31, 2006 and December 31, 2005, respectively. Additionally, the Company used the long-form method to calculate the additional paid-in capital ("APIC") pool, the tax benefit of any resulting excess tax deduction should increase the APIC pool; any resulting tax deficiency should be deducted from the APIC pool. Stock Option Plans ------------------ 2005 Stock Incentive Compensation Plan for Employees. Stock options are granted with an exercise price equal to the market price of the stock at the date of grant. Substantially all of the options granted are exercisable pursuant to a five-year vesting schedule. The fair value of these options is estimated using the Black-Scholes option pricing model which incorporates the assumptions noted in the table below. Expected volatilities are based on the historical performance of our stock. We also use historical data to estimate the timing and amount of option exercises and forfeitures within the valuation model. The expected term of the options is derived from the output of the option pricing model and represents the period of time that options are expected to remain unexercised. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury bond rate in effect at the time of grant. 2005 Stock Option Plan for Non-Employee Directors. Stock options are granted with an exercise price equal to the market price of the stock at the date of grant. Substantially all of the options granted are exercisable pursuant to a three-year vesting schedule. The fair value of these options is estimated using the Black-Scholes option pricing model which incorporates the assumptions noted in the table below. Expected volatilities are based on the historical performance of our stock. We also use historical data to estimate the timing and amount of option exercises and forfeitures within the valuation model. The expected term of the options is derived from the output of the option pricing model and represents the period of time that options are expected to remain unexercised. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury bond rate in effect at the time of grant. The 1996 Stock Incentive Plan for Employees and the 1996 Stock Option Plan for Non-Employee Directors, collectively referred to as the "Prior Plans," expired in accordance with their terms and no further stock options may be granted under these plans. The fair values of grants in the stated period were computed using the following range of assumptions for our various stock option plans: For the Year Ended December 31, 2006 ----------------------- Risk-free interest rate 4.9 % Dividend yield none Expected volatility 77.6 % Expected lives 6.5 years Annual forfeiture rate 4.4 % The Company has various stock option plans. Under these plans, 5,407,100 options to purchase common stock may be granted until May 27, 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 3,894,000 shares of common stock reserved for future grants as of December 31, 2006. Transactions for stock options and warrants are summarized as follows:
Year Ended Weighted Year Ended Weighted Year Ended Weighted December 31, Average December 31, Average December 31, Average 2006 Price 2005 Price 2004 Price ------------ ------------ ------------ ------------ ------------ ------------ Outstanding, Beginning of Year 1,453,358 $ 8.755 1,671,958 $ 9.418 1,414,556 $ 8.587 Granted 494,000 $ 6.752 287,000 $ 6.983 675,000 $ 9.145 Forfeited 215,200 $ 7.200 -- -- -- -- Exercised 35,661 $ 5.777 6,500 $ 3.906 303,898 $ 4.131 Expired or Cancelled 183,397 $ 9.948 499,100 $ 10.004 113,700 $ 11.590 ------------ ------------ ------------ Outstanding, End of Year 1,513,100 $ 8.248 1,453,358 $ 8.755 1,671,958 $ 9.418 ============ ============ ============ Exercisable, End of Year 770,100 $ 9.448 843,308 $ 9.587 492,861 $ 9.226 ============ ============ ============
51 A summary of our stock options outstanding at December 31, 2006 follows:
Options outstanding Options exercisable -------------------------------------------- ----------------------------- Weighted- Weighted- Weighted- Average Average Average Remaining Exercise Exercise Range of Exercise Price Shares Life (yrs) Price Shares Price ----------------------- -------- ---------- --------- -------- --------- $ 1.690 - 6.235 163,800 6.63 $5.3315 42,800 $3.3002 $ 6.250 - 6.825 198,500 7.37 $6.5909 8,100 $6.3224 $ 6.860 - 6.950 246,800 7.70 $6.9248 6,800 $6.8750 $ 7.000 - 7.500 160,500 4.52 $7.2899 62,500 $7.3481 $ 7.719 - 8.075 164,000 4.98 $8.0511 149,600 $8.0567 $ 8.105 - 8.960 169,200 5.38 $8.5807 115,000 $8.5512 $ 9.190 - 10.420 183,800 5.27 $10.0763 158,800 $10.0371 $ 11.165 - 13.445 223,000 5.46 $12.2925 223,000 $12.2925 $ 13.750 - 16.330 2,500 4.90 $14.8100 2,500 $14.8100 $ 16.630 - 16.630 1,000 4.74 $16.6300 1,000 $16.6300 ------------------------------------------------------------------------------------------------------------------ $ 1.690 - 16.630 1,513,100 6.02 $8.2478 770,100 $9.4480 ========= =======
In the years ended December 31, 2006, 2005 and 2004 the weighted-average grant-date fair value of an option granted was $4.89, $4.15 and $5.95 per option, respectively. The total intrinsic value, the difference between the exercise price and the market price on the date of exercise, of all options exercised during the year ended December 31, 2006 was approximately $24 thousand. Total unrecognized compensation expense from stock options outstanding at December 31, 2006 was approximately $2.6 million excluding estimated forfeitures, which is expected to be recognized over a weighted-average period of 2.2 years as follows, in thousands: Compensation Expense Excluding Estimated Year Forfeitures ---- -------------------- 2007 $ 933 2008 690 2009 495 2010 371 2011 111 ------- Total $ 2,600 ======= Share - Based Compensation Fair Value Assumption ------------------------------------------------ The fair value of each option award is estimated on the date of grant using a Black-Scholes-Merton option pricing model that uses the weighted average assumptions noted in the table in footnote number 1. For 2006, 2005 and 2004 volatility is based on historical volatility of CompuDyne's stock. The risk-free interest rate is based on the zero-coupon U.S. Treasury bond. We use historical data to estimate stock option exercises and forfeitures within the valuation model. The expected term of stock option awards granted is derived from historical exercise experience under the share-based employee compensation arrangements and represents the period of time option awards are expected to be outstanding. 17. 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 2006, 2005 and 2004 was $3.2 million, $3.2 million, and $3.2 million, respectively. As of December 31, 2006, future minimum rental payments required under all non-cancelable operating leases are as follows, in thousands: Year Ending December 31, Total ------------ -------- 2007 $ 3,203 2008 2,670 2009 2,179 2010 1,747 2011 1,356 Thereafter 381 -------- $ 11,536 ======== 52 Interest on Contractual Obligations. As of December 31, 2006, 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 $3.1 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 ------------ -------- 2007 $ 2,632 2008 2,614 2009 2,596 2010 2,578 2011 147 Thereafter 376 -------- $ 10,943 ======== 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. Future purchase obligations are as follows, in thousands: Year Ending December 31, Total ------------ -------- 2007 $ 8,363 2008 - 2009 - 2010 - 2011 - Thereafter - -------- $ 8,363 ======== 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. During 2006 we received a letter from a client of our Public Safety and Justice segment indicating their intent to terminate their contract with us for cause. The letter alleges that we failed to complete the project under the terms of the agreement and the applications implemented failed to meet the functionality requirements of the agreement. The customer is seeking a refund of approximately $400 thousand previously paid by them. Costs in excess of billings of approximately $600 thousand related to this project remain as an asset on our books and records as of December 31, 2006. The segment disagrees with the client's views. While the ultimate outcome cannot be predicted, the Company intends to vigorously pursue this matter. The Company has established an accrual for this matter which is included in accounts payable and accrued liabilities on the balance sheet. On November 21, 2006, CompuDyne Corporation ("CompuDyne") and William Blair Mezzanine Capital Fund II, L.P. ("Blair") entered into a Release and Settlement Agreement with Friedman, Billings, Ramsey Group, Inc. ("FBR"), by which FBR agreed to pay $4.5 million to CompuDyne and Blair, CompuDyne and Blair agreed to release FBR, and FBR has agreed to release CompuDyne and Blair, from any and all causes of action arising out of or relating to, among other things, an offering of CompuDyne common stock in 2001 for which FBR acted as lead underwriter and financial advisor. Blair is a former shareholder of CompuDyne which also sold shares in the 2001 offering. After legal and other expenses and payment of Blair's share of the settlement, the net amount recorded by CompuDyne was approximately $2.8 million which is recorded in additional paid-in capital. At December 31, 2006, $1.3 million in cash was received and the balance of $1.5 million was received in January, 2007. 53 The Company has learned that the National Association of Securities Dealers ("NASD") and other regulatory bodies are seeking sanctions against certain purchasers of the Company's common stock in its 2001 PIPE transaction. The Company is investigating these matters, and has filed lawsuits against certain purchasers. The Company is currently attempting to resolve these matters. 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, debarment or fines could have a material adverse effect on the Company. In connection with the acquisition of the assets of Signami, LLC made by the Company in July 2006, the Company issued 93,334 shares to the sellers for which it guaranteed for a 2 year period that upon sale of these securities, the Company would guarantee a price of $7.50 per share for these shares. This period is extended for members precluded from selling their shares due to statutory reasons. Included in other long term liabilities at December 31, 2006 is approximately $86 thousand representing the fair value of this liability. 18. RELATED PARTY TRANSACTION During 2006 and 2005 the Company's Integrated Electronic Systems unit recorded revenue of approximately $339 thousand and $255 thousand, respectively, from sales to a company of which one of CompuDyne's Directors (this director resigned from CompuDyne's Board of Directors during February 2007) was a senior vice president and member of its board of directors. Included in the Integrated Electronic Systems unit at December 31, 2006 and 2005 related to the company at which this Director was employed was $9 thousand and $351 thousand of accounts receivables, respectively, and $9 thousand and $9 thousand of contract costs in excess of billings, respectively. 19. 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 $27 thousand, $33 thousand, and $33 thousand for 2006, 2005, and 2004 respectively. The Company has a 401(k) retirement savings plan covering all employees. All employees are eligible to participate in the 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 $789 thousand, $783 thousand and $694 thousand for 2006, 2005, and 2004, respectively. The Company entered into the CompuDyne Corporation Retention Plan for Selected Employees (the "Retention Plan") effective June 28, 2005. 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, 2006 or 2005 and therefore, the Company did not record a liability or related compensation expense for the Retention Plan. 54 20. OPERATING SEGMENT INFORMATION Segment information has been prepared in accordance with 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, 2006, 2005 and 2004.
Revenues Gross Profit -------- ------------ (in thousands) 2006 2005 2004 2006 2005 2004 ---------- ---------- ---------- ---------- ---------- ---------- Institutional Security Systems $ 48,265 $ 60,652 $ 53,952 $ 7,336 $ 9,896 $ 6,437 Attack Protection 40,241 27,017 25,161 13,081 6,105 1,551 Integrated Electronic Systems 13,894 10,110 14,293 2,986 1,625 2,019 Public Safety and Justice 45,062 43,871 49,376 24,464 24,913 27,671 CompuDyne Corporate - - - - - - ---------- ---------- ---------- ---------- ---------- ---------- $ 147,462 $ 141,650 $ 142,782 $ 47,867 $ 42,539 $ 37,678 ========== ========== ========== ========== ========== ========== Total Assets, at Year End Pre-tax Income (Loss) ------------------------- --------------------- 2006 2005 2004 2006 2005 2004 ---------- ---------- ---------- ---------- ---------- ---------- Institutional Security Systems $ 17,648 $ 23,755 $ 26,895 $ (1,277) $ 629 $ (5,174) Attack Protection 14,196 20,621 15,760 4,672 (2,333) (5,444) Integrated Electronic Systems 6,535 4,354 3,807 985 431 563 Public Safety and Justice 35,573 57,780 56,538 (17,983) (2,928) 2,364 CompuDyne Corporate 29,998 20,182 29,891 (2,122) (4,705) (2,739) ---------- ---------- ---------- ---------- ---------- ---------- $ 103,950 $ 126,692 $ 132,891 $ (15,725) $ (8,906) $ (10,430) ========== ========== ========== ========== ========== ========== Capital Expenditures Depreciation and Amortization -------------------- ----------------------------- 2006 2005 2004 2006 2005 2004 ---------- ---------- ---------- ---------- ---------- ---------- Institutional Security Systems $ 44 $ 132 $ 411 $ 385 $ 388 $ 531 Attack Protection 183 264 64 603 767 644 Integrated Electronic Systems 42 8 16 183 35 41 Public Safety and Justice 1,528 815 1,140 1,938 2,145 1,664 CompuDyne Corporate 55 33 153 58 58 41 ---------- ---------- ---------- ---------- ---------- ---------- $ 1,852 $ 1,252 $ 1,784 $ 3,167 $ 3,393 $ 2,921 ========== ========== ========== ========== ========== ==========
Included in the 2006 results are $14.4 million charge related to the impairment of the Public Safety and Justice Segment's goodwill and a $1.7 million charge related to the impairment of a tradename. In addition Public Safety and Justice expended $4.4 million on its NextGen products which are expected to be sold into the market in 2008. 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. In addition $2.0 million in losses recorded in the ISS segment related to continuing problems in its West Coast office. Additionally, 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. 55 21. SELECTED QUARTERLY FINANCIAL DATA (Unaudited)
First Second Third Fourth (In thousands, except per share data) Quarter Quarter Quarter Quarter Total ----------------------------------------- -------- --------- --------- --------- --------- Year Ended December 31, 2006 Revenues -------- Institutional Security Systems $ 13,355 $ 13,220 $ 11,091 $ 10,599 $ 48,265 Attack Protection 11,684 11,333 8,822 8,402 40,241 Integrated Electronic Systems 3,587 2,983 4,117 3,207 13,894 Public Safety and Justice 11,844 10,858 10,666 11,694 45,062 -------- -------- -------- -------- -------- Total revenues $ 40,470 $ 38,394 $ 34,696 $ 33,902 $147,462 Gross Profit ------------ Institutional Security Systems $ 2,173 $ 1,853 $ 1,780 $ 1,530 $ 7,336 Attack Protection 3,292 3,859 3,279 2,651 13,081 Integrated Electronic Systems 506 494 1,009 977 2,986 Public Safety and Justice 6,538 5,930 5,750 6,246 24,464 -------- -------- -------- -------- -------- Total gross profit $ 12,509 $ 12,136 $ 11,818 $ 11,404 $ 47,867 Pre-tax Income (Loss) --------------------- Institutional Security Systems $ 136 $ (386) $ (360) $ (667) $ (1,277) Attack Protection 1,205 1,548 1,456 463 4,672 Integrated Electronic Systems 184 161 377 263 985 Public Safety and Justice 7 (529) (644) (16,817) (17,983) Unallocated corporate expense (909) (482) (494) (237) (2,122) -------- -------- -------- -------- -------- Pre-tax income (loss) from operations $ 623 $ 312 $ 335 $(16,995) $(15,725) -------- -------- -------- -------- -------- Net income (loss) $ 807 $ 305 $ 327 $(16,432) $(14,993) -------- -------- -------- -------- -------- Basic loss per share $ .10 $ .04 $ .04 $ (1.95) $ (1.82) -------- -------- -------- -------- -------- Diluted loss per share $ .10 $ .04 $ .04 $ (1.95) $ (1.82) -------- -------- -------- -------- -------- 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) -------- -------- -------- -------- --------
56 Included in the fourth quarter 2006 results for the Public Safety and Justice segment is a $14.4 million pre-tax charge to record the impairment of this segment's goodwill and a $1.7 million charge to record impairment of a tradename. Included in the fourth quarter 2006, results for the Public Safety and Justice segment is a $400 thousand charge related to a reserve established for a customer who has indicated their intent to terminate their contract with the Company. 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. 57 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. CompuDyne's aggregate worldwide market value as June 30, 2006, the last business day of CompuDyne's second fiscal quarter, was also less than $50 million; as such CompuDyne continued to be classified as a non-accelerated filer for the year ended December 31, 2006. 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. Disclosure Controls and Procedures As required by Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), the Company conducted 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 Company's disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the disclosure controls and procedures are effective in ensuring that all information required to be disclosed in reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms. There was no significant change in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal year that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. 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, 2006. 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 Consolidated Balance Sheets at December 31, 2006 and 2005 Consolidated Statements of Operations for the years ended December 31, 2006, 2005 and 2004 Consolidated Statement of Changes in Shareholders' Equity for the years ended December 31, 2006, 2005 and 2004 Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004 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, 2006, 2005, and 2004 ($ in thousands) Balance at Charged to Transferred Balance Beginning Costs and (to) from other At End Description Of Period Expenses Accounts (1) Deduction Of Period ----------- ---------- ---------- ------------ --------- --------- Year Ended December 31, 2006 Reserve and allowances deducted from asset accounts: Reserve for excess and slow moving inventory $ 1,371 3 - (457) $ 917 Reserve for accounts receivable $ 2,321 542 - (745) $ 2,118 Deferred tax asset valuation allowance $ 6,126 1,262 (141) - $ 7,247 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
(1) Transferred (to) from other accounts includes adjustments to the deferred tax valuation allowance for the effect of unrealized gains or losses on our marketable securities which is recorded in shareholders' equity through "Accumulated Other Comprehensive Income (Loss)" 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. 4(A) CompuDyne Corporation to Wachovia Bank of Delaware, National Association as Trustee Indenture dated January 15, 2004, filed as Exhibit 4.1 to Form 10-Q filed on May 1, 2006. 4(B) Specimen Note included as Exhibit A to Exhibit 4.1 of Form 10-Q filed on May 1, 2006. 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). 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. 10(E). 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(F).* Compensatory Arrangements. 61 10(G). 2005 Stock Option Plan for Non-Employee Directors, herein incorporated by reference to Registrant's Proxy Statement dated April 29, 2005 for its 2005 Annual Meeting of Shareholders. 10(H). 2005 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(I). Amendment to the 1996 Stock Option Plan for Non-Employee Directors, herein incorporated by reference to Registrant's Proxy Statement dated April 29, 2005 for its 2005 Annual Meeting of Shareholders. 10(J). 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(K). CompuDyne Corporation Retention Plan for Selected Employees, herein incorporated by reference to Exhibit 10.1 to Registrant's 8-K filed July 1, 2005. 10(L) The Joinder Agreement and the First Amendment to the Second Amendment and Restated Revolving Credit and Security Agreement both dated July 14, 2006 by and among CompuDyne Corporation, subsidiaries of the Company as co-borrowers and PNC Bank, National Association, herein incorporated by reference to Exhibits 10.1 and 10.2 to Registrants 8-K filed on July 20, 2006. 10(M)* The Release and Settlement Agreement between the Company, William Blair Mezzanine Capital Fund II, L.P. and Friedman, Billings, Ramsey Group, Inc., initially filed as Exhibit 10.1 to Form 8-K filed November 21, 2006, and refiled herein. 10(N)* The Second Amendment to the Second Amended and Restated Revolving Credit and Security Agreement both dated December 5, 2006 by and among CompuDyne Corporation, subsidiaries of the Company as co-borrowers and PNC Bank, National Association, filed herein. 10(O) Employment Agreement between CompuDyne Corporation and Mr. Bradley Wiggins herein, incorporated by reference to Exhibit 10.1, filed on Form 8-K on November 30, 2006. 10(P) The Third Amendment to the Second Amended and Restated Revolving Credit and Security Agreement dated March 28, 2007 by and among CompuDyne Corporation, subsidiaries of the Company as co-borrowers and PNC Bank, National Association, herein incorporated by reference to Exhibit 10.1, filed on Form 8-K on March 30, 2007. 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. 31.1* Certification by Mr. Martin Roenigk, Chief Executive Officer pursuant to Rule 13a-14(a), filed herewith. 31.2* Certification by Mr. Geoffrey F. Feidelberg, Chief Financial Officer pursuant to Rule 13a-14(a), filed herewith. 32.1* Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, for Mr. Martin Roenigk, Chief Executive Officer, filed herewith. 32.2* Certification Pursuant To Section 906 Of The Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350, for Mr. Geoffrey F. Feidelberg, Chief Financial Officer, filed herewith. * 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: /s/Martin Roenigk ---------------------------- Martin Roenigk Chief Executive Officer By: /s/Geoffrey F. Feidelberg ---------------------------- Geoffrey F. Feidelberg Dated: April 10, 2007 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 April 2, 2007.
______________________ Director, Chairman, President _______________________ Director Martin A. Roenigk and Chief Executive Officer David W. Clark, Jr. (Principle Executive Officer) ______________________ Director _______________________ Director John H. Gutfreund Ronald J. Angelone ______________________ Director _______________________ Director Albert R. Dowden Wade B. Houk ______________________ Director, Chief Financial Officer Geoffrey F. Feidelberg and Treasurer (Principle Financial and Accounting Officer)
63