PART I—FINANCIAL INFORMATION
Item 1.		Financial Statements

		Condensed Consolidated Statements of Operations (unaudited) for the three months ended March 31, 2010 and 2009		4
		Condensed Consolidated Balance Sheets as of March 31, 2010 (unaudited) and December 31, 2009		5
		Condensed Consolidated Statements of Changes in Stockholders' Equity and Comprehensive Loss for the three months ended March 31, 2010 (unaudited)		6

		Condensed Consolidated Statements of Cash Flows (unaudited) for the three months ended March 31, 2010 and 2009		7
		Notes to Condensed Consolidated Financial Statements (unaudited)		8
Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations		13
Item 3.		Quantitative and Qualitative Disclosures About Market Risk		15
Item 4T.		Controls and Procedures		15
PART II—OTHER INFORMATION
Item 1.		Legal Proceedings		16
Item 1A.		Risk Factors		16
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		16
Item 3.		Defaults Upon Senior Securities		16
Item 4.		[Removed and Reserved]		16
Item 5.		Other Information		16
Item 6.		Exhibits		17
Signatures				18

 

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	Three Months Ended March 31,
	2010					2009
Warrants			4,250,756				4,220,256
Options			2,060,000				1,462,500

8.	COMMITMENTS AND CONTINGENCIES

Legal

We acquired CTI on December 19, 2008. As part of that acquisition, we acquired CTI’s exposure to litigation that existed at the acquisition date. On January 23, 2006, the former owners of CTI (from whom we purchased CTI) acquired all of the outstanding capital stock of Omniglow Corporation (the “Transaction”) and changed the name of the company to Cyalume Technologies, Inc. Prior to, or substantially simultaneously with, the Transaction, CTI sold certain assets and liabilities related to Omniglow Corporation’s novelty and retail business to certain former Omniglow Corporation stockholders and management (“the Omniglow Buyers”).  This was done because CTI sought to retain only the Omniglow Corporation assets and current liabilities associated with its government, military and safety business. During 2006, CTI and the Omniglow Buyers commenced litigation and arbitration proceedings against one another. Claims include breaches of a lease and breaches of various other agreements between CTI and the Omniglow Buyers.  The Omniglow Buyers seek compensatory damages of $1.4 million, to be trebled, and recovery of costs and legal fees. We have filed for damages of $368,000 against the Omniglow Buyers.  We continue to rigorously defend our position on these matters, as we believe the Omniglow Buyers’ claims to be without merit. We do not expect this legal proceeding will have a material adverse effect on our future consolidated financial position, operating results, or cash flows.

Management Agreement with Board Member

On October 1, 2009, we entered into a Management Agreement with Selway Capital, LLC (“Selway”) that provides for (but is not limited to) the following services to be performed by Selway on our behalf:

·	Strategic development and implementation as well as consultation to our chief executive officer on a regular basis as per his reasonable requests;

·	Identifying strategic partners with companies with which Selway has relationships and access. In this connection, Selway will focus on building partnerships with companies in Israel, Singapore, India and Europe. The focus will be on the expansion of our munitions business;

·	Advise and support us on our investor relations strategy;

·	Advise and support our future fund raising, including identifying sources of capital in the United States; and

·	Support our mergers and acquisitions strategy and play an active role in our due diligence and analysis.

The Management Agreement stipulates that these services will be performed by Yaron Eitan, a member of our Board of Directors and an employee of Selway, with the assistance as needed from other employees of Selway.  The Management Agreement is retroactive to August 1, 2009, expires on October 1, 2012 and can be terminated by either us or Selway upon 30-days’ written notice or upon our default in payment or Selway’s failure to perform services under the Management Agreement. Selway’s compensation for these services will be $41,667 per month for the duration of the Management Agreement. However, we are only required to pay $16,000 per month, with the balance of $25,667 per month remaining unpaid until our senior lender consents to such payment. We will also reimburse Selway for costs incurred specifically on our behalf for these services. Under the Management Agreement, we indemnify Selway and Selway indemnifies us against certain losses that may be incurred while carrying out its obligations under the Management Agreement.

 

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9.	FAIR VALUE

Under U.S. GAAP, we are required to record certain financial assets and liabilities at fair value and may choose to record other financial assets and financial liabilities at fair value as well. Also under U.S. GAAP, we are required to record nonfinancial assets and liabilities at fair value due to events that may or may not recur in the future, such as an impairment event. When we are required to record such assets and liabilities at fair value, that fair value is estimated using an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. That fair value is determined using inputs based on a fair value hierarchy that is based on significant levels of inputs as follows:

Level 1	Quoted prices for identical assets or liabilities in active markets to which we have access at the measurement date.
Level 2	Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.
Level 3	Unobservable inputs for the asset or liability.

The determination of where assets and liabilities fall within this hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

As of March 31, 2010, our only assets and liabilities required to be reported at fair value on a recurring basis were the interest rate swaps and currency forward contracts described in Note 5, both of which are measured at fair value using level 2 inputs.

We have other non-derivative financial instruments, such as cash, accounts receivable, accounts payable, accrued expenses and long-term debt, whose carrying amounts approximate fair value.

10.	SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

Cash Paid for Interest and Income Taxes (all amounts in thousands):

 

		Three Months Ended March 31,
		2010				2009
Interest		$	628			$	434
Income taxes		$	202			$	833

Non-Cash Investing and Financing Activities (all amounts in thousands):

 

		Three Months Ended March 31,
		2010				2009
Accrual of costs directly related to the acquisition of CTI recorded as goodwill		$	—			$	234

ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

You should read the following discussion of our financial condition and results of operations in conjunction with our interim condensed consolidated financial statements and the accompanying notes to those financial statements included elsewhere in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that involve risks and uncertainties. Unless the content otherwise requires, all references to "we", "us", the “Company" or “Cyalume" in this Quarterly Report on Form 10-Q refers to Cyalume Technologies Holdings, Inc.

Company Overview

We primarily produce products based on technologies whereby light is generated through a chemical reaction known as chemiluminescence. CTI manufactures and sells such chemiluminescent products, in addition to reflective and photoluminescent products, to military, commercial and public safety markets.  Our base product is known as a ‘‘light stick’’ and is typically 6 inches in length. A light stick is a translucent flexible plastic tube that is partly filled with one chemical ingredient and also with a glass container (‘‘ampoule’’) that contains a complementary reactive chemical. When the tube is bent enough to break the glass ampoule, the chemicals contained within the plastic tube mix and light is generated. Additionally, we manufacture and sell a component of 40mm training ammunition; sales of these components have been an increasing source of our revenues in recent years.  Also, we produce reflective (patches) and reflective plus photoluminescent (fire tape) products. Based on our customers’ specifications, our products are manufactured in varying shapes, sizes and functions, and provide light in different colors, intensity and durations.

We have one subsidiary: Cyalume Technologies, Inc. (“CTI”), whose headquarters are also located in West Springfield, MA. CTI has one subsidiary, Cyalume Technologies, SAS (“CTSAS”), located in Aix-en-Provence, France. Our products are manufactured at both the West Springfield and Aix-en-Provence locations.

 

Material Changes in Results of Operations – 3 Months Ended March 31, 2010 versus the 3 Months Ended March 31, 2009

 

Revenues:  For the three-month period ended March 31, 2010, our sales were higher than our sales for the comparable period in 2009. This increase in sales is due primarily to the volume of units sold. Price increases provided some of the additional revenues and product mix remained relatively unchanged between the two periods.

 

Cost of goods sold: For the three-months ended March 31, 2010, our cost of sales was significantly higher than our cost of sales for the comparable period in 2009 due to the increase in units sold discussed above.  Our gross margin for the three months ended March 31, 2010 was 48.2% compared to our 41.7% gross margin for the comparable prior-year period. 2010 margin improved partially due to price increases implemented in late 2009. Gross margin in the three months ended March 31, 2009 was depressed due to lower-than-normal sales of high margin chemical light sticks to the U.S. Military, the cost of a March 2009 workforce reduction and the amortization of $262,000 of the inventory step-up to fair market value arising from our acquisition of CTI in December 2008.

 

General and administrative expenses increased primarily due to expense related to the accrual of share-based awards in 2010, which were not accrued in the first quarter of 2009, and management fees relating to our management agreement with Selway Capital, LLC, which had not yet been entered into as of March 31, 2009.

 

Amortization of intangible assets: In December 2009, we recorded significant impairments on our trademark and customer relationship intangible assets that significantly reduced our amortization of intangible assets in the three months ended March 31, 2010 versus the three months ended March 31, 2009.

 

Provision for (benefit from) income taxes increased significantly for the three months ended March 31, 2010 as compared to the three months ended March 31, 2009 due to our generation of net income during the three months ended March 31, 2010 and operating losses during the three months ended March 31, 2009.

 

Material Changes in Financial Condition – March 31, 2010 versus December 31, 2009

 

Neither total assets nor total liabilities changed significantly from December 31, 2009 to March 31, 2010, however the following components of total assets and total liabilities did change significantly during that time period.

 

Our accounts receivable increased significantly due to higher sales during the three months ending March 31, 2010 versus the three months ending December 31, 2009.  Due to these increased sales, we purchased a higher than usual amount of raw material inventory during the three months ending March 31, 2010, causing total inventory to increase from amounts on hand at December 31, 2009. This caused our accounts payable and accrued liabilities to increase during this time period as well. Our notes payable decreased significantly due to scheduled principal payments made during the first three months of 2010. Our derivatives liability increased significantly since December 31, 2009 primarily due to a decrease in estimated future LIBOR rates used to estimate the fair value of our pay fixed/receive LIBOR interest rate swaps. Our deferred tax liability increased since December 31, 2009 due to (i) amortization of identified intangible assets for U.S. GAAP purposes which is not allowed for income tax purposes; (ii) various changes in the reserve accounts, including increases in unvested stock-based compensation awards; (iii) utilization of net operating losses during the three months ended March 31, 2010; and (iv) unrepatriated earnings of our foreign subsidiary (CTSAS).

 

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Liquidity and Capital Resources

 

As of March 31, 2010 and December 31, 2009, we had $1.6 million and $2.0 million, respectively, in cash on hand. The major sources and uses of cash during the three months ended March 31, 2010 were all in the normal course of business.

 

Before June 30, 2010, we expect to receive proceeds from a subordinated debt offering or an equity offering. The terms of that transaction are currently being negotiated and therefore the full effects of that transaction on our liquidity and capital resources cannot be determined.  In addition to providing us with working capital, this transaction will allow us to satisfy the requirement imposed by our senior lender, TD Bank, N.A., to receive at least $3.0 million from new subordinated debt or an equity offering before June 30, 2010 and to use the proceeds thereof to reduce the outstanding principal balance on our notes payable to TD Bank, N.A.

 

Forecasted principal and interest payments on bank debt for the next 12 months are $9.1 million, including the $3.0 million principal payment to TD Bank discussed in the preceding paragraph, and will be funded from operating cash flows and from the transaction discussed in the preceding paragraph. All other operating and capital expenditures are expected to be funded completely from operating cash flows.

Off-Balance Sheet Arrangements

Other than immaterial operating leases, we did not have any off-balance sheet arrangements during 2010 or 2009.

Contractual Obligations

As a smaller reporting company, we are not required to provide information typically disclosed under this item.

Critical Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods.  Estimates are used when accounting for certain items such as reserves for inventory, accounts receivable and deferred tax assets; assessing the carrying value of intangible assets including goodwill; determining the useful lives of property, plant and equipment and intangible assets; and in determining asset retirement obligations.  Estimates are based on historical experience, where applicable, and assumptions that we believe are reasonable under the circumstances.  Due to the inherent uncertainty involved with estimates, actual results may differ.

Revenue Recognition

Revenue from the sale of products is recognized when the earnings process is complete and the risks and rewards of ownership have transferred to the customer. Costs and related expenses to manufacture the products are recorded as costs of goods sold when the related revenue is recognized.

We have several significant contracts providing for the sale of indefinite quantities of items at fixed per unit prices, subject to adjustment for certain economic factors. Revenue under these contracts is recognized when goods ordered under the contracts are received by the customer. Whenever costs change, we review the pricing under these contracts to determine whether they require the sale of products at a loss. To date, we have no loss contracts which would require the accrual of future losses in the current financial statements.

Income Taxes

Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse.  Deferred tax assets are recognized when, based upon available evidence, realization of the assets is more likely than not.

 

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When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would be ultimately sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, it is more likely than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. Tax positions taken are not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefit associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

We classify interest on tax deficiencies as interest expense and income tax penalties as other miscellaneous expenses.  

Goodwill

Goodwill is deemed to have an indefinite life and accordingly, is not subject to annual amortization.  Goodwill is subject to annual impairment reviews, and, if conditions warrant, interim reviews based upon its estimated fair value.  Impairment charges, if any, are recorded in the period in which the impairment is determined.

Intangible Assets

Intangible assets include developed technologies and patents, customer relationships and non-compete agreements, which are amortized over their estimated useful lives, and trademarks and trade names, which are considered to have indefinite useful lives and therefore are not amortized. The carrying amounts of intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that those carrying amounts may not be recoverable. Costs incurred to renew or extend the term of our intangible assets are expensed when incurred.

Inventories

Inventories are stated at the lower of cost (on a first-in first-out (“FIFO”) method) or net realizable value.  We periodically review the realizability of our inventory. Provisions are recorded and reserves are established for potential obsolescence. Determining adequate reserves for inventory obsolescence requires management’s judgment. Conditions impacting the realizability of our inventory could cause actual write-offs to be materially different than reported inventory reserve balances.

Foreign Operations and Currency

Accounts of our foreign subsidiary are recorded using their local currency (the euro) as the functional currency. For consolidation purposes, income statement accounts are converted to U.S. dollars using the average exchange rate for the monthly period being reported. Assets and liabilities are converted to U.S. dollars using the exchange rate in effect as of the balance sheet date. Equity transactions are converted to U.S. dollars using the exchange rate in effect as of the date of the transaction. Translation gains and losses are reported as a component of accumulated other comprehensive income or loss. Gains and losses resulting from transactions which are denominated in other than the functional currencies are reported as other income or expenses in the statement of operations in the period the gain or loss occurred.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

As a smaller reporting company, we are not required to provide information typically disclosed under this item.

ITEM 4T. CONTROLS AND PROCEDURES

Disclosure controls and procedures

Disclosure controls and procedures are designed to ensure that information required to be disclosed by us in reports filed or submitted under the Securities Exchange Act of 1934 (“Exchange Act”) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls include, without limitation, controls and procedures designed to ensure that information required to be disclosed under the Exchange Act is accumulated and communicated to management, including principal executive and financial officers, as appropriate, to allow timely decisions regarding required disclosure. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.

Our management carried out an evaluation, under the supervision of our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of March 31, 2010. Based upon that evaluation, our management, including our Chief Executive Officer and Chief Financial Officer, concluded that the design and operation of our disclosure controls and procedures were effective as of March 31, 2010.

 

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Changes in internal control over financial reporting

There was no change in our internal control over financial reporting that occurred during the three months ended March 31, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Recent sales of unregistered securities and use of proceeds from registered securities

None.

Purchases of Equity Securities by the Company and Affiliated Purchasers

None.

 

 

ITEM 4. [REMOVED AND RESERVED]

 

ITEM 5. OTHER INFORMATION

There were no changes to the procedures by which security holders may recommend nominees to our Board of Directors during the three months ended March 31, 2010.

There is no information to report under this Item in lieu of reporting that information on Form 8-K.

 

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ITEM 6.    EXHIBITS

Exhibit Number		Description
10.1		Supply Agreement between Cyalume Technologies, Inc. and the U.S. Department of Defense, dated January 22, 2010 (confidential treatment has been requested for certain portions of this agreement which have been redacted). (1)
31.1	*	Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	*	Certification of Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	*	Certification of Principal Executive Officer and Principal Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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*	Filed herewith.

(1)	Incorporated by reference to (a) the Current Report on Form 8-K dated January 27, 2010 and filed with the Commission February 1, 2010 and (b) Exhibit 10.27 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2009 filed on March 22, 2010.

 

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