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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT

PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

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

For the fiscal year ended December 31, 2008

OR

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

For the transition period from                                  to

Argyle Security, Inc.

(Name of issuer as specified in its charter)

Registrant’s telephone number, including area code:   (210) 828-1700

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.0001 par value

(Title of Class)

Common Stock Purchase Warrants

(Title of Class)

Units consisting of one share of Common Stock and one

Common Stock Purchase Warrant

(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yeso   Nox

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yesx   Noo

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   o

Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yeso   Nox

State the aggregate market value of the voting and non-voting stock held by non-affiliates of the Issuer as of the last business day of the registrant’s most recently completed second fiscal quarter: $15,375,187.

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock, as of the latest practicable date: 6,267,105 at March 30, 2009.

DOCUMENTS INCORPORATED BY REFERENCE:

Part III of this Annual Report on Form 10-K is incorporated by reference to the proxy statement for the registrant’s annual meeting of stockholders to be held in 2009.

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PART I

Item 1. Business

Background

Argyle Security, Inc. (formerly Argyle Security Acquisition Corporation) (“Argyle”) was incorporated in Delaware in June 2005 to acquire, through merger, capital stock exchange, asset acquisition, or other similar business combination, a business in the security industry. Argyle completed its initial public offering in January 2006.  On July 31, 2007, Argyle consummated its initial acquisition through the acquisition of 100% of the outstanding capital stock of ISI Security Group, Inc. (f/k/a ISI Detention Contracting Group, Inc., referred to herein as “ISI”) and its subsidiaries. As a result of the merger, ISI became a wholly owned subsidiary of Argyle. When used herein, “Argyle”, the “Company”, “we”, “us”, “our”, refers to the pre-acquisition company until July 31, 2007 and the post-acquisition company after July 31, 2007.

Argyle is a comprehensive security solutions provider to our diverse customer base because it addresses the majority of their physical electronic security requirements.  Argyle is a detention and commercial equipment contractor that specializes in designing and integrating security solutions, including turnkey installations, design, engineering, supply, and installation of various detention, surveillance and access control equipment and software solutions for correctional facilities and commercial institutions. The work is performed under fixed-price contracts. The projects are located in various cities throughout the United States. The length of the contracts varies but is typically less than two years. Argyle also provides turnkey installations covering the full spectrum of electronic security and low voltage systems, including fire alarm, access control, closed circuit television, intercom, sound/paging and other custom designed systems.

In February 2008, we organized our business under the name of “Argyle Security USA” and then, in January 2009, we eliminated the name “Argyle Security USA” and, for the sole purpose of debt covenant compliance calculation which only considers the operating business’ financial condition, organized the operational business of Argyle under the name “Argyle Security Operations”, or “ASO”, through which we provide security solutions to commercial, governmental and correctional customers.  Argyle has two reporting segments or business divisions: “Argyle Corrections” and “Argyle Commercial Security”.

Argyle Corrections specializes in the design and installation of turnkey security solutions for public and privately-owned/operated detention facilities. Argyle Corrections designs, assembles, supplies, installs, and maintains access control, video and integrated electronic control systems for correctional and government facilities throughout the United States. Argyle Corrections offers a complete array of electronic security system solutions revolving around access control, including: electronic locking systems and hardware and security doors and frames. Argyle Corrections also includes the sale and design of jail furniture, security glazing and other security-based systems. It provides the above goods and services to detention market integrators, electrical contractors and competitors of Argyle that lack their own in-house electronic solutions. Whether acting as prime contractor or as a subcontractor for projects spanning all levels of security, Argyle Corrections’ product offerings include security locking systems, security hollow metal doors and wall panels, security windows, security glass and glazing, security furnishings and accessories, design support and full installation capabilities.

Argyle Corrections consists of all of our businesses in the corrections sector, including Metroplex Control Systems, Inc. (“MCS”), ISI-Detention, as well as Com-Tec and PDI.  Com-Tec and PDI were acquired in January 2008.  Argyle Corrections includes:

·                  MCS (also referred to as MCS-Detention), which designs, engineers, supplies, installs and maintains complex, customized physical and software security solutions, access control, video and electronic security control system solutions at correctional and government facilities;

·                  ISI-Detention, which designs, engineers, supplies, installs and maintains a full array of detention systems and equipment, targeting correctional facilities throughout the United States;

·                  PDI, which is a full-service, turnkey solutions provider that manufactures high-security metal barriers, high-security observation window systems, detention furniture and accessories; and

·                  Com-Tec, which is an industry leader in the custom design and manufacture of electronic security and communications systems.

Argyle Commercial Security has built a parallel business to Argyle Corrections, targeting commercial and industrial facilities. Argyle Commercial Security focuses on the commercial security sector and provides turnkey, electronic security systems to the commercial market. Currently, MCS Commercial Fire & Security, referred to as MCS-Commercial, operates out of its own San Antonio headquarters and five regional offices in Texas and Colorado. The offices in Austin, Houston, and Denver resulted from acquisitions made by ISI before it was acquired by Argyle. Its security systems cover access control, video systems, intrusion detection systems,

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proximity and smart cards, biometric technology, photo identification (ID) printers and supplies among others. It also secures the community by levering leading edge technology through installation of intelligent perimeter security, wireless video, IP video and intelligent video surveillance. Its industry-leading fire detection systems include QuickStart, EST2 & EST3, integrated life support systems, control panels, detectors, and audible and visible signals. Argyle Federal Systems is currently a newly operational business unit which focuses on providing security solutions and services targeted at the federal government. In November 2008, Argyle Commercial Security was awarded a supply contract through the U.S. General Services Administration (“GSA”) to provide integrated security solutions and products to the various departments in the United States federal government and any other entity that purchases off the GSA contract. These solutions and products consist of Access Control, Video, Perimeter Security and ID Credentials that have been very successful in the commercial marketplace, and now will be available to all governmental entities with access to the GSA contracts.

The following is an illustration of our business segments and business units.

On January 1, 2008, MCFSA, Ltd. and all of the partnership interests of which are directly or indirectly wholly owned by ISI, acquired substantially all of the business assets and liabilities of Fire Quest Inc. (“Fire Quest”). Fire Quest is engaged in the business of alarm system sales and service.

On January 4, 2008, ISI acquired substantially all of the business assets and liabilities of Peterson Detention, Inc. (“PDI”).  PDI manufactures and fabricates detention furniture and accessories, high security metal barriers and high security observation window systems.

On January 31, 2008, ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI, which in turn is a wholly owned subsidiary of the Company, closed a transaction, pursuant to which ISI-Controls acquired 100% of the outstanding limited liability company units of Com-Tec Security LLC (“Com-Tec”), resulting in Com-Tec becoming a wholly owned subsidiary of ISI-Controls. Com-Tec is engaged in the business of custom design, manufacture and installation of electronic security and communications systems.

MCS-Detention

MCS-Detention provides electronic security systems for correctional facilities. MCS-Detention develops electronic security systems for its customers, including door controls, intercoms, closed circuit television and other low voltage electronic security systems that can all be controlled from one location at one console. MCS-Detention does not manufacture any of the hardware that is sold and installed as part of its security solutions. Hardware is purchased from third parties and installed as required by the plans and specifications for each project. MCS-Detention’s expertise lies in designing, engineering, supplying, installing and maintaining complex, customized security, access control, video and electronic security control system solutions at correctional and government facilities. MCS-Detention also provides fully-integrated, complex electronic and software systems for command center controls and monitoring. Typically, MCS-Detention is a subcontractor to another entity, which entity could be a general contractor, ISI-Detention or a competitor of ISI-Detention.

Many solutions are simultaneously provided for the customer, because MCS-Detention determines the needs of its customer and puts systems together (from many different manufacturers) to fit those needs. More importantly, MCS-Detention can integrate the operation of those varied systems so that they work together without conflict. Because of the complexity of the systems involved, MCS-Detention regularly designs the security electronic systems and prepares the drawings for architects and engineers. This complex design work involves coordination of wiring and conduit on a project, plus developing the requirements for local control and satellite

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control stations. Included in their offerings are access control, closed circuit television (including cameras, camera management and video image mass storage), detention control, fire alarm, intercom, perimeter protection, sound/paging, video visitation and other custom designed systems. Experience in planning, installation and service, combined with state-of-the-art equipment, provides MCS-Detention with a distinct advantage in marketing and developing customized solutions for clients.

Contracting Structure: Most transactions in which MCS-Detention becomes involved result in a contract with a customer that is an owner or construction manager (where ISI is a prime or direct contractor), or an agreement with a general contractor or electrical contractor (where ISI is a subcontractor). MCS-Detention’s customers also include ISI-Detention and competitors of ISI-Detention that lack the in-house capability to undertake a security electronics project. MCS-Detention may seek these projects on its own as a stand-alone vendor or as part of a team that has been assembled to pursue the project. The team approach is more commonly utilized by ISI-Detention, though it is an important part of MCS-Detention’s business model to act as a stand-alone vendor.

Team Contracting: A team is typically assembled by a general contractor, architect, engineer, developer or a private correctional facility operator to submit a proposal to negotiate with a customer or submit a competitive bid on a correctional project. In these teams, MCS-Detention is the ‘‘Electronic Security Solutions Principal’’. The members of the team negotiate the amount and terms of the contract for their respective parts of the project. This means that MCS-Detention (and the other construction-related members of the team) would enter into a contract with a general contractor without having to directly participate in a bid competition. This can occur because the members of the team have previously worked together, and the team members have experience in dealing with most, if not all, of the other team members, and know their capabilities. Once the security and other components of the proposal are completed, the team submits the proposal in a competition or commences negotiations with the ultimate customer. For purposes of actually submitting the proposal, a ‘‘lead contractor’’ structure is utilized. This means that the principals on the team enter into agreements with the general contractor, and the construction portion of the team’s proposal is submitted in the name of the general or lead contractor.

Contracts with owners, construction managers, general contractors and electrical are pursued in both competitively-bid situations and negotiated transactions. These constitute approximately 90% of MCS-Detention’s annual project volume. The processes related to competitively bid contracts and negotiated transactions are as follows:

MCS-Detention maintains its sales force in San Antonio, Texas and in Noblesville, Indiana. Sales are pursued nationwide from those locations.

MCS-Detention estimates the cost and pricing of a project in a process that is similar to that of ISI-Detention. MCS-Detention will review the design drawings and written specifications to create the same ‘‘take-offs,’’ or lists, of products and materials that are required on a project. MCS-Detention will then distribute the lists to vendors, receive the vendors’ bids on their respective portions of the project, and then MCS-Detention will calculate the costs to furnish and install the products required. MCS-Detention then adds profit and overhead to its calculations and determines the final price for the customer. In determining the final price, MCS-Detention uses the same subjective criteria that ISI-Detention uses.

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The contracts that MCS-Detention secures are subject to similar competitive bidding processes as are the contracts entered into by ISI-Detention. All products supplied by MCS-Detention are purchased from third-party vendors, assembled and prepared by MCS-Detention, and then sold by MCS-Detention to its customer. Typically, all MCS-Detention systems are installed and tested by MCS personnel. The terms of the contracts MCS-Detention enters into with its customers are similar to the types of contracts entered into by ISI-Detention. The types of customers that are served by MCS-Detention are the same types of customers that are served by ISI-Detention. The electronic security products of MCS-Detention are linked into an integrated system using applications software developed and provided by MCS-Detention.

ISI-Detention

ISI-Detention has been involved in furnishing and installing detention equipment in more than 1,900 correctional facilities since its inception in 1976. ISI-Detention designs, engineers, supplies, installs, and maintains a full array of detention systems and equipment, targeting correctional facilities throughout the United States. Its expertise and track record position ISI-Detention favorably among the nation’s leading providers of products and solutions for correctional facilities. Its custom-designed systems meet local standards and are in full compliance with the applicable standards of the American Correctional Association, a voluntary organization whose standards for correctional facility design, operation and construction are the recognized industry benchmark for quality and safety.

ISI-Detention offers a complete array of electronic security system solutions revolving around electronic locking systems and hardware, security doors and frames, jail furniture, security glazing and other security-based systems. ISI-Detention acts as prime contractor or as a subcontractor for projects spanning all levels of security.

The contracting structure and the contracts with owners, construction managers, general contractors and electrical contractors are pursued in both competitively bid situations and negotiated transactions in a manner similar to MCS-Detention.

Product solutions for ISI-Detention primarily include detention hardware (prison bars, locks and locking systems), security glass, security furniture (metal furniture), detention grade hollow metal doors, frames and windows and labor to install these items. All of these items are purchased from third-party vendors and sold through ISI-Detention to its customer. ISI-Detention does not manufacture the hardware installed as part of its security solutions. Hardware is purchased from third parties and installed as required by the plans and specifications for each project. All of these products are sold to general contractors that are building, expanding or renovating a jail or prison, or they are sold to the owner (governmental or private entity) of a jail or prison that is being built, expanded or renovated. In either situation, these products are installed in city lockups, county jails, state prisons and federal prisons.

The security solution created by ISI-Detention for each customer is a unique combination of different security devices, made by many different manufacturers. These devices include access controls (keypads, card swipe readers, and key fob proximity readers at doorways), electric locks, closed circuit television equipment, fire alarm systems and smoke detectors, etc. These many different devices were not originally manufactured to work together in an integrated system. Each manufacturer developed its product to work in a “typical” environment, and each manufacturer determined what ‘‘typical’’ would be.

At the beginning of a project (the design phase), ISI-Detention works with architects, engineers and contractors to help design the project by writing specifications, developing schedules (detailed lists) of doors, windows, door hardware and glazing for the customer. During this stage of development, ISI-Detention writes specifications for specific locking systems, analyzes particular conditions and requirements and recommends products that correspond to the needs of that correctional facility, depending on the type of security that is required and the underlying budget. The design process provides all the vendors and contractors with a clear outline of what is needed for the project. This provides the customer with a detailed list of the precise items that ISI-Detention will supply to the customer, and the cost for those items.

To determine the pricing of a project, ISI-Detention will obtain the design drawings of the project in question (which are basically the building construction drawings) and determine the precise quantity of each item needed for the project. ISI-Detention provides these lists of required items to the appropriate vendors. Some vendors perform their own quantity determinations (“takeoffs”), rather than relying upon the takeoffs prepared by ISI-Detention. The vendor then provides ISI-Detention with the price for the items required. Once all the costs are received from vendors, and ISI-Detention determines the cost of the services that it will provide, ISI-Detention then adds profit and overhead, depending on many factors, including but not limited to what other competitors are known to be bidding on the project, local labor and other conditions, size of the project, complexity of the project, schedule for completion, etc. ISI-Detention then determines a sales price. This price is given to ISI-Detention’s customer. That customer may be a general contractor or the owner of the project — a city, county, state or federal agency.

In many cases, ISI-Detention is part of a team that prepares a bid. This team works together to create a total construction bid. The head of the team is usually a general contractor or private prison operator. Typically, ISI-Detention is invited to be part of this team because of its repeat customer relationship. The team then competes for the contract as a group. This type of repeat customer relationship allows ISI the ability to negotiate most of the work sold to repeat customers.

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Typically, when ISI-Detention creates an initial budget for a project (before the detailed formal estimating of all job costs is completed), ISI-Detention typically estimates that 13% of the construction dollars will be allocated to ISI-Detention’s scope of work on that project, including the higher-margin, security electronics portion. This is an initial estimate that ISI-Detention uses in the early stages of a project before final design is completed. While the final amount of the ISI-Detention scope of work changes from project to project, depending on many factors relating to the design and the intended use of the facility being built or renovated, management has found that an initial budget of 13% of the estimated total construction amount for a project has proven to be a reliable basis for estimating the size of ISI-Detention’s portion of the project.

Most governmental agencies require that their significant contracts be competitively bid. Typically, they utilize the ‘‘Request for Proposal’’ (RFP) method where several competitors submit their sealed proposals for a particular project, or the ‘‘Request for Qualifications’’ (RFQ) process where competitors submit their Qualifications for consideration by the customer. Some contracts are let upon the standard ‘‘Straight Bid’’ process where the detailed plans and specifications for a project are published and contractors submit a ‘‘Bid’’ or fixed price, for the contract to build the project. Other competitive bidding processes may also be utilized, such as the Construction Manager at Risk model, where a Construction Manager is hired for a fee to build the project for a fixed price, or ‘‘cost plus profit and overhead’’ basis. When ISI-Detention responds to an RFP, RFQ, Straight Bid, or other competitive bidding process, it typically provides the response to a general contractor (where ISI-Detention is one of several contractors in different disciplines that are part of the total design/bid team providing a proposal with prices) or directly to the owner (governmental agency or private entity) of a correctional project. The quality of ISI-Detention’s estimating process, knowledge of the industry, knowledge of its customers and other issues requiring significant judgment and expertise are key factors in determining whether ISI-Detention will ‘win’ the competitive bid process and be offered the contract for the project.

When the customer sends ISI-Detention a contract, it contains typical construction contract terms and conditions, such as provision for retainage, certification of completion for progress payments, fixed markup on change orders, coordination responsibility, and similar provisions. Most contracts allow for progress payments on a monthly basis, and most contracts are fixed price.

ISI-Detention’s customers require that ISI-Detention provide not only the detention equipment but the security electronics as well. When this occurs, ISI-Detention uses MCS-Detention (a wholly owned subsidiary of Argyle) to provide the security electronics to ISI-Detention. The price for the detention equipment and the price for the security electronics (closed circuit television, infrared alarms, access control systems, etc.) are combined together and submitted by ISI-Detention to its customer as a package price.

Progress payments and retainage provisions control the amount and timing of payments to ISI-Detention. For example, upon execution of a contract, an agreed upon mobilization payment may be paid to ISI-Detention. Thereafter, each month ISI-Detention certifies to the customer the percentage of the total work that has been completed through the preceding month. A third party (typically an architect) also provides the owner of the project with a certification of the percentage of completion. If the third party agrees with ISI-Detention’s certification of its percentage of completion, then ISI-Detention is entitled to receive that percentage of the entire contract amount, less the amount of retainage (typically 5% to 10%). (For example, if ISI-Detention claims that 60% of its work under its contract has been completed, then ISI-Detention is entitled to be paid 60% of the contract amount, less the retainage amount). At the conclusion of the project, assuming no other changes or charges, ISI-Detention should have been paid the full contract amount less the retainage. When the owner of the project, ISI-Detention’s customer and the third party have all certified that the project is complete and that all sub-contractors of ISI-Detention have been paid or other appropriate documentation provided, the retainage amount is paid to ISI-Detention.

After a project is sold and ISI-Detention receives a contract, ISI-Detention prepares engineering drawings and schedules or lists creating more detail and information than in the design phase, which takes place early on in the development of a project. During the construction phase of the project, ISI-Detention orders materials from vendors and arranges for those materials to be shipped to the project site. Typically, ISI-Detention sends its employees to the job site to install this equipment. ISI-Detention’s projects usually take 9 to 14 months; some larger projects may run longer.

When competitive bids are solicited in connection with the construction of a correctional facility, ISI-Detention bids for the detention equipment portion of the overall project as a direct contractor or as one of the subcontractors for a general contractor. The furnished and installed package proposed by ISI-Detention typically includes security locking systems and hardware, security hollow metal (doors and frames), detention furniture (tables, bunks, benches, mirrors, etc.), security electronic controls (closed circuit television, intercom, etc.) and security glass and glazing. By providing this complete package furnished and installed, ISI-Detention is able to provide a warranty program and insure that all the pieces and components are fully integrated and inter-operate correctly.

ISI-Detention’s typical warranty is a limited warranty of one year and is provided in more than 95% of the contracts entered into. This warranty provides for repair or replacement of defective materials or workmanship, if a failure occurs within one year of installation of the product. In very limited circumstances, ISI-Detention will provide an extended warranty of two years (with the same repair and replacement obligations as the one year warranty) when it is demanded by a significant customer or is otherwise required to secure a contract. In even more limited circumstances, an extended warranty of three years (with the same repair and replacement obligations as the one year warranty) will be provided.

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The aggregate cost of fulfilling ISI-Detention’s warranty obligations on completed contracts in 2007 and 2008 has been less than $150,000 for those years combined, and there have been no claims asserted by customers or users of ISI-Detention’s products that are outside the normal scope of warranty work required. Additionally, since all of the products sold by ISI-Detention are manufactured by others, the ultimate burden for warranty of those items is passed on to the manufacturers by ISI-Detention.

PDI

PDI is a fabricator and full-scope provider of detention products and furniture. PDI manufactures high security metal barriers, high security observation window systems, detention furniture and accessories. PDI was started in 1977 by Mike and Leonard Peterson. Since then, PDI has completed hundreds of successful projects, and its customer list features some of the nation’s most widely recognized and well-respected owners and contractors. PDI’s product line includes wire mesh, accessories, bar grating, the patented “Steel Block” and detention furniture – both standard and custom, including stainless steel.

Most transactions are on a purchase order basis with a customer that is an owner, construction manager or detention contractor (DEC) of a facility. PDI’s customers also include ISI-Detention and competitors of ISI-Detention. In a wide variety of projects across the country, architects specify PDI as their steel detention products supplier. PDI provides in-house drafting and design, pre-sale and post-sale support teams, a complete product line from coast to coast.

As a full-scope provider, PDI offers a range of products that are often manufactured to customers’ precise specifications. PDI’s in-house detailers and support staff provide design and expertise needed to ensure total compliance — regardless of a project’s size or scope.

PDI holds an exclusive license from Gregory Holdings, LLC to distribute “Steel Block”, which is a high-quality steel masonry block that serves to secure attachments to reinforced concrete masonry walls and can also be used for accessory purposes. Sized to the exact dimensions of a concrete unit and installed by masons, Steel Blocks are grouted and held in place with a vertical and/or horizontal reinforcing bar and become an integral part of the wall. Items are attached to the Steel Blocks by welding, by using weld nuts or by drilling and tapping the steel face plate. In addition, Steel Block may be used to provide a secure, flush installation of accessories such as soap dishes, handcuff anchors and intercom blocks, designed for use primarily in detention and institutional facilities that cannot be dislodged from a concrete masonry wall. Management believes that the unique nature of Steel Block gives PDI a competitive advantage in the market where secured anchoring is highly desired.

PDI specifically tailors its quotes from information received from customers or from plans acquired from architects. Once a project is awarded to PDI, we detail the work for approval of the customer.

The company is headquartered in Orange, California and has an additional manufacturing plant in Tucson, Arizona.

PDI has developed a full service website e-Store feature intended to better assist customers by providing a way to order products online. This feature will allow customers to order detention furniture, accessories, wire mesh and custom fabrication with many of the standard products available for delivery the same day. It is expected that the e-Store will become fully active during 2009.

Com-Tec

Com-Tec has been in the business of integrated systems custom design and manufacturing of electronic security and communications systems throughout the United States since 2004. Com-Tec’s primary markets include correctional facilities, city and county jails, as well as commercial facilities. Com-Tec’s integrated systems combine a wide range of functions into a single-operated control console. Every function of the system is specifically engineered and integrated to operate smoothly and efficiently together. Com-Tec’s systems include remote diagnostics to aid in trouble shooting which dramatically reduces maintenance labor.

Com-Tec integrates the complex components, skills and disciplines needed to create quality electronic security systems for correctional facilities. Com-Tec has expertise in the following correctional-related security systems: Touch Screen Based Control Systems, UL 508A Control Panels, Door and Gate Control Systems, Closed Circuit Television Systems, Integrated Intercom and Paging Systems, Security Management Systems, Access Control Systems, Perimeter Intrusion Detection Systems, Television Distribution Systems, Facility Upgrades and Retrofits UL 508A Certified Manufacturer. Com-Tec designs its systems with future updating and expansion in mind, knowing that the needs and requirements of its customers grow and change over time. Com-Tec offers a package of services and products from the initial stages of specification development to preventative maintenance contracts during and after the sale.

Com-Tec assigns experienced managerial personnel to each individual project who take responsibility for every major aspect of coordination and integration of the system including application and design engineering, factory assembly and testing, installation, field testing and service and warranty work.

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Com-Tec’s focus in the commercial industry is to provide integrated electronic systems and service to customers in health care, industrial, commercial, or educational facilities. Com-Tec is part of the Argyle National Service Call Center (NSCC) which provides technical assistance, service calls and annual service contracts for a customer’s security needs. The Argyle NSCC provides on-call, 24-hour assistance from technical specialists and engineers in order to help customers through any and all issues they might face.

Com-Tec has a 35,000-square foot facility in Appleton, Wisconsin.

In contrast to ISI-Detention and MCS-Detention, Com-Tec typically subcontracts the installation of wire and operating system-filed devices in lieu of performing these tasks with its own labor force.

MCS-Commercial

MCS-Commercial designs, engineers, supplies, installs and maintains professional security, access control, video and fire alarm system solutions for large commercial customers. Its core market focus creating integrated security solutions related to the security of petro-chemical, healthcare, utilities, education and similar facilities.

MCS-Commercial supplies security electronic products to end-users and contractors. A total solution is sold to the end-user whereby MCS-Commercial utilizes the most appropriate products and configurations for a particular need. In addition, it also provides the ongoing service needs of the customers. These products include: access control systems, fire alarms, video, CCTV, sound paging systems and structured cabling. In contrast to ISI-Detention and MCS-Detention, which sell their products to the corrections industry for jails and prisons, MCS-Commercial typically sells its products to contractors that are building or renovating commercial projects, or to owners of commercial properties. MCS-Commercial does not manufacture any of the hardware that is sold and installed as part of its security solutions. Hardware is purchased from third parties and installed as required by the plans and specifications for each project. Although the products of MCS-Commercial and MCS-Detention are similar in many respects (i.e. access control systems, CCTV, etc.), MCS-Commercial sells products only to commercial customers for commercial projects.

Contracting Structure: Approximately 34% of the work of MCS-Commercial is negotiated service work, which is not subject to competitive bidding and is billed on an hourly basis for time and materials. The remaining 66% of MCS-Commercial’s work is generally equally divided between negotiated contracts and competitively bid transactions on commercial (not correctional) projects. Most non-service work transactions result in a contract with a customer that is an owner or construction manager of a project (where MCS-Commercial is a prime or direct contractor) or an agreement with a general contractor or electrical contractor on a project (where MCS-Commercial is a subcontractor).

MCS-Commercial has focused upon relationship selling and negotiated contracts, because in the commercial (non-governmental) arena, competitive bidding is not mandated by law, and the parties have the option of negotiating a contract should they choose to do so. MCS-Commercial will continue to focus upon the negotiated transaction sector of its business, by aggressively seeking out and courting relationships with owner/customers.

MCS-Commercial pursues the majority of its work on its own as a stand-alone vendor, though a smaller portion is pursued as part of a team that has been assembled to pursue the project. The team approach is more commonly utilized by ISI Detention, though it is an important part of MCS-Commercial’s business model.

 MCS-Commercial maintains sales/service offices in Dallas, San Antonio, Austin and Houston, Texas as well as in Denver, Colorado. Each office is responsible for selling and servicing MCS-Commercial products in its respective geographical area.

The process of estimating and pricing projects for MCS-Commercial is substantially the same process used by ISI-Detention and MCS-Detention. Additionally, MCS-Commercial enters into contracts that are similar, if not identical, in terms and conditions to the contracts entered into by ISI-Detention and MCS-Detention. MCS-Commercial buys and resells all of its products to its customers. Installation is performed by MCS-Commercial employees and also by subcontractors.

As used above, the term ‘hardware’ is intended to mean hard goods generally related to all facets of modern security systems. Therefore, this term includes not only operational computer terminals (with software loaded upon them), computer monitors and networking devices, but it also includes security grade doors, windows, locks, hinges, door closers, door handles, cameras, sensors, intercoms, fire alarms, smoke alarms, access controls, installation hardware (screws, nuts, bolts, cables, etc.) and similar goods involved in modern correctional, governmental and commercial security systems.

General

Other than PDI, none of the business units manufactures the hardware that it sells. Hardware is purchased from third parties and

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resold. None of the business units have long-term agreements with their third-party hardware vendors. Most of the hardware that the business units typically recommend be used in any particular customized security solution for a customer is available to them from more than one hardware vendor. Accordingly, we do not believe that such long-term agreements are necessary. MCS-Commercial has distribution agreements in place with some of its third-party vendors to distribute certain product lines. Computers are included in the hardware that the divisions sell to their customers. Those computers require software, and that software is purchased from third parties. None of our proprietary software is sold separately to our customers. The divisions load the third-party software on the computers (or it is installed by the manufacturer of the computer) and insure that the computers are working properly before they are sold and shipped to the customer.

We have made a concerted effort to become a total solutions provider of security and detention solutions for the corrections design/build market. In the security industry, a ‘‘total solutions provider’’ means that a vendor has the ability to design customized solutions for a wide range of security needs, and provide all of the hardware and software for those solutions, rather than designing a wide array of solutions, but only actually fulfilling the design in one or two areas. If a customer selects a series of security vendors, each providing a separate and independent system that addresses only a limited security need, then the numerous systems required to provide overall security can cause many unanticipated problems in operations, maintenance, and upgrades. ISI, as a ‘‘total solutions provider,’’ can provide its customers with one source for a wide range of security solutions that are tested and proven to work together.

Our operating units provide a range of products, as well as value-added services, such as design assistance to architects, engineers and owners through writing specifications, providing CAD documents, equipment selection and vendor recommendation. The breadth of our offerings has enabled us to establish a leadership position in the design/build corrections market; in turn, this recognized expertise in providing customized, high-level solutions to the most demanding of customers has allowed us to acquire projects in other security-sensitive sectors, such as the healthcare industry, water treatment plants, utilities, federal courthouses and upscale private commercial buildings.

Through our design assistance and performance, we develop relationships that make repeat business with customers more likely. For example, more than 60% of the revenues during 2006, 2007 and 2008 has been the result of contracts with repeat customers. These repeat customers typically allow us to negotiate the work, especially on design-build projects. Design-build projects are contracts where we provide substantial design assistance to its customers.

Hardware re-sales are not impacted by whether we act as a contractor or subcontractor on a particular project. In either instance, whether as a subcontractor or a contractor, we purchase hardware, pre-assemble and test it, and once approved, ship the goods to the jobsite, where the hardware is installed. Whether we are a subcontractor to a general contractor, or a party to a direct contract with an owner of a project, these internal processes at Argyle do not change. The key relevant difference in Argyle acting as a general/prime contractor or a subcontractor with regard to hardware re-sales is merely the identity of the party with whom Argyle contracts and the party to whom Argyle looks for initial payment.

Whether we are acting as a general/prime contractor or a subcontractor, the cost of the hardware is included in Cost of Revenues/Contract Costs in our financial statements, and the revenues generated by the sale of that hardware is reflected in Contract Revenues in our financial statements. The profit from the sale of hardware is first reflected in Gross Profit in our financial statements, which is then reduced by general, sales and administrative costs, etc. In either situation, the results of the resale of the hardware are reflected in the internal financial results of each project, and ultimately in our financial results, as any other component of a project such as labor, utilities, or supplies.

Each project presents us with a unique combination of a one-of-a-kind array of security related devices in a unique geographic configuration and utilization, and security deployment environment. Examples of those disparate environments include a city jail in a humid coastal area with hundreds of prisoners being booked in and out each day, the searing heat of a desert prison with long-term inmates where classroom education is the key activity, or a downtown high-rise with residents and business tenants demanding comprehensive 24/7 personal safety that does not intrude upon their private or business lives. Making these systems work together is a key value-added service that the business units provide.

The communication and operational interaction between systems presented to us in each project requires project-specific programming to resolve. The cost of such project-dedicated programming is charged to each individual project. The programming solution is stored for use at a later time should a similar requirement arise. Over time, we have developed a library or warehouse of these unique software solutions, which helps us solve the communications conflicts among disparate systems quickly and accurately.

This library of unique software solutions, created on a project-by-project basis, is the foundation of the proprietary TotalWerks suite of software programs that we use to solve communications conflicts among security devices. This suite of software is a development tool used by us, and it is not sold to any customer. The TotalWerks suite allows the fabrication and engineering personnel of MCS-Detention and MCS-Commercial to quickly create the software solutions that are needed for a specific project.

Before any system is shipped to a customer, it is first assembled at our offices in a simulated real-world environment. The

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TotalWerks software is used during this intensive testing, and allows the engineering and fabrication staff to test every input/output device (door switch, card swipe reader, security keyboard, night watchman guard tour signal device, etc.) in the expected real-world environment for that project in order to insure that each device works properly with all the other required systems, before the system is shipped to the customer.

The TotalWerks suite of software is essentially a combination of the adaptations and tools that we have created for individual projects, and the cost of developing almost all of the component pieces of the Suite was charged to individual projects for which each separate adaptation or tool was created. The cost of the additional work completed on the TotalWerks suite to streamline its operation has been minimal. Therefore, we do not maintain a separate research and development program or “cost center”.

There are two software packages that are loaded on these computers, including Microsoft Windows XP and Wonderware that require licensing, and the transfer of the license to our customer is handled differently for each of the packages.

Bonding

Bid, performance and payment bonds are an important component of our business. Many owners or contractors will require that we submit a bid bond when we place a bid for new projects. Many owners or contractors require that performance and payment bonds be delivered to the customer before we can enter into a contract. Approximately 30% of contract revenues and 20% of overall company revenues for 2008 were generated by “bonded” contracts (contracts that require performance and payment bonds), and approximately 28% of Argyle’s revenues in the past three years have been derived from bonded contracts.

A bid bond guarantees the owner or a general contractor that the bidding contractor will honor its bid and will sign all contract documents if awarded the contract. The owner or general contractor may sue the bidding contractor and its surety to enforce the bond. If the bidding contractor refused to honor the bid, it and its surety are liable on the bond for any additional costs the owner or general contractor may incur in reletting the contract. This usually is the difference in dollar amount between the low bid and the second low bid. A performance bond guarantees the owner or general contractor that the working contractor will complete the contract according to its terms including price and time. A payment bond guarantees the owner that subcontractors and suppliers will be paid the monies that they are due from the principal.

 From 2004 through the ISI merger in July 2007, bonding capacity had been made available to us through ISI*MCS, an entity created and owned by the Chief Executive Officer and President of ISI, Sam Youngblood and Don Carr, respectively. Since the consummation of the acquisition of ISI, ISI*MCS has not provided any new bonded contracts for Argyle. We have secured adequate bonding capacity that we believe will address the total expected business in 2009.

The bonding company that issues performance and payment bonds is an interested party in all matters regarding the bonded contracts. A bonding company is obligated to complete a project for which it has issued bonds and will typically seek recovery of its costs to complete the contract from all available parties. The result is that a dispute with an owner or general contractor arising from a bonded contract must also include consideration of the interests of the bonding company, typically a well-financed and highly sophisticated party. The addition of this sophisticated party to disputes regarding bonded contracts increases the risk that a default or breach of a bonded contract by Argyle will result in a loss to Argyle. Even if Argyle is able to resolve or avoid a dispute with an owner or general contractor, resolving a dispute with a bonding company that has paid a claim to complete a project will increase the potential risk of loss.

Acquisitions

On July 31, 2007, Argyle consummated a business combination, acquiring 100% of the outstanding capital stock of ISI Detention Contracting Group, Inc. (which became ISI Security Group, Inc. upon the close of the transaction) and its subsidiaries, the value of which the Board of Directors determined was greater than 80% of Argyle’s assets at the time of the merger. Prior to the acquisition, we had no operations and we were considered a developmental stage enterprise. ISI is deemed to be a ‘‘predecessor’’ to the combined company. The accompanying consolidated balance sheet includes the assets and liabilities related to the acquisition of ISI, adjusted to fair value pursuant to Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations .

Argyle used an estimated $20.5 million (excluding Argyle and ISI transaction costs) of the net proceeds of the initial public offering to acquire ISI.  At the closing of the merger, the consideration paid by the Company to the stockholders and debt holders of ISI was $18.6 million in cash; 1,180,000 shares of common stock of Argyle (valued at approximately $9.2 million); and $1.9 million of unsecured promissory notes which were convertible or redeemable by the Company into shares of our common stock at a price of $10.00 per share.

On January 1, 2008, MCFSA, Ltd. (“MCFSA”), all of the partnership interests of which are directly or indirectly wholly owned by ISI, acquired substantially all of the business assets and liabilities of Fire Quest. Fire Quest is engaged in the business of alarm system sales and service.  In consideration for the sale of its assets to MCFSA, Fire Quest received cash in the amount of $0.75 million and a promissory note in the aggregate principal amount of $0.25 million (“Fire Quest Promissory Note”). The Promissory

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Notes will bear interest at the rate of 7.25% per year and will become due and payable on January 1, 2009.

On January 4, 2008, ISI acquired substantially all of the business assets and liabilities of Peterson Detention for cash in the amount of $1.5 million and convertible promissory notes (the “PDI Promissory Notes”) in the aggregate principal amount of $3.0 million. The aggregate principal amount of the PDI Promissory Notes may be reduced depending on the occurrence of certain events described in the Asset Purchase Agreement. The payment of the PDI Promissory Notes is guaranteed by and secured by the assets of ISI and the Company; bears interest at 6% per year and will become due and payable on December 31, 2012. As of February 28, 2008, the holders of the PDI Promissory Notes may convert up to $1,500,000 of the outstanding balance of the PDI Promissory Notes into shares of Argyle’s common stock at the average closing price of Argyle’s common stock for the 20 trading days preceding the conversion date, provided that the conversion price may be no less than $8.00 per share.

On January 31, 2008, ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI, closed a transaction, pursuant to which ISI-Controls acquired 100% of the outstanding units of Com-Tec Security, LLC (“Com-Tec”), resulting in Com-Tec becoming a wholly owned subsidiary of ISI-Controls. Com-Tec is engaged in the business of custom design, manufacture and installation of electronic security and communication systems.  In consideration for the sale of the units to ISI-Controls, the holders of units in Com-Tec (the “Seller”) received cash in the amount of $3.0 million and a secured subordinated promissory note in the aggregate principal amount of $3.515 million (the “Com-Tec Promissory Note”). The aggregate principal amount of the Com-Tec Promissory Note may be reduced depending on the occurrence of certain events described in the Unit Purchase Agreement by and among ISI-Controls, the Seller and Jeffrey E. Corcoran as the Seller Representative (the “Unit Purchase Agreement”). The Com-Tec Promissory Note is guaranteed by and secured by the assets of ISI and the Company; bears interest at 7% per year and will become due and payable on April 1, 2011. On March 2, 2009, the principal of the Promissory Note was reduced to $3,491,290.80 as a result of adjustments made because of uncollected accounts receivable.

Customers

Our company is customer focused and takes pride in its customer retention. More than 60% of the revenues for ISI-Detention and MCS-Detention in 2006, 2007 and 2008 has been the result of contracts with repeat customers. We continuously focus on finding ways to better serve our clients. Our diverse customer base consists primarily of contractors, construction companies and architects catering to publicly and privately run detention facilities and commercial construction. Our top three customers in 2006 amounted to 33% of total revenues. For fiscal year 2007, we generated 8% of total revenues from our top customer, 15% from the top two and 20% from the top three. For fiscal year 2008, we generated 9% of total revenues from our top customer, 19% from the top two and 27% from the top three. Our largest customer represented $12.7 million of total revenues in 2008.

Competition

The security services industry is a large and competitive market. We compete for contracts based on our strong client relationships, successful past performance record, significant technical expertise and specialized knowledge.

The Argyle Corrections business segment often competes against detention systems integrators, as well as specialized information technology consulting and outsourcing firms. Our competitors include Norment Security Group, Cornerstone Detention Products, Sierra Steel, CCC Group, G-S Company, and Pauly Jail Building Company. Our competitors for our hardware/software solutions include Norment Security Group, Stanley Integrator (part of Stanley Works), Simplex Grinnell (part of Tyco), ESi Companies, Southwest Communications, and Accurate Controls.  PDI, principally competes against prison furniture fabricators such as PSI, LLC, Mustang Metal and Cornerstone Detention and Com-Tec competes against TremTech (part of Norment), Accurate Controls and MTI.

The Argyle Commercial Security business segment faces a much broader array of competitors such as: Koetter, Siemens, DSS, Fire Alarm Services, Fire Alarm Control Services, Tyco, Chubb and Lone Star. There are also several smaller regional companies that compete with us.

Some of the companies we compete with are much larger than Argyle, and such companies have significantly greater resources than us. However, the larger conglomerates that compete in the detention sector offer only the electronic portion of our detention security solution. There are very few companies that provide both electronic and physical security solutions, Norment being the most prominent, allowing general contractors to deal with a single supplier for all of their correctional security needs. The commercial security sector has always had a few very large competitors and many moderate-size competitors. The latter companies continue to thrive on the basis of their sales capability, project execution performance and their after-project service. The commercial security market has proven to be large enough in prior years to support growth for both large and moderate size security companies. Management does not expect competition in any of the sectors to decline in the foreseeable future.

Employees

As of December 31, 2008, we had approximately 592 full-time employees. Future success depends significantly on our ability to attract, retain and motivate qualified personnel. We are not a party to any collective bargaining agreement, have not experienced any strikes or work stoppages and consider our relationship with our employees to be satisfactory.

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Market

The Company’s primary focus markets include the corrections and detention market and the critical infrastructure segments of the commercial security market in attractive geographic areas.

Corrections and Detention Market.  The United States has the largest prison population in the world and incarcerates its citizens at a greater rate than any other country and the detention market has been expanding in recent years. The number of inmates housed in U.S. prisons and jails reached a record high of 2.3 million during 2007. As a result of this situation, some states have had to move their excess prisoners to other states where detention facilities have some excess capacity to absorb additional prisoners. Management believes that we are well positioned to take advantage of the continued growth in population in detention facilities. The statistics presented above were obtained from publicly available U.S. Department of Justice Bureau of Justice Statistics Bulletins.

The current prison construction programs of various federal agencies, states, counties and cities are driven by many different factors pertaining to inmate populations. In addition to annual increases in inmate population, these factors include the increase in the rate of juvenile and female incarceration, the segmenting of violent sexual predators, the segmenting of aging inmates, the recent rapid increase in the rate of illegal alien incarceration, plus the significant transient movement of the population, which also causes an increase in incarceration rates in different locations. According to the American Institute of Architects semi-annual forecast, the public safety construction sector will perform relatively well compared to other nonresidential sectors and will avoid the worst of the declines in project activity for the next two years.

Private prison operators are growing at a much faster rate than the 2.5%-to-3.0% increase in inmate growth (Bureau of Justice Statistics Bulletin). One of the reasons for this accelerated growth is the increasing acceptance of the financing plans that have been developed by the private operators.

Commercial Security Market. The North American electronic security market reached $27.1 billion by the end of 2007, of which 67% was in the commercial/industrial sector — MCS-Commercial’s market. The fastest growing sectors within that market are video (10% per year) and access control (8 - 9% per year), both areas in which MCS-Commercial competes. MCS-Commercial also competes in the fire protection area. MCS-Commercial is also able to design and provide fire alarm products and services. The fire alarm market is a potential catalyst for garnering video and access control business because of the unique licensing requirements mandated by state and local authorities which oversee an industry that is focused more on life-safety than on property protection. Many of the organizations vying for commercial/industrial business lack the fire alarm certification licensing needed to provide a total system solution.

Note: The statistics presented above were obtained from documents originally published by JP Freeman & Co., IMS Research, and The Freedonia Group, market research organizations serving the physical security industry.

Business Strategy

 Our Company is a comprehensive security solutions provider to our diverse customer base, because we address the majority of their physical electronic security requirements.  We meet these requirements with a broad range of specific but custom integrated, security solutions delivered on a turnkey basis.  Our goal is to become a trusted resource to our customers and, in doing so, to develop long standing relationships, through which we then become an ongoing provider of recurring maintenance and support services for both systems installed by us as well as legacy systems.  We view our most important asset, as well as our ongoing and continuous focus, to be the value and trust that we have developed with our customers by meeting or exceeding their expectations.  In both our corrections and commercial markets, our long-term customer relationships represent a growing source of predictable future installation revenues as well as recurring services — at growth rates that well exceed that of our competitors.  Currently, our primary business is the delivery of these solutions as a systems integrator, though we currently produce some of our own proprietary software and hardware for the corrections market, which we will also sell to other system integrators.  We may consider acquisitions if we determine that our ownership of such technologies will not compromise the best possible products and services to our customer base.

The graphic below depicts our current comprehensive focus areas as well as our desired future service offerings.

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Solutions Focus. As the industry continues to grow, we are focusing our efforts in a manner that will allow us to respond to the needs of our customers.  In order to accomplish the goals of our clients, we have implemented a business strategy that is client-oriented and solutions focused. The key elements of the strategy include:

· Capitalize on the opportunities emerging from digital convergence, new technologies and growing markets to offer customers total security solutions:

PRODUCTS + SOFTWARE + SERVICE = SOLUTIONS

· Employ both organic growth and strategic acquisitions to create a publicly held global security company that operates in the areas of our focus markets and channels.

· Capitalize on acquisition targets in a globally fragmented market.

· Move expeditiously to reach critical mass — a size sufficient to attract global customers, larger acquisition candidates, exceptional people and efficient capital.

· Leverage technology, products, channels and skill sets.

· Enhance and leverage valuable brands and relationships across new geographic regions and channels.

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Key Alliances

At Argyle Corrections, creating, maintaining and enhancing key alliances with architects, security consultants and general contractors involved in the development and construction of detention facilities is critical for the development of a steady and recurring revenue stream in a market that is steadily growing.

At Argyle Commercial Security the focus is to develop alliances with very large and multi-site regional or national organizations that will then utilize our capabilities for their security needs in growth/expansion projects and/or in many locations, so as to provide a steady and profitable revenue stream for us.  The technology partners that are critical to our success are in the primary areas of access control, video, biometrics, fire detection, printers, intercom and perimeter security.  We have established relationships with companies in each of those fields.

Geographic Expansion and Strategic Acquisitions

We believe that the acquisition of comprehensive manufacturing and product integration capability that can be tightly integrated with Argyle’s other products and will greatly enhance our competitive posture in capturing business and will also result in more of the project revenue remaining in-house for enhanced margin.  In addition, through our strategic acquisitions, we have added office locations throughout the U.S., resulting in our detention sector having the ability to better service our customers.

We believe that in Argyle Commercial Security, either acquisition of existing solution providers in some of the larger metropolitan markets in the U.S., or internal expansion to address those markets, will enlarge our national footprint and better enable us to service the multi-site organizations that are being sought as customers. External acquisitions will give us access to new customers in the regions that are of interest and would give us a running start as opposed to the slower build-up that would ensue from internal expansion.

Sales

Our sales goals are to focus on sales and marketing to niche target markets and those markets operating in regions of the market that are not currently addressed today. We want to maintain a dedicated, highly motivated and organized national account sales team with the necessary credentials to capture larger scale and multi-site commercial security opportunities.

Marketing

Successfully branding ourselves and each of our business units to create greater visibility in the industry and across the nation is the central goal of our marketing efforts.  We want to coordinate media and public relations campaigns for all Argyle products and services and establish new ideas regarding ways to promote the “Argyle” brand, service, Company, and industry experts through researching news and daily events. We want to continue to develop and improve a centralized database system where all sales and marketing staff can track sales leads and customer information, continue to enhance project bid spreadsheet for cost code and pricing structure, facilitate and refine “smarts and parts” bidding requirements and roll out revised project “turn-over” procedures. We also plan to develop a risk analysis format and develop enterprise risk management systems to monitor internal and external risks.

Competitive Strengths

Our management team believes that Argyle is competitively well positioned and believes that it has a number of strengths versus the competition:

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·                  A solid reputation in both the detention and the commercial market sectors with its customers for on-time project execution, security solution performance and customer service that results in a significant amount of repeat business being garnered. For example, more than 60% of the revenues for ISI-Detention and MCS-Detention during 2006, 2007, and 2008 have been the result of contracts with repeat customers.

·                  Ability to react to changing technological needs.

·                  A software platform that lends itself to very rapid adaptation to the specific requirements of individual facilities and to the use of the two major operating systems in the market-Windows and Linux, with minimal effort.

·                  A broad array of software drivers that allow our solutions to utilize a wide variety of security system peripherals from many different third-party suppliers.

Many of our competitors do not have the in-house capability for electronic system solutions. We provide these solutions to our customers thereby further enhancing our value to clients.  Furthermore, we believe that we have leading edge solutions, including touch screen and PDA wireless control for the detention industry, plus a software development process that provides timely and efficient security solutions for customers.

Research and Development

We do not currently have a research and development department or “cost center”. A software development team within MCS-Detention provides our operating arms with new features and capabilities in developing security solutions. Software development allows new technologies to be reviewed and incorporated into our product lines.  The development team not only looks at software advances but also hardware breakthroughs.  The development team has projects in various stages of development which, when completed, will provide us with technology and integration advantages over our competition.  For example, technology is being developed to allow our customers to have a more active role in modifications to their own products.  Technologies using RFID, Bluetooth, Multi-Touch, RSS, Pod casting, Ultra-wideband and VoIP will bring enhancements and new feature sets to an already technologically well positioned product line.  Product lines acquired during recent acquisitions are being researched.  New hardware and software feature sets for these products are being developed which will again set standards in the marketplace but also reduce the fabrication time allowing quicker jobsite deployments.

Government Regulations

Various states within the United States require companies performing the type of work performed by us in detention facilities to be licensed. We maintain active licenses in every state in which we do business that requires licensing. Outside of detention facilities, many states and local municipalities require companies that provide turnkey electronic security systems for commercial facilities to obtain and maintain special security licenses.

The process of obtaining specialty security licenses is bureaucratic. We have designated personnel to oversee the process for maintaining all of our licenses. Obtaining new licenses typically requires that a test be taken in that state, if it requires a state license. If a state license expires or is revoked for any reason, it could prevent us from being authorized to enter into a contract in that state. If a local license expires or is revoked for any reason, we may be assessed a fine, depending on the delinquency in regard to that license.

The following is a list of the specialty licenses that we have secured as of December 31, 2008:

Alabama — Detention & Security Equipment

Arkansas — Sound & Intercom Systems, Fire Detection Systems, Signal & Burglar Alarm Systems, Computer Cabling

Arizona — Low Voltage Communication Systems

California — Low Voltage Systems

Florida — Alarm System Contractor

Georgia — Unrestricted Low Voltage

Iowa — Subcontractor

Idaho — Electrical Limited Energy Specialty Contractor

Illinois — Private alarm contractor

Louisiana — Electrical Controls, Prison, Penitentiary, Jail Confinement Institutional Equipment

Minnesota — Technology Systems Contractor

Mississippi — Security, Burglar & Fire Alarms, Detention Equipment

Montana — Subcontractor (Bid Only Certificate)

North Carolina — Low Voltage Electrical and Alarm

North Dakota — Subcontractor

Nebraska — Subcontractor

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New Mexico — Sound, Intercommunication, Alarm System, Installation of Detention Furnishings, Automatic Fire Detection & Alarm Systems

Nevada — Low Voltage Systems, Detention Equipment

Oklahoma — Access Control, CCTV, Nurse Call, Locksmith

Oregon — Subcontractor

South Carolina — General Contractor

Tennessee - Electrical Controls

Texas — Private Security Alarm License and Fire Alarm License

Utah — Contractor

Virginia — Electronic Communications

Washington — Contractor

City of Arvada — Building Subcontractor

City of Aurora — Fire Alarm Contractor and Fire Alarm Supervisor

City of Boulder — Fire Alarm Systems

City of Broomfield — Contractor

City of Centennial — Business license and Access Control and Security

City of Colorado Springs — Fire Alarm

City of Denver — Access Control System and Electrical Signal

City of Lakewood — Contractor

City of Littleton — Miscellaneous

City of Loveland — Fire Alarm

City of Thornton — Contractor — Fire Alarm

City of Westminster — General Building Contractor

City of Wheat Ridge — Electrical Signal

Available Information

We electronically file our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K with the Securities and Exchange Commission (SEC) pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. Any materials we file with the SEC are accessible to the public at the SEC’s Public Reference Room at 100 F. Street, N.E., Washington, DC 20549. You may obtain information on the operation of the SEC’s Public Reference Room by calling the SEC at (800) SEC-0330. The public may also utilize the SEC’s Internet website, which contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of the SEC website is http://www.sec.gov.

You may obtain free copies of our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports on our website at http://www.argylesecurity.com, or by contacting our corporate office by calling (210) 828-1700, or by sending an e-mail message to dneville@argylesecurity.com.

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Item 1A. Risk Factors

In addition to the other information in this annual report, the following factors should be considered carefully in evaluating the Company’s business and prospects. THE FOLLOWING MATTERS, AMONG OTHERS, MAY HAVE A MATERIAL ADVERSE EFFECT ON THE BUSINESS, FINANCIAL CONDITION, LIQUIDITY, RESULTS OF OPERATIONS OR PROSPECTS, FINANCIAL OR OTHERWISE, OF THE COMPANY. REFERENCE TO THIS CAUTIONARY STATEMENT IN THE CONTEXT OF A FORWARD-LOOKING STATEMENT OR STATEMENTS SHALL BE DEEMED TO BE A STATEMENT THAT ANY ONE OR MORE OF THE FOLLOWING FACTORS MAY CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN SUCH FORWARD-LOOKING STATEMENT OR STATEMENTS. We are subject to, among others, the following risks:

We have made significant operational changes in response to both operational and reporting inefficiencies. An inability to successfully implement the changes may reduce our profitability.

During 2008, we experienced many operational challenges which were largely a result of an integration of newly acquired entities, as well as, rapid expansion of our existing businesses. In response to these challenges, during the second half of 2008, we made a number of personnel changes, as well as implemented changes in our financial reporting and accounting systems. Such corrective actions are essential to the continued success of Argyle. There is no assurance that such corrective actions and management changes will be successful. Further, any failure to implement newly installed financial controls and accounting oversight could result in negative budget variances and potential defaults of financial covenants. Such failures to successfully implement the changes could result in decreased profitability and a reduction in our revenues.

We operate under fixed price contracts, and our failure to accurately estimate our costs may reduce our profitability.

Approximately 90% of our revenues result from fixed price contracts. If we do not accurately estimate our costs on projects, we could suffer losses on fixed price contracts. Unanticipated increases in the cost of raw materials could also result in our losing money on contracts. If we suffer losses on our contracts, our profitability will be reduced. In addition, the revenues that we record under these contracts are recognized under the “percentage-of-completion method of accounting.” This method requires considerable judgment and, as a result, the estimates derived at any point in time could differ significantly and result in material discrepancies between the estimates and the financial reality of the applicable contract.

Budget constraints of federal, state and local governments could reduce our revenues.

Contracts for which federal, state or local governments are the ultimate customer have historically accounted for a major portion of our business. The detention systems segment, the largest revenue-producing business segment, outfits correctional facilities and courthouses. Many state and local governments operate under very tight budget constraints. These budget constraints could cause them to delay, reduce the scope of, or cancel pending projects, which could reduce our revenues.

Our failure to obtain and/or maintain required local/state licenses could reduce our Revenues.

A portion of our business depends upon obtaining and maintaining required licenses. All such licenses are subject to audit by the relevant government agency. Any failure to obtain or maintain required licenses could result in the termination of certain of our contracts or cause us to be unable to bid or re-bid on certain contracts. In addition, we and/or our employees may be required to maintain certain facility security clearances. If we or our employees were found not to be in compliance, we could be excluded from bidding on certain contracts, removed from projects and/or fined, all of which would adversely impact our financial condition and good standing.

ISI had been subject to one audit of its licensing. In 2005, the Arkansas Licensing Board conducted a hearing regarding the renewal of ISI’s Contractor License for the State of Arkansas. The outcome of the hearing was successful, and ISI was issued a Contractor’s License.

Our ability to obtain bid, payment and/or performance bonds is critical to our ability to conduct business.

Bid, performance and payment bonds are an important component of our business. Many customers require that performance and payment bonds be delivered to the customer before the customer will enter into a contract. Approximately 30% of Contract Revenues and 20% of overall Revenues for 2008 were generated by “bonded” contracts (contracts that require performance and payment bonds), and approximately 28% of our revenues in the past three years have been derived from bonded contracts.

We believe that we have sufficient bonding capacity to address the total expected business for the remainder 2009. However, there can be no assurance that such bonding capacity will be increased or whether it will always be available and as a result of the current economic environment, our bonding requirements may significantly increase. If we are unable to secure bonding, then we may not be able to enter into contracts that require such bonds. This would significantly reduce our expected sales and reduce the level of

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our future financial performance. Some of the additional factors that might cause us to be unable to obtain such bonds include, but are not limited to, unacceptably high premium rates for such bonds, the unavailability of bonding capacity at an acceptable cost from a bonding company with an acceptable financial rating, or the collateral/financial requirements of the bonding company. Such requirements are generally intended to provide liquidity to a bonding company should it become obligated to pay a claim. These requirements can include minimum cash reserves, letters of credit for the benefit of the bonding company and other irrevocable commitments of working capital that are unacceptably high.

If we are required to make any significant payments as a result of our indemnification obligations arising from specified ISI*MCS bonding contracts or guarantees, such payments may negatively impact our operating results.

Argyle agreed that, after the acquisition of ISI was consummated, it would indemnify and hold harmless Sam Youngblood and Don Carr, their spouses, attorneys, agents and permitted assignees against any losses incurred arising from a contract or agreement that is the subject of a performance or payment bond provided by ISI*MCS or guarantees by the indemnitees relating to any of the performance or payment bonds provided by ISI*MCS, to the extent such contract had not been fully paid as of the closing of the acquisition. These indemnification obligations survive until July 30, 2011 and the obligations are not subject to a cap or maximum amount. Although it is not anticipated that Argyle will be required to make any payments under this provision, if Argyle were required to do so, it could result in Argyle having to pay Mr. Youngblood and/or Mr. Carr a significant amount of money. Management estimates that the potential risk on such indemnification could be approximately $1,958,815, which consists of all potential liability that could arise from all bonded contract obligations due and owing as of December 31, 2008 and assumes that all work performed or to be performed on bonded contracts is unsatisfactorily completed.

Our significant debt could adversely affect our financial health and pose challenges for conducting our business.

We have and will continue to have a significant amount of debt and other obligations, primarily to support our bonding requirements and customer financing activities. As of December 31, 2008, we had $36.4 million of total debt. Our total cash and cash equivalents was $13.6 million at December 31, 2008 (of which $5.0 million of cash is restricted). Our substantial debt and other obligations could have important consequences. For example, it could (i) increase our vulnerability to general adverse economic and industry conditions; (ii) limit our ability to obtain additional financing for future working capital, capital expenditures, acquisitions and other general corporate requirements; (iii) increase our vulnerability to interest rate fluctuations because a portion of our debt has variable interest rates; (iv) require us to dedicate a substantial portion of our cash flows from operations to service debt and other obligations thereby reducing the availability of our cash flows from operations for other purposes; (v) limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate; and (vi) place us at a competitive disadvantage compared to our competitors that have less debt. If new debt is added to our current debt levels such as the incurrence of debt to partially fund acquisitions, these related risks could increase.

We may violate certain financial covenants related to our senior and subordinated debt facilities.

Our ability to comply with the financial and other covenants contained in our senior and subordinated debt facilities may be affected by our own operating performance, changes in economic or business conditions, or other events beyond our control. If we do not comply with these covenants and restrictions, we could be in default and the debt, together with accrued interest, could be declared immediately payable. If we are unable to repay any borrowings when due, the lenders could proceed to take action to satisfy the obligations by taking possession of their collateral, which includes most of our assets. If any of our debt is accelerated, we may not have sufficient assets to repay amounts due. The senior debt facility entered into by us contains covenants that require us to maintain certain total and senior debt-to-EBITDA and fixed-charge-coverage ratios. We have received a waiver for any violation of covenants at December 31, 2008. It is possible that we may violate the financial covenants in its senior debt facility at some point in the future for which we may not be able to receive a waiver. There can be no assurance that we will be able to obtain waivers in the future in the event another violation occurs.

If we are unable to design and market our security solutions in a timely and efficient manner, we may not remain competitive.

Some of our markets are characterized by continuing technological advancement, changes in customer requirements and evolving standards. In particular, the detention and corrections market relies on the development, implementation, and support of complex, integrated software and hardware systems. To compete successfully, we must develop and market new products that provide increasingly higher levels of performance and reliability. Product development is highly uncertain, and we cannot guarantee that we will successfully develop new products. Our inability to develop and market these products, or to achieve customer acceptance of these products, could limit our ability to compete in the market.

In addition, we offer a wide variety of solutions. If the design or marketing of a security solution, is not successful and we must allocate more resources to ensure more sales, it could lower the profitability of the work, or affect customer perceptions as to the quality of the products and services being offered.

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We depend on third-party hardware for our customized security solutions.

We purchase the hardware for our customized security solutions from third-party vendors. Currently our ISI-Detention and MCS-Detention divisions do not have long-term agreements with the third-party vendors with whom they do business. Any reduction or interruption in the supply or manufacturing of hardware from these third-party vendors could limit our ability to offer and deliver complete security solutions to its customers and could result in reduced revenues.

MCS-Commercial has distribution agreements in place with some of its third-party vendors. If any of these vendors were to terminate or cancel its agreement with MCS-Commercial, this division would lose its ability to market that vendor’s specific product line to our customers. To the extent that we are unable to find a competing brand with the same level of acceptance among our customers, we could suffer the loss of some customers.

We are subject to substantial government regulation that could cause delays in the delivery of our products and services and may subject Argyle to audits or other similar review processes.

As a contractor and subcontractor to agencies of various federal, state and local governments, we are obligated to comply with a variety of regulations governing our operations and the workplace. Unforeseen problems in the performance of contracts could cause the loss of licensing to do business within a particular city, county, state, or other governmental entity resulting in us losing contracts with that entity. In addition, changes in federal, state and local laws and regulations may impact our ability to secure new contracts or require us to make costly changes to our operations which could reduce our profitability in order to obtain contracts.

Our inability to effectively integrate future acquisitions could reduce our profitability.

Part of our business strategy is to grow through strategic acquisitions and, since December 31, 2007, we acquired PDI, Com-Tec and Fire Quest. For the acquisition of other new businesses to be successful, we must integrate the operations, systems and personnel from those acquired businesses into Argyle. This integration process requires, among other things, that we continually evaluate our operations, financial systems and controls and, when necessary, enhance and adjust those systems and controls. If the acquired businesses are not successfully integrated into Argyle, the key employees and their relationships with new customers, as well as their expertise and reputation in the industry, could be lost and/or destroyed, resulting in lower than expected sales and reduced repeat business, if any, from those acquired customers. Additionally, the new customers acquired could be lost which would reduce expected revenues from the acquisition and reduce expected profitability.

We may need additional financing for bonding requirements, working capital and capital expenditures, and additional financing may not be available on favorable terms.

In order to operate the business, we may need to obtain additional surety bonds, maintain working capital or make significant capital expenditures. In order to do any of those things, we may need to obtain additional capital. Therefore, our ability to operate and grow is dependent upon, and may be limited by, among other things, the availability of financing arrangements. If we are not able to obtain the additional capital necessary to pursue new projects or maintain our operations, we may not be able to grow as quickly as we plan. In addition, even if we are able to obtain additional financing, the additional financing may not be on terms which are favorable to us and could hamper our profitability.

We could potentially incur liability to clients and others.

Our involvement in the public security, physical security and surveillance and justice businesses exposes us to potential liability claims from our clients. Our products are used in applications where their failure could result in serious personal injuries or death. In the area of corrections, prisoners are generally viewed as litigious. We have sought ways to minimize losses from these sources by obtaining product liability and professional liability insurance policies; however, a successful claim could result in liability in excess of coverage limits or the cancellation of insurance coverage and result in our having to pay a large amount of our working capital to cover those claims.

We are dependent upon key personnel.

We depend on the expertise, experience and continued services of our senior management and key employees such as:

·                                          Bob Marbut —Chief Executive Officer of Argyle Security, Inc. Mr. Marbut is the Chief Executive Officer of Argyle, and his knowledge of our business and reputation in the industry make him important to our success.

·                                          Ron Chaimovski —Executive Chairman of the Board of Argyle Security, Inc. Mr. Chaimovski is the Executive Chairman of the Board of Directors of Argyle, and his knowledge of our business and reputation in the industry make him important to our success.

·                                          Sam Youngblood — President and Chief Operating Officer of Argyle Security, Inc. Mr. Youngblood is President and

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Chief Operating Officer of Argyle, and his knowledge of our business and reputation in the industry make him important to our success.

·                                          Donald F. Neville — Executive Vice President and Chief Financial Officer of Argyle Security, Inc. Mr. Neville is the Chief Financial Officer of Argyle, and his knowledge and experience in capital markets make him important to our success.

Our operations and most decisions concerning our business will be made, or significantly influenced, by such individuals. The loss of members of senior management or key employees could result in the deterioration or loss of relationships with certain customers or suppliers, which could result in a material loss of business.

We are in a competitive industry with well financed competitors.

As a result of increasing consolidation in the corrections and security industries and increasing attention from venture funds and private equity groups, many of our competitors, some of which were already larger and better financed than us, have grown and obtained significant financing. Accordingly, we expect competition to increase in the near future. We also expect that some of our competitors will feel increasing pressure to underbid government and commercial projects, in order to deploy their workforces and maintain or step up their activity levels. This may make it more difficult for us to prevail on competitive bids for projects to the degree we have historically experienced.

Many of our new contracts are subject to competitive bidding.

Most governmental agencies and many commercial customers require that their significant contracts be competitively bid. Typically they utilize the “Request for Proposal” (RFP) method where several competitors submit their sealed proposals for a particular project, or the “Request for Qualifications” (RFQ) process where competitors submit their qualifications for consideration by the customer. Some contracts are open for bidding, using the standard “Straight Bid” process where the detailed specifications for a project are published and contractors submit a “Bid” or fixed price, for the contract to build the project. Other competitive bidding processes are also utilized. Our success in responding to an RFP, RFQ, Straight Bid, or other competitive bidding process is dependent upon the quality of our estimating process, knowledge of the industry, knowledge of our customers and other factors requiring significant judgment and expertise. Because of the nature of the bidding process, we cannot know if we will be successful on any given bid, which makes it difficult to accurately forecast the timing of projects and budget the allocation of resources. To the extent we have made significant capital expenditures in the development and estimating of a contract or project, we may not recover our entire capital investment in that project.

When seeking competitive bids, one of the factors that most governmental entities and commercial customers evaluate is the financial strength of the bidders. To the extent they believe we do not have sufficient financial resources, we will be unable to effectively compete for contracts.

Our ability to win new contracts depends on many factors outside of our control.

Our growth in the corrections industry is generally dependent upon our ability to win new contracts. This depends on a number of factors we cannot control, including crime rates and sentencing patterns in various jurisdictions. Accordingly, the demand for security-related goods and services for new correctional facilities could be adversely affected by the relaxation of enforcement efforts, leniency in conviction and sentencing practices or through the legal decriminalization of certain activities that are currently proscribed by criminal laws. For instance, changes in laws relating to drugs and controlled substances or illegal immigration could reduce the number of persons arrested, convicted and sentenced, thereby potentially reducing demand for new correctional facilities to house them. Similarly, reductions in crime rates could lead to reductions in arrests, convictions and sentences requiring new correctional facilities.

Furthermore, desirable locations for proposed correctional facilities may be in or near populated areas and, therefore, may generate legal action or other forms of opposition from residents in areas surrounding a proposed site. Such actions could substantially delay a correctional project or cause the project to be reduced in scope or be eliminated completely.

We offer some bids for new contracts directly to government agencies and commercial customers as a direct contractor to provide the security solutions for a project. In other instances, we provide our bid for security solutions to a general contractor, who adds our pricing to all the other pricing for an entire project. In those instances we act as a subcontractor to the general contractor. The owner of the project (the governmental entity or commercial owner) will choose whether they wish to receive bids only from general contractors, or whether they wish to receive bids separately from the entities providing security solutions, such as us and our competitors. When we are acting as a subcontractor to a general contractor, we have far less control and input over the final price for the project submitted to the owner by the general contractor than when we submit a bid directly, therefore, such circumstances reduce our ability to win contracts.

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Governmental agencies may investigate and audit our contracts and, if any improprieties are found, we may be required to refund revenues, pay unexpected taxes, forego anticipated revenues and/or may be subject to penalties and sanctions, including prohibitions on our bidding in response to competitive bidding processes.

Governmental agencies and most commercial customers will have the authority to audit and investigate our contracts with them. As part of that process, some governmental agencies review our performance on the contract, our pricing practices, change orders, other compliance with the terms of the contracts, and applicable laws, regulations and standards. For example, if an agency determines that we have improperly classified a specific contract as non-taxable, we could be required to pay sales, use or other taxes for which no reserve was created at the time the bid was submitted by us. If the agency determines that we have improperly billed the governmental entity in violation of the terms of the contract, we could be required to refund revenues, or forgo anticipated revenues. If a government audit uncovers improper or illegal activities by us or it otherwise determines that these activities have occurred, we may be subject to civil and criminal penalties and administrative sanctions, including termination of contracts, forfeitures of profits, suspension of payments, fines and suspension or disqualification from doing business with the government.

Budgetary pressure on federal, state, county and local governments may result in contract cancellation by prison operators, which would reduce our profitability.

Our cash flow is subject to the receipt of sufficient funding of and timely payment by contracting governmental entities. If the appropriate governmental agency does not receive sufficient appropriations to cover its contractual obligations, a contract may be terminated or the amounts payable to us may be deferred or reduced.

Federal, state, county and local governments have encountered, and are expected to continue to encounter, significant budgetary constraints that may result in a reduction of spending on the outsourced services that we provide. Such budgetary limitations may cause the contractual commitments for new construction projects to be delayed, reduced or even eliminated. Many states, as well as the federal government, are facing significant budget deficits and are under pressure to reduce current levels of spending or control additional spending. Examples of this budget pressure include the need of the federal government to operate under a continuing resolution as a result of its failure to pass a new 2008/2009 year budget and reported budget pressures in various states, including Georgia and California. If such budgetary pressure continues, we may see a reduction in the amount of business conducted by the Argyle Corrections business segment until such funding becomes available.

Public reporting of financial statements and negative media coverage, including inaccurate or misleading information, could injure our reputation and our ability to bid for new business.

Our competitors and our customers may use our SEC filings, press releases and conference calls to our competitive disadvantage. We compete for new business with some companies that do not have public reporting requirements and which do not file press releases announcing financial results. In some cases, the requirements we have as a public reporting company may result in public disclosure of financial information, although accurate, that may be potentially harmful to our business.

In addition, the media frequently focuses its attention on contracts with governmental agencies. If the media coverage regarding the contracts for the design, development, construction, financing or operation of a new correctional facility project is negative, it could influence government officials to slow the pace of building a correctional project or cause the cancellation of a planned correctional facility.

Jails, prisons and other public correctional projects may prompt higher than normal media scrutiny. In that atmosphere, inaccurate, misleading, or negative media coverage about us could harm our reputation and, accordingly, our ability to bid for and win new contracts.

Inability to effectively implement our strategy to more efficiently and effectively implement our plan to reduce operating costs may have a significant impact on our cash flow.

During the second half of 2008 and into 2009, we have made significant systematic and personnel changes in order to manage project cost increases as well as our operational expenses. We have employed new individuals or reassigned other individuals to implement our plans.  Achievement of our goals to manage costs is not assured. In the event that we do not effectively implement our plans, we may see a decrease in its cash flow and we may continue to have further margin erosion and decline in EBITDA.

Inability to effectively implement changes to our internal controls over our financial reporting systems to remedy existing and eliminate future significant deficiencies and material weaknesses may have a significant impact on our business.

During the last several months we have made significant systemic changes in order to attempt to remedy certain organizational and financial reporting deficiencies which have led to our discovery of significant deficiencies and a material weakness in our internal controls. We have employed new individuals or reassigned other individuals to handle the implementation of our plans.  In the event that our control system changes are not effective, we may be subject to increased scrutiny by our independent public accounting firm

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and our Board of Directors. Further, in the event that our financial statements or business model are deemed unreliable as a result of significant deficiencies or material weaknesses in our internal controls for financial reporting, we may become in default of our loan obligations, may not be able to attract new investors and the price of our securities on the OTC Bulletin Board may decrease.

The volatility and disruption of the capital and credit markets and adverse changes in the economy may negatively impact our ability to access financing, and to generate revenues and earnings.

The capital and credit markets have been experiencing extreme volatility and disruption for more than 12 months.  In the third and fourth quarters of 2008, such volatility and disruption have reached unprecedented levels.  The markets have exerted downward pressure on availability of liquidity and credit capacity for many issuers, including us.

While we intend to finance our operations with existing cash, cash flow from operations and borrowing under our existing senior credit facility, we may require additional financing to support our continued growth.  However, due to the existing uncertainty in the capital and credit markets, access to capital may be limited on terms acceptable to us, or unavailable.  Our customers may also come under greater budgetary pressure as a result of economic and financial market conditions, which could negatively impact our revenues and earnings.

If we fail to satisfy our contractual obligations, our ability to compete for future contracts will be limited.

Our failure to comply with contract requirements or to meet our clients’ performance expectations when performing a contract could injure our reputation, which, in turn, would impact our ability to compete for new contracts. Our failure to meet contractual obligations could also result in substantial actual and consequential damages. In addition, our contracts often require us to indemnify clients for our conduct that causes losses to the client. Some contracts may contain liquidated damages provisions and financial penalties related to performance failures. Although we have liability insurance, the policy limits may not be adequate to provide protection against all potential liabilities.

 We derive a significant portion of our revenues from a small number of customers, and the loss of a significant customer could significantly reduce our revenues.

Our customer base and revenues are concentrated among a limited number of customers, and the loss of any one of these customers could significantly reduce our revenues.  During the fiscal year ended December 31, 2008, revenues from our top three customers, which were all from the Argyle Corrections business segment, represented 27% of our total revenues.  During the fiscal year ended December 31, 2008, we had revenues from our top two customers, which were all from Argyle Corrections, which each represented 19% of our total revenues.  These concentrations are up from the fiscal year ended December 31, 2007, when the top three customers represented 20% of our total revenues, but down from the fiscal year ended December 31, 2006, when the top three customers represented 33% of our total revenues.  As a result of the current economic environment, there has been a greater emphasis on pricing. In the past, the best products and value were factors in the bidding process; recently customers have been solely concerned with accepting the lowest bid. Because of this change, we believe that there is a likelihood that certain future proposals by Argyle Corrections will not be accepted, that may have been accepted in the past. Although we have existing relationships and technological advantages that could result in our proposals being more attractive than a less costly proposal, there is no guarantee that we will be awarded such contracts in the future.

Registration rights held by our stockholders may keep the market price of our stock lower than it would otherwise be.

Some of our stockholders, including those who purchased common stock prior to our initial public offering and the holders of our Series A Convertible Preferred Stock are entitled to demand that we register the resale of their shares at various times. If such stockholders exercise their registration rights with respect to all of their shares, there will be significant additional shares of common stock eligible for trading in the public market. The presence of these additional shares could keep the market price of our stock lower than it would otherwise be.

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Because we do not intend to pay dividends on our common stock, stockholders will benefit from an investment in our common stock only if it appreciates in value.

We have never declared or paid any cash dividends on our shares of common stock. We intend to retain all future earnings, if any, for use in the operations and expansion of the business. As a result, we do not anticipate paying cash dividends in the foreseeable future. Any future determination as to the declaration and payment of cash dividends will be at the discretion of our Board of Directors and will depend on factors the Board of Directors deems relevant, including among others, our results of operations, financial condition and cash requirements, business prospects, and the terms of our credit facilities, preferred stock, and other financing arrangements. The debt financing arrangements we put into place prohibits us from declaring or paying dividends without the consent of our lenders. Accordingly, realization of a gain on stockholders’ investments will depend on the appreciation of the price of our common stock. There is no guarantee that our common stock will appreciate in value.

Our securities are quoted on the Over-the-Counter Bulletin Board, which may limit the liquidity and price of our securities more than if the securities were quoted or listed on an exchange.

Our securities are quoted on the Over-the-Counter Bulletin Board, a FINRA-sponsored and operated inter-dealer automated quotation system. Quotation of our securities on the Over-the-Counter Bulletin Board will limit the liquidity and price of our securities more than if the securities were quoted or listed on an exchange.

We may choose to redeem our outstanding warrants at a time that is disadvantageous to the warrant holders.

Subject to there being a current prospectus under the Securities Act of 1933, Argyle may redeem all of its outstanding warrants at any time after they become exercisable at a price of $0.01 per warrant, upon a minimum of 30 days prior written notice of redemption, if and only if, the last sale price of our common stock equals or exceeds $11.50 per share for any 20 trading days within a 30 trading day period ending three business days before Argyle sends the notice of redemption. Calling all of our outstanding warrants for redemption could force the warrant holders:

·                                          To exercise the warrants and pay the exercise price for such warrants at a time when it may be disadvantageous for the holders to do so;

·                                          To sell the warrants at the then current market price when they might otherwise wish to hold the warrants; or

·                                          To accept the nominal redemption price which, at the time the warrants are called for redemption, is likely to be substantially less than the market value of the warrants.

Our warrant holders may not be able to exercise their warrants, which may create liability for us.

Holders of the warrants we issued in our initial public offering and private placement will be able to receive shares upon exercise of the warrants only if (i) a current registration statement under the Securities Act of 1933 relating to the shares of its common stock underlying the warrants is then effective and (ii) such shares are qualified for sale or exempt from qualification under the applicable securities laws of the states in which the various holders of warrants reside. Although we have agreed to use our best efforts to maintain a current registration statement covering the shares underlying the warrants to the extent required by federal securities laws, and we intend to comply with such agreement, we cannot assure that we will be able to do so. In addition, some states may not permit us to register the shares issuable upon exercise of our warrants for sale. The value of the warrants will be greatly reduced if a registration statement covering the shares issuable upon the exercise of the warrants is not kept current or if the securities are not qualified, or exempt from qualification, in the states in which the holders of warrants reside. Holders of warrants who reside in jurisdictions in which the shares underlying the warrants are not qualified and in which there is no exemption will be unable to exercise their warrants and would either have to sell their warrants in the open market or allow them to expire unexercised. If and when the warrants become redeemable, we may exercise our redemption right even if we are unable to qualify the underlying securities for sale under all applicable state securities laws. Since our obligations in this regard are subject to a “best efforts” standard, it is possible that, even if we are able to successfully assert a defense to a claim by warrant holders due to the impossibility of registration, a court may impose monetary damages on us to compensate warrant holders due to the change in circumstances that led to us being unable to fulfill our obligations.

If outstanding public warrants are exercised, the underlying common shares will be eligible for future resale in the public market. ‘‘Market overhang’’ from the warrants results in dilution and could keep the market price of our stock lower than it would otherwise be.

Outstanding public warrants and unit purchase options to purchase an aggregate of 4,075,046 shares of common stock issued in connection with Argyle’s initial public offering and those for services rendered in connection with a financing transaction are currently exercisable. If they are exercised, a substantial number of additional shares of our common stock will be eligible for resale in the public market, which could keep the market price of our stock lower than it would otherwise be.

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The agreements governing our shares of convertible preferred stock contain covenants and restrictions that may limit our ability to operate our business.

The terms of our Series A and Series B Convertible Preferred Stock limit our ability to, among other things, declare or pay dividends or distributions on our common equity securities, create or incur additional preferred stock, repurchase common stock, and to utilize funds from the sale of the Series A Convertible Preferred Stock for the payment of debt of ISI and its subsidiaries, make acquisitions or pay bonuses to executive management unless we have $50 million of bonding availability.  These restrictions could adversely affect our ability to raise additional equity to fund our future operations.  In addition, upon any sale or liquidation, the holders of the preferred stock would be entitled to receive payment of their liquidation preference prior to any payment to our common stockholders.  The holders of our preferred stock also have registration rights which, if exercised, would result in additional shares of our common stock being available for resale and could adversely impact the market price of our common stock.

Item 1B. Unresolved Staff Comments

None.

Item 2. Description of Property

The principal properties of the Company at December 31, 2008 are as follows. Property at each location is leased.

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(1)  Properties leased by Green Wing Management, Ltd., an entity owned and controlled by Sam Youngblood and Don Carr.  The leases on these properties were amended as part of the acquisition of ISI to reflect a term of 12 years ending in 2019 and to require that an appraisal be completed by a qualified appraiser to determine the market rate of the leases. The rental rate to be paid on these properties, after the acquisition of ISI, is limited to no more than 90% of the market rate determined by the third-party appraiser. Additional appraisals by a third-party appraiser are to be conducted every three years during the 12 year terms and the annual lease rate in the leases can increase at the time of these appraisals, but only to a level that does not to exceed 90% of the market rate determined by the third-party appraiser. Argyle has the right to purchase these three properties at any time, at the then current market value; however, the purchase price cannot be less than the value determined in the last appraisal preceding the effective date of the acquisition of ISI.

(2)  During the first quarter of 2008, the Company entered into a Board-approved agreement with Sec-Tec Global, Inc. (“Sec-Tec”) to share certain expenses related to common office space in New York, NY as well as administrative related expenses in the New York office. These expenses are being borne by the Company to reflect realistic expenses associated with the Company’s conduct of business in New York. The Company has agreed to share expenses totaling $175,000 on an annual basis that are to be paid in quarterly payments of $43,750. Sec-Tec is a wholly-owned subsidiary of Electronics Line 3000 of which the Company’s Executive Chairman and CEO are stockholders and board members.

Item 3. Legal Proceedings

From time to time, the Company has various lawsuits, claims, and contingent liabilities arising from the conduct of its business; however, in the opinion of management, other than specifically mentioned below, they are not expected to have a material adverse effect on the combined results of operations, cash flows, or financial position of the Company.

On April 21, 2008, Metroplex Control Systems, Inc. (“MCS”) made claims in the United States District Court for the District of Colorado for Breach of Contract and Bad Faith insurance practices against Travelers and Richard E. Gash Electric Company (“Gash”) arising out of a Payment Bond, Bond No. 104612565 whereby the penal sum of the Bond is $5,998,488.00 (the “Bond”), issued by Travelers as surety on behalf of Gash as principal in relation to the design and construction of the access control point at the Pueblo Chemical Depot in Pueblo, Colorado (the “Project”). The total loss incurred by MCS as a result of non-payment was approximately $950,000. On September 26, 2008, the Parties entered into a Settlement Agreement in order to provide for payment in full settlement and discharge of all claims against Travelers in any way relating to the Bond and/or Civil Action and for the assignment of claims and judgments which MCS has in regard to Gash’s performance on the Project (the “Settlement”). Travelers paid to MCS a settlement payment of $643,654.20. As a result of the Settlement, MCS accounted for an uncollected receivable of $310,246.

On January 23, 2009, MCS-Detention filed a claim of breach of fiduciary duty against Master Control Systems, Inc. and each of Mr. Chris Bowling and Mr. John Lyon, two ex-employees of MCS Detention (collectively, the “Defendants”) who started a business in November 2007 to specifically compete with MCS-Detention. Further, the individuals solicited existing customers and utilized proprietary information in an attempt to disparage MCS-Detention. The case is currently in the discovery phase. On February 23, 2009, the Defendants responded to the complaint by entering a general denial of all claims and asserting affirmative defenses. In addition, the Defendants asserted counterclaims for failure to pay for overtime as non-exempt employees under the U.S. Fair Labor Standards Act and for failure to pay bonuses, vacation pay and personal and vehicle expenses incurred during the course of employment. We are preparing our response to these counterclaims. The Defendants have not requested a specific request for damages.

Item 4. Submission of Matters to a Vote of Security Holders

During the fourth quarter of our fiscal year ended December 31, 2008, there were no matters submitted to a vote of security holders.

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PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Argyle’s common stock, warrants and units are quoted on the OTC Bulletin Board under the symbols ARGL, ARGLW and ARGLU respectively.

Argyle’s units commenced public trading on January 30, 2006, and common stock and warrants commenced public trading on March 2, 2006. The table below sets forth, for the calendar quarters indicated, the high and low bid prices for the securities as reported on the OTC Bulletin Board in U.S. dollars. These quotations reflect inter-dealer prices, without markup, markdown or commissions, and may not represent actual transactions.

(1)   Price equal less than one cent.

Number of Holders of Common Stock

As of December 31, 2008, there were of record 34 holders of common stock, three of warrants, and one of units. Argyle believes the number of beneficial holders of each of these securities is significantly greater than the number of record holders. Based on the last search conducted by Broadridge Financial Solutions, Inc. on February 11, 2009, we believe there are approximately 134 beneficial holders of our common stock.

Dividends

We have never declared or paid cash dividends on our capital stock and do not anticipate declaring or paying cash dividends in the foreseeable future. Payments of future dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs, plans for expansion and other factors that our board of directors may deem relevant.

Recent Sales of Unregistered Securities

During the fourth quarter of our fiscal year ended December 31, 2008, there were no issuances of securities that were not previously reported.

On January 8, 2009, we entered into a Securities Purchase Agreement (the “Purchase Agreement “) with Mezzanine Management Fund IV A, L.P. and Mezzanine Management Fund IV Coinvest A, L.P. (the “Purchasers”), and Sam Youngblood, Ron Chaimovski and Bob Marbut (together, with their affiliates, the “Stockholders”), pursuant to which the Purchasers purchased 27,273 shares of a newly created series of our preferred stock, designated “Series B Convertible Preferred Stock”, par value $0.0001 per share (the “Series B Preferred Shares”) for $110 per share, for an aggregate purchase price of $3,000,030 (the “Series B Financing”).

Each Series B Preferred Share is convertible into 100 shares of our common stock at any time, at the option of the holder, initially at a conversion price of $1.10 per share of common stock for up to 2,727,300 shares of common stock, subject to adjustment for stock dividends, stock splits or similar capital reorganizations, and weighted average price protection for certain issuances below the conversion price.

The Series B Preferred Shares have voting rights equal to the number of shares of common stock the holder would receive if all Series B Preferred Shares had been converted into common stock. The holders of the Series B Preferred Shares may also designate one individual to serve on the Company’s Board of Directors.

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The holders of the Series B Preferred Shares shall be entitled to receive, on a cumulative basis, cash dividends, when, as and if declared by the our Board of Directors, at the greater of (i) 4% per annum or (ii) the dividend payable on the equivalent amount of common stock into which the Series B Preferred Shares could be converted; provided, however, that such cash dividend must be paid at the earliest any of the following occur:  (A) we pay a dividend on the common stock, (B) we liquidate or there is a change in control, or (C) upon conversion of the Series B Preferred Shares, but only with respect to those Series B Preferred Shares so converted.

The Series B Preferred Shares have a liquidation preference as to both the Series A Convertible Preferred Stock, par value $0.0001 per share (“Series A Preferred Shares”) and the common stock equal to the greater of (i) the sum of the original issue price (subject to adjustment for stock dividends, stock splits or similar capital reorganizations) plus all accrued but unpaid dividends, or (ii) the amount the holder would receive if all Series B Preferred Shares had been converted into common stock.

For as long as any shares of Series B Preferred Shares remain outstanding, we will be prohibited from (i) amending, waiving, altering or repealing in a way that adversely affects the rights, powers, preferences, or other special rights or privileges of the holders of the Series B Preferred Shares, whether by amendment to the Certificate of Incorporation, Bylaws, Certificate of Designation or other organization documents, or by merger, consolidation, reorganization or otherwise, (ii) increasing or decreasing (other than by redemption or conversion) the authorized number of shares of preferred stock or Series B Preferred Shares, (iii) creating, issuing or authorizing the issuance of any equity securities senior to the Series B Preferred Shares, or (iv) repurchasing, redeeming or reissuing any equity securities to which the Series B Preferred Shares rank senior and prior (whether with respect to dividends, redemption, or upon liquidation or otherwise), including the Series A Preferred Shares and the common stock, and any rights or options exercisable or convertible therefor, other than repurchases of shares of common stock from employees, officers, directors or consultants under agreements providing for such repurchase under certain conditions.

Under the Purchase Agreement, we also granted piggyback registration rights to the Purchasers.  We have granted a preemptive right to the Purchasers with respect to future financings by Argyle and a right of first offer to provide financing for certain transactions. In addition, the Stockholders have granted a right of first refusal to the Purchasers until January 31, 2010 as to any transfers of Argyle’s securities held by the Stockholders.

Neither the Series B Preferred Shares, nor the shares of common stock issuable upon conversion of the Series B Preferred Shares, have been registered under the Securities Act, and may not be offered or sold in the United States absent registration or an applicable exemption from such registration requirement.

On February 1, 2009 we granted 90,000 unregistered shares of our common stock to Officers and key employees listed below. Ability to sell, transfer or assign these shares vest December 31 in three equal tranches on each of 2009, 2010, and 2011. The holders have the right to vote all shares, regardless of the vesting schedule.

Also, on February 1, 2009, we granted options to purchase an aggregate of up to 300,000 shares of our common stock to Officers and key employees of the listed below. The exercise price of the options is $1.10 per share and the options vest December 31 in three equal annual tranches on each of 2009, 2010 and 2011.

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In addition, on February 1, 2009, we granted 110,000 performance unit awards to Officers and key employees listed below. The awards vest fully on December 31, 2012 at which time a cash payment amount per unit award shall be determined by the Board based on the Company achieving or exceeding performance goals set by the Compensation Committee of the Board.

On March 19, 2009 we granted 45,000 unregistered shares of our common stock to the Directors listed below. These shares vest in full seven (7) days after the Director is no longer serving on the Board.

Such shares, options and performance unit awards were issued pursuant to the exemption from registration contained in Section 4(2) of the Securities Act as they were issued to Officers and Directors of Argyle.

Repurchases of Equity Securities

During the fourth quarter of our fiscal year ended December 31, 2008, there were no repurchases of common stock.

Redemption of Promissory Notes

On January 12, 2009, Argyle elected to redeem each of the unsecured promissory notes issued in connection with the merger with ISI at a conversion price of one share of common stock for each $10.00 of outstanding principal and accrued and unpaid interest for an aggregate of 192,763 shares of common stock.

Performance Graph

The information contained in the Performance Graph shall not be deemed to be “soliciting material” or “filed” with the SEC or subject to the liabilities of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), except to the extent that we specifically incorporate it by reference into a document filed under the Securities Act of 1933, as amended (the “Securities Act”), or the Exchange Act.

The following performance graph compares the performance of our cumulative stockholder return with that of the NASDAQ composite index and a published industry index (the Hemscott Group Index) for each fiscal year since March 2, 2006, the date we commenced public trading. The cumulative stockholder return for shares of our Common Stock and each of the indices is calculated assuming that $100 was invested on March 2, 2006. We paid no cash dividends during the periods shown. The performance of the indices is shown on a total return (dividends reinvested) basis. The graph lines merely connect year-end dates and do not reflect fluctuations between those dates.

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COMPARISON OF CUMULATIVE TOTAL RETURN

AMONG ARGYLE SECURITY, INC.,

NASDAQ MARKET INDEX AND HEMSCOTT GROUP INDEX

ASSUMES $100 INVESTED ON MAR. 2, 2006

ASSUMES DIVIDEND REINVESTED

FISCAL YEAR ENDING DEC. 31, 2008

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Item 6. Selected Financial Data

The following table summarizes our selected historical consolidated financial information and selected consolidated financial information of ISI, which should be read in conjunction with ‘‘Management’s Discussion and Analysis of Financial Condition and Results of Operations’’ and the financial statements and related notes included elsewhere in this document. The information as of and for the periods ended December 31st, and for the seven month period ended July 31, 2007 for ISI, are derived from the respective audited financial statements of Argyle and ISI and the information as of and for the other periods presented are derived from their respective unaudited interim financial statements.

ISI Security Group, Inc.

(1)                                 ‘‘Revenues - related party’’ are those revenues generated by work sub-contracted from ISI*MCS (an entity owned 67% by Sam Youngbood and 33% by Don Carr, Vice President of ISI). Messrs. Youngblood and Carr created ISI*MCS in 2004 to provide bonding on contracts that require bonding. The performance of those contracts is subcontracted to ISI as a subcontractor to ISI*MCS. The subcontracted work is for third party customers of ISI*MCS that require bonded contracts. After the merger, ISI*MCS will no longer provide bonding and subcontract work to ISI and ISI will secure its own bonding capacity and use that bonding capacity to directly enter into bonded contracts with third party customers, thereby eliminating the need to contract for the work as a subcontractor to ISI*MCS. After the merger, the amount of ‘‘Revenues - related party’’ will decrease annually as the contracts with ISI*MCS, outstanding at the time of the merger, are completed.

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Argyle Security Inc.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward Looking Statements

This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in our other Securities and Exchange Commission filings. The following discussion should be read in conjunction with our Financial Statements and related Notes thereto included elsewhere in this report.

Overview

Argyle Security, Inc. (formerly Argyle Security Acquisition Corporation) was incorporated in Delaware in June 2005 as a blank check company formed to acquire, through merger, capital stock exchange, asset acquisition, or other similar business combination, a business in the security industry. Argyle completed its initial public offering in January 2006.  On July 31, 2007, Argyle consummated its initial acquisition through the acquisition of 100% of the outstanding capital stock of ISI and its subsidiaries.

Argyle is a comprehensive security solutions provider to our diverse customer base because it addresses the majority of their physical electronic security requirements.  Argyle is a detention and commercial equipment contractor that specializes in designing and integrating security solutions, including turnkey installations, design, engineering, supply, and installation of various detention, surveillance and access control equipment and software solutions for correctional facilities and commercial institutions. The work is performed under fixed-price contracts. The projects are located in various cities throughout the United States. The length of the contracts varies but is typically less than two years. Argyle also provides turnkey installations covering the full spectrum of electronic security and low voltage systems, including fire alarm, access control, closed circuit television, intercom, sound/paging and other custom designed systems.

In February 2008, we organized our business under the name of “Argyle Security USA” and then, in January 2009, we eliminated the name “Argyle Security USA” and, for the sole purpose of debt covenant compliance calculation which only considers the operating business’ financial condition, organized the operational business of Argyle under the name “Argyle Security Operations”, or “ASO”, through which we provide security solutions to commercial, governmental and correctional customers.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based on the accompanying consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. As such, we are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of Revenues and expenses during the reporting period. By their nature, these estimates and judgments are subject to an inherent degree of uncertainty. Our management reviews its estimates on an on-going basis, including those related to revenue recognition based on the percentage-of-completion methodology, sales allowances, recognition of service sales revenues and the allowance for doubtful accounts. We base our estimates and assumptions on historical experience, knowledge of current conditions and our understanding of what we believe to be reasonable that might occur in the future considering available information. Actual results may differ from these estimates, and material effects on our operating results and financial position may result.

Percentage-of-Completion Estimates — Other than for PDI, each of our business units uses percentage-of-completion accounting to determine revenues and gross margin earned on projects. Estimating the percentage completion on a project is a critical estimate used by Argyle when budgeting for its projects. This estimate is determined as follows:

·                                          The contract amount and all contract estimates are input into a job cost accounting system with detail of all significant estimates of purchases by vendor type, subcontractor and labor.

·                                          As the project is performed and purchases and costs are incurred, these are recorded in the same detail as the original estimate.

·                                          The contract amount and estimated contract costs are updated monthly to record the effect of any contract change order received.

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·                                          On a monthly basis, management, along with project managers who are overseeing the contracts, review these estimated costs to complete the project and compare them to the original estimate and the estimate that was used in the prior month to determine the percentage-of-completion. If the cost to complete, determined by management and the project managers for the current month, confirms that the estimate used in the prior month is correct, then no action is taken to change the estimate and/or the percentage complete in that current month. However, if the current cost-to-complete estimate calculated by the management and the project managers differ, then adjustments are made. If the costs are in excess of the estimate used in the prior month, then a decrease in the percentage complete on the project through the current month in the accounting period is made. If the costs are less than the estimate used in the prior accounting period, then the new estimate increases the percentage complete on the project.

·                                          Revenues from construction contracts are recognized on the percentage-of-completion method in accordance with SOP 81-1. We recognize revenues on signed letters of intent, contracts and change orders. Argyle generally recognizes revenues on unsigned change orders where it has written notices to proceed from the customer and where collection is deemed probable. Percentage-of-completion for construction contracts is measured principally by the percentage of costs incurred and accrued to date for each contract to the estimated total costs for each contract at completion. We generally consider contracts to be substantially complete upon departure from the work site and acceptance by the customer. If any jobs are identified during the review process which are estimated to be a loss job (where estimated costs exceed contract price), the entire estimated loss is recorded in full, without regard to the computed percentage-of-completion.

These estimates percentage-of-completion of a project determine the amounts of revenues and gross margin that are earned to date on a project. For example, if a contract is $100,000 with a 20% gross margin of $20,000, then a project that is estimated to be 50% complete accrues $50,000 in revenues and $10,000 in gross margin. If the percentage completed is adjusted to 25%, then the revenues on the contact would be $25,000, and the earned gross margin would be $5,000. These estimates would be changed in the current month, and the actual accrual of the revenues and gross margin earned on this project would be reduced in the current month.

During the year ended December 31, 2008, we conducted regular reviews and evaluations for the cost estimates associated with all of the approximately 1,200 active Construction Contracts in our Work—in-Process.  As a result of the review, the cost estimates for the Work-in-process Construction Contracts (that existed as of year-ended December 31, 2007) increased by a net $6.1 million. In a few cases, the reviews resulted in a total of $46,000 ($0.01 basic and diluted earnings per share) in contract loss accruals that have been have been computed as cost-of-sales for the year ended December 31, 2008.  Of the aforementioned net estimated cost increases of $6.1 million, 41 contracts had cost estimate changes of approximately $100,000 or greater resulting in $7.1 million of the net increase.  30 of the 41 contracts resulted in cost estimate increases totaling $9.5 million while 11 contracts had estimated cost decreases totaling $2.4 million.  Approximately 1,150 of the remaining contracts with variances of less than $100,000 resulted in a net decrease in cost estimates of $1.0 million.

Another effect of the change in the estimated costs and percentage complete is that it changes the percentage of gross margin earned. For example, in the project mentioned above, if the estimated costs changed to 90% from 80% because of projected cost overruns, this would then reduce the gross margin percentage to 10% from 20%. Management recognizes losses (overruns of cost estimates) as soon as they can be quantified. Management attempts to recognize gains (under-runs of cost estimates) when they can be quantified and are certain.

Costs incurred prior to the award of contracts are expensed as incurred. The balances billed but not paid by customers pursuant to retainage provisions in construction contracts will be due upon completion of the contracts and acceptance by the customer. Based on our experience with similar contracts in recent years, the retention balance at each balance sheet date will be collected within the subsequent fiscal year.

The current asset “Costs and Estimated Earnings in Excess of Billings on Incomplete Contracts” represents revenues recognized in excess of amounts billed which management believes will be billed and collected within the subsequent year. The current liability “Billings in Excess of Costs and Estimated Earnings on Incomplete Contracts” represents billings in excess of revenues recognized.

Revenue Recognition for Shipped Products - Revenues are recognized by PDI when the product is shipped by the customer in accordance with the contractual shipping terms. In almost all cases, the shipping of products to PDI’s customers is FOB Origin, whereby title passes to the purchaser when the product leaves the PDI premises under the bail of a common carrier.  In only rare instances (less than 2% of all shipments), are products shipped to PDI customers as FOB Destination, whereby title passes to the purchaser when the product reaches the destination. When delivery to the customer’s delivery site has occurred, the customer takes title and assumes the risks and rewards of ownership.

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Service Sales - Service revenues are recognized when the services have been delivered to and accepted by the customer. These are generally short-term projects which are evidenced by signed service agreements or customer work orders or purchase orders. These sales agreements/customer orders generally provide for billing to customers based on time that are at quoted hourly or project rates, plus costs of materials and supplies furnished by us.

IBNR Estimates for Health Insurance - On a quarterly basis, Argyle estimates its health insurance cost, for its self-insured employee base at the acquired companies, ISI, PDI and Com-Tec, based upon expected health insurance claims for the current year. The insurance company which provides both the stop-loss and total aggregate insurance coverage also provides the average or expected and maximum claims for each class. The average and maximum claims are based on our demographics and prior claim history. Argyle uses the average claims history for the trailing the 12 months as its basis for accruing health care cost.

Sales and Use Taxes — The Company collects and remits taxes on behalf of various state and local tax authorities. For the year ended 2008, the Company collected $0.7 million and remitted $0.5 million in taxes.

Deferred Income Taxes - Deferred income taxes are provided for temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts for tax purposes. Valuation allowances are provided against the deferred tax asset amounts when the realization is uncertain.

Allowance for Doubtful Accounts - Argyle provides an allowance for bad debt through an analysis in which the bad debts that had been written off over previous periods are compared on a percentage basis to the aggregate sales for the same periods. The resulting percentage is applied to the year-to-date sales, and a monthly reserve is accrued accordingly. Additionally, management analyzes specific customer accounts receivable for any potentially uncollectible accounts and will add such accounts to the reserve, or write them off if warranted, after considering lien and bond rights, and then considers the adequacy of the remaining unallocated reserve compared to the remaining accounts receivable balance (net of specific doubtful accounts).

Impairment of Long-lived Intangible Assets - Long-lived assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. Examples include a significant adverse change in the extent or manner in which we use a long-lived asset or a change in its physical condition.   When evaluating long-lived assets for impairment, we compare the carrying value of the asset to the asset’s estimated undiscounted future cash flows.  Impairment is indicated if the estimated future cash flows are less than the carrying value of the asset. The impairment is the excess of the carrying value over the fair value of the long-lived asset.  We recorded impairment charges related to long-lived assets in accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, of $4.5 million in fiscal year 2008.

Our impairment analysis contains uncertainties due to judgment in assumptions and estimates surrounding undiscounted future cash flows of the long-lived asset, including forecasting useful lives of assets and selecting the discount rate that reflects the risk inherent in future cash flows to determine fair value.

We have not made any material changes in the accounting methodology used to evaluate the impairment of long-lived assets during the last two fiscal years.  We do not believe there is a reasonable likelihood there will be a material change in the estimates or assumptions used to calculate impairments of long-lived assets. The Company’s discount rate, the Weighted Average Cost of Capital (“WACC”) and the growth rates assumed for revenues have not changed significantly in the last two planning cycles given the last two year of operations.  However, if actual results are not consistent with our estimates and assumptions used to calculate estimated future cash flows, we may be exposed to impairment losses that could be material.

Goodwill - Represents the excess of the purchase price over the fair value of net assets acquired, including the amount assigned to identifiable intangible assets.  Goodwill is reviewed for impairment annually, or more frequently if impairment indicators arise.  Our annual impairment review requires extensive use of accounting judgment and financial estimates.   The analysis of potential impairment of goodwill requires a two-step process.   The first step is to identify if a potential impairment exists by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, Goodwill of the reporting unit is not considered to have a potential impairment, and the second step of the impairment test is not necessary. However, if the carrying amount of a reporting unit exceeds its fair value, the second step is performed to determine if goodwill is impaired and to measure the amount of impairment loss to recognize, if any.

The second step compares the implied fair value of goodwill with the carrying amount of goodwill. If the implied fair value of goodwill exceeds the carrying amount, then goodwill is not considered impaired. However, if the carrying amount of goodwill exceeds the implied fair value, an impairment loss is recognized in an amount equal to that excess.

The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination (i.e., the fair value of the reporting unit is allocated to all the assets and liabilities, including any unrecognized intangible assets, as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit were the purchase price paid to acquire the reporting unit).

We have elected to make the first day of the third quarter the annual impairment assessment date for goodwill and other intangible assets. However, we could be required to evaluate the recoverability of goodwill and other intangible assets prior to the required annual assessment if we experience disruptions to the business, unexpected significant declines in operating results, divestiture of a

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significant component of the business or a sustained decline in market capitalization.

The Company identified its reporting units under the guidance of SFAS 142 Goodwill and Other Intangible Assets (FAS 142) and EITF Topic D-101, Clarification of Reporting Unit Guidance in Paragraph 30 of FASB Statement No. 142. The Company’s reporting units are ISI-Detention, MCS-Detention, PDI, Com-Tec (which comprise the Argyle Corrections segment), and MCS-Commercial which comprises the Argyle Commercial segment.

During the quarter ended September 30, 2008, we began an analysis of goodwill impairment in accordance with SFAS 142, Goodwill and Other Intangible Assets, for the acquisition of ISI completed July 31, 2007, the acquisition of Fire Quest on January 1, 2008, the acquisition of PDI on January 4, 2008 and the acquisition of Com-Tec on January 31, 2008.   The initial analysis (first step) was performed by our management team and a valuation firm after the conclusion of the third quarter.  Based on a combination of factors, including the current economic environment, our operating results and a sustained decline in our market capitalization, we concluded that there were a number of indicators which required us to perform a goodwill impairment analysis as of September 30, 2008. For the purposes of this analysis, our estimates of fair value were based on a combination of the income approach, which estimates the fair value of our reporting units based on the future discounted cash flows, and the market approach, which estimates the fair value of our reporting units based on comparable market prices.  Accordingly, we recorded a $16.9 million non-cash goodwill impairment charge, representing our best estimate of the impairment loss, during the third quarter of fiscal year 2008.

We estimate the fair value of our reporting units, using various valuation techniques, with the primary technique being a discounted cash flow analysis. A discounted cash flow analysis requires us to make various judgmental assumptions about sales, operating margins, growth rates and discount rates. Assumptions about sales, operating margins and growth rates are based on our budgets, business plans, economic projections, anticipated future cash flows and marketplace data. Assumptions are also made for varying perpetual growth rates for periods beyond the long-term business plan period.

While estimating the fair value of our reporting units, we assumed operating margins in future years in excess of the margins realized in the most current year. The fair value estimates for these reporting units assume normalized operating margin assumptions and improved operating efficiencies based on anticipated improvements, given recent changes in the management structure and actual operations.  In our analyses, the carrying value of all of our reporting units except Com-Tec was in excess of the fair value thus requiring impairment charges.  Our estimates in the fair value of our Corrections and Commercial reporting segments would not have been in excess of their carrying amount, including goodwill, even by sustaining long-term operating margins of over 20%, since the Company’s total market capitalization and implied fair value of equity as of December 31, 2008 was approximately $2.9 million and $38.6 million versus:

·                  working capital of $31.4 million and $20.0 for 2008 and 2007;

·                  net tangible assets of $66.4 million and $43.2 million for 2008 and 2007 and ;

·                  net equity of $7.3 million and $4.7 million for 2008 and 2007, respectively.

Other intangible asset fair values have been calculated for trademarks using a relief from royalty rate method and using the present value of future cash flows for patents and in-process technology. Assumptions about royalty rates are based on the rates at which similar brands and trademarks are licensed in the marketplace.

Our impairment analysis contains uncertainties due to uncontrollable events that could positively or negatively impact the anticipated future economic and operating conditions.  We have not made any material changes in the accounting methodology used to evaluate impairment of goodwill and other intangible assets during the last two years.

While we believe we have made reasonable estimates and assumptions to calculate the fair value of the reporting units and other intangible assets, it is possible a material change could occur. If our actual results are not consistent with our estimates and assumptions used to calculate fair value, we may be required to perform the second step in future periods which could result in further impairments of our remaining goodwill.

During the fourth quarter of fiscal year 2008, the management team and a valuation firm began the two-step valuation process of the impairment to our goodwill and intangible assets.  During the latter part of the second half of fiscal year 2008 and continuing into December 2008, our market capitalization was below book value. We considered this information, as well as our discount rate and WACC of 14% and overall revenue and operating growth rate assumptions for fiscal years 2009 through 2012.   We considered the market capitalization decline in our evaluation of fair value of goodwill and believe the decline to be primarily attributed to the negative market conditions as a result of the credit crisis, indications of a possible recession and current issues within the overall economy in the United States and globally.

Our fiscal 2008 goodwill and intangible asset impairment analysis resulted in a December 31, 2008 charge of $9.7 million in addition to the estimate made as of September 30, 2008 of $16.9 million.  The non-cash, total impairment charges for goodwill and intangible assets for the year ended December 31, 2008 were $26.6 million.

Non Cash Compensation Expense - On January 1, 2006, Argyle adopted SFAS No. 123 (revised 2004), Share Based Payment. SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values.

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Purchase options (ISO / non-qualified) grants:

We compute the value of newly-issued purchase options (Incentive Stock Options and Non-Qualified Stock Options) on the date of grant by utilizing the Black-Scholes valuation model based upon their expected life vesting period, industry comparables for volatility and the risk-free rate on U.S. Government securities with matching maturities. The value of the purchase options are then straight-line expensed over the life of the purchase options.

Restricted stock and performance unit award grants:

We compute the value of newly issued stock grants on the date of grant based on the share price as of the award date. The values of the common shares are then straight-line expensed over the life of the corresponding vesting period.

We recognize compensation expense on the performance unit awards based on the fair value of the underlying common stock at the end of each quarter over the remaining vesting period.

Pro Forma and Adjusted Pro Forma Financial Information

Because we acquired ISI in July 2007, and Fire Quest, PDI and Com-Tec in January 2008, we do not believe a comparison of the results of operations and cash flows for the years ended December 31, 2008 versus December 31, 2007 is beneficial to our stockholders. In order to assist investors in better understanding the changes in our business between the years ended December 31, 2007 and December 31, 2008, we are presenting in this Management’s Discussion and Analysis section, the Pro Forma and Adjusted Pro Forma results of operations for the Company and the acquisitions for the years ended December 31, 2008 and December 31, 2007 as if the acquisitions occurred on January 1, 2008 and January 1, 2007, respectively. We derived the pro forma results and adjusted pro forma results of operations from (i) the unaudited consolidated financial statements of ISI for the one and seven months ended July 31, 2007, (ii) the unaudited consolidated financial statements of Com-Tec for the one month ended January 31, 2008 and the audited  consolidated financial statements of Com-Tec year ended December 31, 2007, (iii) the audited financial statements of PDI for the year ended December 31, 2007, (iv) the unaudited financial statements of Fire Quest for the year ended December 31, 2007 and (v) the audited consolidated financial statements of the Company for the year ended December 31, 2008 and 2007. We are presenting the pro forma and the adjusted pro forma information in order to provide, what we believe to be, a more meaningful comparison of our operating results with prior periods.

Adjusted pro forma net income is an alternative view of performance used by management, and we believe that investors’ understanding of our performance is enhanced by disclosing this performance measure. We report adjusted pro forma net income in order to present the results of our major operations, the construction, installation, marketing and sale of various electronic security systems for commercial accounts, and detention hardware (including security doors and frames, jail furniture, security glazing, and other security-based systems) and electronic control systems for correctional facilities, prior to considering certain income statement elements, principally amortization of intangible assets.   We have defined adjusted pro forma net income as net income before the impact of purchase accounting for acquisitions, acquisition-related costs, amortization of intangibles, discontinued operations and certain significant items including one-time expenses associated with stock appreciation rights. The adjusted pro forma net income measure is not, and should not be viewed as, a substitute for U.S. GAAP net income.

The adjusted pro forma net income measure is an important internal measurement for us. We measure the performance of the overall Company on this basis. The following are examples of how the adjusted pro forma net income measure was utilized for the year ended December 31, 2008:

·                                          Senior management receives a monthly analysis of our operating results that is prepared on an adjusted pro forma net income basis;

·                                          Our annual budgets are prepared on an adjusted pro forma net income basis; and

·                                          Annual and long-term compensation, including annual cash bonuses, merit-based salary adjustments, and share-based payments for various levels of management will consider financial measures that include adjusted pro forma net income and the associated earnings per share. The adjusted pro forma net income measure will represent a significant portion of target objectives that are utilized to determine the annual compensation for various levels of management, although the actual weighting of an objective may vary by level of management and job responsibility and may be considered in the determination of certain long-term compensation plans.

Despite the importance of this measure to management in goal setting and performance measurement, we stress that adjusted pro forma net income is a non-GAAP financial measure that has no standardized meaning under US-GAAP and therefore, has limits in its usefulness to investors. Because of its non-standardized definition, adjusted pro forma net income (unlike U.S. GAAP Net Income) may not be comparable with the calculation of similar measures for other companies.

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Adjusted pro forma net income is presented solely to permit investors to more fully understand how management assesses our performance.

We also recognize that, as an internal measure of performance, the adjusted pro forma net income and the associated earnings per share measure has limitations which is the reason we do not restrict our performance-management process solely to this metric. A limitation of the adjusted pro forma net income measure is that it provides a view of our operations without including all events during a period such as the effects of an acquisition or amortization of purchased intangibles and does not provide a comparable view of our performance to other companies in the security detention and construction industries.

In addition, annual and long-term compensation, including annual cash bonuses, merit-based salary adjustments and share-based payments for various levels of management that may be made in future years may include a non-discretionary formula that measures our performance using revenue growth and relative total shareholder return.

Adjusted pro forma EBITDA is used by management as a performance measure for benchmarking against the Company’s peers and competitors. The Company believes that EBITDA is useful to investors because it is frequently used by securities analysts, investors and other interested parties to evaluate companies in the security industry. Additionally, we use adjusted pro forma EBITDA for internal performance measurements. EBITDA is not a recognized term under GAAP. We compute EBITDA using the same consistent method from quarter to quarter. EBITDA includes net income before interest, taxes, depreciation and amortization. The presentation of EBITDA is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with GAAP.

The Adjusted Pro Forma Results of Operations are not necessarily indicative of the results of operations that may have actually occurred had the merger taken place on the dates noted, or our future financial position or operating results. The pro forma adjustments are based upon available information and assumptions that we believe are reasonable. The presentation of EBITDA (earnings before interest, taxes, depreciation and amortization) and adjusted pro forms results is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with GAAP.

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Below is a table showing Argyle’s Adjusted Pro Forma Consolidated Statements of Operations. The Pro Forma Consolidated Statements of Operations are included in the notes to our financial statements on page F-14.

Argyle Security, Inc

Adjusted Pro Forma Consolidated Statements of Operations

(in thousands, except per share data)

(unaudited)

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Below is a reconciliation of GAAP net income (loss) to: pro forma net income (loss); to adjusted pro forma net income (loss); and to pro forma EBITDA. The presentation of EBITDA is not intended to be considered in isolation or as a substitute for the financial information prepared and presented in accordance with GAAP.

Reconciliation of GAAP Net Income to Pro Forma Net Income

Adjusted Pro Forma Net Income and Pro Forma EBITDA

(in thousands except per share data)

(unaudited)