UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2010

OR

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                             to                              

Commission File Number 000-52247

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Cyalume Technologies Holdings, Inc.

(Exact name of registrant as specified in its charter)

Delaware		20-3200738
(State or other jurisdiction of  incorporation or organization)		(I.R.S. Employer  Identification No.)

96 Windsor Street, West Springfield, Massachusetts		01089
(Address of principal executive offices)		(Zip Code)

(413) 858-2500

(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  x     No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ¨    No ¨    

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of "large accelerated filer", "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act:

Large accelerated filer ¨

Accelerated filer ¨

Non-accelerated filer ¨  (Do not check if a smaller reporting company)

Smaller reporting company x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨    No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of October 26, 2010, there were outstanding 15,749,070 shares of the registrant’s Common Stock, par value $.001 per share.

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Cyalume Technologies Holdings, Inc.

FORM 10-Q

PART I—FINANCIAL INFORMATION
Item 1.		Financial Statements
		Condensed Consolidated Statements of Operations (unaudited) for the three months ended September 30, 2010 and 2009		4
		Condensed Consolidated Statements of Operations (unaudited) for the nine months ended September 30, 2010 and 2009		5
		Condensed Consolidated Balance Sheets as of September 30, 2010 (unaudited) and December 31, 2009		6
		Condensed Consolidated Statements of Changes in Stockholders' Equity and Comprehensive Income for the nine months ended September 30, 2010 (unaudited)		7
		Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2010 and 2009		8
		Notes to Condensed Consolidated Financial Statements (unaudited)		9
Item 2.		Management's Discussion and Analysis of Financial Condition and Results of Operations		16
Item 3.		Quantitative and Qualitative Disclosures About Market Risk		19
Item 4.		Controls and Procedures		19
PART II—OTHER INFORMATION
Item 1.		Legal Proceedings		20
Item 1A.		Risk Factors		20
Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds		20
Item 3.		Defaults Upon Senior Securities		20
Item 4.		[Removed and Reserved]		20
Item 5.		Other Information		20
Item 6.		Exhibits		21
Signatures				22

 

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		September 30, 2010				December 31, 2009
Raw materials		$	4,903			$	4,887
Work-in-process			3,305				3,439
Finished goods			1,059				1,903
			9,267				10,229
Less: Reserve for obsolescence			(391	)			(909	)
		$	8,876			$	9,320

5.	NOTES PAYABLE

On July 29, 2010 we issued $8.5 million in convertible notes due in 2014. The convertible notes require monthly interest payments starting on September 1, 2010 at a rate of 11% per annum and mature on March 19, 2014, unless earlier repurchased or converted. No principal payments are required on these convertible notes until maturity. We have the right to prepay the notes in whole or in part at any time without penalty. The convertible notes are senior secured obligations and rank junior to all senior debt held by TD Bank, N.A. but senior to all other remaining long-term debt including existing and future subordinated debt. The notes are convertible at any time into 2,666,667 shares of our common stock at a conversion price of approximately $3.19 per share. Under certain circumstances, such a conversion feature could be considered to be a “beneficial” conversion feature, as defined by U.S. GAAP, requiring separate measurement and accounting. We determined that the convertible notes’ conversion feature was not “beneficial” under U.S. GAAP. 

		Three Months Ended September 30,					Nine Months Ended September 30,
		2010		2009			2010		2009
Options and warrants		6,388,256			6,225,256		6,495,756			6,225,256

9.	COMMITMENTS AND CONTINGENCIES

Civil Action No. 06-706 in Superior Court of the Commonwealth of Massachusetts

On January 23, 2006, before we owned CTI, the former owners of CTI (from whom we purchased CTI) (the “Former Owners”) 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 sought compensatory damages of $1.4 million, to be trebled, and recovery of costs and legal fees. CTI filed for damages of $368,000 against the Omniglow Buyers.  These proceedings are known as Civil Action No. 06-706 in Superior Court of the Commonwealth of Massachusetts.

 

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Cyalume Technologies Holdings, Inc.

Notes to Condensed Consolidated Financial Statements

On December 19, 2008, while Civil Action 06-706 was still unresolved, we acquired CTI (the “Acquisition”). According to the Acquisition’s Stock Purchase Agreement between the Former Owners and us, the Former Owners retained the responsibility for paying for all costs and liabilities associated with Civil Action 06-706.

On June 11, 2010, CTI received preliminary Findings of Fact, Rulings of Law and Order for Judgment (the “Findings”) regarding Civil Action No. 06-706.  Pursuant to the Findings, the court found in favor of the Omniglow Buyers and ruled that the Omniglow Buyers were entitled to calculable damages of approximately $828,000 from CTI, in addition to damages for certain lost profits that have not been calculated, costs and attorney’s fees. These additional damages, costs and fees have not yet been calculated or determined by the court. On August 17, 2010, the court vacated this judgment. The court will enter a final judgment once the court issues an order on these additional damages, costs and fees.

CTI is considering its alternatives relating to the suit in light of the Findings. No amounts have been reported in these interim condensed consolidated financial statements since payment of damages or loss is not yet deemed to be probable since all of our legal remedies have not been exhausted.

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 with our chief executive officer on a regular basis as per his reasonable requests;

·

Identifying strategic partnerships with companies with which Selway has relationships and access, including 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. Through July 2010, Selway’s compensation for these services was $41,667 per month. However, we were only required to pay $16,000 per month, with the balance of $25,667 per month remaining unpaid until our senior lender consented 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.

On July 29, 2010 we amended our management agreement (the “Amended Management Agreement”) with Selway. Pursuant to the Amended Management Agreement, (i) the monthly compensation payable to Selway was reduced to $11,667 and (ii) we were required to issue to Selway 45,000 shares of our common stock in full satisfaction of all accrued and unpaid liabilities (including all management fees) we owed to Selway pursuant to this management agreement through July 2010. Those 45,000 shares were issued in July 2010.

10.	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 based on significant inputs contained in a fair value hierarchy as follows:

 

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Cyalume Technologies Holdings, Inc.

Notes to Condensed Consolidated Financial Statements

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 September 30, 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 6, 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.

11.	SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

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

 

	Nine Months Ended September 30,
	2010				2009
Interest		$	1,686			$	1,495
Income taxes			192				608

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

 

		Nine Months Ended September 30,
		2010				2009
Warrants issued in conjunction with issuance of convertible notes		$	205			$	—
Stock issued as payment for accounts payable			146				—
Debt issuance costs withheld from convertible note proceeds			558				—
Increase in the Acquisition date fair value of intangible assets (a reduction of goodwill)			—				2,024
Increase in the Acquisition date fair value of property, plant & equipment (a reduction of goodwill)			—				372
Accrual of costs directly related to the Acquisition (an increase to goodwill)			—				435
Reduction of goodwill resulting from subsequent recognition of deferred taxes			—				549
Remeasurement of asset retirement obligation			—				26
Extinguishment of notes payable due to related parties by issuing common stock			—				82

 

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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 that uses our light-stick technology; 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 – Three Months Ended September 30, 2010 versus the Three Months Ended September 30, 2009

 

Revenues:   For the three-month period ended September 30, 2010, sales were higher than for the comparable period in 2009 due primarily to the volume of units sold. Price increases provided some of the additional revenues for the most recent 3-month period.

 

Cost of goods sold: For the three-months ended September 30, 2010, cost of goods sold was lower than for the comparable period in 2009 despite the increase in sales discussed in the previous paragraph.  Gross margin for the quarter was 52.6% compared to a 39.8% gross margin for the comparable prior-year period. 2010 margin improved primarily due to (i) a product mix resulting in improved sales levels of higher margin products, (ii) price increases and (iii) the impact of the amortization of inventory step-up to fair market value arising from our acquisition of CTI in December 2008, which depressed 2009 gross margin. ..

 

Expenses: Selling expenses increased 15.9% primarily due to payroll costs of additional hires that was incurred in the three-month period ended September 30, 2010 but not incurred in the three-month period ended September 30, 2009. General and administrative expenses increased 51.4% primarily due to increases in expenses related to (i) share-based award accruals, (ii) depreciation expense and  (iii) employee bonus accruals.  The increase in the share-based expenses is primarily due to awards issued in 2010. The increase in depreciation expense is primarily due to our new enterprise resource planning (“ERP”) computer system, which began depreciating in 2010. Accruals for employee bonuses have increased in 2010 due to our increased profitability in 2010

 

Research and development expenses decreased primarily due to lower patent maintenance and defense costs.

 

Amortization of intangible assets: In December 2009, we recorded impairments on our trademark and customer relationship intangible assets that significantly reduced our intangible assets to be amortized in the three months ended September 30, 2010 compared to same period in the prior year.

 

Provision for (benefit from) income taxes increased significantly for the three months ended September 30, 2010 as compared to the three months ended September 30, 2009 due to our generation of net income in 2010 and operating losses in 2009.

Other, net consists primarily of the effects of changes in foreign exchange rates.

Material Changes in Results of Operations – Nine Months Ended September 30, 2010 versus the Nine Months Ended September 30, 2009

 

Revenues:   For the nine-month period ended September 30, 2010, sales were higher than for the comparable period in 2009 due primarily to the volume of units sold. Price increases provided approximately 12% of the additional revenues for the 2010 period, with the higher number of units sold comprising the rest of the increase.

 

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Cost of goods sold: For the nine-months ended September 30, 2010, cost of goods sold was 2.2% higher than the comparable period in 2009 due to the increase in units sold discussed above.  Gross margin for the period was 50.8% compared to a 41.1% gross margin for the comparable prior-year period. 2010 margin improved partially due to price increases as discussed in the previous paragraph. Gross margin in the nine months ended September 30, 2009 was depressed by the amortization of the inventory step-up to fair market value arising from our acquisition of CTI in December 2008.

 

Expenses: Selling expenses increased 6.8% primarily due to (i) 2010 payroll costs of additional hires, (ii) increased bonuses accrued for sales staff due to our increased profitability in 2010 and (iii) other expenses that typically increase when sales increase, such as commissions and freight on sales.  General and administrative expenses increased 17.8% primarily due to increases in expenses related to (i) share-based award accruals, (ii) depreciation expense, (iii) employee bonus accruals and (iv) consultants.  The increase in the share-based expenses is primarily due to awards issued in 2010. The increase in depreciation expense is primarily due to our new ERP computer system, which began depreciating in 2010. Accruals for employee bonuses have increased in 2010 due to our increased profitability in 2010.

 

Research and development expenses decreased primarily due to lower patent maintenance and defense costs.

 

Amortization of intangible assets: In December 2009, we recorded impairments on our trademark and customer relationship intangible assets that significantly reduced our intangible assets to be amortized in the nine months ended September 30, 2010 compared to same period in the prior year.

 

Provision for (benefit from) income taxes increased significantly for the nine months ended September 30, 2010 as compared to the nine months ended September 30, 2009 due to our generation of net income in 2010 and operating losses in 2009.

Other, net consists primarily of the effects of changes in foreign exchange rates.

Material Changes in Financial Condition – September 30, 2010 versus December 31, 2009

Assets, other than cash: Assets, other than cash, were $95.7 million at September 30, 2010 compared to $96.2 million at December 31, 2009. The decrease is primarily due to intangible assets amortization, fixed asset depreciation and a decrease in inventories. Those decreases were partially offset by the purchase and installation of our new ERP computer system, an increase in accounts receivable resulting from increased sales activity during 2010 and an increase in capitalized debt issuance costs incurred when we incurred new convertible debt in July 2010. The remaining changes in asset values are the result of normal business activities.

Liabilities: Liabilities were $39.4 million at September 30, 2010, compared to $42.7 million at December 31, 2009. The decrease is due primarily to scheduled payments made on our notes payable and complete repayment of our line of credit. The December 31, 2009 line of credit balance of $3.2 million was repaid by $500,000 of the proceeds of our July 2010 convertible debt issuance and by $2.7 million of operating cash flows. Our derivatives liability increased 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. Also, our income tax liability increased in 2010 due to our being profitable in 2010. The remaining changes are the result of normal business activities.

Liquidity and Capital Resources

Cash on hand was $2.5 million at September 30, 2010 and $2.0 million at December 31, 2009. The increase since December 31, 2009 resulted primarily improved sales levels offset by payments on debt and related debt issuance costs and payments for property, plant and equipment.

During the nine months ended September 30, 2010, we did not sell any shares of our common stock. However 298,500 common shares were issued for stock-based compensation awards and 45,000 common shares were issued to Selway Capital, LLC in full satisfaction of all accrued and unpaid liabilities (including all management fees) we owed to Selway pursuant to this management agreement through July 2010.

On July 29, 2010 we issued $8.5 million in convertible notes due in 2014. The convertible notes require monthly interest payments that started on September 1, 2010 at a rate of 11% per annum and will mature on March 19, 2014, unless earlier repurchased or converted. No principal payments are required on these convertible notes until maturity. We have the right to prepay the notes in whole or in part at any time without penalty. The notes are convertible at any time into 2,666,667 shares of our common stock at a conversion price of approximately $3.19 per share.  In addition, the lenders received 160,000 warrants for our common stock, exercisable at the lenders’ option for $2.00 per share. The warrants have a five-year term. The convertible notes are senior secured obligations and rank junior to all senior debt held by TD Bank, N.A. but senior to all other remaining long-term debt including existing and future subordinated debt.

 

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We used $7.2 million of the net proceeds of the convertible notes to reduce, but not eliminate, the outstanding principal balance on our senior debt held by TD Bank, N.A. Also, we used $500,000 of the net proceeds of the convertible notes to reduce the outstanding principal balance on our line of credit with TD Bank, N.A. As part of this transaction, the remaining unpaid TD Bank, N.A. senior debt was modified to have reduced principal payments and lower interest rates.  However, because the convertible notes and the modified TD Bank, N.A. senior debt, on a combined basis, have a higher weighted-average interest rate than the pre-modified TD Bank, N.A. senior debt, we expect that our interest expense will be higher than it would have been had we not partially repaid and modified the TD Bank, N.A. senior debt. Because the convertible notes and the modified TD Bank, N.A. senior debt require lower monthly principal payments than the pre-modified TD Bank, N.A. senior debt, we expect our future debt levels to be higher than they would have been had we not partially repaid and modified the TD Bank, N.A. senior debt. We do expect the lower monthly principal payments to significantly improve our short-term cash flows.

In addition to the $500,000 reduction of our line of credit described in the preceding paragraph, the December 31, 2009 line of credit balance of $3.2 million was reduced to $0 by $2.7 million in cash payments obtained from operating cash flows. We have the ability to access this line of credit for up to a maximum of $5 million (not including a $1million reserve for pending legal issues).

We own interest rate swaps on a majority of our senior debt with TD Bank, N.A. in order to minimize the effect of variable interest rates charged on that TD Bank, N.A. debt.

Forecasted principal and interest payments on debt for the next 12 months are $3.2 million and are expected to be funded from operating cash flows. All other operating and capital expenditures are also 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.

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 amortization.  Goodwill is subject to an annual impairment review, and, if conditions warrant, an interim impairment review.  Impairment charges, if any, are recorded in the period in which the impairment is determined. Our annual impairment review was performed as of August 31, 2010 and we determined that no impairment of goodwill has occurred.

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. Costs to third parties that are related to internally developing or successfully defending an intangible asset are capitalized as part of the intangible asset developed or defended and amortized over that asset’s remaining useful life. Such costs to third parties that are related to patent applications that are ultimately rejected by the relevant government authority are expensed upon rejection.

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 its local currency (the euro) as the functional currency. For consolidation purposes, our foreign subsidiary’s (i) income statement accounts are converted to U.S. dollars using the average exchange rate for the monthly period being reported, (ii) assets and liabilities are converted to U.S. dollars using the exchange rate in effect as of the balance sheet date and (iii) equity transactions are converted to U.S. dollars using the exchange rate in effect as of the date of the transaction. The resulting 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, net 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 4.

CONTROLS AND PROCEDURES

Evaluation of 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.

 

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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 September 30, 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 September 30, 2010.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2010 that materially affected, or are 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 3.

DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4.

[REMOVED AND RESERVED]

ITEM 5.

OTHER INFORMATION