CLAYTON HOLDINGS, INC. AND SUBSIDIARIES

INDEX

			Page
Part I. Financial Information
Item 1. Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005		1
	Condensed Consolidated Statements of Income (unaudited) for the three and nine months ended September 30, 2006 and 2005		2
	Condensed Consolidated Statement of Changes in Stockholders’ Equity (unaudited) for the nine months ended September 30, 2006		3
	Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2006 and 2005		4
	Notes to Condensed Consolidated Financial Statements (unaudited)		6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		20
Item 3.	Quantitative and Qualitative Disclosures About Market Risk		32
Item 4.	Controls and Procedures		32
Part II. Other Information
Item 1.	Legal Proceedings		34
Item 1A.	Risk Factors		34
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		34
Item 3.	Defaults Upon Senior Securities		34
Item 4.	Submission of Matters to a Vote of Security Holders		34
Item 5.	Other Information		34
Item 6.	Exhibits		34
Signatures			35
Exhibit Index

 

PART I. FINANCIAL INFORMATION

Item 1.   Financial Statements

CLAYTON HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

 

		September 30, 2006			December 31, 2005
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	23,407,841		$	7,208,875
Cash held in escrow		1,002,777			—
Restricted cash		25,378,170			4,966,839
Accounts receivable, net of allowance for doubtful accounts of $121,703 and $72,264 as of September 30, 2006  and December 31, 2005, respectively		39,940,992			37,205,223
Unbilled receivables		17,077,495			14,925,988
Prepaid expenses and other current assets		3,290,791			3,942,676
Prepaid income taxes		1,811,026			3,730,970
Deferred tax assets		350,805			165,566
Due from affiliated entities		—			23,434
Total current assets		112,259,897			72,169,571
Property and equipment, net		20,340,742			18,175,717
Goodwill		73,958,797			69,843,468
Intangible assets, net		77,864,475			84,739,774
Other assets, net		1,841,197			2,576,827
Total assets		$	286,265,108		$	247,505,357
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Long-term debt and capital lease obligations, current portion		$	1,097,368		$	1,639,411
Accounts payable and accrued expenses		23,042,095			18,842,078
Servicer escrow liability		25,378,170			4,966,839
Total current liabilities		49,517,633			25,448,328
Long-term debt and capital lease obligations, net of current portion		79,527,023			148,777,172
Deferred tax liabilities		2,961,220			3,381,001
Deferred revenue		68,534			217,888
Deferred rent		1,008,204			1,013,687
Total liabilities		133,082,614			178,838,076
Commitments and contingencies
Series A convertible preferred stock, par value $0.01 per share, no shares authorized, issued and outstanding as of September 30, 2006; 8,825,241 shares authorized, issued and outstanding as of December 31, 2005		—			12,258,319
Series B convertible preferred stock, par value $0.01 per share, no shares authorized, issued and outstanding as of September 30, 2006; 24,185,493 shares authorized, issued and outstanding as of December 31, 2005		—			43,866,683
Stockholders’ equity:
Common stock, par value $0.01 per share, 150,000,000 and 60,000,000 shares authorized and 20,564,926 and 3,281,607 shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively		205,649			32,816
Class B common stock, par value $0.01 per share, no shares authorized, issued and outstanding as of September 30, 2006; 357,020 shares authorized, issued and outstanding as of December 31, 2005		—			3,570
Preferred stock, par value $0.01 per share, 10,000,000 shares authorized, no shares issued and outstanding as of September 30, 2006		—			—
Additional paid-in capital		140,252,582			4,115,827
Retained earnings		12,724,263			8,390,066
Total stockholders’ equity		153,182,494			12,542,279
Total liabilities and stockholders’ equity		$	286,265,108		$	247,505,357

 

The accompanying notes are an integral part of these statements.

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CLAYTON HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(unaudited)

		For the three months ended September 30,						For the nine months ended September 30,
		2006			2005			2006			2005
Revenue		$	60,969,255		$	54,031,051		$	178,000,902		$	151,201,610
Cost of services:
Compensation expense		29,707,045			24,923,443			90,439,495			71,764,024
Travel and related expenses		6,302,644			7,455,077			20,182,431			21,924,136
Other direct costs		2,164,172			1,672,184			7,548,790			4,037,539
Total cost of services		38,173,861			34,050,704			118,170,716			97,725,699
Gross profit		22,795,394			19,980,347			59,830,186			53,475,911
Operating expenses:
Salaries and benefits		5,960,658			4,718,809			16,990,876			14,000,953
Other selling, general and administrative expenses		5,064,044			4,014,497			14,948,766			12,400,510
Depreciation and amortization		2,184,949			1,187,304			5,684,205			3,137,926
Amortization of intangibles		2,577,696			2,540,172			7,721,125			7,633,833
Total operating expenses		15,787,347			12,460,782			45,344,972			37,173,222
Income from operations		7,008,047			7,519,565			14,485,214			16,302,689
Interest expense, net		1,760,016			1,999,319			6,505,625			5,825,451
Loss from extinguishment of debt		—			—			746,002			—
Income before provision for income taxes		5,248,031			5,520,246			7,233,587			10,477,238
Income tax expense		2,188,133			2,184,517			2,899,390			4,162,461
Net income		$	3,059,898		$	3,335,729		$	4,334,197		$	6,314,777
Earnings per share:
Basic		$	0.15		$	0.28		$	0.24		$	0.53
Diluted		$	0.14		$	0.27		$	0.23		$	0.51
Weighted average shares outstanding:
Basic		20,536,709			11,889,201			17,776,603			11,887,779
Diluted		21,312,210			12,378,509			18,578,126			12,288,909

 

The accompanying notes are an integral part of these statements.

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CLAYTON HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(unaudited)

		Number of shares				Value
		Common Stock		Class B Common Stock		Common Stock			Class B Common Stock			Additional paid- in capital			Retained Earnings			Total
Balance, December 31, 2005		3,281,607		357,020		$	32,816		$	3,570		$	4,115,827		$	8,390,066		$	12,542,279
Issuance of common stock		8,625,000		—		86,250			—			131,753,767			—			131,840,017
Conversion of convertible preferred stock to redeemable preferred stock and redemption of redeemable preferred stock, net		8,252,679		—		82,527			—			3,277,523			—			3,360,050
Conversion of series B common stock		357,020		(357,020	)	3,570			(3,570		)	—			—			—
Stock based compensation		—		—		—			—			1,023,759			—			1,023,759
Exercise of stock options		48,620		—		486			—			81,706			—			82,192
Net income for the nine months ended September 30, 2006		—		—		—			—			—			4,334,197			4,334,197
Balance, September 30, 2006		20,564,926		—		$	205,649		—			$	140,252,582		$	12,724,263		$	153,182,494

 

The accompanying notes are an integral part of this statement.

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CLAYTON HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

 

		For the nine months ended September 30,
		2006			2005
Cash flows from operating activities:
Net income		$	4,334,197		$	6,314,777
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,684,205			3,137,926
Amortization of intangibles		7,721,125			7,633,833
Amortization of debt issuance cost		267,693			450,838
Accretion of note		—			69,512
Loss from extinguishment of debt		746,002			—
Stock based compensation		1,023,759			148,356
Deferred income taxes		(605,026		)	(1,170,122		)
Loss on sale of fixed assets		5,648			120,239
Provision for doubtful accounts		178,743			226,690
Changes in operating assets and liabilities, net of business combinations:
Accounts receivable		(2,125,487		)	(14,476,737		)
Unbilled receivables		(2,151,507		)	878,459
Prepaid expenses and other current assets		667,301			(1,389,279		)
Prepaid income taxes		1,919,945			(1,250,894		)
Due to an affiliated entity		23,434			(267,990		)
Other assets, net		(90,921		)	(13,490		)
Accounts payable and accrued expenses		4,236,695			1,097,780
Deferred revenue		(816,390		)	581,618
Deferred rent		(5,483		)	405,731
Net cash provided by operating activities		21,013,933			2,497,247
Cash flows from investing activities:
Proceeds from sale of fixed assets		35,000			20,055
Capital expenditures		(6,698,654		)	(8,026,002		)
Acquisition of businesses		(5,727,168		)	(825,326		)
Cash held in escrow from acquisition of businesses inclusive of interest earned		(1,002,777		)	—
Net cash used in investing activities		(13,393,599		)	(8,831,273		)
Cash flows from financing activities:
Proceeds from revolving credit facility		7,400,000			25,150,000
Repayments of revolving credit facility		(7,400,000		)	(16,726,908		)
Repayments of loans payable		—			(75,155		)
Repayments of capital lease obligations		(216,966		)	(81,519		)
Repayment of term loan		(70,200,501		)	(3,875,000		)
Deferred charges related to the issuance of debt		(161,158		)	—
Proceeds from issuance of common stock upon initial public offering		146,625,000			—
Underwriting commissions and offering expenses		(14,784,499		)	—
Redemption of convertible preferred stock		(52,764,950		)	—
Proceeds from the exercise of stock options		81,706			19,047
Distributions to stockholders		—			(4,000,000		)
Net cash provided by financing activities		8,578,632			410,465
Net increase (decrease) in cash and cash equivalents		16,198,966			(5,923,561		)
Cash and cash equivalents at the beginning of the period		7,208,875			12,450,147
Cash and cash equivalents at the end of the period		$	23,407,841		$	6,526,586

 

The accompanying notes are an integral part of these statements.

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CLAYTON HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (continued)

(unaudited)

 

 

		For the nine months ended September 30,
		2006			2005
Supplementary disclosures of cash flow information:
Cash paid during the period for:
Income taxes		$	1,577,965		$	6,523,503
Interest		$	5,979,195		$	5,397,013
Other noncash investing and financing activities:
Assets acquired under capital lease		$	600,503		$	187,050
Liabilities assumed from acquisitions		$	1,013,143		$	401,664

 

The accompanying notes are an integral part of these statements.

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CLAYTON HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1—Organization, Description of Business and Basis of Presentation

Clayton Holdings, Inc. (collectively with its wholly owned subsidiaries, the “Company”) was formed on March 31, 2005 as a Delaware corporation. The Company was formed to combine two companies which were under common control, GRP Holdings, Inc. (“GRP”), a Delaware corporation, and TMHC Holdings, Inc. (“TMHC”), a Delaware corporation. GRP was formed to acquire Clayton Services, Inc. (“CSI”) and First Madison Services, Inc. (“FMS”) from unrelated parties on August 2, 2004. TMHC was formed to acquire Clayton Fixed Income Services Inc., formerly known as “The Murrayhill Company” (“CFIS”), from an unrelated party on May 24, 2004. Each holding company was controlled by TA Associates (“TA”) prior to the combination. In accordance with accounting principles generally accepted in the United States of America (“US GAAP”), assets transferred between entities under common control are accounted for at historical cost similar to a pooling of interests, and the financial statements of previously separate companies for periods they were under common control are restated on a combined basis. The Company’s consolidated financial statements include the results of GRP and TMHC beginning from the date of acquisition of a controlling interest by TA, which were August 2, 2004 and May 24, 2004, respectively.

The Company provides a full suite of outsourced services, information-based analytics and specialty consulting for buyers and sellers of, and investors in, mortgage-related loans and securities and other debt instruments. The Company’s services include transaction management, which consists of due diligence, conduit support services, professional staffing services, compliance products and services as well as credit risk management and securities surveillance, and special servicing. The Company uses proprietary technology and processes to provide these services across the lifecycle of a loan, from loan origination, aggregation and securities issuance to the surveillance and administration of loans and securities. The Company provides a majority of its services to participants in the non-agency segment of the mortgage-backed securities, or MBS, market and the non-conforming mortgage loan market.

Basis of Presentation

The accompanying condensed consolidated financial statements are unaudited. In the opinion of management, all adjustments, consisting of only normal recurring adjustments considered necessary for a fair presentation, have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements, accounting policies and notes included in the Company’s registration statement on Form S-1 (File No. 333-129526) declared effective by the Securities and Exchange Commission on March 23, 2006, which includes audited financial statements for the year ended December 31, 2005. Results for the interim periods are not necessarily indicative of results for the full year.

Initial Public Offering of Common Stock

On March 29, 2006, the Company sold 8,625,000 shares, inclusive of an over-allotment option of 1,125,000 shares, of its common stock in an initial public offering (“IPO”) of common stock at a price to the public of $17.00 per share, for net proceeds of approximately $131,800,000 after deducting the underwriting discount and approximately $4,500,000 of offering expenses. The Company used approximately $130,200,000 of the proceeds to pay down indebtedness and to redeem all outstanding shares of redeemable preferred stock, which were issued upon the conversion of the Company’s convertible preferred stock. The Company used the remaining approximately $1,600,000 for general corporate purposes. After giving effect to this offering, the Company had 20,516,306 shares of common stock outstanding.

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All share information has been adjusted to reflect a 1-for-4 reverse stock split of common stock and class B common stock, which was consummated on March 1, 2006.

Note 2—Summary of Significant Accounting Policies

Significant accounting policies followed by the Company, as summarized below, are in conformity with US GAAP.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company. All significant intercompany transactions and balances have been eliminated in consolidation.

Use of Estimates

The preparation of consolidated financial statements in conformity with US GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities in the financial statements and accompanying notes. Some of these accounting policies require the application of significant judgment by management in the selection of appropriate assumptions for determining these estimates. By their nature, these judgments are subject to an inherent degree of uncertainty; therefore, the Company cannot give assurance that actual results will not differ significantly from estimated results. Management bases these judgments on the Company’s historical experience, management’s forecasts and other available information, as appropriate. The most significant estimates reflected in the financial statements include deferred tax assets and liabilities, income tax accruals, valuation allowance for accounts receivable, unbilled receivables, asset impairments, the valuation of stock options and the valuation of intangible assets and assessments of their useful lives, and related party transactions. Actual results could differ from estimated amounts. The Company also makes estimates in determining other ordinary accruals.

Segment Reporting

The Company’s activities are considered to be in a single industry segment for financial reporting purposes. The Company provides services that support the purchase and sale of, and investment in, mortgage loans and related securities across the mortgage loan lifecycle. Revenues from the Company’s various products and services are affected by the same factors, primarily the origination of non-conforming mortgage loans and the issuance of non-agency mortgage-backed securities.

Deferred Financing Costs

The Company amortizes the costs that it incurs to obtain debt financing over the terms of the underlying obligations using the effective interest method for the portion of the costs associated with term loan debt and using the straight line method for the portion of the costs associated with the revolving credit facility. The amortization of deferred financing costs is included in interest expense. Unamortized deferred financing costs are included in “other assets, net” in the accompanying condensed consolidated balance sheets. As a result of the Company’s IPO (see Note 1) on March 29, 2006, the Company repaid $70,000,000 of principal on its $150,000,000 term loan and wrote off a proportionate share of the unamortized deferred financing costs associated with the term loan. A loss on extinguishment of $746,002 reflecting this write off is reflected in the statement of income for the nine months ended September 30, 2006. Unamortized deferred financing costs at September 30, 2006 and December 31, 2005 were $1,501,562 and $2,354,099, respectively, and are included on the accompanying consolidated balance sheets in “other assets, net.”

Revenue Recognition

Revenue is recognized when persuasive evidence of an arrangement exists, the service has been performed, the fee is fixed and determinable, and collection of the resulting receivable is reasonably assured.

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The Company derives most of its revenues from professional service activities.  Revenues consisting of billed fees and pass-through expenses are recorded as work is performed and expenses are incurred. Revenues also include expenses billed to clients, which includes travel and other out-of-pocket expenses, and other reimbursable expenses. Based on aggregate volume of all travel expenses incurred for both corporate purposes and client service activities, the Company is eligible to receive certain retroactive volume discounts from several of its travel providers. Such amounts are accrued as earned, are netted against travel and related expenses and historically have not been material.  For the three months ended September 30, 2006 and 2005, pass-through expenses included in revenues were $6,302,644 and $7,455,077, respectively.  For the nine months ended September 30, 2006 and 2005, pass-through expenses included in revenues were $20,182,431 and $21,924,136, respectively.

The Company records provisions for fee adjustments and discretionary pricing adjustments as a reduction of revenues. Revenues recognized, but not yet billed to clients, have been recorded as unbilled receivables in the accompanying condensed consolidated balance sheets.

Stock-based Compensation

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Accounting for Stock Based Compensation” which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires an issuer to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This eliminates the exception to account for such awards using the intrinsic method previously allowable under Accounting Principles Board (“APB”) Opinion No. 25. In March 2005, the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-Based Payment,” which expresses views of the SEC Staff about the application of SFAS No. 123(R). SFAS No. 123(R) became effective for annual reporting periods beginning on or after June 15, 2005. The Company previously adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” for all awards granted to employees. On January 1, 2006, the Company adopted SFAS No. 123(R) and SFAS No. 123(R) does not have a material impact on its financial statements.

According to the provisions of the incentive stock option agreements between the Company and its employees, the vesting term for certain options outstanding as of the date of the IPO accelerated by either one year or twenty percent, varying in accordance with the terms of the employee’s specific incentive stock option agreement. In addition, 130,208 of performance based options became immediately vested. Therefore, on March 29, 2006, the Company recognized $611,696 of additional compensation expense from this accelerated vesting.

Concentration of Credit Risk and Significant Customers

At September 30, 2006, 23.9% and 31.6% of the Company’s billed and unbilled receivables were related to its two largest clients, respectively. At December 31, 2005, 30.1% and 25.5% of the Company’s billed and unbilled receivables were related to its two largest clients, respectively.

For the three months ended September 30, 2006 and 2005, revenue from the Company’s largest three clients accounted for an aggregate of 30.2% and 33.3% of total revenue, respectively. Revenue from two clients exceeded 10% of revenue for the three months ended September 30, 2006 and revenue from three clients exceeded 10% of revenue for the three months ended September 30, 2005.

For the nine months ended September 30, 2006 and 2005, revenue from the Company’s largest three clients accounted for an aggregate of 32.0% and 35.5% of total revenue, respectively. Revenue from two clients exceeded 10% of revenue for the nine months ended September 30, 2006 and revenue from three clients exceeded 10% of revenue for the nine months ended September 30, 2005.

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Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted-average number of shares of common stock and common stock equivalents outstanding during the period. The Company’s convertible preferred stock is deemed to be a common stock equivalent and included in the computation of basic earnings per share because it receives dividends at a rate that results in a per share amount that is equivalent to the per share amount paid on common stock. Diluted earnings per share gives effect to dilutive options, warrants and other potential common stock outstanding during the period.  At September 30, 2006, outstanding options to purchase 210,000 and 130,000 common shares had exercise prices in excess of the average market price of common shares for the three and nine month periods ended September 30, 2006, respectively.  At September 30, 2005, outstanding options to purchase 254,580 and 887,094 common shares had exercise prices in excess of the average market price of common shares for the three and nine month periods ended September 30, 2005, respectively.  These options were not included in the computation of diluted earnings per share for the respective periods because the effect would be antidilutive.

The following table presents a reconciliation of the numerators and denominators of basic and diluted net income per share for the three and nine months ended September 30, 2006 and 2005:

 

		For the three months ended						For the three months ended
		September 30, 2006						September 30, 2005
		Basic			Diluted			Basic			Diluted
Net income		$	3,059,898		$	3,059,898		$	3,335,729		$	3,335,729
Weighted average number of common shares outstanding		20,536,709			20,536,709			11,889,201			11,889,201
Dilutive effect of stock options		—			775,501			—			489,308
Total weighted average number of common shares outstanding		20,536,709			21,312,210			11,889,201			12,378,509
Earnings per share		$	0.15		$	0.14		$	0.28		$	0.27

 

		For the nine months ended						For the nine months ended
		September 30, 2006						September 30, 2005
		Basic			Diluted			Basic			Diluted
Net income		$	4,334,197		$	4,334,197		$	6,314,777		$	6,314,777
Weighted average number of common shares outstanding		17,776,603			17,776,603			11,887,779			11,887,779
Dilutive effect of stock options		—			801,523			—			401,130
Total weighted average number of common shares outstanding		17,776,603			18,578,126			11,887,779			12,288,909
Earnings per share		$	0.24		$	0.23		$	0.53		$	0.51

 

Adoption of New Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement 109.”  FIN 48 prescribes a comprehensive model for recognizing, measuring, presenting and disclosing in the financial statements tax positions taken or expected to be taken on a tax return including a decision whether to file or not to file in a particular jurisdiction.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  If there are changes in net assets as a result of application of FIN 48 these will be accounted for as an adjustment to retained earnings.  The Company is currently assessing the impact of FIN 48 on its consolidated financial position and results of operations.

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In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.”   SFAS No. 157 establishes a common definition for fair value to be applied to US GAAP guidance requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact of SFAS No. 157 on its consolidated financial position and results of operations.

In September 2006, the Securities and Exchange Commission (“SEC”) staff issued Staff Accounting Bulletin (“SAB”) 108 “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.”  SAB 108 requires that public companies utilize a “dual-approach” to assessing the quantitative effects of financial misstatements.  This dual approach includes both an income statement focused assessment and a balance sheet focused assessment.  The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. The Company is currently assessing the impact of adopting SAB 108 but does not expect that it will have a material effect on its consolidated financial position or results of operations.

Note 3—Business Acquisitions

Asset Purchase from M R Network I, Ltd.

On February 3, 2006, the Company entered into an asset purchase agreement through a subsidiary pursuant to which the subsidiary acquired substantially all of the assets and assumed certain liabilities of M R Network I, Ltd. (formerly d/b/a Mortgage Resource Network and currently d/b/a Clayton Lender Solutions, Inc.) for an estimated aggregate purchase price of $5,727,168, pending a final closing balance sheet. The asset purchase agreement provided for a 60-day period subsequent to the closing date to provide a closing balance sheet which will be used to determine final fair market values.  The agreement also established two escrow accounts aggregating $600,000 which are reflected in the accompanying condensed consolidated balance sheet, including accumulated interest, at September 30, 2006 as cash held in escrow. This escrow is held against any claims the Company may have for indemnification or a working capital shortfall upon preparation of the final closing balance sheet. The 60-day period to reach agreement on the final closing balance sheet was extended so that the Company can better evaluate the fair value of assets acquired.

In July, 2006, an additional escrow account in the amount of $392,842 was established by the former principal owners of M R Network I, Ltd.  This amount will be retained by the Company if the Company is not able to collect certain accounts receivable balances included in the assets acquired by the Company.  As a result, the purchase price and the amount allocated to goodwill were reduced by the amount of the escrow account.  This acquisition has not been presented on a pro forma basis because it is not deemed to be material.

The purchase price was allocated as follows:

 

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Note 4—Cash, Cash Equivalents and Restricted Cash

At September 30, 2006 and December 31, 2005, the Company maintained cash and cash equivalent balances in excess of $100,000 at two separate financial institutions. Accounts at these institutions are insured by the Federal Deposit Insurance Corporation up to $100,000. At September 30, 2006 and December 31, 2005, the cash balances exceeded $100,000 by $46,831,575 and $13,447,318, respectively, including restricted cash.

At September 30, 2006 and December 31, 2005, the Company maintained restricted cash balances of $25,378,170 and $4,966,839, respectively. This balance represented funds received in connection with certain loan servicing functions the Company performs for a customer. Such funds are received throughout the month and remitted to the customer on a monthly basis. The balance on hand is included in servicer escrow liability in the accompanying condensed consolidated balance sheets.

Note 5—Property and Equipment, net

Property and equipment, net consists of the following:

 

Included in software at September 30, 2006 and December 31, 2005, is $10,213,442 and $3,189,915, respectively, of internally developed software placed in service. Software under development represents other internally developed software that has not yet been placed in service.

For the three months ended September 30, 2006 and 2005 depreciation and amortization expense charged to operations was $2,184,949 and $1,187,304, respectively. For the nine months ended September 30, 2006 and 2005 depreciation and amortization expense charged to operations was $5,684,205 and $3,137,926, respectively.

Note 6—Goodwill and Other Intangible Assets

As of September 30, 2006 and December 31, 2005, intangible assets not subject to amortization consist of goodwill of $73,958,797 and $69,843,468, respectively, and trade names and trademarks of $15,504,917 and $15,504,338, respectively.

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At September 30, 2006, the Company’s intangible assets with identifiable useful lives, which continue to be amortized, consist of the following:

 

		Gross carrying amount			Accumulated amortization			Net
Customer relationships
Transaction management and advisory		$	36,400,000		$	4,381,482		$	32,018,518
Staffing services		4,300,000			931,667			3,368,333
Portfolio management		11,485,600			2,761,009			8,724,591
Client backlog		2,146,200			1,010,791			1,135,409
Technology		26,842,900			11,746,441			15,096,459
Noncompetition agreements		3,568,950			1,566,598			2,002,352
Patent		20,451			6,555			13,896
		$	84,764,101		$	22,404,543		$	62,359,558

 

At December 31, 2005, the Company’s intangible assets with identifiable useful lives, which continue to be amortized, consist of the following:

 

		Gross carrying amount			Accumulated amortization			Net
Customer relationships
Transaction management and advisory		$	36,400,000		$	2,864,815		$	33,535,185
Staffing services		4,300,000			609,167			3,690,833
Portfolio management		10,714,600			1,776,817			8,937,783
Client backlog		2,146,200			688,861			1,457,339
Technology		26,842,900			7,720,006			19,122,894
Noncompetition agreements		3,494,950			1,022,292			2,472,658
Patent		20,204			1,460			18,744
		$	83,918,854		$	14,683,418		$	69,235,436

 

Amortization expense for the three months ended September 30, 2006 and 2005 was $2,577,696 and $2,540,172, respectively.  Amortization expense for the nine months ended September 30, 2006 and 2005 was $7,721,125 and $7,633,833, respectively.

Note 7—Revolving Credit Facility, Long-Term Debt and Capital Lease Obligations

Long-term debt and capital lease obligations consist of the following:

 

 

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Credit Agreement

On December 8, 2005 the Company entered into a credit agreement (the “Credit Agreement”) with a financial institution. The Credit Agreement, provided the Company with a $150,000,000 term loan, all of which was funded at closing, and a $40,000,000 revolving credit facility, none of which was funded at closing. Subject to the agreement of the lenders to increase their commitments, the Company had the option to borrow up to an additional $10,000,000 under the revolving credit facility, for an aggregate revolving credit facility of $50,000,000. On January 11, 2006 and April 28, 2006, the Company exercised its option and amended the Credit Agreement to increase the revolving credit facility by $5,000,000 on each date, such that the Company had an aggregate revolving credit facility of $50,000,000 as of, and subsequent to, April 28, 2006. The Credit Agreement expires on December 8, 2011.

After the Company’s initial public offering was completed on March 29, 2006 the Company repaid $70,000,000 of the $150,000,000 outstanding term loan balance without incurring any prepayment penalty. In addition, $7,400,000 which was outstanding under the revolving credit facility was repaid. The first $375,000 of the $70,000,000 term loan payment was applied against the principal payment due on March 31, 2006 and future principal repayments were recalculated pro rata based on the remaining balance.  Therefore, scheduled quarterly payments of the term loan through December 31, 2010 were reduced from $375,000 to $200,501 with the remaining balance of $76,190,476 payable in four quarterly installments of $19,047,619 in 2011. As a result of the repayment of the term loan the Company wrote off a proportionate share of deferred financing costs associated with the term loan (see Note 2, Deferred Financing Costs) and reflected a loss on extinguishment of $746,002 in the condensed consolidated statement of income for the nine months ended September 30, 2006.

The Credit Agreement is collateralized by substantially all of the assets of the Company. The agreement contains covenants which, among other matters, require the Company to maintain certain levels of interest coverage ratio, fixed charge ratio and total leverage ratio. Such covenants commenced effectiveness on March 31, 2006. The Company is in compliance with these covenants. In addition, the Credit Agreement places limitations on total annual capital expenditures, indebtedness, liens, dividends and distributions, asset sales, transactions with affiliates, acquisitions and conduct of business, all as defined in the agreement. The Credit Agreement also contains provisions for an increased rate of interest during periods of default.

Loans under the Credit Agreement bear interest at the applicable London interbank offered rate (“LIBOR”) plus 3.00% or Prime rate plus 2.0%, at the Company’s option. In addition, the Company is required to pay a commitment fee of 0.5% based on the calculation of the excess of the revolving credit loan commitment over the revolving outstanding balance as defined.

At September 30, 2006 and December 31, 2005, the revolving credit facility had no outstanding balance and there was an outstanding balance of $79,799,499 and $150,000,000, respectively, under the term loan with an interest rate of 8.33% and 9.25%, respectively.

Interest Rate Cap

In September 2004, CSI purchased an interest rate cap agreement to reduce the potential impact that interest rate increases could have on its floating-rate debt interest expense. The terms of the interest rate cap provide that the Company would receive quarterly payments equal to the notional amount multiplied by the difference by which LIBOR exceeds 5%.  During the third quarter of 2006 the Company received approximately $19,300 which was recorded as a reduction of interest expense.  The initial notional amount was $20,000,000 and declines during the term of the agreement, which expired on September 30, 2006. As of December 31, 2005, the notional amount was $16,937,500. The interest rate cap does not qualify for hedge accounting under SFAS No. 133, as amended. The initial premium of $29,900 was recorded as an asset on the date of purchase. Subsequent declines in the fair value of this derivative were recorded as interest expense in the accompanying condensed consolidated statements of income. For the three and nine months ended September 30, 2005, the Company recorded $0 and $7,860, respectively, of interest expense to reflect a decline in the fair value of this asset during the respective periods.  In January 2006, the Company recorded interest expense of $1,915 to reduce the book value of this asset to zero.

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Capitalized Lease Obligations

At September 30, 2006, the Company leased $1,068,087 of equipment under agreements accounted for as capital leases with accumulated depreciation of $240,219. The obligations for the equipment required the Company to make monthly payments through March 2011, with implicit interest rates from 7.06% to 19.06%.

At December 31, 2005, the Company leased $467,584 of equipment under agreements accounted for as capital leases with accumulated depreciation of $51,597. The obligations for the equipment required the Company to make monthly payments through August 2010, with implicit interest rates from 7.06% to 19.06%.

Note 8—Preferred Stock

As of December 31, 2005 the Company had 8,825,241 shares designated as Series A Redeemable Preferred Stock, par value $0.01 per share, and 27,837,046 shares designated as Series B Redeemable Preferred Stock, par value $0.01 per share, none of which were outstanding. As of December 31, 2005, the Company had 8,825,241 shares designated as Series A Convertible Preferred Stock, par value $0.01 per share, and 24,185,493 shares designated as Series B Convertible Preferred Stock, par value $0.01 per share, all of which were outstanding. As of December 31, 2005, the Series A and Series B convertible preferred stock were carried on the consolidated balance sheet at their liquidation preference of $12,258,319 and $43,866,683, respectively.

On March 29, 2006, the Company completed its initial public offering of common stock, resulting in the conversion of the Series A Convertible Preferred Stock into 2,206,308 shares of common stock, par value $0.01 per share, and 8,825,241 shares of Series A Redeemable Preferred Stock, and the conversion of 24,185,493 shares of Series B Convertible Preferred Stock into 6,046,371 shares of common stock, par value $0.01 per share, and 24,185,493 shares of Series B Redeemable Preferred Stock. A portion of the proceeds from the initial public offering was used to redeem all shares of the Series A Redeemable Preferred Stock and Series B Redeemable Preferred Stock for $52,764,950, and all of the Series A and Series B Redeemable Preferred Stock were immediately retired. The difference between the liquidation preference amount of the convertible preferred stock and the redemption amount of the redeemable preferred stock was allocated to the common stock resulting from the conversion and credited to additional paid-in capital.

Note 9—Commitments and Contingencies

Operating Leases

The Company leases its office facilities and certain equipment under noncancelable operating lease arrangements expiring on various dates through 2013. Such leases include fixed or minimum payments plus, in some cases, scheduled base rent increases over the term of the lease and additional rents based on the Consumer Price Index. Certain leases provide for monthly payments of real estate taxes, insurance and other operating expenses applicable to the property.

For the three months ended September 30, 2006 and 2005, rent expense was approximately $895,651 and $696,621, respectively. For the nine months ended September 30, 2006 and 2005, rent expense was approximately $2,790,855 and $2,090,008, respectively.

Litigation

In the normal course of business, the Company is subject to various legal proceedings and claims, the resolution of which, in management’s opinion, will not have a material adverse effect on the financial position or the results of operations of the Company.

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Note 10—Common Stock

At December 31, 2005, the Company had 60,000,000 shares of common stock authorized, of which 3,281,607 were issued and outstanding.

Prior to the initial public offering, the Company’s outstanding capital stock consisted of: (i) 3,281,607 shares of common stock, par value $0.01 per share; (ii) 357,020 shares of Class B common stock, par value $0.01 per share; (iii) 8,825,241 shares of Series A Convertible Preferred Stock, par value $0.01 per share; and (iv) 24,185,493 shares of Series B Convertible Preferred Stock, par value $0.01 per share.

In connection with, and upon the completion of, the initial public offering on March 29, 2006, 8,825,241 shares of Series A Convertible Preferred Stock were converted into 2,206,308 shares of common stock and 8,825,241 shares of Series A Redeemable Preferred Stock, and 24,185,493 shares of Series B Convertible Preferred Stock were converted into 6,046,371 shares of common stock and 24,185,493 shares of Series B Redeemable Preferred Stock.

Upon the consummation of the initial public offering, all outstanding shares of Class B common stock were converted into 357,020 shares of common stock, par value $0.01 per share, and each share of Class B Common Stock was retired.

Inclusive of an over-allotment option of 1,125,000 shares of its common stock, the Company sold 8,625,000 shares of common stock in its initial public offering at a price to the public of $17.00 per share, for net proceeds of approximately $131,800,000 after deducting the underwriting discount and approximately $4,500,000 of offering expenses. After giving effect to this offering and the conversion transactions described above, the Company had 20,516,306 shares of common stock outstanding as of March 29, 2006.

On March 29, 2006, in connection with the Company’s initial public offering, the Fourth Amended and Restated Certificate of Incorporation, which was adopted by the stockholders prior to the initial public offering, was filed with the State of Delaware. The Company’s Certificate of Incorporation was amended to change the authorized capital stock of the Company from an aggregate of 160,000,000 shares, consisting of (a) 69,673,021 shares of preferred stock, par value $0.01 per share, consisting of Series A Convertible Preferred Stock, Series B Convertible Preferred Stock, Series A Redeemable Preferred Stock and Series B Redeemable Preferred Stock, (b) 80,326,979 shares of common stock, consisting of common stock and Class B common stock, and (c) 10,000,000 shares of undesignated preferred stock to a total of 160,000,000 shares of capital stock consisting of (i) 150,000,000 shares of common stock, par value $0.01 per share, and (ii) 10,000,000 shares of undesignated preferred stock, par value $0.01 per share.

All share information has been adjusted to reflect a 1-for-4 reverse stock split of common stock and class B common stock, which was consummated on March 1, 2006.

At September 30, 2006, the Company had 150,000,000 shares of common stock authorized, of which 20,564,926 were issued and outstanding.

Note 11- Related Party Transactions

On March 29, 2006 the Company paid $52,764,950 from proceeds from its IPO to redeem from investment funds affiliated with TA Associates and other preferred stockholders, including Brian L. Libman, a director of the Company, all of the shares of redeemable preferred stock outstanding immediately following the conversion of Series A Convertible Preferred Stock and Series B Convertible Preferred Stock.

The Company’s Chief Executive Officer, who was appointed in April 2005, has served on the Board of Directors of another public company since 1995 and is currently the chairman of this entity’s audit committee. This unrelated entity acquires and originates non-conforming residential and commercial loans.

15

The Company has provided due diligence and professional staffing services to this entity and revenues aggregated $27,375 for the three and nine month periods ended September 30, 2006, and $64,042 and $643,809 for the three and nine month periods ended September 30, 2005, respectively.

CFIS has contracts to perform Credit Risk Management services for portfolios managed by a stockholder. Revenues generated from the contracts for the nine months ended September 30, 2006 and 2005 were approximately $476,421 and $507,748, respectively, and for the three months ended September 30, 2006 and 2005 were approximately $162,698 and $215,349, respectively, and were included in service fee revenue in the condensed consolidated statements of income. Accounts receivable from this party at September 30, 2006 and December 31, 2005, were $90,077 and $74,555, respectively.

Until December 8, 2005, the Company had subordinated note and subordinated convertible note purchase agreements with certain stockholders of the Company. For the nine months ended September 30, 2005 interest expense on these notes was $2,706,667. There was no interest expense on these notes in the nine months ended September 30, 2006.

Note 12—Stock Options

The Company’s 2005 Stock Option and Grant Plan (“2005 Option Plan”) permitted the Company to make grants of incentive stock options, non-qualified stock options, restricted stock awards and unrestricted stock awards to officers, employees, directors, consultants and other key persons. Stock options granted under the 2005 Option Plan have a maximum term of ten years from the date of grant and incentive stock options have an exercise price of no less than the fair market value of the common stock on the date of grant. In connection with the adoption of the Company’s 2006 Option Plan, which is discussed below, the board of directors determined not to grant any further awards under the 2005 Option Plan.

On January 26, 2006, the Company’s Board of Directors approved the adoption of the Company’s 2006 Stock Option and Incentive Plan (“2006 Option Plan”), and the 2006 Option Plan was subsequently approved by stockholders on March 8, 2006. The 2006 Option Plan permits grants of incentive stock options, non-qualified stock options, stock appreciation rights, deferred stock awards, restricted stock awards, unrestricted stock awards and dividend equivalent rights. The Company reserved 1,814,130 shares of common stock for issuance of awards under the 2006 Option Plan, subject to adjustment for any stock split, dividend or other change in the Company’s capitalization. Generally, shares that are forfeited or cancelled from awards under the 2006 Option Plan will be available for future grants. Stock options granted under the 2006 Option Plan have a maximum term of ten years from the date of grant and incentive stock option awards have an exercise price of no less than the fair market value of the common stock on the date of grant, which will be on the last day of the month of the award.  The options generally vest over a period of four years, with 25% of each grant vesting after one year and the remaining shares vesting monthly over the following three years.  As of September 30, 2006, 210,000 awards had been granted under the 2006 Option Plan.  The Company issues new shares upon the exercise of stock options.

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Changes in options outstanding during the nine months ended September 30, 2006 are as follows:

 

The intrinsic value of options exercised in the nine months ended September 30, 2006 was approximately $530,000.

Changes in unvested options outstanding during the nine months ended September 30, 2006 are as follows:

 

		Number of Shares		Weighted Average Exercise Price
Unvested options outstanding, December 31, 2005		1,209,592		$	4.77
Granted		209,001		14.13
Vested		719,598		4.73
Cancelled or forfeited		36,922		3.85
Unvested options outstanding, September 30, 2006		662,073		$	7.83

 

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The following table summarizes information about stock options outstanding at September 30, 2006:

 

September 30, 2006
					Options Outstanding							Options Exercisable
Exercise Price					Number Outstanding		Remaining Contractual Life (yrs)		Intrinsic Value as of September 30, 2006			Number Exercisable			Weighted Average Exercise Price			Intrinsic Value as of September 30, 2006
	$	0.98			361,132		8.17		$	4,187,123		252,762			$	0.98		$	2,930,634
	4.00				62,500		7.65		535,625			57,291			4.00			490,984
	4.13				86,817		8.24		732,909			65,936			4.13			556,632
	6.00				520,833		8.57		3,421,873			366,210			6.00			2,406,000
	6.36				109,869		8.82		682,286			58,678			6.36			364,390
	6.80				229,590		9.00		1,324,734			116,356			6.80			671,374
	12.34				30,000		9.92		6,900			—			12.34			—
	12.57				25,000		10.00		—			—			12.57			—
	13.05				25,000		9.80		—			—			13.05			—
	14.05				102,000		9.67		—			—			14.05			—
	17.00				15,500		9.48		—			1,435			17.00			—
	20.40				5,000		9.49		—			—			20.40			—
	21.38				7,500		9.51		—			—			21.38			—
					1,580,741		8.66		$	10,891,450		$	918,668		$	4.50		$	7,420,01

 

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Accounting for Stock Based Compensation” which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires an issuer to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This eliminates the exception to account for such awards using the intrinsic method previously allowable under Accounting Principles Board (“APB”) Opinion No. 25. In March 2005, the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-Based Payment,” which expresses views of the SEC Staff about the application of SFAS No. 123(R). SFAS No. 123(R) became effective for annual reporting periods beginning on or after June 15, 2005. The Company previously adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” for all awards granted to employees. On January 1, 2006 the Company adopted SFAS No. 123(R) and SFAS No. 123(R) does not have a material impact on its financial statements.

The Company completed its initial public offering on March 29, 2006. According to the provisions of incentive stock option agreements between the Company and its employees, the vesting term for certain options outstanding as of the date of the IPO accelerated by either one year or twenty percent, varying in accordance with the terms of the employee’s specific incentive stock option agreement. In addition, 130,208 of performance based options became immediately vested. Therefore, on March 29, 2006 the Company recognized $611,696 of additional compensation expense from this accelerated vesting.

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The ongoing effect on consolidated results of operations of financial condition will be dependent upon future stock based compensation awards granted.  The Company utilizes the Black-Scholes option valuation method to calculate the fair market value of the options using assumptions in effect on the date of the grant, as follows:

		Nine Months Ended
		September 30, 2006		September 30, 2005
Expected life (in years)		6.5–7.5		6.25
Risk-free interest rate		4.6–5.1	%	3.9–4.2	%
Volatility		25–28	%	25	%
Dividend		0	%	0	%

 

For the three months ended September 30, 2006 and 2005 the Company recognized expenses related to the stock option grants summarized above over the vesting period of such options of approximately $170,000 and $70,000, respectively. For the nine months ended September 30, 2006 and 2005 the Company recognized expenses related to the stock option grants summarized above over the vesting period of such options of approximately $1,024,000 and $148,000, respectively.  In addition, the Company will recognize approximately $1,755,000 of expense related to these grants over the remaining vesting period of such options.  This expense is expected to be recognized over a weighted-average period of 2.92 years.

Note 13—Subsequent Events

On October 18, 2006, the Company accepted the resignation of its Chief Information Officer.  In connection with this resignation, which shall be effective on February 28, 2007, the Company and the employee entered into a separation agreement, filed as Exhibit 10.1 to the Form 8-K filed by the Company on October 18, 2006.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 

Forward Looking Statements and Projections

This Quarterly Report on Form 10-Q contains forward looking statements. Forward looking statements relate to future events or our future financial performance. We generally identify forward looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “could,” “intends,” “target,” “projects,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar words. These statements are only predictions. We have based these forward looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, results of operations and financial condition. The outcome of the events described in these forward looking statements is subject to risks, uncertainties and other factors described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,”  elsewhere in this Quarterly Report on Form 10-Q and in our Quarterly Report on Form 10-Q for the three month period ended March 31, 2006. Accordingly, you should not rely upon forward looking statements as predictions of future events. We cannot assure you that the events and circumstances reflected in the forward looking statements will be achieved or occur, and actual results could differ materially from those projected in the forward looking statements. The forward looking statements made in this Quarterly Report on Form 10-Q relate only to events as of the date on which the statements are made. We undertake no obligation to update any forward looking statement to reflect events or circumstances after the date on which the statement is made or to reflect the occurrence of unanticipated events.

Overview

We provide a full suite of outsourced services, mortgage-related analytics and specialized consulting services for buyers and sellers of, and investors in, mortgage-related loans and securities and other debt instruments. Our services include transaction management, which consists of due diligence, mortgage processing services for buyers of mortgage loans (conduit support services), professional staffing services, and compliance products and services, as well as monitoring of mortgage-backed securities (credit risk management and surveillance), and specialized loan servicing services (special servicing). We provide a majority of our services to participants in the non-agency mortgage-backed securities, or MBS, market and the non-conforming mortgage loan market. We believe that several trends support the demand for our services, including:

·                  the growth in outsourced services by capital markets firms and other major mortgage loan market participants;

·                  the increased complexities and requirements of federal, state and local regulations applicable to the mortgage loan industry;

·                  investors’ growing demand for loan performance data; and

·                  buyers purchasing smaller pools of loans from a larger number of sellers, increasing the need for our conduit support services.

Our revenue is also driven by non-agency MBS issuance and the aggregate number of non-conforming mortgage loan originations. Changes in the volume of non-agency MBS issuances and non-conforming mortgage loan originations may impact the number of loans for which we perform our services, leading to a corresponding change in gross revenue. We are increasingly utilizing our centralized underwriting facilities to perform our services which should reduce the amount of per loan travel expenses.

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We believe the volume of non-agency MBS securitizations and non-conforming mortgage loan originations may be lower in 2006 than in 2005. We expect the non-agency MBS securitization and non-conforming mortgage loan origination markets to continue growing over the long term, although the rate of growth may be slower than in recent years. We believe there is an increasing demand for and the availability of new loan products, increased home ownership driven in part by first-time homeowners, minorities and immigrants, and increased liquidity in the non-agency MBS market. We face a number of risks in our industry and the market for our services is highly competitive. Our business is driven in part by the MBS market, the mortgage lending industry and the housing market, each of which is highly sensitive to trends in the general economy, including interest rates, perceived and actual economic conditions, taxation policies, availability of credit, employment levels and wage and salary levels. Adverse changes in any of these trends, or a decline in the sale of both new and existing homes or in home values, could lessen the demand for mortgage loans, which could result over time in a reduced demand for our services and diminish our revenue. A material reduction in the number of loans available for securitization may cause our clients to engage us for fewer services, which could have an adverse effect on our business and results of operations. Moreover, the majority of our business is generated through our largest 20 clients. The loss of one or more of these clients could adversely affect our business and results of operations. Lastly, we are dependent on our independent loan review specialists to perform our services. Our business could suffer if we are unable to recruit and retain additional qualified independent loan review specialists.

Basis of Presentation

We were formed as a Delaware corporation in March 2005, following the combination of the holding companies of each of Clayton Services and its subsidiaries, including First Madison, and CFIS, formerly The Murrayhill Company, or Murrayhill. Prior to the combination, each holding company was controlled by investment funds affiliated with TA Associates. In accordance with US GAAP relating to companies under common control prior to their combination, the financial statements of the previously separate companies under common control are restated on a combined basis from the dates of their respective acquisitions by the controlling entity. Accordingly, for accounting purposes, the date of our inception was May 24, 2004, the date that investment funds affiliated with TA Associates acquired CFIS, the first of the combined entities that were brought under common control.

Critical Accounting Policies

Basis of Presentation

Our condensed consolidated financial statements are unaudited. In our opinion, all adjustments, consisting of only normal recurring adjustments considered necessary for a fair presentation, have been included. Certain information and footnote disclosures normally included in financial statements prepared in accordance with US GAAP have been condensed or omitted. It is suggested that these unaudited condensed consolidated financial statements be read in conjunction with the consolidated financial statements, accounting policies and notes included in our registration statement on Form S-1 (File No. 333-129526) declared effective by the Securities and Exchange Commission on March 23, 2006, which includes audited financial statements for the year ended December 31, 2005. Results for the interim periods are not necessarily indicative of results for the full year.

In preparing our financial statements in conformity with US GAAP, we have to make estimates and assumptions about future events that affect the amounts of reported assets, liabilities, revenues and expenses, as well as the disclosure of contingent assets and liabilities in the financial statements and accompanying notes. Some of our accounting policies require the application of significant judgment by management in the selection of appropriate assumptions for determining these estimates. By their nature, these judgments are subject to an inherent degree of uncertainty; therefore, we cannot assure you that actual results will not differ significantly from estimated results. We base these judgments on our historical experience, management’s forecasts and other available information, as appropriate.

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Our most critical accounting policies, which reflect significant management estimates and judgment in determining reported amounts in the condensed consolidated financial statements are as follows:

Revenue Recognition

Revenue is recognized when persuasive evidence of an arrangement exists, the service has been performed, the fee is fixed and determinable, and collection of the resulting receivable is reasonably assured.

We derive most of our revenue from professional service activities. Revenue consisting of billed fees and pass-through expenses is recorded as work is performed and expenses are incurred. Revenue also includes expenses billed to clients, which include travel and other out-of-pocket expenses, and other reimbursable expenses.

We record provisions for fee adjustments and discretionary pricing adjustments as a reduction of revenue. Revenue recognized, but not yet billed to clients, has been recorded as unbilled receivables in the Company’s condensed consolidated balance sheets.

Stock-Based Compensation

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Accounting for Stock Based Compensation” which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires an issuer to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This eliminates the exception to account for such awards using the intrinsic method previously allowable under Accounting Principles Board (“APB”) Opinion No. 25. In March 2005, the SEC released Staff Accounting Bulletin (“SAB”) 107, “Share-Based Payment,” which expresses views of the SEC Staff about the application of SFAS No. 123(R). SFAS No. 123(R) became effective for annual reporting periods beginning on or after June 15, 2005. We previously adopted the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” for all awards granted to employees. On January 1, 2006 we adopted SFAS No. 123(R) and it does not have a material impact on our financial statements.

According to the provisions of incentive stock option agreements between the Company and its employees, the vesting term for certain options outstanding as of the date of the IPO accelerated by either one year or twenty percent, varying in accordance with the terms of the employee’s specific incentive stock option agreement. In addition, 130,208 of performance based options became immediately vested. Therefore, on March 29, 2006, we recognized $611,696 of additional compensation expense from this accelerated vesting.

Options to purchase 210,000 shares were granted in the nine months ended September 30, 2006 with an average exercise price of $14.14 per share.

Earnings Per Share

Basic earnings per share is computed by dividing net income by the weighted-average number of shares of common stock and common stock equivalents outstanding during the period. Our convertible preferred stock is deemed to be a common stock equivalent and included in the computation of basic earnings per share because it receives dividends at a rate that results in a per share amount that is equivalent to the per share amount paid on common stock. Diluted earnings per share gives effect to dilutive options, warrants and other potential common stock outstanding during the period.   At September 30, 2006, outstanding options to purchase 210,000 and 130,000 common shares had exercise prices in excess of the average market price of common shares for the three and nine month periods ended September 30, 2006, respectively.   At September 30, 2005, outstanding options to purchase 254,580 and 887,094 common shares had exercise prices in excess of the average market price of common shares for the

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three and nine month periods ended September 30, 2005, respectively. These options were not included in the computation of diluted earnings per share for the respective periods because the effect would be antidilutive.

Valuation of Long-lived Assets Excluding Goodwill

We evaluate all of our long-lived assets, including intangible assets other than goodwill and fixed assets, periodically for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (SFAS No. 144). SFAS No. 144 requires that long-lived assets be evaluated for impairment when events or changes in facts and circumstances indicate that their carrying value may not be recoverable. If events or circumstances indicate that the carrying value of an asset may not be recoverable, we assess the recoverability of identified intangible assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. The amount of impairment will be measured as the difference between the carrying value and the fair value of the impaired asset. An impairment will be recorded as an operating expense in the period of the impairment and as a reduction in the carrying value of that asset.

Intangible Assets

Intangible assets consist of customer relationships, technology, trade name and trademarks, non-competition agreements and excess of cost over fair value of net assets acquired, or goodwill. Customer relationships are the value of the specifically acquired customer relationships. Technology is the value of recreating the completed technology infrastructure. Trade name and trademarks are the value inherent in the recognition of “Clayton” and the other names that we use. The value of the non-competition agreements are an appraisal of potential lost revenues that would arise from an individual initiating a competing enterprise.

Except for goodwill, trade names and trademarks, all intangible assets are stated at cost less accumulated amortization. The costs attributable to the identified intangibles were based on a number of significant assumptions as determined by the Company and its independent appraisal expert. Identifiable intangible assets with finite lives are amortized under the straight-line method over their applicable estimated useful lives.

The Company adopted SFAS No. 142 “Goodwill and Other Intangible Assets” (“SFAS No. 142”), which provides, among other things, that goodwill and intangibles with indefinite lives are no longer amortized but are reviewed for impairment at least annually (beginning with the first anniversary of the acquisition date). Annual impairment tests were conducted for Clayton Services and CFIS in 2006 and there was no impairment to goodwill or intangibles with indefinite lives of either entity.

Revenue

We generate a majority of our revenue by providing professional outsourced services across the lifecycle of a mortgage loan.

Our transaction management services are provided under “time-and-materials” or per file billing arrangements. Under “time-and-materials” arrangements, we bill our clients on an hourly basis with travel and other reimbursable expenses passed through and recognized as revenue. Under per file billing arrangements, we bill our clients for each file reviewed with travel and other reimbursable expenses passed through separately or included in the per file rate. Revenues consisting of billed fees and pass-through expenses, which include travel and other reimbursable expenses, are recorded as work is performed and expenses are incurred. Revenues recognized, but not yet billed to clients, have been recorded as unbilled receivables in our condensed consolidated balance sheets.  For the three and nine months ended September 30, 2006, transaction management revenue accounted for 79.4% of total revenue.

Our credit risk management, surveillance and special servicing services provide a revenue stream which is generally recurring in nature. In a typical MBS transaction for which we provide surveillance services, we are engaged by the trustee of an MBS issuance to provide our services over the life of the trust and are paid monthly directly from the cash flow of the trust. A majority of our surveillance revenue is based upon a negotiated rate multiplied by the outstanding principal balance of the underlying mortgage

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loans in the MBS issuance. These fees are recognized each month as services are rendered. Our special servicing activities are conducted under annual or multi-year contracts for which we typically receive revenue on a per loan per month basis. For the three and nine months ended September 30, 2006, surveillance and special servicing services revenue accounted for 20.6% of total revenue.

For the three months ended September 30, 2006 and 2005, revenue from our largest three clients accounted for an aggregate of 30.2% and 33.3% of total revenue, respectively. Revenue from two clients exceeded 10% of revenue for the three months ended September 30, 2006 and revenue from three clients exceeded 10% of revenue for the three months ended September 30, 2005.

For the nine months ended September 30, 2006 and 2005, revenue from our largest three clients accounted for an aggregate of 32.0% and 35.5% of total revenue, respectively. Revenue from two clients exceeded 10% of revenue for the nine months ended September 30, 2006 and revenue from three clients exceeded 10% of revenue for the nine months ended September 30, 2005.

Cost of Services

Compensation Expense

Compensation expense consists primarily of compensation for independent loan review specialists and employees directly involved in the delivery of our services, which include our client service managers who manage our engagements. Compensation expense also includes payroll related benefits for our direct employees. The professionals we retain from a professional employment organization, including our independent loan review specialists, do not receive any employee benefits from us and are only compensated for actual hours worked. Our direct cost of operations does not include an allocation of overhead costs.

Travel and Related Expenses

Travel and related expenses consist of expenses incurred in enabling employees and independent loan review specialists to travel to clients’ sites and are comprised of airfare, hotel and car rental expenses. A majority of these expenses is either directly billed to clients or included in the per file rates charged. As such, these expenses are directly or indirectly included in our revenue.

Other Direct Costs

Other direct costs include the cost of third party mortgage loan services (primarily collateral appraisal fees), outside support for our compliance services used in connection with our loan reviews, independent loan review specialist training and miscellaneous non-billable transaction costs.

Operating Expenses

Operating expenses primarily consist of corporate overhead costs not directly associated with a specific transaction or contract, such as salaries and benefits, marketing and administrative expenses, professional fees and depreciation and amortization expenses.

In connection with becoming a public company, we have incurred significant additional operating expenses such as increased audit fees, professional fees, directors and officers’ insurance costs, compensation for our board of directors, and expenses related to hiring additional personnel and expanding our administrative functions. Many of these expenses either were not incurred or were incurred at a lower level by us as a private company.

Salaries and Benefits

Salaries and benefits consist of employee compensation for those employees who are not directly billable to a particular assignment including costs of administrative, finance, human resources, technology and executive personnel.

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Other Selling, General and Administrative Expenses

Other selling, general and administrative expenses consist of costs such as rent and utilities, marketing, advertising and promotion expenses, non-reimbursable travel and entertainment, information technology, insurance, education, training and hiring expenses other than for independent loan review specialists and professional fees consisting of legal, accounting and other consulting fees in connection with the ongoing operation of our business including audit and Sarbanes-Oxley Act of 2002 compliance.

Depreciation and Amortization

We incur depreciation and amortization expenses for costs related to the capitalization of property and equipment and software developed for internal use on a straight-line basis over the estimated useful lives of the assets, which range from three to seven years. Leasehold improvements and assets under capital lease are amortized over the shorter of the estimated useful life of the asset or the lease term.

Treatment of Goodwill and Amortization of Intangibles

We also incur amortization expenses for costs related to the capitalization of identifiable intangible assets including customer relationships, technology and non-competition agreements.

We account for acquisitions of companies in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations (SFAS No. 141). We allocate purchase price to tangible assets, intangible assets, and liabilities based on fair values with the excess of purchase price amount being allocated to goodwill. The allocation of the purchase price to these intangible assets is based on a number of significant assumptions as determined by us and in the case of material acquisitions our independent appraisal expert, including evaluations of the future income producing capabilities of these assets and related future expected cash flows. We also make estimates about the useful lives of the acquired intangible assets. Should different conditions result in the determination that the value of the goodwill and acquired intangible assets has been impaired, we could incur write-downs of goodwill or intangible assets, or changes in the estimation of useful lives of those intangible assets. In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142), goodwill is not amortized, but is subject to annual impairment testing which is discussed in greater detail below.

In accordance with SFAS No. 142, goodwill is subject to annual impairment tests or on a more frequent basis if events or conditions indicate that goodwill may be impaired. Goodwill is tested for impairment at a level of reporting referred to as a reporting unit.  The first step of our annual test is to compare the fair value of our shares to the carrying value of our net assets of the reporting unit. If we determine that our carrying value exceeds our fair value, we would conduct a second step to the goodwill impairment test. The second step compares the implied fair value of the goodwill (determined as the excess fair value over the fair value assigned to our other assets and liabilities) to the carrying amount of goodwill. When the carrying amount of goodwill exceeds the implied fair value of goodwill, an impairment loss is recognized.

We evaluate all of our long-lived assets, including intangible assets other than goodwill and fixed assets, periodically for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (SFAS No. 144). SFAS No. 144 requires that long-lived assets be evaluated for impairment when events or changes in facts and circumstances indicate that their carrying value may not be recoverable. If events or circumstances indicate that the carrying value of an asset may not be recoverable, the amount of impairment will be measured as the difference between the carrying value and the fair value of the impaired asset. An impairment will be recorded as an operating expense in the period of the impairment and as a reduction in the carrying value of that asset.

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