Summary of CYALUME TECHNOLOGIES HOLDINGS, INC.

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

Company Overview

We are a global, technology-based manufacturer primarily providing tactical and training solutions to the military of the U.S. and other select countries, through both products and services. We manufacture chemical light, reflective and battlefield effects simulator products while our services include planning and implementing tactical training exercises simulating real world experiences. In addition, and to a lesser extent, we also sell these products into the law enforcement, commercial public safety and other markets. With the acquisition of CSP in 2011, we also manufacture and sell chemical products to the pharmaceutical, military and other markets.

We do not sell products as novelties.

We manufacture products in West Springfield, MA; Bound Brook, NJ; and Aix-en-Provence, France.

We maintain principal executive offices at 96 Windsor Street, West Springfield, Massachusetts 01089. We have two direct U.S.-based subsidiaries: Cyalume Technologies, Inc. ("CTI") and Cyalume Specialty Products, Inc. ("CSP"). CTI is located in West Springfield, Massachusetts and CSP is located in Bound Brook, New Jersey. CTI has one non-U.S.-based subsidiary, Cyalume Technologies, SAS ("CTSAS"), located in Aix-en-Provence, France, and two U.S.-based subsidiaries, Cyalume Realty, Inc. ("CRI") and Combat Training Solutions, Inc. ("CTS"), based in West Springfield, Massachusetts.

Material Changes in Results of Operations - 3 Months Ended June 30, 2012 versus the 3 Months Ended June 30, 2011

In our Form 10-K for the fiscal year ended December 31, 2011, we indicated our belief that uncertainty from the prospective military budgets in the U.S., combined with the drawdown /reassignment of military troops in Iraq and Afghanistan, had a significant adverse impact on our business in 2011. We also had indications that the military was drawing down stocks to limit purchases. We continue to believe that these circumstances have continued to affect us during 2012. Based on our understanding of these circumstances, we expect the military (non-ammunition) chemical light sales to remain at depressed levels until these budget uncertainties are resolved.

Revenues for the second quarter of 2012 of $8.9 million increased from the prior year by $0.2 million, as shown in the following table of revenues by sector.

         Category ($ in millions)            2012      2011      Change
Military (non-ammunition)                    $ 5.1     $ 6.5     $  (1.4 )
Ammunition                                     0.8       1.1        (0.3 )
Law enforcement / commercial public safety     0.9       1.1        (0.2 )
Specialty products                             2.1         -         2.1
Total                                        $ 8.9     $ 8.7     $   0.2

For 2012, military non-ammunition revenues decreased from the prior year due to the matters discussed above. Ammunition revenues for 2012 decreased due to lower purchases of existing products and delays in selling new products. Regarding specialty product revenues, CSP was acquired on August 31, 2011 and thus these revenues did not exist for us in 2011.

Cost of goods sold for 2012 of approximately $5.0 million increased from the prior year amount of $4.4 million due to higher revenues. Gross profit margin for 2012 was 43.6% versus 48.9% for the prior year. This decrease was largely attributable to a product mix change resulting from the decrease in military (non-ammunition) product sales, which generally yield us margins that are higher than other product types.

Sales and marketing expenses increased in 2012 primarily due to increases in payroll costs resulting from severance agreements with two former executives whose employment was terminated during the three months ended June 30, 2012. Also, additional sales personnel were added via the acquisitions of CSP and CTS, which took place after June 30, 2011.

General and administrative expenses decreased in 2012 primarily due to lower payroll expenses in CTI resulting from staff reductions in the second half of 2011 and the reversal of expenses relating to performance-based equity awards determined to have not been earned. The decrease was partially offset by 2012 general and administrative costs incurred by CSP and CTS, both of which were not owned by us before June 30, 2011.

Research and development expenses decreased in 2012 primarily due to the reversal of expenses relating to performance-based equity awards determined to have not been earned and a decrease in CTI personnel. The decrease was partially offset by 2012 research and development expenses incurred by CSP and CTS, both of which were not owned by us before June 30, 2011.

The change in fair value of contingent consideration is due to the fact that this amount is driven by changes in the fair value of the contingent consideration liabilities that resulted from the acquisitions of CSP and CTS, both of which occurred after June 30, 2011.

Other, net was higher in 2011 due to our earning reimbursement of certain product development costs from customers. Fewer of those transactions occurred in 2012. 2011 income was partially offset by the adverse effects of changes in foreign exchange rates. On the other hand, the strengthening of the U.S. dollar versus the euro increased 2012 other income.

Material Changes in Results of Operations - 6 Months Ended June 30, 2012 versus the 6 Months Ended June 30, 2011

Revenues for 2012 of $16.9 million were down from the prior year by $0.8 million, as shown in the following table of revenues by sector.

         Category ($ in millions)             2012       2011      Change
Military (non-ammunition)                    $  9.6     $ 12.8     $  (3.2 )
Ammunition                                      1.6        2.8        (1.2 )
Law enforcement / commercial public safety      1.9        2.1        (0.2 )
Specialty products                              3.8          -         3.8
Total                                        $ 16.9     $ 17.7     $  (0.8 )

Cost of goods sold for 2012 of approximately $9.4 million increased from the prior year amount of $9.0 million, resulting in gross profit margins for 2012 and 2011 of 44.4% and 49.4%, respectively. The decrease in margins was largely attributable to a product mix change resulting from the decrease in military (non-ammunition) product sales, which generally yield us margins that are higher than other product types.

Sales and marketing expenses increased in 2012 primarily due to increases in payroll costs resulting from severance agreements with two former executives whose employment was terminated during 2012. Also, additional sales personnel were added via the acquisitions of CSP and CTS, which took place after June 30, 2011.

General and administrative expenses increased in 2012 primarily due to an increase in payroll costs resulting from a severance agreement with our former Chief Executive Officer, who was replaced in April 2012, and due to 2012 general and administrative costs incurred by CSP and CTS, both of which were not owned by us before June 30, 2011.

For 2012, we had a tax benefit primarily due to the pre-tax loss versus a tax benefit in 2011 that was the result of (i) the creation of foreign tax credits through our France-based subsidiary CTSAS, (ii) a reduction in the valuation allowance against accumulated foreign tax credits and (iii) changes in repatriated earnings from CTSAS. Despite having a net loss for the six months ended June 30, 2012, we believe our net deferred tax assets are realizable due to forecasted taxable income.

Material Changes in Financial Condition - June 30, 2012 versus December 31, 2011

Our accounts receivable increased due to higher sales in the month of June 2012 versus the month of December 2011. Our receivables are generally collected within 30 days, thus revenues recorded in the 30-day period preceding the measurement date significantly influence the reported balances. We have no significant collection problems with our accounts receivable.

Our inventory balance is typically higher in June than in December due to lower levels of production in the fourth quarter. Several of our inventory items, such as glass, chemical and packaging components, are purchased in bulk several times a year to obtain better pricing.

Restricted cash and the line of credit due to a related party decreased since 2011 due to returning that restricted cash to repay that line of credit in full.

Accounts payable and accrued expenses, on a combined basis, increased primarily due to the timing of vendor payments and the accrual of severance payables in 2012. Note payable to related party decreased as the note was paid during 2012. Our notes payable decreased due to scheduled principal payments made during 2012, net of amortization of debt issuance costs.

Contingent consideration liabilities increased due to (i) the passage of time,
(ii) changes in estimates used to determine the liabilities' fair value and
(iii) the finalization of the initial accounting for the acquisitions. Specifically, the contingent consideration liability incurred in the CTS acquisition decreased $47,000 during the six months ended June 30, 2012. This decrease was a result of (i) the finalization of the CTS acquisition accounting,
(ii) the time value of money, and (iii) a $600,000 decrease in the in the undiscounted estimated future liability (down from $3,375,000 from December 31, 2011). The contingent consideration liability incurred in the CSP acquisition increased $435,000 during the six months ended June 30, 2012; a portion of this increase was due to a $400,000 increase (from $2,200,000 as of December 31, 2011) in the undiscounted estimated future liability while the remainder of the increase was a result of the time value of money.

Our deferred tax liability decreased since December 31, 2011 primarily due to estimated increases in the following items: (i) temporarily non-deductible stock-based compensation and (ii) foreign tax credits being created during 2012.

Income taxes refundable increased due to required estimated tax payments by CTSAS during 2012 which we believe will be refunded when CTSAS' 2012 tax forms are filed.

Liquidity and Capital Resources

As of June 30, 2012 and December 31, 2011, we had $1.5 million and $3.0 million, respectively, of cash on hand. The major sources and uses of cash during 2012 were all in the normal course of business.

Forecasted principal and interest payments on debt for the next 12 months are $4.5 million, which includes $0.9 million outstanding under a line of credit which matures in December 2012 that we expect to renew. All operating and capital expenditures are expected to be funded completely from operating cash flows and net proceeds from our line of credit.

We have recorded an approximately $3.7 million payable for ongoing litigation which a related party has retained the responsibility of paying. Assuming (i) our appeal of these findings is not successful and (ii) our related party is unable to reimburse us for these findings (and the related legal costs we incur), our liquidity and capital resources could be adversely affected. We believe that the related party receivable is collectible.

Off-Balance Sheet Arrangements

Other than immaterial operating leases, we did not have any off-balance sheet arrangements during 2012 or 2011.

Critical Accounting Policies

Use of Estimates

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

Revenue Recognition

Revenue from the sale of products or providing of services is recognized when the earnings process is complete and the risks and rewards of ownership have transferred to the customer. Depending on the terms of the individual sales arrangement with our customer, sales are recognized at either the shipping point or upon receipt by the customer. Costs and related expenses to manufacture the products are recorded as costs of goods sold when the related revenue is recognized.

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

Income Taxes

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

In assessing the realization of long-term deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The realization of deferred income tax assets depends upon future taxable income in years before net operating loss carryforwards expire. We evaluate the recoverability of deferred income tax assets on a quarterly basis. If we determine that it is more likely than not that deferred income tax assets will not be recovered, we establish a valuation allowance against some or all deferred income tax assets.

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

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

Goodwill

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

Intangible Assets

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

Inventories

Inventories are stated at the lower of cost (on a first-in first-out ("FIFO") method) or net realizable value. We periodically review the realizability of inventory. Provisions are recorded for potential obsolescence which requires management's judgment. Conditions impacting the realizability of inventory could cause actual write-offs to be materially different than provisions for obsolescence.

Contingent Consideration

We purchased both CSP and CTS using a combination of cash, common stock and contingent consideration. The contingent consideration represents the present value of payments expected to be made in 2014 to the sellers of the businesses following the achievement of certain financial performance targets in 2012 and 2013. The contingent consideration is updated to fair value at the end of each reporting period.

Considerable judgment is applied by management when estimating the fair value of the contingent consideration. The contingent consideration liabilities' fair value is determined by calculating the present value of the estimated liability that is expected to be paid in the future. This requires the use of (i) estimated future discount rates and (ii) hypothetical scenarios in which the consideration could be earned and weighting those scenarios based on our expectations that those scenarios will actually occur. Such assumptions may not reflect actual future results.

Foreign Operations and Currency

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