Table of Contents





UNITED
STATES
SECURITIES AND EXCHANGE COMMISSIONWashington,
D.C. 20549

|         
|---------
|         
|FORM 10-Q
|         

|  |                                                                                          
|- | -----------------------------------------------------------------------------------------
|x | QUARTERLY
 REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|  |                                                                                          
|  | For the quarterly period
 ended June 30, 2009                                            
|  |                                                                                          
|  | OR                                                                                       
|  |                                                                                          
|o | TRANSITION
 REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|  |                                                                                          
|  | For the transition period
 from ________________ to ________________                     

|                                                       
|-------------------------------------------------------
|Commission
 file number: 0-26056                       
|                                                       
|                                                       
|                                                       
|Image Sensing Systems, Inc.                            
|(Exact
 name of registrant as specified in its charter)

|                                          |  |                     
|----------------------------------------- |  | --------------------
|Minnesota                                 |  | 41-1519168          
|(State
 or other jurisdiction of          |  | (I.R.S.
 Employer   
|incorporation
 or organization)           |  | Identification
 No.)
|                                          |  |                     
|500 Spruce Tree Centre                    |  |                     
|1600 University Avenue West               |  |                     
|St. Paul, MN                              |  | 55104               
|(Address
 of principal executive offices) |  | (Zip
 Code)         

|                                                                                   
|-----------------------------------------------------------------------------------
|(651) 603-7700                                                                     
|(Registrants
 telephone number, including area code)                              
|                                                                                   
|Not Applicable                                                                     
|(Former
 name, former address and former fiscal year, if changed since last report)
|                                                                                   
|                                                                                   

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

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

| |                                                |  |                            
| | ---------------------------------------------- |  | ---------------------------
| | Large accelerated filer o                      |  | Accelerated filer o        
| |                                                |  |                            
| | Non-accelerated filer o                        |  | Smaller reporting company x
| | (Do not check if a smaller
 reporting company) |  |                            

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

Indicate
the number of shares outstanding of each of the issuers classes of common
stock, as of the latest practicable date.

|                                         |  |                               
|---------------------------------------- |  | ------------------------------
|Class                                    |  | Outstanding
 at August 3, 2009
|Common
 Stock, $0.01 par value per share |  | 3,985,819
 shares             





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IMAGE SENSING SYSTEMS, INC.

TABLE OF CONTENTS

|               |  |                                                                                        |  |          
|-------------- |  | -------------------------------------------------------------------------------------- |  | ---------
|               |  |                                                                                        |  | Page
 No.
|               |  |                                                                                        |  |          
|PART I.        |  | FINANCIAL
 INFORMATION                                                                 |  | 1        
|               |  |                                                                                        |  |          
|Item 1.        |  | Financial
 Statements (unaudited):                                                     |  | 1        
|               |  |                                                                                        |  |          
|               |  | Condensed
 Consolidated Balance Sheets                                                 |  | 1        
|               |  |                                                                                        |  |          
|               |  | Condensed
 Consolidated Statements of Income                                           |  | 2        
|               |  |                                                                                        |  |          
|               |  | Condensed
 Consolidated Statements of Cash Flows                                       |  | 3        
|               |  |                                                                                        |  |          
|               |  | Notes to
 Condensed Consolidated Financial Statements                                  |  | 4        
|               |  |                                                                                        |  |          
|Item 2.        |  | Managements
 Discussion and Analysis of Financial Condition and Results of Operations |  | 9        
|               |  |                                                                                        |  |          
|Item 3.        |  | Quantitative
 and Qualitative Disclosures About Market Risks                           |  | 15       
|               |  |                                                                                        |  |          
|Item 4T.       |  | Controls
 and Procedures                                                               |  | 15       
|               |  |                                                                                        |  |          
|PART II.       |  | OTHER
 INFORMATION                                                                     |  | 16       
|               |  |                                                                                        |  |          
|Item 1.        |  | Legal
 Proceedings                                                                     |  | 16       
|               |  |                                                                                        |  |          
|Item 1A.       |  | Risk
 Factors                                                                          |  | 16       
|               |  |                                                                                        |  |          
|Item 2.        |  | Unregistered
 Sales of Equity Securities and Use of Proceeds                           |  | 16       
|               |  |                                                                                        |  |          
|Item 3.        |  | Defaults
 Upon Senior Securities                                                       |  | 16       
|               |  |                                                                                        |  |          
|Item 4.        |  | Submission
 of Matters to a Vote of Security Holders                                   |  | 16       
|               |  |                                                                                        |  |          
|Item 5.        |  | Other
 Information                                                                     |  | 17       
|               |  |                                                                                        |  |          
|Item 6.        |  | Exhibits                                                                               |  | 17       
|               |  |                                                                                        |  |          
|SIGNATURES     |  | 18                                                                                    
|               |  |                                                                                       
|EXHIBIT
 INDEX |  | 19                                                                                    

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Table of Contents

PART I.
FINANCIAL INFORMATION

|        |                                   
|------- | ----------------------------------
|Item 1. | Financial
 Statements (unaudited):

Image Sensing Systems, Inc.Condensed Consolidated Balance Sheets
(Unaudited)
(in thousands)

|                                                  |  |                |        |                     |   |        |  
|------------------------------------------------- |  | -------------- | ------ | ------------------- | - | ------ | -
|                                                  |  | June 30,
 2009 |        | December
 31,
 2008 |  
|Assets                                            |  |                |        |                     |   |        |  
|Current
 assets:                                  |  |                |        |                     |   |        |  
|Cash and cash equivalents                         |  | $              | 7,556  |                     | $ | 10,289 |  
|Short-term investments, net (restricted in
 2008) |  |                | 3,967  |                     |   | 4,000  |  
|Accounts receivable, net                          |  |                | 4,856  |                     |   | 6,620  |  
|Inventories                                       |  |                | 2,598  |                     |   | 1,608  |  
|Prepaid expenses                                  |  |                | 380    |                     |   | 376    |  
|Deferred income taxes                             |  |                | 379    |                     |   | 376    |  
|Total
 current assets                             |  |                | 19,736 |                     |   | 23,269 |  
|                                                  |  |                |        |                     |   |        |  
|Property and
 equipment, net                      |  |                | 851    |                     |   | 728    |  
|                                                  |  |                |        |                     |   |        |  
|Deferred
 income taxes                            |  |                | 1,575  |                     |   | 1,575  |  
|Goodwill and
 intangible assets                   |  |                | 10,180 |                     |   | 10,536 |  
|Total assets                                      |  | $              | 32,342 |                     | $ | 36,108 |  
|                                                  |  |                |        |                     |   |        |  
|Liabilities and Shareholders Equity              |  |                |        |                     |   |        |  
|Current
 liabilities:                             |  |                |        |                     |   |        |  
|Accounts payable                                  |  |                | 930    |                     |   | 251    |  
|Bank debt, current portion                        |  |                |       |                     |   | 1,000  |  
|Accrued compensation                              |  |                | 553    |                     |   | 1,091  |  
|Accrued warranty and other                        |  |                | 467    |                     |   | 793    |  
|EIS earn-out payable                              |  |                |       |                     |   | 1,164  |  
|Income taxes payable                              |  |                | 142    |                     |   | 283    |  
|Total
 current liabilities                        |  |                | 2,092  |                     |   | 4,582  |  
|                                                  |  |                |        |                     |   |        |  
|Bank debt,
 long-term                             |  |                |       |                     |   | 2,750  |  
|Income taxes
 payable                             |  |                | 248    |                     |   | 246    |  
|                                                  |  |                |        |                     |   |        |  
|Shareholders
 equity:                            |  |                |        |                     |   |        |  
|Common stock                                      |  |                | 40     |                     |   | 40     |  
|Additional paid-in capital                        |  |                | 11,836 |                     |   | 11,652 |  
|Accumulated other comprehensive loss              |  |                | (290   | )                   |   | (147   | )
|Retained earnings                                 |  |                | 18,416 |                     |   | 16,985 |  
|                                                  |  |                | 30,002 |                     |   | 28,530 |  
|Total
 liabilities and shareholders equity       |  | $              | 32,342 |                     | $ | 36,108 |  

See
accompanying notes.

- 1 -

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Table of Contents

Image Sensing Systems, Inc.Condensed Consolidated Statements of Income
(Unaudited)
(in thousands, except per share data)

|                                                       |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|------------------------------------------------------ |  | ------------------------------------ | ----- | ---------------------------------- | - | ----- |  | ---- | ------ |  | - | ------ | 
|                                                       |  | Three-Month
 Periods Ended
 June 30, |       | Six-Month
 Periods Ended
 June 30, |  
|                                                       |  | 2009                                 |       | 2008                               |   | 2009  |  | 2008 |       
|Revenue:                                               |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|International sales                                    |  | $                                    | 1,159 |                                    | $ | 1,446 |  | $    | 2,341  |  | $ | 2,801  | 
|North American sales                                   |  |                                      | 1,738 |                                    |   | 1,923 |  |      | 3,050  |  |   | 3,548  | 
|Royalties                                              |  |                                      | 3,383 |                                    |   | 3,373 |  |      | 5,679  |  |   | 6,265  | 
|                                                       |  |                                      | 6,280 |                                    |   | 6,742 |  |      | 11,070 |  |   | 12,614 | 
|                                                       |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Costs of revenue:                                      |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|International sales                                    |  |                                      | 326   |                                    |   | 633   |  |      | 720    |  |   | 1,241  | 
|North American sales                                   |  |                                      | 585   |                                    |   | 773   |  |      | 958    |  |   | 1,367  | 
|                                                       |  |                                      | 911   |                                    |   | 1,406 |  |      | 1,678  |  |   | 2,608  | 
|Gross profit                                           |  |                                      | 5,369 |                                    |   | 5,336 |  |      | 9,392  |  |   | 10,006 | 
|                                                       |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Operating expenses:                                    |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Selling, marketing and product support                 |  |                                      | 1,921 |                                    |   | 1,660 |  |      | 3,551  |  |   | 2,993  | 
|General and administrative                             |  |                                      | 803   |                                    |   | 1,015 |  |      | 1,778  |  |   | 1,903  | 
|Research and development                               |  |                                      | 862   |                                    |   | 765   |  |      | 1,673  |  |   | 1,466  | 
|Amortization of intangible assets                      |  |                                      | 192   |                                    |   | 192   |  |      | 384    |  |   | 384    | 
|                                                       |  |                                      | 3,778 |                                    |   | 3,632 |  |      | 7,386  |  |   | 6,746  | 
|Income from
 operations                                |  |                                      | 1,591 |                                    |   | 1,704 |  |      | 2,006  |  |   | 3,260  | 
|                                                       |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Other income,
 net                                     |  |                                      | 21    |                                    |   | 23    |  |      | 9      |  |   | 64     | 
|Income
 before income taxes                            |  |                                      | 1,612 |                                    |   | 1,727 |  |      | 2,015  |  |   | 3,324  | 
|Income taxes                                           |  |                                      | 442   |                                    |   | 512   |  |      | 584    |  |   | 1,053  | 
|Net income                                             |  | $                                    | 1,170 |                                    | $ | 1,215 |  | $    | 1,431  |  | $ | 2,271  | 
|                                                       |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Net income
 per common share:                          |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Basic                                                  |  | $                                    | 0.29  |                                    | $ | 0.31  |  | $    | 0.36   |  | $ | 0.58   | 
|Diluted                                                |  | $                                    | 0.29  |                                    | $ | 0.30  |  | $    | 0.35   |  | $ | 0.57   | 
|                                                       |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Weighted
 average number of common shares outstanding: |  |                                      |       |                                    |   |       |  |      |        |  |   |        | 
|Basic                                                  |  |                                      | 3,985 |                                    |   | 3,929 |  |      | 3,985  |  |   | 3,929  | 
|Diluted                                                |  |                                      | 4,067 |                                    |   | 3,999 |  |      | 4,061  |  |   | 4,013  | 

See
accompanying notes.

- 2 -

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Image Sensing Systems, Inc.Condensed Consolidated Statements of Cash Flows
(Unaudited) 
(in thousands)

|                                                                                  |  |                                    |        |      |   |        |  
|--------------------------------------------------------------------------------- |  | ---------------------------------- | ------ | ---- | - | ------ | -
|                                                                                  |  | Six-Month
 Periods Ended
 June 30, |       
|                                                                                  |  | 2009                               |        | 2008 |  
|Operating activities:                                                             |  |                                    |        |      |   |        |  
|Net income                                                                        |  | $                                  | 1,431  |      | $ | 2,271  |  
|Adjustments to reconcile net income to net
 cash provided by operating activities |  |                                    |        |      |   |        |  
|Depreciation and amortization                                                     |  |                                    | 600    |      |   | 573    |  
|Stock option expense                                                              |  |                                    | 180    |      |   | 159    |  
|Change in operating assets and liabilities                                        |  |                                    | 301    |      |   | (798   | )
|Net cash provided by operating activities                                         |  |                                    | 2,512  |      |   | 2,205  |  
|                                                                                  |  |                                    |        |      |   |        |  
|Investing activities:                                                             |  |                                    |        |      |   |        |  
|Net purchases of property and equipment                                           |  |                                    | (340   | )    |   | (188   | )
|Payment of EIS earn-out                                                           |  |                                    | (1,192 | )    |   |       |  
|Net (purchases) sales of investments                                              |  |                                    | 33     |      |   | (5,400 | )
|Net cash used in investing activities                                             |  |                                    | (1,499 | )    |   | (5,588 | )
|                                                                                  |  |                                    |        |      |   |        |  
|Financing activities:                                                             |  |                                    |        |      |   |        |  
|Proceeds from exercise of stock options                                           |  |                                    | 4      |      |   | 6      |  
|Repayment of bank debt                                                            |  |                                    | (3,750 | )    |   | (166   | )
|Cash released from restriction                                                    |  |                                    |       |      |   | 5,263  |  
|Net cash provided by (used in) financing
 activities                              |  |                                    | (3,746 | )    |   | 5,103  |  
|                                                                                  |  |                                    |        |      |   |        |  
|Increase (decrease) in cash and cash
 equivalents                                 |  |                                    | (2,733 | )    |   | 1,720  |  
|                                                                                  |  |                                    |        |      |   |        |  
|Cash and cash equivalents, beginning of
 period                                   |  |                                    | 10,289 |      |   | 5,613  |  
|Cash and cash equivalents, end of period                                          |  | $                                  | 7,556  |      | $ | 7,333  |  

See accompanying notes.

- 3 -

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Table of Contents

IMAGE SENSING SYSTEMS, INC.

Notes to Condensed Consolidated Financial
Statements
(Unaudited) 
June 30, 2009

Note A: Basis of Presentation

The
accompanying unaudited condensed consolidated financial statements of Image
Sensing Systems, Inc. (the Company) have been prepared in accordance with
accounting principles generally accepted in the United States of America for
interim financial information and with the instructions to Form 10-Q.
Accordingly, they do not include all of the information and footnotes required
by accounting principles generally accepted in the United States of America for
complete financial statements. It is the opinion of management that the
unaudited condensed consolidated financial statements include all adjustments
consisting of normal recurring accruals considered necessary for a fair
presentation. Operating results for the three-month and six-month periods ended
June 30, 2009 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2009. For further information, refer
to the consolidated financial statements and footnotes thereto in our Annual
Report on Form 10-K for the year ended December 31, 2008.

We evaluated
our quarter ended June 30, 2009 consolidated financial statements for subsequent events through
August 13, 2009, the date the
financial statements were available to be issued. We are not aware of any subsequent events
which would require recognition or disclosure in the financial statements

Note B: Investments

Investments and marketable securities held at
June 30, 2009 that
do not qualify as cash equivalents have been designated as available for sale in accordance with Statement of
Financial Accounting Standard (SFAS) No. 115, Accounting
for Certain Investments in Debt and Equity Securities.
The estimated fair value of the
investments held at June 30, 2009 was determined under SFAS No. 157, Fair
Value Measurements, using level 1 measurements.

At December 31, 2008, we held $4.0 million
(par value) of investments comprised of auction rate securities, or ARS which
were designated as trading under SFAS No. 115. The
balance of investments at December 31, 2008, consisted
of the combination of the fair value of ARS as determined under SFAS No. 157
and the fair value of the settlement rights that we received from the
broker/dealer under a settlement agreement reached in November 2008. The
settlement rights allowed us to put the ARS to the broker/dealer at par between
the dates of January 2, 2009 and January 2, 2011. In January 2009, our ARS were purchased
by the broker/dealer at par.

Note C: Acquisition

In 2007, we
purchased certain assets of EIS Electronic Integrated Systems, Inc. (EIS),
including its RTMS radar product line. As part of the purchase agreement, the
sellers are eligible to receive an earn-out based on the performance of the EIS
assets purchased for approximately the three years after the December 2007
purchase date. Earn-outs will be calculated and paid annually. Based on target
achievement, the sellers would receive $2.0 million annually or a total of $6.0
million. Earn-out payments related to the EIS asset purchase will be recorded
as additional goodwill when earned. In 2008, the sellers earned an earn-out of
approximately $1.2 million, which was paid in 2009.

EIS was named
in a U.S. lawsuit in 2006 for infringement of a patent. On October 31, 2007,
the court entered judgment that EIS had not infringed on the patent. The
plaintiff has appealed the decision, and EIS has continued its defense as
provided in the EIS asset purchase agreement. In addition, EIS must indemnify
us for all expenses, claims or judgments related to this lawsuit up to the
amount of the purchase price, including any earn-out payments. Management
believes that the ultimate outcome of this legal action will not have a
material adverse effect on our financial statements.

- 4 -

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Table of Contents

Note D: Goodwill and intangible assets

Goodwill
consists of $1.1 million related to our acquisition of Flow Traffic Ltd. and
$5.0 million related to the EIS asset purchase, consisting of $3.8 million
recorded at the purchase date and an additional $1.2 million recognized for
earn-out consideration earned for 2008.

Intangible
assets consisted of the following (dollars in thousands):

|                                          |  |                |        |                    |   |       |  
|----------------------------------------- |  | -------------- | ------ | ------------------ | - | ----- | -
|                                          |  | June 30,
 2009 |        | December 31,
 2008 |  
|Developed technology (8 year life)        |  | $              | 3,900  |                    | $ | 3,900 |  
|Trade names (5 year life)                 |  |                | 1,200  |                    |   | 1,200 |  
|Other intangibles (5 year life)           |  |                | 200    |                    |   | 200   |  
|Less: Accumulated amortization            |  |                | (1,203 | )                  |   | (819  | )
|Total identifiable intangible assets, net |  | $              | 4,097  |                    | $ | 4,481 |  

We have and
expect to continue to recognize amortization expense for the intangible assets
in the above table of $768,000 in each of our years ending December 31, 2008,
2009, 2010 and 2011 and of $749,000 in 2012. Goodwill and intangible assets
related to the EIS asset purchase are deductible for tax purposes over 15
years.

We monitor on
a quarterly basis our carrying value, the market capitalization of our stock
and other variables to determine whether a triggering event has occurred that
would require an interim impairment evaluation of our goodwill. We have
concluded that no triggering events have occurred during the quarter ended June
30, 2009.

Note E: Net Income Per Common Share and Comprehensive Income (Loss)

The following
table sets forth the computations of basic and diluted net income per common
share for the three-month and six-month periods ended June 30, 2009 and 2008
(in thousands, except per share data):

|                                                                 |  |                                     |       |                                   |   |       |  |      |       |  |   |       | 
|---------------------------------------------------------------- |  | ----------------------------------- | ----- | --------------------------------- | - | ----- |  | ---- | ----- |  | - | ----- | 
|                                                                 |  | Three-Month Periods
 Ended June 30, |       | Six-Month Periods Ended
 June 30, |  
|                                                                 |  | 2009                                |       | 2008                              |   | 2009  |  | 2008 |      
|Numerator:                                                       |  |                                     |       |                                   |   |       |  |      |      
|Net income                                                       |  | $                                   | 1,170 |                                   | $ | 1,215 |  | $    | 1,431 |  | $ | 2,271 | 
|Denominator:                                                     |  |                                     |       |                                   |   |       |  |      |       |  |   |       | 
|Shares used in basic net income per common
 share calculation    |  |                                     | 3,985 |                                   |   | 3,929 |  |      | 3,985 |  |   | 3,929 | 
|Effect of diluted securities:                                    |  |                                     |       |                                   |   |       |  |      |       |  |   |       | 
|Employee and director stock options                              |  |                                     | 82    |                                   |   | 70    |  |      | 76    |  |   | 84    | 
|Shares used in diluted net income per
 common share calculations |  |                                     | 4,067 |                                   |   | 3,999 |  |      | 4,061 |  |   | 4,013 | 
|Basic net income per common share                                |  | $                                   | 0.29  |                                   | $ | 0.31  |  | $    | 0.36  |  | $ | 0.58  | 
|Diluted net income per common share                              |  | $                                   | 0.29  |                                   | $ | 0.30  |  | $    | 0.35  |  | $ | 0.57  | 

Our
comprehensive income for the three-month periods ended June 30, 2009 and 2008
was $1.5 million and $1.2 million, respectively, and for the six-month periods
ended June 30, 2009 and 2008 was $1.3 million and $2.1 million, respectively.
In each period, the main difference between net income and comprehensive income
arose from foreign currency translation adjustments.

- 5 -

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Table of Contents

Note F: Stock-based Compensation

We recorded
$184,000 and $159,000 of stock-based compensation in general and administrative
expense for the six-month periods ended June 30, 2009 and 2008, respectively.
Options to purchase 64,000 and 20,000 shares, at a weighted average exercise
price of $8.72 and $15.00, and options to purchase 68,000 and 31,000 shares, at
a weighted average exercise price of $8.62 and $15.85, were granted during the
three-month and six-month periods ended June 30, 2009 and 2008, respectively.
In addition, in June 2009, under a shareholder approved plan, we exchanged
options to purchase 168,500 shares with exercise prices ranging from $12.37 to
$17.50 on a one-for-one basis for options at an exercise price of $9.22. As of
June 30, 2009, $1.0 million of total unrecognized compensation expense related
to non-vested stock option awards is expected to be recognized over a weighted
average period of 3.3 years.

We used the
Black-Scholes option pricing model to determine the weighted average fair value
of options during the three-month and six-month periods ended June 30, 2009 and
2008, respectively.

The Companys
stock options generally vest over three to five years of service and have a
contractual life of six to ten years. As of June 30, 2009, we had 97,500 shares
available for grants under the 2005 Stock Incentive Plan.

The following
table summarizes information about the stock options outstanding at June 30,
2009:

|                         |             |                     |  |                                                 |  |                                   |  |                     |       |                                   |  |         |  |   |       |  | 
|------------------------ | ----------- | ------------------- |  | ----------------------------------------------- |  | --------------------------------- |  | ------------------- | ----- | --------------------------------- |  | ------- |  | - | ----- |  | 
|                         |             | Options Outstanding |  | Options Exercisable                             | 
|Range of
 Exercise Price |             | Number
 Outstanding |  | Weighted
 Average
 Remaining
 Contractual
 Life |  | Weighted
 Average
 Exercise Price |  | Number
 Exercisable |       | Weighted
 Average
 Exercise Price | 
|$                        | 1.30-1.99   |                     |  | 59,100                                          |  | 2.9 years                         |  | $                   | 1.34  |                                   |  | 59,100  |  | $ | 1.34  | 
|                         | 2.00-2.99   |                     |  | 16,200                                          |  | 2.6 years                         |  |                     | 2.35  |                                   |  | 16,200  |  |   | 2.35  | 
|                         | 3.00-3.99   |                     |  | 38,933                                          |  | 3.3 years                         |  |                     | 3.15  |                                   |  | 38,933  |  |   | 3.15  | 
|                         | 7.00-7.99   |                     |  | 10,000                                          |  | 2.3 years                         |  |                     | 7.30  |                                   |  | 6,000   |  |   | 7.50  | 
|                         | 8.00-8.99   |                     |  | 52,000                                          |  | 6.2 years                         |  |                     | 8.66  |                                   |  |        |  |   |      | 
|                         | 9.00-9.99   |                     |  | 180,500                                         |  | 5.9 years                         |  |                     | 9.21  |                                   |  |        |  |   |      | 
|                         | 12.00-12.99 |                     |  | 49,000                                          |  | 5.7 years                         |  |                     | 12.46 |                                   |  | 19,750  |  |   | 12.52 | 
|                         | 15.00-15.99 |                     |  | 36,000                                          |  | 2.5 years                         |  |                     | 15.31 |                                   |  | 36,000  |  |   | 15.31 | 
|                         |             |                     |  | 441,733                                         |  | 4.8 years                         |  |                     | 8.12  |                                   |  | 175,983 |  |   | 6.16  | 

Note G: Segment Information

We currently
operate in two reportable segments: Autoscope and RTMS. Autoscope is our
machine-vision product line, and revenue consists of royalties (all of which
are received from Econolite Control Products, Inc.), as well as a portion of
international sales. RTMS is our radar product line acquired in the EIS asset
purchase in 2007, and revenue consists of all North American sales and a
portion of international sales. All segment revenues are derived from external
customers.

The following
table sets forth selected unaudited financial information for each of the
Companys reportable segments for the three-month periods ended June 30, 2009
and 2008 (in thousands):

|                                  |  |           |        |      |   |        |  |      |        |      |   |        |  |   |        |  |   |        | 
|--------------------------------- |  | --------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------ |  | - | ------ | 
|                                  |  | Autoscope |        | RTMS |   | Total  | 
|                                  |  | 2009      |        | 2008 |   | 2009   |  | 2008 |        | 2009 |   | 2008   | 
|Revenue                           |  | $         | 4,164  |      | $ | 4,337  |  | $    | 2,116  |      | $ | 2,405  |  | $ | 6,280  |  | $ | 6,742  | 
|Depreciation                      |  |           | 81     |      |   | 61     |  |      | 31     |      |   | 30     |  |   | 112    |  |   | 91     | 
|Amortization of intangible assets |  |           |       |      |   |       |  |      | 192    |      |   | 192    |  |   | 192    |  |   | 192    | 
|Income before income taxes        |  |           | 1,187  |      |   | 1,286  |  |      | 425    |      |   | 441    |  |   | 1,612  |  |   | 1,727  | 
|Capital expenditures              |  |           | 161    |      |   | 103    |  |      | 30     |      |   | 48     |  |   | 191    |  |   | 151    | 
|Total assets                      |  | $         | 22,018 |      | $ | 22,022 |  | $    | 10,324 |      | $ | 11,108 |  | $ | 32,342 |  | $ | 33,130 | 

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The following
table sets forth selected unaudited financial information for each of the
Companys reportable segments for the six-month periods ended June 30, 2009 and
2008 (in thousands):

|                                   |  |           |        |      |   |        |  |      |        |      |   |        |  |   |        |  |   |        | 
|---------------------------------- |  | --------- | ------ | ---- | - | ------ |  | ---- | ------ | ---- | - | ------ |  | - | ------ |  | - | ------ | 
|                                   |  | Autoscope |        | RTMS |   | Total  | 
|                                   |  | 2009      |        | 2008 |   | 2009   |  | 2008 |        | 2009 |   | 2008   | 
|Revenue                            |  | $         | 7,410  |      | $ | 8,400  |  | $    | 3,660  |      | $ | 4,214  |  | $ | 11,070 |  | $ | 12,614 | 
|Depreciation                       |  |           | 147    |      |   | 133    |  |      | 59     |      |   | 56     |  |   | 206    |  |   | 189    | 
|Amortization
 of intangible assets |  |           |       |      |   |       |  |      | 384    |      |   | 384    |  |   | 384    |  |   | 384    | 
|Income
 before income taxes        |  |           | 1,554  |      |   | 2,620  |  |      | 461    |      |   | 704    |  |   | 2,015  |  |   | 3,324  | 
|Capital
 expenditures              |  |           | 285    |      |   | 140    |  |      | 55     |      |   | 48     |  |   | 340    |  |   | 188    | 
|Total assets                       |  | $         | 22,018 |      | $ | 22,022 |  | $    | 10,324 |      | $ | 11,108 |  | $ | 32,342 |  | $ | 33,130 | 

Note H: Derivative Instruments

We have purchased foreign currency forward contracts with our bank to
reduce the exposure and volatility arising from fluctuations in foreign
currency exchange rates as it relates to payroll and inventory purchases in
certain foreign locations. These contracts have been designated as effective
cash flow hedges. At June 30, 2009, we had future commitments through September
2009 to purchase $600,000 of Canadian dollars at rates ranging from .8059 to
..8072 and through December 2009 to purchase $1.2 million of British pounds at
rates ranging from 1.4788 to 1.6614.

The fair value of the Companys derivative instruments is estimated in
accordance with the framework for measuring fair value contained in SFAS No.
157, and it is recorded as either an asset or liability in the balance sheet
based on changes in the current spot rate as compared to the exchange rates
specified in the contracts. For these instruments, the effective portion of the
gain or loss on the derivative is reported as a component of other
comprehensive income and is reclassified into earnings in the same period or
periods during which the hedged transaction affects earnings. Gains and losses
on the derivative representing either hedge ineffectiveness or hedge components
excluded from the assessment of effectiveness are recognized in current
earnings. The fair value measurement of the Companys derivative instruments is
estimated using Level 2 inputs which, as defined in SFAS No. 157, are inputs
other than quoted prices that are directly or indirectly observable for the
asset or liability. We did not record any unrealized gain or losses on our
derivative instruments as of June 30, 2009, as the unrealized gain was
immaterial.

Note I: New Accounting Pronouncements

In December
2007, the Financial Accounting Standards Board (FASB) issued SFAS No. 141
(Revised 2007), Business Combinations.
SFAS No. 141(R) will significantly change the accounting for business
combinations. Under SFAS No. 141(R), an acquiring entity will be required to
recognize all the assets acquired and liabilities assumed in a transaction at
the acquisition-date fair value with limited exceptions. SFAS No. 141(R) will
change the accounting treatment for certain specific items. SFAS No. 141(R)
also includes a substantial number of new disclosure requirements. SFAS No.
141(R) applies to us prospectively for business combinations beginning in 2009,
and this adoption did not have a material impact on our financial statements.

In December
2007, the FASB issued SFAS No. 160, Noncontrolling
Interests in Consolidated Financial Statements  An Amendment of ARB No. 51.
SFAS No. 160 establishes new accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. SFAS No. 160 also includes expanded disclosure requirements
regarding the interests of the parent and its noncontrolling interest. SFAS No.
160 is effective for fiscal years, and interim periods within those fiscal
years, beginning on or after December 15, 2008. The adoption of SFAS No. 160
did not have a material impact on our financial statements.

In May 2008,
the FASB issued SFAS No. 162, The Hierarchy
of Generally Accepted Accounting Principles. SFAS No. 162 identifies
the sources of accounting principles and the framework for selecting the
principles to be used in the preparation of financial statements of
nongovernmental entities that are presented in conformity with generally
accepted accounting principles. SFAS No. 162 is effective 60 days following the
approval by the Securities and Exchange Commission of the Public Company Accounting
Oversight Board amendments to AU Section 411, The
Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles. We do not anticipate that the adoption of SFAS No. 162
will materially impact the Company.

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In May 2009, the FASB issued SFAS
No. 165, Subsequent Events, to
incorporate the accounting and disclosure requirements for subsequent events
into U.S. generally accepted accounting principles (GAAP). SFAS
No. 165 introduces new terminology, defines a
date through which management must evaluate subsequent events, and lists the
circumstances under which an entity must recognize and disclose events or
transactions occurring after the balance sheet date. It is effective prospectively for interim
or annual reporting periods ending after June 15, 2009. We adopted SFAS No. 165 as of the
required effective date and have applied its provisions. We do not believe the adoption of SFAS
No. 165 will have a material effect on our
consolidated financial statements.

In June 2009, the FASB issued SFAS
No. 168, The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles  a
replacement of FASB Statement 162. The FASB Accounting Standards Codification (Codification)
will become the source of authoritative U.S. generally accepted accounting
principles (GAAP) recognized by the FASB to be applied by nongovernmental
entities. Rules and
interpretive releases of the Securities and Exchange Commission (SEC) under
authority of federal securities laws are also sources of authoritative GAAP for
SEC registrants. On
the effective date of SFAS No. 168, the Codification will supersede all
then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC
accounting literature not included in the Codification will become
nonauthoritative. After the effective date of SFAS No. 168, the Board will not issue new standards in the form of
Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts.
Instead, it will issue Accounting
Standards Updates, which will not be authoritative in their own right, but will
serve only to update the Codification. SFAS No. 168 is effective for
financial statements issued for interim and annual periods ending after
September 15, 2009. We
will adopt SFAS No. 168
as of the required effective date,
September 15, 2009, and we will apply its provisions prospectively.
We do not believe the adoption of SFAS
No. 168 will have a material effect
on our consolidated financial statements.

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|        |                                                                                       
|------- | --------------------------------------------------------------------------------------
|Item 2. | Managements Discussion and Analysis of Financial
 Condition and Results of Operations

Overview

General.
We provide software based computer enabled detection, or CED, products and
solutions that use advanced signal processing software algorithms to detect and
monitor objects in a designated field of view. Our technology analyzes the
signal from a sophisticated sensor and passes the information along to management
systems, controllers or directly to users. Our core products, the Autoscope®
Video Vehicle Detection System and the RTMS® Radar Detection System, operate
using our proprietary software in conjunction with video cameras or radar and
commonly available electronic components. Each of these systems is used by
traffic managers primarily to improve the flow of vehicle traffic and to
enhance safety at intersections, main thoroughfares, freeways and tunnels.

Autoscope
systems are sold to distributors and end users of traffic management products
in North America, the Caribbean and Latin America by Econolite Control
Products, Inc., or Econolite, our exclusive licensee in these regions. We sell
RTMS systems to distributors and end users in North America. We also sell both
Autoscope and RTMS systems to distributors and end users in Europe and Asia
through our European and Hong Kong subsidiaries, respectively. End users of our
products throughout the world are generally funded by government agencies
responsible for traffic management or traffic law enforcement.

EIS
Asset Purchase. In 2007, we purchased certain
assets from EIS Electronic Integrated Systems Inc., or EIS, including its
principal product line, the RTMS system. In its fiscal year ended September 30,
2007, EIS had revenue of $8.7 million, substantially all of which related to
RTMS sales.

Trends
and Challenges in Our Business

We believe the
historical growth in our business can be attributed primarily to the following
global trends:

|                                                      |   |                                                                                                                                                                                                                                                                                                    
|----------------------------------------------------- | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                                      |  | worsening traffic
 caused by increased numbers of vehicles in metropolitan areas without
 corresponding expansions of road infrastructure, which increased demand for
 our products;                                                                                                               
|                                                      |   |                                                                                                                                                                                                                                                                                                    
|                                                      |  | advances in
 information technology, which have made our products easier to market and
 implement;                                                                                                                                                                                                 
|                                                      |   |                                                                                                                                                                                                                                                                                                    
|                                                      |  | the
 continuing rise in funding allocations in large cities for centralized
 traffic management services, which increased the ability of our primary end
 users to implement our products; and                                                                                                     
|                                                      |   |                                                                                                                                                                                                                                                                                                    
|                                                      |  | general
 increases in the cost-effectiveness of electronics, which make our products
 more affordable for end users.                                                                                                                                                                               
|                                                      |   |                                                                                                                                                                                                                                                                                                    
|We believe
 our future growth primarily depends upon:
|                                                     
|                                                      |  | continued
 adoption and governmental funding of intelligent transportation systems, or
 ITS, for traffic control in developed countries;                                                                                                                                                           
|                                                      |   |                                                                                                                                                                                                                                                                                                    
|                                                      |  | countries in
 the developing world adopting above-ground detection technology, such as
 video or radar, instead of in-pavement loop technology to manage traffic;                                                                                                                                  
|                                                      |   |                                                                                                                                                                                                                                                                                                    
|                                                      |  | the use of
 CED to provide solutions to security/surveillance and environmental issues
 associated with increasing automobile use in metropolitan areas; and                                                                                                                                       
|                                                      |   |                                                                                                                                                                                                                                                                                                    
|                                                      |  | our ability
 to develop new products, such as hybrid CED devices incorporating, for
 example, radar and video technologies, that provide increasingly accurate
 information and enhance the end users ability to cost-effectively manage
 traffic, security/surveillance and environmental issues.

Because our
principal end users are governmental entities, we are faced with challenges
related to potential delays in purchase decisions by those entities and changes
in budgetary constraints. These contingencies could result in significant
fluctuations in our revenue between periods. The current worldwide recession is
further adding to the unpredictability of purchase decisions, creating more
delays than usual and decreasing governmental budgets, and it is likely to
negatively affect our total 2009 revenue. We believe we may be a beneficiary of
the federal stimulus bill enacted early in 2009, but it is too early to
determine the level or timing of impact to our operations.

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Key
Financial Terms and Metrics

Revenue. Revenue
historically has been derived from two sources: (1) royalties received from
Econolite for sales of the Autoscope system in North America, the Caribbean and
Latin America and (2) revenue received from direct sales of Autoscope systems
in Europe and Asia. Royalties from Econolite historically have provided the
majority of our revenue. We calculate the royalties using a profit sharing
model where we split the gross profit on sales of Autoscope product made
through Econolite. This royalty arrangement has the benefit of decreasing our
cost of revenues and our selling, marketing and product support expenses
because these costs and expenses are borne primarily by Econolite. Although
this royalty model has a positive impact on our gross margin, it also
negatively impacts our total revenue, which would be higher if all the sales
made by Econolite were made directly by us. The royalty arrangement is exclusive
under a long-term agreement. Our acquisition of the RTMS product line in 2007,
which we assemble, gives us an additional source of revenue that has increased
our overall revenue and lessened fluctuations in our revenue from period to
period due to our ownership of more than one product line and the higher
volumes it brings, notwithstanding normal seasonality.

Cost of Revenue.
There is no cost of revenue related to royalties, as virtually all
manufacturing, warranty and related costs are incurred by Econolite. Cost of
revenue related to direct product sales consists primarily of the amount
charged by our third party contractors to manufacture the Autoscope and RTMS
hardware platforms, which is influenced mainly by the cost of electronic
components. The cost of revenue also includes logistics costs and estimated
expenses for product warranties and inventory reserves. The key metric that we
follow is achieving certain gross margin percentages by geographic region.

Operating Expenses.
Our operating expenses fall into three categories: (1) selling, marketing and
product support; (2) general and administrative; and (3) research and
development. Selling, marketing and product support expenses consist of various
costs related to sales and support of our products, including salaries,
benefits and commissions paid to our personnel, commissions paid to third
parties, travel, trade show and advertising costs, second-tier technical
support for Econolite, and general product support, where applicable. General
and administrative expenses consist of certain corporate and administrative
functions that support the development and sales of our products and
provide an infrastructure to support future growth. General and administrative
expenses reflect management, supervisory and staff salaries and benefits, legal
and auditing fees, travel, rent and costs associated with being a public
company, such as board of director fees, Sarbanes-Oxley compliance, listing
fees and annual reporting expenses. Research and development expenses consist
mainly of salaries and benefits for our engineers and third party costs for
consulting and prototyping. We measure all operating expenses against our
annually approved budget, which is developed with achieving a certain operating
margin as a key focus. Also included in operating expenses is non-cash expense
for intangible asset amortization.

Seasonality. Our
quarterly revenues and operating results have varied significantly in the past
due to the seasonality of our business. Our first quarter generally is the
weakest due to weather conditions that make roadway construction more difficult
in North America, Europe and northern Asia. We expect such seasonality to
continue for the foreseeable future. Additionally, our international revenues
have a significant large project component, resulting in a varying revenue
stream. Accordingly, we believe that quarter-to-quarter comparisons of our
financial results should not be relied upon as an indication of our future
performance. No assurance can be given that we will be able to achieve or
maintain profitability on a quarterly or annual basis in the future.

History. We were
incorporated in the state of Minnesota in December 1984 and began operations by
pioneering the commercial application of wide-area video vehicle detection for
traffic management. The technology underlying our products was initially
developed at the University of Minnesota. In 1989, the University was awarded a
patent for that technology, which it exclusively licensed to us. In 1991, we sub-licensed
this technology to Econolite, a leading manufacturer and seller of traffic
control products in North America and the Caribbean, to manufacture and
distribute products incorporating the technology.

Segments. We
currently operate in two reportable segments: Autoscope and RTMS. Autoscope is
our machine-vision product line, and revenue consists of royalties (all of
which are received from Econolite), as well as a portion of international
sales. RTMS is our radar product line acquired in the EIS asset purchase in
2007, and revenue consists of all North American sales and a portion of
international sales. All segment revenues are derived from external customers
(see Note G).

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Results of Operations

The following
table sets forth, for the periods indicated, (1) certain statements of income
data as a percent of total revenue, (2) gross profit on product sales and
royalties as a percentage of product sales and royalties, respectively, and (3)
period-to-period changes of items in the consolidated statements of income from
2009 to 2008:

|                                                 |  |                                      |       |                                |  |       |   |  |       |   
|------------------------------------------------ |  | ------------------------------------ | ----- | ------------------------------ |  | ----- | - |  | ----- | --
|                                                 |  | Three-Month
 Periods
 Ended June 30, |       | Quarter
 Over
 Quarter
 Change | 
|                                                 |  | 2009                                 |       | 2008                           | 
|International
 sales                             |  |                                      | 18.4  | %                              |  | 21.4  | % |  | (19.8 | )%
|North
 American sales                            |  |                                      | 27.7  |                                |  | 28.5  |   |  | (9.6  | ) 
|Royalties                                        |  |                                      | 53.9  |                                |  | 50.1  |   |  | 0.3   |   
|Total
 revenue                                   |  |                                      | 100.0 |                                |  | 100.0 |   |  | (6.9  | ) 
|Gross profit
  international sales              |  |                                      | 71.9  |                                |  | 56.2  |   |  | 2.5   |   
|Gross profit
  North American sales             |  |                                      | 66.3  |                                |  | 59.8  |   |  | 0.3   |   
|Gross profit
  royalties                        |  |                                      | 100.0 |                                |  | 100.0 |   |  | 0.3   |   
|Selling,
 marketing and product support expenses |  |                                      | 30.6  |                                |  | 24.6  |   |  | 15.7  |   
|General and
 administrative expenses             |  |                                      | 12.8  |                                |  | 15.1  |   |  | (20.9 | ) 
|Research and
 development expenses               |  |                                      | 13.7  |                                |  | 11.3  |   |  | 12.7  |   
|Amortization
 of intangible assets               |  |                                      | 3.1   |                                |  | 2.8   |   |  | n/m   |   
|Income from
 operations                          |  |                                      | 25.3  |                                |  | 25.3  |   |  | (6.6  | ) 
|Other
 income, net                               |  |                                      | 0.3   |                                |  | 0.3   |   |  | n/m   |   
|Income taxes                                     |  |                                      | 7.0   |                                |  | 7.6   |   |  | (13.7 | ) 
|Net income                                       |  |                                      | 18.6  |                                |  | 18.0  |   |  | (3.7  | ) 

|                                                 |  |                                    |       |                             |  |       |   |  |       |   
|------------------------------------------------ |  | ---------------------------------- | ----- | --------------------------- |  | ----- | - |  | ----- | --
|                                                 |  | Six-Month
 Periods
 Ended June 30, |       | Period Over
 Period
 Change | 
|                                                 |  | 2009                               |       | 2008                        |  |      
|International
 sales                             |  |                                    | 21.1  | %                           |  | 22.2  | % |  | (16.4 | )%
|North
 American sales                            |  |                                    | 27.6  |                             |  | 28.1  |   |  | (14.0 | ) 
|Royalties                                        |  |                                    | 51.3  |                             |  | 49.7  |   |  | (9.4  | ) 
|Total
 revenue                                   |  |                                    | 100.0 |                             |  | 100.0 |   |  | (12.2 | ) 
|Gross profit
  international sales              |  |                                    | 69.2  |                             |  | 55.7  |   |  | 3.9   |   
|Gross profit
  North American sales             |  |                                    | 68.6  |                             |  | 61.5  |   |  | (4.1  | ) 
|Gross profit
  royalties                        |  |                                    | 100.0 |                             |  | 100.0 |   |  | (9.4  | ) 
|Selling,
 marketing and product support expenses |  |                                    | 32.1  |                             |  | 23.7  |   |  | 18.6  |   
|General and
 administrative expenses             |  |                                    | 16.1  |                             |  | 15.1  |   |  | (6.6  | ) 
|Research and
 development expenses               |  |                                    | 15.1  |                             |  | 11.6  |   |  | 14.1  |   
|Amortization
 of intangible assets               |  |                                    | 3.5   |                             |  | 3.0   |   |  | n/m   |   
|Income from
 operations                          |  |                                    | 18.1  |                             |  | 25.8  |   |  | (38.5 | ) 
|Other
 income, net                               |  |                                    | 0.1   |                             |  | 0.5   |   |  | (85.9 | ) 
|Income taxes                                     |  |                                    | 5.3   |                             |  | 8.3   |   |  | (44.5 | ) 
|Net income                                       |  |                                    | 12.9  |                             |  | 18.0  |   |  | (37.0 | ) 

Total revenue
decreased to $6.3 million in the three-month period ended June 30, 2009 from
$6.7 million in the same period in 2008, a decrease of 6.9%, and to $11.1
million in the first half of 2009 from $12.6 million in the same period in
2008, a decrease of 12.2%. Royalties were $3.4 million in both the second
quarter of 2009 and 2008, and they decreased to $5.7 million in the first half
of 2009 from $6.3 million in the same period in 2008, a decrease of 9.4%. We
attribute the decrease in royalties to the economic recession in North America
and its negative impact on state and federal spending. North American sales,
which are sales of RTMS in North America, decreased to $1.7 million in the
second quarter of 2009 from $1.9 million in the same period in 2008, a decrease
of 9.6%, and to $3.1 million in the first half of 2009 from $3.5 million in the
same period in 2008, a decrease of 14.0%, also reflecting the difficult
economic environment in North America. International sales, which include both
Autoscope and RTMS sales outside of North America, decreased to $1.2 million in
the second quarter of 2009 from $1.4 million in the second quarter of 2008, a
decrease of 19.8%, and to $2.3 million in the first half of 2009 from $2.8
million in the first half of 2008, a decrease of 16.4%. The decrease was due
mainly to weakness in the Asian market.

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Gross margins
for international sales increased to 71.9% in the three months ended June 30,
2009 from 56.2% in the same period in 2008, and to 69.2% in the first half of
2009 from 55.7% in the same period in 2008. Gross margins for North American
sales increased to 66.3% in the second quarter of 2009 from 59.8% in the first
quarter of 2008 and to 68.6% in the first half of 2009 from 61.5% in the first
half of 2008. The increases resulted mainly from a positive revenue mix shift and
to a lesser extent from positive currency exchange rates and lower inventory
reserves recorded in 2009 as compared to 2008. Gross margins on royalty income
remained consistent at 100.0% in each of the periods of 2009 and 2008.

Selling,
marketing and product support expense increased to $1.9 million, or 30.6% of
total revenue, in the three months ended June 30, 2009 from $1.7 million, or
24.6% of total revenue, in the second quarter of 2008, and to $3.6 million, or
32.1% of total revenue, in the first half of 2009 from $3.0 million, or 23.7%
of total revenue, in the first half of 2008. The change related mostly to an
investment in market expansion activities in Eastern Europe and Asia and the
realization of the impact of headcount additions made late in 2008. We
anticipate that for the remainder of 2009, the dollar amount of our quarterly
selling, marketing and product support expense will remain at levels similar to
or below those of the 2009 first half level.

General and
administrative expense decreased to $803,000, or 12.8% of total revenue, in the
three months ended June 30, 2009, from $1.0 million, or 15.1% of total revenue,
in the same period in 2008, and to $1.8 million, or 16.1% of total revenue, in
the first half of 2009, from $1.9 million, or 15.1% of total revenue, in the
same period in 2008. The 2009 decrease in costs resulted mainly from lower
incentive pay expense which was partially offset by increased professional
services expenses. We anticipate that for the remainder of 2009, the dollar amount
of our quarterly general and administrative expense will remain at levels
similar to that of the second quarter of 2009.

Research and
development expense increased to $862,000, or 13.7% of total revenue, in the
first quarter of 2009, up from $765,000, or 11.3% of total revenue, in the same
period in 2008, and to $1.7 million, or 15.1% of total revenue, in the first
half of 2009, up from $1.5 million, or 11.6% of total revenue, in the same
period in 2008. The increase was directly related to our investment in
video/radar hybrid solutions and tailored international offerings, development
projects to reduce manufacturing costs, and the realization of the impact of
headcount additions made late in 2008. We anticipate that for the remainder of
2009, the dollar amount of our quarterly research and development expense will
remain at levels similar to that of the second quarter of 2009.

Amortization
of intangibles expense was $192,000 in the second quarter of 2009 and $384,000
in the first half of 2009, the same as in these periods in 2008, and reflects
the amortization of intangible assets acquired in the EIS asset purchase.
Assuming there are no changes to our intangible assets, we anticipate
amortization expense will be $768,000 for all of 2009.

Other income
was $9,000 in the first half of 2009 as compared to other income of $64,000 in
the same period in 2008. In 2009, interest on bank debt offset most interest
income as we moved into securities that had lower yields than in 2008.

Income tax
expense was $442,000, or 27.4% of pretax income, in the second quarter of 2009,
compared to $512,000, or 29.6% of pretax income, in the comparable quarter of
2008, and was $584,000, or 29.0% of pretax income, in the first half of 2009,
compared to $1.1 million, or 31.7% of pretax income, in the comparable period
of 2008. We anticipate an effective tax rate of approximately 30% for all of
2009.

Liquidity and Capital
Resources

At June 30, 2009, we had $7.6
million in cash and cash equivalents and $4.0 million in short-term investments,
compared to $10.3 million in cash and cash equivalents and $4.0 million in
short-term investments at December 31, 2008. Our investments held at December
31, 2008 were auction rate securities that were redeemed at par in January
2009.

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Net cash
provided by operating activities was $2.5 million in the first six months of
2009, compared to $2.2 million in 2008. The increase in 2009 was mainly a
result of decreased receivable balances as opposed to an increase in 2008,
which more than offset lower net income. We anticipate that average receivable
collection days in 2009 will increase over 2008 but that the increase will not
have a material impact on our liquidity. Our planned additions of property and
equipment are discretionary, and we do not expect them to exceed historical
levels in 2009. In addition to equipment purchases, in 2009 we paid our 2008
earn-out liability of $1.2 million to the sellers of the EIS assets. We also
retired our bank debt in full in February 2009, paying a total of $3.75 million
during the quarter ended March 31, 2009.

We have a
revolving line of credit agreement with our bank, Associated Bank. The
revolving line of credit provides for up to $5.0 million at an annual
interest rate equal to the greater of 4.5% or LIBOR plus 2.75%, as reset from
time to time by the bank. Advances on the line of credit cannot exceed a
borrowing base determined under a formula, which is a percentage of the amounts
of receivables. The line of credit currently has no borrowings outstanding and
matures on May 1, 2011. We believe, on an ongoing basis, we have regular
availability to draw a minimum of $3.0 million on our line of credit based on
qualifying assets.

In conjunction
with our EIS asset purchase, the sellers have an earn-out arrangement over
approximately three years from the December 2007 date of purchase. The earn-out
is based on earnings from RTMS sales less related cost of revenue and operating
expenses, depreciation and amortization, and it is calculated annually. If the
earnings are at target levels, the sellers would receive $2.0 million annually,
or $6.0 million in total. Superior performance of the assets could lead to an
earn-out in excess of $2 million, as the earn-out is not capped. Earn-out
payments generally are due within three months of the end of an earn-out
period. The first earn-out period ran from December 6, 2007 to December 31,
2008. Based on the results for RTMS for the first earn-out period, which ended
December 31, 2008, the sellers of the EIS assets were entitled to receive a
$1.2 million earn-out payment, which was paid in March and April 2009. If we
are acquired or sell substantially all of our assets before December 6, 2010,
we must pay EIS $6.0 million less earn-out amounts previously paid as an
acceleration of potential earn-out payments under the EIS asset purchase
agreement.

EIS was named
in a U.S. lawsuit in 2006 for infringement of a patent. On October 31, 2007,
the court entered judgment that EIS had not infringed on the patent. The
plaintiff has appealed the decision, and EIS has continued its defense as
provided in the EIS asset purchase agreement. In addition, EIS must indemnify
us for all expenses, claims or judgments related to this lawsuit up to the
amount of the purchase price, including any earn-out payments. Management
believes that the ultimate outcome of this legal action will not have a
material adverse effect on our financial statements or liquidity.

We believe
that cash and cash equivalents on hand at June 30, 2009, along with the
availability of funds under our $5.0 million revolving line of credit and cash
provided by operating activities, will satisfy our projected working capital
needs, payments under the EIS earn-out, investing activities, and other cash
requirements for the foreseeable future.

Off-Balance Sheet
Arrangements

We do not
participate in transactions or have relationships or other arrangements with an
unconsolidated entity, including special purpose and similar entities or other
off-balance sheet arrangements.

Critical Accounting
Policies

Our
significant accounting policies are described in Note 1 to the Consolidated
Financial Statements in our Annual Report on Form 10-K for the year ended
December 31, 2008. The accounting policies used in preparing our interim 2009
Condensed Consolidated Financial Statements set forth elsewhere in this
Quarterly Report on Form 10-Q are the same as those described in our Annual
Report on Form 10-K.

New and Recently
Adopted Accounting Pronouncements

In December
2007, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standard (SFAS) No. 141 (Revised 2007), Business Combinations. SFAS
No. 141(R) will significantly change the accounting for business
combinations. Under SFAS No. 141(R), an acquiring entity will be required
to recognize all the assets acquired and liabilities assumed in a transaction
at the acquisition-date fair value with limited exceptions. SFAS
No. 141(R) will change the accounting treatment for certain specific
items. SFAS No. 141(R) also includes a substantial number of new
disclosure requirements. SFAS No. 141(R) applies to us prospectively for
business combinations beginning in 2009, and its adoption did not have a
material impact on our financial statements.

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Table of Contents

In December
2007, the FASB issued SFAS No. 160, Noncontrolling
Interests in Consolidated Financial Statements  An Amendment of ARB No. 51.
SFAS No. 160 establishes new accounting and reporting standards for the
noncontrolling interest in a subsidiary and for the deconsolidation of a
subsidiary. SFAS No. 160 also includes expanded disclosure requirements
regarding the interests of the parent and its noncontrolling interest. SFAS
No. 160 is effective for fiscal years, and interim periods within those
fiscal years, beginning on or after December 15, 2008. The adoption of SFAS
No. 160 did not have a material impact on our financial statements.

In May 2008,
the FASB issued SFAS No. 162, The
Hierarchy of Generally Accepted Accounting Principles. SFAS
No. 162 identifies the sources of accounting principles and the framework
for selecting the principles to be used in the preparation of financial
statements of nongovernmental entities that are presented in conformity with
generally accepted accounting principles. SFAS No. 162 is effective 60
days following the approval by the Securities and Exchange Commission of the
Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With
Generally Accepted Accounting Principles. We do not anticipate that
the adoption of SFAS No. 162 will materially impact the Company.

In
May 2009, the FASB issued SFAS No. 165, Subsequent Events, to incorporate the
accounting and disclosure requirements for subsequent events into U.S.
generally accepted accounting principles (GAAP). SFAS No. 165 introduces new
terminology, defines a date through which
management must evaluate subsequent events, and lists the circumstances under
which an entity must recognize and disclose events or transactions occurring
after the balance sheet date. It is effective prospectively for interim or annual
reporting periods ending after June 15, 2009. We adopted SFAS No. 165 as of the required effective date
and have applied its provisions. We do not believe the adoption of SFAS No. 165
will have a material effect on our consolidated financial
statements.

In June 2009, the FASB issued SFAS
No. 168, The FASB Accounting Standards
Codification and the Hierarchy of Generally Accepted Accounting Principles  a
replacement of FASB Statement 162. The FASB Accounting Standards Codification (Codification)
will become the source of authoritative U.S. generally accepted accounting
principles (GAAP) recognized by the FASB to be applied by nongovernmental
entities. Rules and
interpretive releases of the Securities and Exchange Commission (SEC) under
authority of federal securities laws are also sources of authoritative GAAP for
SEC registrants. On
the effective date of SFAS No. 168, the Codification will supersede all
then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC
accounting literature not included in the Codification will become
nonauthoritative. After the effective date of SFAS No. 168, the Board will not issue new standards in the form of
Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts.
Instead, it will issue Accounting
Standards Updates, which will not be authoritative in their own right, but will
serve only to update the Codification. SFAS No. 168 is effective for
financial statements issued for interim and annual periods ending after
September 15, 2009. We
will adopt SFAS No. 168
as of the required effective date,
September 15, 2009, and we will apply its provisions prospectively.
We do not believe the adoption of SFAS
No. 168 will have a material effect
on our consolidated financial statements.

Cautionary Statement:

This Quarterly
Report on Form 10-Q contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of
the Securities Exchange of 1934, as amended. Forward-looking statements
represent our expectations or beliefs concerning future events and can be
identified by the use of forward-looking words such as expects, believes,
may, will, should, intends, plans, estimates, or
anticipates or
other comparable terminology. Forward-looking statements are subject to risks
and uncertainties that may cause our actual results to differ materially from
the results described in the forward-looking statements. Factors that might
cause such differences include, but are not limited to:

| |   |                                                                    
| | - | -------------------------------------------------------------------
| |  | historical
 dependence on a single product for most of our revenue;

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Table of Contents

| |   |                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | budget
 constraints by governmental entities that purchase our products, including
 constraints caused by declining tax revenue;                                                         
| |   |                                                                                                                                                                                          
| |  | continuing
 ability of our licensee to pay royalties owed;                                                                                                                               
| |   |                                                                                                                                                                                          
| |  | dependence
 on third parties for manufacturing and marketing our products;                                                                                                               
| |   |                                                                                                                                                                                          
| |  | dependence
 on single-source suppliers to meet manufacturing needs;                                                                                                                      
| |   |                                                                                                                                                                                          
| |  | failure to
 secure adequate protection for our intellectual property rights;                                                                                                             
| |   |                                                                                                                                                                                          
| |  | development
 of a competing product by another business using the underlying technology
 included in the patent we had licensed from the University of Minnesota, which
 expired in 2006;
| |   |                                                                                                                                                                                          
| |  | our
 inability to develop new applications and product enhancements;                                                                                                                     
| |   |                                                                                                                                                                                          
| |  | our
 inability to respond to low-cost local competitors in Asia and elsewhere;                                                                                                           
| |   |                                                                                                                                                                                          
| |  | our
 inability to properly manage any growth in revenue and/or production
 requirements;                                                                                                 
| |   |                                                                                                                                                                                          
| |  | the
 influence over our voting stock by insiders;                                                                                                                                        
| |   |                                                                                                                                                                                          
| |  | our
 inability to hire and retain key scientific and technical personnel;                                                                                                                
| |   |                                                                                                                                                                                          
| |  | our
 inability to achieve and maintain effective internal controls;                                                                                                                      
| |   |                                                                                                                                                                                          
| |  | our
 inability to comply with international regulatory restrictions over hazardous
 substances and electronic waste; and                                                                 
| |   |                                                                                                                                                                                          
| |  | conditions
 beyond our control such as war, terrorist attacks, health epidemics and
 economic recession.                                                                                 

We caution
that the forward-looking statements made in this report or in other
announcements made by us are further qualified by the risk factors set forth in
Item 1A. to our Annual Report on Form 10-K for the fiscal year ended December
31, 2008.

|        |                                                             
|------- | ------------------------------------------------------------
|Item 3. | Quantitative and Qualitative Disclosures About
 Market Risks

Our foreign
sales and results of operations are subject to the impact of foreign currency
fluctuations. We have not historically hedged our exposure to translation gains
and losses. Beginning in 2009, we have entered into a limited number of hedges
that we anticipate will decrease our overall translation exposure. A 10%
adverse change in foreign currency rates would not have a material effect on
our results of operations or financial position.

We entered
into a number of currency hedging arrangements in 2009. The purpose of the
hedging was to lock in what we believe to be favorable rates on certain
currencies and to increase our predictability on certain expenses at our
foreign subsidiaries. All hedging activity is intended to qualify for hedge
accounting under SFAS No. 133, Accounting
for Derivative Instruments and Hedging Activities, as amended. We
believe all contracts will be utilized to provide funds to cover operating
expenses.

|         |                        
|-------- | -----------------------
|Item 4T. | Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we evaluated the effectiveness
of the design and operation of our disclosure controls and procedures (as
defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the
Exchange Act)). Based upon that evaluation, our Chief Executive Officer and
Chief Financial Officer concluded that, as of the end of the period covered by
this report, our disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

During the
fiscal quarter covered by this report, there was no change in our internal
control over financial reporting (as defined in Rule 13a-15(f) under the
Exchange Act) that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.

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Table of Contents

PART II. OTHER
INFORMATION

|        |                  
|------- | -----------------
|Item 1. | Legal Proceedings

None.

|         |             
|-------- | ------------
|Item 1A. | Risk Factors

Some of the
risk factors to which we and our business are subject are described in the
section entitled Item 1A. Risk Factors in our Annual Report on Form 10-K for
the year ended December 31, 2008. The risks and uncertainties described in our
Annual Report are not the only risks we face. Additional risks and
uncertainties not presently known to us or that our management currently deems
immaterial also may impair our business operations. If any of the risks
described were to occur, our business, financial condition, operating results
and cash flows could be materially adversely affected.

|        |                                                             
|------- | ------------------------------------------------------------
|Item 2. | Unregistered Sales of Equity Securities and Use of
 Proceeds

None.

|        |                                
|------- | -------------------------------
|Item 3. | Defaults Upon Senior Securities

None.

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

We held our
Annual Meeting of Shareholders on May 20, 2009 in St. Paul, Minnesota. In
connection with the Annual Meeting, we filed our definitive proxy statement
with the Securities and Exchange Commission pursuant to Regulation 14A under the
Exchange Act and solicited proxies. The only matters voted on at the Annual
Meeting were the election of directors, approval of a stock option exchange
program and the approval of Grant Thornton LLP as our independent registered
public accounting firm for 2009. The votes on these matters were as follows:

|   |                       
|-- | ----------------------
|1. | Election of directors:

| |                         |  |           |  |                    | 
| | ----------------------- |  | --------- |  | ------------------ | 
| | Director                |  | For       |  | Withhold Authority
| |                         |  |           |  |                   
| | Kenneth R.
 Aubrey      |  | 3,537,892 |  | 227,934            | 
| | James W.
 Bracke        |  | 3,674,404 |  | 91,422             | 
| | Michael G.
 Eleftheriou |  | 3,669,876 |  | 95,950             | 
| | Panos G.
 Michalopoulos |  | 3,499,744 |  | 266,082            | 
| | James
 Murdakes         |  | 3,590,562 |  | 175,264            | 
| | Sven A.
 Wehrwein       |  | 3,611,479 |  | 154,347            | 

|   |                                              
|-- | ---------------------------------------------
|2. | Approval of
 a stock option exchange program:

|          |  |         |  |         |  |                  
|--------- |  | ------- |  | ------- |  | -----------------
|For       |  | Against |  | Abstain |  | Broker
 Non-votes
|          |  |         |  |         |  |                  
|2,026,157 |  | 574,540 |  | 17,831  |  | 1,147,298        

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|   |                                                                                                            
|-- | -----------------------------------------------------------------------------------------------------------
|3. | Approval of
 Grant Thornton LLP as our independent registered public accounting firm for
 fiscal year 2009:

|          |  |         |  |        
|--------- |  | ------- |  | -------
|For       |  | Against |  | Abstain
|          |  |         |  |        
|3,698,938 |  | 11,300  |  | 55,588 

|        |                  
|------- | -----------------
|Item 5. | Other Information

None.

|        |         
|------- | --------
|Item 6. | Exhibits

The following
exhibits are filed as part of this quarterly report on Form 10-Q for the
quarterly period ended June 30, 2009:

|                |  |                                                                                                                                    
|--------------- |  | -----------------------------------------------------------------------------------------------------------------------------------
|Exhibit
 Number |  | Description                                                                                                                        
|                |  |                                                                                                                                    
|31.1            |  | Certification
 of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
 of 2002.                              
|                |  |                                                                                                                                    
|31.2            |  | Certification
 of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
 of 2002.                              
|                |  |                                                                                                                                    
|32.1            |  | Certification
 of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
 of 2002.                              
|                |  |                                                                                                                                    
|32.2            |  | Certification
 of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
 of 2002.                              
|                |  |                                                                                                                                    
|99.1            |  | Amendment X
 to Office Lease Agreement dated May 12, 2009 by and between Image Sensing
 Systems, Inc. and Spruce Tree Centre L.L.P.

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Table of Contents

SIGNATURES

In accordance
with the requirements of the Securities Exchange Act of 1934, the registrant
has duly caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.

|                        |                              |                                              
|----------------------- | ---------------------------- | ---------------------------------------------
|                        | Image
 Sensing Systems, Inc.
|                        |                              |                                              
|Dated:
 August 13, 2009 | By:                          | /s/ Kenneth
 R. Aubrey                       
|                        |                              | Kenneth R.
 Aubrey                           
|                        |                              | President
 and Chief Executive Officer       
|                        |                              | (principal
 executive officer)               
|                        |                              |                                              
|Dated:
 August 13, 2009 | By:                          | /s/ Gregory
 R. L. Smith                     
|                        |                              | Gregory R.
 L. Smith                         
|                        |                              | Chief
 Financial Officer                     
|                        |                              | (principal financial
 and accounting officer)

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Table of Contents

EXHIBIT INDEX

|            |  |                                                                                                                                    
|----------- |  | -----------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                        
|            |  |                                                                                                                                    
|31.1        |  | Certification
 of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
 of 2002.                              
|            |  |                                                                                                                                    
|31.2        |  | Certification
 of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act
 of 2002.                              
|            |  |                                                                                                                                    
|32.1        |  | Certification
 of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
 of 2002.                              
|            |  |                                                                                                                                    
|32.2        |  | Certification
 of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act
 of 2002.                              
|            |  |                                                                                                                                    
|99.1        |  | Amendment X
 to Office Lease Agreement dated May 12, 2009 by and between Image Sensing
 Systems, Inc. and Spruce Tree Centre L.L.P.

- 19 -

---