Table of Contents





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



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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 September 30, 2008                                        
|  |                                                                                          
|  | 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



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|                                                                                    |  |                     
|----------------------------------------------------------------------------------- |  | --------------------
|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 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 (Do not check if a smaller reporting
 company) |  | Smaller reporting company x

Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).Yes 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 November 4, 2008
|                                         |  |                                
|Common
 Stock, $0.01 par value per share |  | 3,957,019
 shares              





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IMAGE SENSING SYSTEMS, INC.

TABLE OF CONTENTS

|                               |          |                                                                                        |          
|------------------------------ | -------- | -------------------------------------------------------------------------------------- | ---------
|                               |          |                                                                                        | Page
 No.
|                               |          |                                                                                        |          
|                               |         
|PART I.
 FINANCIAL INFORMATION | 2       
|                               |         
|                               | Item 1.  | Financial
 Statements, Unaudited                                                       | 2        
|                               |          |                                                                                        |          
|                               | Item 2.  | Managements
 Discussion and Analysis of Financial Condition and Results of Operations | 9        
|                               |          |                                                                                        |          
|                               | Item 3.  | Quantitative
 and Qualitative Disclosures About Market Risk                            | 15       
|                               |          |                                                                                        |          
|                               | Item 4.  | Controls
 and Procedures                                                               | 16       
|                               |          |                                                                                        |          
|PART II.
 OTHER INFORMATION    | 17      
|                               |         
|                               | Item 1.  | Legal
 Proceedings                                                                     | 17       
|                               |         
|                               | Item 1A. | Risk Factors                                                                           | 17       
|                               |          |                                                                                        |          
|                               | Item 2.  | Unregistered
 Sales of Equity Securities and Use of Proceeds                           | 18       
|                               |          |                                                                                        |          
|                               | Item 3.  | Defaults
 Upon Senior Securities                                                       | 18       
|                               |          |                                                                                        |          
|                               | Item 4.  | Submission
 of Matters to a Vote of Security Holders                                   | 18       
|                               |          |                                                                                        |          
|                               | Item 5.  | Other
 Information                                                                     | 19       
|                               |          |                                                                                        |          
|                               | Item 6.  | Exhibits                                                                               | 19       
|                               |          |                                                                                        |          
|SIGNATURES                     | 20      
|                               |          |                                                                                        |          
|EXHIBIT
 INDEX                 | 21      

1

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Table of Contents

PART I. FINANCIAL INFORMATION

|        |                                
|------- | -------------------------------
|Item 1. | Financial Statements, Unaudited

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

|                                            |  |                     |        |                    |   |        | 
|------------------------------------------- |  | ------------------- | ------ | ------------------ | - | ------ | 
|                                            |  | September 30,
 2008 |        | December 31,
 2007 |  
|                                            |  |                     |        |                    |  
|                                            |  | (Unaudited)         |        | (Note)             |  
|                                            |  |                     |        |                    |   |        | 
|Assets                                      |  |                     |        |                    |   |        | 
|Current assets:                             |  |                     |        |                    |   |        | 
|Cash and cash equivalents                   |  | $                   | 7,673  |                    | $ | 5,613  | 
|Restricted cash                             |  |                     |       |                    |   | 5,263  | 
|Accounts receivable, net                    |  |                     | 5,945  |                    |   | 4,997  | 
|Inventories                                 |  |                     | 2,090  |                    |   | 1,579  | 
|Prepaid expenses                            |  |                     | 215    |                    |   | 228    | 
|Deferred income taxes                       |  |                     | 142    |                    |   | 142    | 
|                                            |  |                     |        |                    |   |        | 
|Total current assets                        |  |                     | 16,065 |                    |   | 17,822 | 
|                                            |  |                     |        |                    |   |        | 
|Property and equipment,
 net                |  |                     | 652    |                    |   | 700    | 
|                                            |  |                     |        |                    |   |        | 
|Restricted investments,
 net                |  |                     | 4,951  |                    |   |       | 
|Deferred income taxes                       |  |                     | 1,893  |                    |   | 1,676  | 
|Goodwill and intangible
 assets             |  |                     | 9,564  |                    |   | 10,140 | 
|                                            |  |                     |        |                    |   |        | 
|Total assets                                |  | $                   | 33,125 |                    | $ | 30,338 | 
|                                            |  |                     |        |                    |   |        | 
|                                            |  |                     |        |                    |   |        | 
|Liabilities
 and Shareholders Equity       |  |                     |        |                    |   |        | 
|Current liabilities:                        |  |                     |        |                    |   |        | 
|Accounts payable                            |  | $                   | 362    |                    | $ | 816    | 
|Bank debt, current portion                  |  |                     | 1,000  |                    |   | 5,000  | 
|Accrued compensation                        |  |                     | 867    |                    |   | 703    | 
|Accrued warranty and other                  |  |                     | 699    |                    |   | 510    | 
|Income taxes payable                        |  |                     | 313    |                    |   |       | 
|                                            |  |                     |        |                    |   |        | 
|Total current liabilities                   |  |                     | 3,241  |                    |   | 7,029  | 
|                                            |  |                     |        |                    |   |        | 
|Bank debt                                   |  |                     | 3,000  |                    |   |       | 
|Income taxes payable                        |  |                     | 150    |                    |   | 84     | 
|                                            |  |                     |        |                    |   |        | 
|Shareholders equity:                       |  |                     |        |                    |   |        | 
|Common stock                                |  |                     | 40     |                    |   | 39     | 
|Additional paid-in capital                  |  |                     | 11,358 |                    |   | 11,004 | 
|Accumulated other comprehensive income      |  |                     | (118   | )                  |   | 161    | 
|Retained earnings                           |  |                     | 15,454 |                    |   | 12,021 | 
|                                            |  |                     |        |                    |   |        | 
|Total shareholders equity                  |  |                     | 26,734 |                    |   | 23,225 | 
|                                            |  |                     |        |                    |   |        | 
|Total liabilities and
 shareholders equity |  | $                   | 33,125 |                    | $ | 30,338 | 
|                                            |  |                     |        |                    |   |        | 

Note: The balance sheet at
December 31, 2007 has been derived from the audited financial statements at
that date but does not include all of the information and footnotes required by
accounting principles generally accepted in the United States of America for
complete financial statements.

See accompanying notes to
condensed consolidated financial statements.

2

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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 
 September 30, |       | Nine-Month Periods Ended 
 September 30, |  
|                                                       |  |                                           |       |                                          |  
|                                                       |  | 2008                                      |       | 2007                                     |   | 2008  |  | 2007 |       
|                                                       |  |                                           |       |                                          |   |       |  |      |       
|Revenue:                                               |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|International sales                                    |  | $                                         | 1,420 |                                          | $ | 1,143 |  | $    | 4,221  |  | $ | 2,232 | 
|North American sales                                   |  |                                           | 920   |                                          |   |      |  |      | 4,468  |  |   |      | 
|Royalties                                              |  |                                           | 3,742 |                                          |   | 3,041 |  |      | 10,007 |  |   | 7,636 | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|                                                       |  |                                           | 6,082 |                                          |   | 4,184 |  |      | 18,696 |  |   | 9,868 | 
|Costs of
 revenue:                                     |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|International sales                                    |  |                                           | 397   |                                          |   | 536   |  |      | 1,638  |  |   | 951   | 
|North American sales                                   |  |                                           | 463   |                                          |   |      |  |      | 1,830  |  |   |      | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|                                                       |  |                                           | 860   |                                          |   | 536   |  |      | 3,468  |  |   | 951   | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Gross profit                                           |  |                                           | 5,222 |                                          |   | 3,648 |  |      | 15,228 |  |   | 8,917 | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Operating
 expenses:                                   |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Selling, marketing and product support                 |  |                                           | 1,695 |                                          |   | 749   |  |      | 4,688  |  |   | 2,310 | 
|General and administrative                             |  |                                           | 980   |                                          |   | 710   |  |      | 2,883  |  |   | 1,832 | 
|Research and development                               |  |                                           | 701   |                                          |   | 553   |  |      | 2,167  |  |   | 1,681 | 
|Amortization of intangible assets                      |  |                                           | 192   |                                          |   |      |  |      | 576    |  |   |      | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|                                                       |  |                                           | 3,568 |                                          |   | 2,012 |  |      | 10,314 |  |   | 5,823 | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Income from operations                                 |  |                                           | 1,654 |                                          |   | 1,636 |  |      | 4,914  |  |   | 3,094 | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Other income (expense),
 net                           |  |                                           | (6    | )                                        |   | 149   |  |      | 58     |  |   | 429   | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Income before income taxes                             |  |                                           | 1,648 |                                          |   | 1,785 |  |      | 4,972  |  |   | 3,523 | 
|Income taxes                                           |  |                                           | 486   |                                          |   | 488   |  |      | 1,539  |  |   | 968   | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Net income                                             |  | $                                         | 1,162 |                                          | $ | 1,297 |  | $    | 3,433  |  | $ | 2,555 | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Net income per common
 share:                          |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Basic                                                  |  | $                                         | 0.29  |                                          | $ | 0.35  |  | $    | 0.87   |  | $ | 0.68  | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Diluted                                                |  | $                                         | 0.29  |                                          | $ | 0.34  |  | $    | 0.86   |  | $ | 0.66  | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Weighted average number of
 common shares outstanding: |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Basic                                                  |  |                                           | 3,942 |                                          |   | 3,780 |  |      | 3,933  |  |   | 3,777 | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 
|Diluted                                                |  |                                           | 4,005 |                                          |   | 3,866 |  |      | 4,010  |  |   | 3,876 | 
|                                                       |  |                                           |       |                                          |   |       |  |      |        |  |   |       | 

See accompanying notes to
condensed consolidated financial statements.

3

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Table of Contents

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

|                                                                                  |  |                                          |        |      |   |        |  
|--------------------------------------------------------------------------------- |  | ---------------------------------------- | ------ | ---- | - | ------ | -
|                                                                                  |  | Nine-Month Periods Ended 
 September 30, |       
|                                                                                  |  |                                          |       
|                                                                                  |  | 2008                                     |        | 2007 |  
|                                                                                  |  |                                          |        |      |  
|Operating activities:                                                             |  |                                          |        |      |   |        |  
|Net income                                                                        |  | $                                        | 3,433  |      | $ | 2,555  |  
|Adjustments to reconcile net income to net cash
provided by operating
 activities |  |                                          |        |      |   |        |  
|Depreciation and amortization                                                     |  |                                          | 863    |      |   | 197    |  
|Stock option expense                                                              |  |                                          | 246    |      |   | 132    |  
|Change in operating assets and liabilities                                        |  |                                          | (1,215 | )    |   | (2,234 | )
|                                                                                  |  |                                          |        |      |   |        |  
|Net cash provided by operating activities                                         |  |                                          | 3,327  |      |   | 650    |  
|                                                                                  |  |                                          |        |      |   |        |  
|Investing
 activities:                                                            |  |                                          |        |      |   |        |  
|Net purchases of property and equipment                                           |  |                                          | (239   | )    |   | (71    | )
|Net (purchases) sales of investments                                              |  |                                          | (5,400 | )    |   | 2,100  |  
|                                                                                  |  |                                          |        |      |   |        |  
|Net cash provided by (used in) investing
activities                               |  |                                          | (5,639 | )    |   | 2,029  |  
|                                                                                  |  |                                          |        |      |   |        |  
|Financing
 activities:                                                            |  |                                          |        |      |   |        |  
|Proceeds from exercise of stock options                                           |  |                                          | 109    |      |   | 35     |  
|Repayment of bank debt                                                            |  |                                          | (1,000 | )    |   |       |  
|Cash released from restriction                                                    |  |                                          | 5,263  |      |   |       |  
|                                                                                  |  |                                          |        |      |   |        |  
|Net cash provided by financing activities                                         |  |                                          | 4,372  |      |   | 35     |  
|                                                                                  |  |                                          |        |      |   |        |  
|                                                                                  |  |                                          |        |      |   |        |  
|Increase in cash and cash
 equivalents                                            |  |                                          | 2,060  |      |   | 2,714  |  
|                                                                                  |  |                                          |        |      |   |        |  
|Cash and cash equivalents,
 beginning of period                                   |  |                                          | 5,613  |      |   | 11,626 |  
|                                                                                  |  |                                          |        |      |   |        |  
|Cash and cash equivalents,
 end of period                                         |  | $                                        | 7,673  |      | $ | 14,340 |  
|                                                                                  |  |                                          |        |      |   |        |  

See accompanying notes to condensed consolidated financial
statements.

4

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Table of Contents

IMAGE SENSING SYSTEMS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS
(Unaudited)
September 30, 2008

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 nine-month periods
ended September 30, 2008 are not necessarily indicative of the results
that may be expected for the year ending December 31, 2008. 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, 2007.

Note B: Investments

Investments
and marketable securities 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. Available-for-sale securities are carried at fair value,
with unrealized gains and losses reported in Accumulated other comprehensive
income, a component of shareholders equity.

At September
30, 2008, we held $5.4 million (par value) of investments comprised of auction
rate securities, or ARS, with maturity dates ranging from 2031 to 2047, which
were purchased from UBS ($4.0 million) and Credit Suisse ($1.4 million). All
our ARS held are AAA/Aaa rated, with substantially all collateralized by
student loans guaranteed by the U.S. government under the Federal Family
Education Loan Program. Until February 2008, the auction rate securities market
was highly liquid. Since mid-February 2008, a substantial number of auctions
have failed. The immediate effect of a failed auction is that holders cannot
sell the securities at auction. In the case of a failed auction, with respect
to the ARS held by us, the ARS are deemed not currently liquid. In the case of
funds invested by us in ARS which are the subject of a failed auction, we may
not be able to access the funds in the near term without a loss of principal
unless a future auction on these investments is successful or the issuer calls
the security pursuant to a mandatory tender or redemption prior to maturity.

In the third
quarter of 2008, both UBS and Credit Suisse announced settlement offers with
governmental authorities in which the banks agreed to repurchase the ARS from
their clients at par. Based on the information made available from the banks,
we believe that the repurchases of our ARS will be completed by the end of
January 2009. While we believe that the repurchases are highly probable to
occur, we have determined the proper accounting for these investments is to
continue to consider them long-term and record unrealized gains and losses
based on their fair value until such repurchases are completed.

At September
30, 2008, there was insufficient observable ARS market information available to
determine the fair value of our investments. Therefore, we estimated fair value
by using broker quotes. Based on this analysis, we recorded an unrealized loss
of $449,000 in other comprehensive income ($297,000 net of tax) related to our
ARS investments. The ARS investments are pledged as collateral for our bank
debt.

Credit Suisse
purchased the $1.4 million of ARS held in our account at par in November 2008.

Note C: Acquisition

On December 6,
2007, we purchased certain assets of EIS Electronic Integrated Systems, Inc.
(EIS), including its RTMS radar product line. The purchase price was $10.9
million in cash plus 147,202 shares of our common stock valued at approximately
$2.5 million. We borrowed $5.0 million from a bank to partially finance the
purchase. In addition to the purchase price, we incurred $506,000 in direct
acquisition costs. As part of the purchase agreement, the sellers are eligible
to receive an earn-out based on the performance of the assets for the next
three years. 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. Following the purchase, the former
operations of EIS were split into two subsidiaries: ISS Image Sensing Systems
Canada Ltd. (ISS/Canada) and ISS Canada Sales Corp. (Canada Sales Corp.).

5

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Table of Contents

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 any of our 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.

The results of
operations of ISS/Canada and Canada Sales Corp. are included in the
accompanying financial statements since the date of the EIS asset purchase. The
following pro forma summary presents the results of operations as if the EIS
asset purchase had occurred on January 1, 2007. The pro forma results are not
necessarily indicative of the results that would have been achieved had the EIS
asset purchase taken place on that date (in thousands, except per share
amounts):

|                      |  |                                           |       |                                          |   |        | 
|--------------------- |  | ----------------------------------------- | ----- | ---------------------------------------- | - | ------ | 
|                      |  | Three-monthperiod endedSeptember 30, 2007 |       | Nine-monthperiod endedSeptember 30, 2007 |  
|                      |  |                                           |       |                                          |  
|Total revenue         |  | $                                         | 6,550 |                                          | $ | 16,034 | 
|Net income            |  |                                           | 1,302 |                                          |   | 2,321  | 
|                      |  |                                           |       |                                          |   |        | 
|Net income per share: |  |                                           |       |                                          |   |        | 
|Basic                 |  | $                                         | 0.33  |                                          | $ | 0.59   | 
|Diluted               |  | $                                         | 0.32  |                                          | $ | 0.58   | 

Note D: Goodwill and Intangible Assets

Goodwill
consists of $1.1 million related to our acquisition of Flow Traffic Ltd. and
$3.8 million recorded in 2007 for the EIS asset purchase.

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

|                                           |  |                    |       |                   |   |       |  
|------------------------------------------ |  | ------------------ | ----- | ----------------- | - | ----- | -
|                                           |  | September 30, 2008 |       | December 31, 2007 |  
|                                           |  |                    |       |                   |  
|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             |  |                    | (627  | )                 |   | (51   | )
|                                           |  |                    |       |                   |   |       |  
|Total identifiable
 intangible assets, net |  | $                  | 4,673 |                   | $ | 5,249 |  
|                                           |  |                    |       |                   |   |       |  

We expect to
recognize amortization expense for the intangible assets in the above table of
$768,000 in each of the 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.

Note E: Net Income Per Common Share

The following
table sets forth the computations of basic and diluted net income per common
share for the three-month and nine-month periods ended September 30, 2008 and
2007 (in thousands, except per share data ):

|                                                                |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|--------------------------------------------------------------- |  | --------------------------------------- | ----- | ------------------------------------- | - | ----- |  | ---- | ----- |  | - | ----- | 
|                                                                |  | Three-Month
 Periods EndedSeptember 30, |       | Nine-Month Periods EndedSeptember 30, |  
|                                                                |  |                                         |       |                                       |  
|                                                                |  | 2008                                    |       | 2007                                  |   | 2008  |  | 2007 |      
|                                                                |  |                                         |       |                                       |   |       |  |      |      
|Numerator:                                                      |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|Net income                                                      |  | $                                       | 1,162 |                                       | $ | 1,297 |  | $    | 3,433 |  | $ | 2,555 | 
|                                                                |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|Denominator:                                                    |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|Shares used in basic net income per common share
calculation    |  |                                         | 3,942 |                                       |   | 3,780 |  |      | 3,933 |  |   | 3,777 | 
|Effect of diluted securities:                                   |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|Employee and director stock options                             |  |                                         | 63    |                                       |   | 86    |  |      | 77    |  |   | 99    | 
|                                                                |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|Shares used in diluted net income per common share
calculations |  |                                         | 4,005 |                                       |   | 3,866 |  |      | 4,010 |  |   | 3,876 | 
|                                                                |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|Basic net income per
 common share                              |  | $                                       | 0.29  |                                       | $ | 0.35  |  | $    | 0.87  |  | $ | 0.68  | 
|                                                                |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 
|Diluted net income per
 common share                            |  | $                                       | 0.29  |                                       | $ | 0.34  |  | $    | 0.86  |  | $ | 0.66  | 
|                                                                |  |                                         |       |                                       |   |       |  |      |       |  |   |       | 

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Comprehensive
income was $1.0 million and $1.3 million in the three-month periods ended
September 30, 2008 and 2007, respectively, and was $3.1 million and $2.6
million in the nine-month periods ended September 30, 2008 and 2007, respectively.

Note F: Stock-Based Compensation

We recorded
$246,000 and $132,000 of stock-based compensation in general and administrative
expense for the nine-month periods ended September 30, 2008 and 2007,
respectively. Options to purchase 31,500 shares and -0- shares, at a weighted
average exercise price of $14.37 and $-0-, and options to purchase 62,500
shares and 106,000 shares, at a weighted average exercise price of $15.10 and
$14.68, were granted for the three-month and nine-month periods ended September
30, 2008 and 2007, respectively. As of September 30, 2008, $868,000 of total
unrecognized compensation expense related to non-vested stock option awards is
expected to be recognized over a weighted average period of 2.7 years.

We used the
Black-Scholes option pricing model to determine the weighted average fair value
of options during the three-month and nine-month periods ended September 30,
2008 and 2007, 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 September 30, 2008, we had
165,500 shares available for grants under the 2005 Stock Incentive Plan.

The following
table summarizes information about the stock options outstanding at September
30, 2008:

|                       |             |                     |                     |                                                |                     |                                   |  |                     |       |                                   |  |         |  |   |       |  | 
|---------------------- | ----------- | ------------------- | ------------------- | ---------------------------------------------- | ------------------- | --------------------------------- |  | ------------------- | ----- | --------------------------------- |  | ------- |  | - | ----- |  | 
|                       |             |                     | Options Outstanding |                                                | Options Exercisable |                                  
|                       |             |                     |                     |                                                |                     |                                  
|Range ofExercise Price |             | Number
 Outstanding |                     | Weighted
 Average
 Remaining
 Contractual Life |                     | Weighted
 Average
 Exercise Price |  | Number
 Exercisable |       | Weighted
 Average
 Exercise Price | 
|                       |             |                     |                     |                                                |                     |                                   |  |                     |       |                                   | 
|$                      | 1.301.99   |                     |                     | 61,300                                         |                     | 3.4
 years                        |  | $                   | 1.34  |                                   |  | 61,300  |  | $ | 1.34  | 
|                       | 2.002.99   |                     |                     | 42,200                                         |                     | 1.5
 years                        |  |                     | 2.38  |                                   |  | 42,200  |  |   | 2.38  | 
|                       | 3.003.99   |                     |                     | 38,933                                         |                     | 4.0
 years                        |  |                     | 3.15  |                                   |  | 38,933  |  |   | 3.15  | 
|                       | 7.007.99   |                     |                     | 6,000                                          |                     | 1.6
 years                        |  |                     | 7.50  |                                   |  | 6,000   |  |   | 7.50  | 
|                       | 12.0012.99 |                     |                     | 62,000                                         |                     | 6.2
 years                        |  |                     | 12.44 |                                   |  | 6,000   |  |   | 12.61 | 
|                       | 14.0014.99 |                     |                     | 105,500                                        |                     | 4.8
 years                        |  |                     | 14.25 |                                   |  | 17,750  |  |   | 14.20 | 
|                       | 15.0015.99 |                     |                     | 39,000                                         |                     | 3.0
 years                        |  |                     | 15.34 |                                   |  | 16,000  |  |   | 15.70 | 
|                       | 16.0016.99 |                     |                     | 15,000                                         |                     | 5.1
 years                        |  |                     | 16.00 |                                   |  | 3,750   |  |   | 16.00 | 
|                       | 17.0017.99 |                     |                     | 32,000                                         |                     | 5.2
 years                        |  |                     | 17.50 |                                   |  |        |  |   |      | 
|                       |             |                     |                     |                                                |                     |                                   |  |                     |       |                                   |  |         |  |   |       | 
|                       |             |                     |                     | 401,933                                        |                     | 4.1
 years                        |  |                     | 10.01 |                                   |  | 191,933 |  |   | 5.15  | 
|                       |             |                     |                     |                                                |                     |                                   |  |                     |       |                                   |  |         |  |   |       | 

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 December 2007 (see Note C), and revenue consists of all North
American sales and a portion of international sales. All segment revenues are
derived from external customers.

The following
tables set forth selected unaudited financial information for each of the
Companys reportable segments (in thousands):

|                                             |  |           |        |      |   |        |   |   |        | 
|-------------------------------------------- |  | --------- | ------ | ---- | - | ------ | - | - | ------ | 
|Three-month period ended September 30, 2008: |  | Autoscope |        | RTMS |   | Total  |  
|                                             |  |           |        |      |   |        |  
|Revenue                                      |  | $         | 4,893  |      | $ | 1,189  |   | $ | 6,082  | 
|Depreciation                                 |  |           | 67     |      |   | 31     |   |   | 98     | 
|Amortization of intangible
 assets           |  |           |       |      |   | 192    |   |   | 192    | 
|Income (loss) before income
 taxes           |  |           | 1,952  |      |   | (304   | ) |   | 1,648  | 
|Capital expenditures                         |  |           | 46     |      |   | 5      |   |   | 51     | 
|Total assets                                 |  |           | 22,664 |      |   | 10,461 |   |   | 33,125 | 

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|                                            |  |           |        |      |   |        |  |   |        | 
|------------------------------------------- |  | --------- | ------ | ---- | - | ------ |  | - | ------ | 
|Nine-month period ended September 30, 2008: |  | Autoscope |        | RTMS |   | Total  | 
|                                            |  |           |        |      |   |        | 
|Revenue                                     |  | $         | 13,293 |      | $ | 5,403  |  | $ | 18,696 | 
|Depreciation                                |  |           | 200    |      |   | 87     |  |   | 287    | 
|Amortization of intangible
 assets          |  |           |       |      |   | 576    |  |   | 576    | 
|Income before income taxes                  |  |           | 4,572  |      |   | 400    |  |   | 4,972  | 
|Capital expenditures                        |  |           | 186    |      |   | 53     |  |   | 239    | 
|Total assets                                |  |           | 22,664 |      |   | 10,461 |  |   | 33,125 | 

Note H: New and Recently Adopted Accounting Pronouncements:

In September
2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157,
Fair
Value Measurements. SFAS No. 157 defines fair value,
establishes a framework for measuring fair value and expands disclosures about
fair value measurement but does not require any new fair value measurements.
SFAS No. 157 is effective for financial statements issued for fiscal years
beginning after November 15, 2007 and interim periods within those fiscal
years. However, on February 12, 2008, the FASB issued proposed FASB Staff
Position (FSP) FAS 157-2 which delayed the effective date of SFAS No. 157
for all nonfinancial assets and nonfinancial liabilities, except those that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually). This FSP partially defers the effective date of SFAS
No. 157 to fiscal years beginning after November 15, 2008, and interim
periods within those fiscal years for items within the scope of this FSP.
Effective for 2008, we have adopted SFAS No. 157 except as it applies to
those nonfinancial assets and nonfinancial liabilities as noted in proposed FSP
FAS 157-2. The partial adoption of SFAS No. 157 impacted our disclosures
surrounding our restricted long-term investments.

On February
15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities  Including an Amendment of FASB Statement
No. 115. This standard permits an entity to choose to measure
many financial instruments and certain other items at fair value. The fair
value option established by SFAS No. 159 permits all entities to choose to
measure eligible items at fair value at specified election dates. SFAS
No. 159 is effective for the Company as of January 1, 2008. The impact of
adopting this pronouncement had no effect on our consolidated financial
statements because we did not elect the fair value option for any financial
assets or liabilities.

In December
2007, the 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 prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15, 2008. Earlier
adoption is prohibited. SFAS No. 141(R) will impact us if we complete an
acquisition after the effective date.

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 with those fiscal years,
beginning on or after December 15, 2008. Earlier adoption is prohibited. We are
currently assessing the potential impact that the adoption of SFAS No. 160
will have on our financial statements.

In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities  an amendment of FASB Statement
No. 133. SFAS No. 161 requires enhanced disclosures about
an entitys derivative and hedging activities and is effective for financial
statements issued for fiscal years beginning after November 15, 2008. We
are currently assessing the impact of SFAS No. 161 on our disclosures.

In April 2008,
the FASB issued FSP FAS 142-3, Determination of the Useful Life of Intangible Assets,
to provide guidance for determining the useful life of recognized intangible
assets and to improve consistency between the period of expected cash flows
used to measure the fair value of a recognized intangible asset and the useful
life of the intangible asset as determined under SFAS No. 142, Goodwill and
Other Intangible Assets. The FSP requires that an entity consider
its own historical experience in renewing or extending similar arrangements.
However, the entity must adjust that experience based on entity-specific
factors under FAS No. 142. FSP FAS 142-3 is effective for fiscal years and
interim periods that begin after November 15, 2008. The Company intends to
adopt FSP FAS 142-3 effective January 1, 2009 and to apply its provisions
prospectively to recognized intangible assets acquired after that date. The
Company has periodically purchased recognized intangible assets and is in the
process of evaluating the impact that the adoption of FSP FAS 142-3 will have
on its financial statements.

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In May 2008,
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 SECs approval 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.

|        |                                                                                       
|------- | --------------------------------------------------------------------------------------
|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 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.
On December 6, 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. Our consolidated financial
statements include revenue and expenses related to the operations of the EIS
asset purchase from December 7, 2007 forward.

Trends and
Challenges in Our Business.

We believe
recent 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 roadway infrastructure, which has 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 has 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 continued 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;                                                                                                                                  
|                                                         |   |                                                                                                                                                                                                                                                                                                    
|                                                         |  | 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.

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Because our
principal end users are governmental entities, we are faced with challenges
related to potential delays in purchase decisions by those entities and
unforeseen changes in budgetary constraints. These contingencies could result
in significant and unforeseen fluctuations in our revenue between periods.

Key Financial Terms
and Metrics.

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.

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 evenly 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, which we assemble, gives us an additional source of revenue that we
expect will significantly increase our overall revenue and lessen 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.

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
December 2007 (see Note C), 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).

10

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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
2008 to 2007:

|                                                 |  |                                          |                               |      |  |       |   |  |       |  
|------------------------------------------------ |  | ---------------------------------------- | ----------------------------- | ---- |  | ----- | - |  | ----- | -
|                                                 |  | Three-Month Periods
 Ended September 30, |                               |      | 
|                                                 |  |                                          | Quarter Over
 Quarter
 Change |     
|                                                 |  |                                          |                               |     
|                                                 |  | 2008                                     |                               | 2007 |  |      
|                                                 |  |                                          |                               |      |  |       |  
|International
 sales                             |  |                                          | 23.3                          | %    |  | 27.3  | % |  | 24.3  | %
|North
 American sales                            |  |                                          | 15.1                          |      |  |      |   |  | n/m   |  
|Royalties                                        |  |                                          | 61.6                          |      |  | 72.7  |   |  | 23.1  |  
|                                                 |  |                                          |                               |      |  |       |   |  |       |  
|Total
 revenue                                   |  |                                          | 100.0                         |      |  | 100.0 |   |  | 45.4  |  
|Gross profit
  international sales              |  |                                          | 72.0                          |      |  | 53.1  |   |  | 68.5  |  
|Gross profit
  North American sales             |  |                                          | 49.8                          |      |  |      |   |  | n/m   |  
|Gross profit
  royalties                        |  |                                          | 100.0                         |      |  | 100.0 |   |  | 23.1  |  
|Selling,
 marketing and product support expenses |  |                                          | 27.9                          |      |  | 17.9  |   |  | 126.3 |  
|General and
 administrative expenses             |  |                                          | 16.1                          |      |  | 17.0  |   |  | 38.0  |  
|Research and
 development expenses               |  |                                          | 11.5                          |      |  | 13.2  |   |  | 26.8  |  
|Amortization
 of intangible assets               |  |                                          | 3.2                           |      |  |      |   |  | n/m   |  
|Income from
 operations                          |  |                                          | 27.2                          |      |  | 39.1  |   |  | 1.1   |  
|Other income
 (expense), net                     |  |                                          | (0.1                          | )    |  | 3.6   |   |  | n/m   |  
|Income taxes                                     |  |                                          | 8.0                           |      |  | 11.7  |   |  | (0.4  | )
|Net income                                       |  |                                          | 19.1                          |      |  | 31.0  |   |  | (10.4 | )
|                                                 |  |                                          |                               |      |  |       |   |  |       |  
|                                                 |  |                                          |                               |      |  |       |   |  |       |  
|                                                 |  | Nine-Month Periods
 Ended September 30,  |                               |      |  |      
|                                                 |  |                                          | Period Over
 Period
 Change   |     
|                                                 |  |                                          |                               |     
|                                                 |  | 2008                                     |                               | 2007 |  |      
|                                                 |  |                                          |                               |      |  |       |  
|International
 sales                             |  |                                          | 22.6                          | %    |  | 22.6  | % |  | 89.1  | %
|North
 American sales                            |  |                                          | 23.9                          |      |  |      |   |  | n/m   |  
|Royalties                                        |  |                                          | 53.5                          |      |  | 77.4  |   |  | 31.1  |  
|                                                 |  |                                          |                               |      |  |       |   |  |       |  
|Total
 revenue                                   |  |                                          | 100.0                         |      |  | 100.0 |   |  | 89.5  |  
|Gross profit
  international sales              |  |                                          | 61.2                          |      |  | 57.4  |   |  | 101.6 |  
|Gross profit
  North American sales             |  |                                          | 59.0                          |      |  |      |   |  | n/m   |  
|Gross profit
  royalties                        |  |                                          | 100.0                         |      |  | 100.0 |   |  | 31.1  |  
|Selling,
 marketing and product support expenses |  |                                          | 25.1                          |      |  | 23.4  |   |  | 102.9 |  
|General and
 administrative expenses             |  |                                          | 15.4                          |      |  | 18.6  |   |  | 57.4  |  
|Research and
 development expenses               |  |                                          | 11.6                          |      |  | 17.0  |   |  | 28.9  |  
|Amortization
 of intangible assets               |  |                                          | 3.1                           |      |  |      |   |  | n/m   |  
|Income from
 operations                          |  |                                          | 26.3                          |      |  | 31.4  |   |  | 58.8  |  
|Other income,
 net                               |  |                                          | 0.3                           |      |  | 4.3   |   |  | (86.5 | )
|Income taxes                                     |  |                                          | 8.2                           |      |  | 9.8   |   |  | 59.0  |  
|Net income                                       |  |                                          | 18.4                          |      |  | 25.9  |   |  | 34.4  |  

Total revenue
increased to $6.1 million, or 45.4%, in the third quarter of 2008, from $4.2
million in the third quarter of 2007 and to $18.7 million, or 89.5%, in the
first nine months of 2008 from $9.9 million in the comparable period of 2007.
Royalties for the third quarter of 2008 increased to $3.7 million, or 61.6% of
revenue, from $3.0 million, or 72.7% of revenue, in 2007, and for the first
nine months of 2008 increased to $10.0 million, or 53.5% of revenue, from $7.6
million, or 77.4% of revenue, in 2007. The increase in royalties in 2008
resulted primarily from a similar increase in sales volume of Autoscope
products by Econolite. International sales for the third quarter of 2008
increased to $1.4 million, or 23.3% of revenue, from $1.1 million, or 27.3% of
revenue, in 2007, and for the first nine months of 2008 increased to $4.2
million, or 22.6% of revenue, from $2.2 million, or 22.6% of revenue, in 2007.
The 89.1% increase in international sales for the first nine months of 2008 was
due primarily to increasing acceptance of Autoscope Terra products in European
and Asian markets, as well as the sales of the newly added RTMS product line.
North American sales were 15.1% and 23.9% of revenue in the third quarter and
first nine months of 2008, respectively, and reflect the addition of the RTMS
product line. In the first quarter of 2008, we began reporting two segments:
Autoscope and RTMS. Revenue in the third quarter and first nine months of 2008
for the Autoscope segment was $4.9 million and $13.3 million, respectively,
compared to $4.2 million and $9.9 million in the comparable periods of 2007.
The increase in Autoscope segment revenues for these periods resulted from increased
sales volumes worldwide, including increasing acceptance of Autoscope Terra
products in European and Asian markets. Revenue in the third quarter and first
nine months of 2008 for the RTMS segment was $1.2 million and $5.4 million,
respectively. There is no comparable period information for 2007 because the
RTMS product line was acquired in December 2007.

11

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Gross profit
margins on international sales for the third quarter of 2008 were 72.0%, up
from 53.1% in the comparable quarter of 2007, and 61.2% in the first nine
months of 2008, up from 57.4% in the comparable quarter of 2007. The third
quarter margin, and to a lesser extent the nine months margin, was positively
impacted by a reversal of manufacturing build cost accruals that subsequently
were not incurred. Gross profit margins on North American sales for the third
quarter and first nine months of 2008 were 49.7% and 59.0%, respectively.
Margins in the third quarter were negatively impacted by inventory reserves
established to reflect the transition from the third generation RTMS product
line to the fourth generation.

Operating
expenses increased to $3.6 million for the third quarter of 2008 from $2.0
million for the comparable period in 2007, and to $10.3 million for the first
nine months of 2008 from $5.8 million for the comparable period in 2007,
increases of 77.3% and 77.1%, respectively. The primary reason for the
increases was the addition of operating expenses from the EIS asset purchase in
December 2007, which currently has a run rate of approximately $700,000 per
quarter, before variable selling expense, including research and development
expense for the next-generation RTMS system. Additionally, increases were in
selling, marketing and general product support expenses, which was attributable
to headcount additions for sales and product support and in general and
administrative, which included increased stock option and compensation expense
and higher fees for professional services. In the third quarter of 2008, we
recognized a $221,000 charge for costs incurred in conjunction with our
withdrawn stock offering. The expense is recognized in the general and
administrative line on the statements of income. We also began incurring
amortization expense on intangible assets purchased as part of the EIS asset
purchase. We expect the level of expenses in each of the selling, marketing and
product support and research and development operating expense categories to
increase in absolute dollars in the fourth quarter of 2008 as opposed to the
third quarter, while general and administrative and amortization of intangible
assets are expected to remain stable.

Income from
operations in the third quarter of 2008 was $1.7 million, or 27.2% of revenue,
compared to $1.6 million, or 39.1% of revenue, in the comparable quarter in
2007, an increase of 1.1%. Income from operations in the first nine months of
2008 was $4.9 million, or 26.2% of revenue, compared to $3.1 million, or 31.4%
of revenue, in the comparable quarter in 2007, an increase of 58.8%. The
increase resulted primarily from growth in all revenue categories, which was
offset in part by increased operating expenses as described above.

Other income
(expense), net, decreased to ($6,000) in the third quarter of 2008 from
$149,000 in the comparable quarter of 2007 and to $58,000 in the first nine
months of 2008 from $429,000 in the comparable period of 2007 as a result of
lower cash balances and interest expense incurred on bank debt.

Income tax
expense was $486,000, or 28.7% of pretax income, in the third quarter of 2008,
compared to $488,000, or 27.3% of pretax income in the comparable quarter of
2007. Income tax expense was $1.5 million, or 30.7% of pretax income, in the
first nine months of 2008, compared to $968,000, or 27.5% of pretax income, in
the comparable period of 2007. The increase in the nine months effective rate
was due primarily to there being no tax-exempt interest income in 2008 versus
significant amounts in 2007 and recognition of the federal research and
development credit in 2007 versus none in 2008. The research and development
credit has been reinstated as of our fourth quarter and will reduce the annual
provision accordingly. With this change, we anticipate that the effective tax
rate for 2008 will decrease to approximately 30%.

Net income was
$1.2 million in the third quarter of 2008, a 10.4% decrease, compared to $1.3
million in the comparable quarter of 2007 and $3.4 million in the first nine
months of 2008, a 34.4% increase, compared to $2.6 million in the comparable period
of 2007 due to the factors described above.

Liquidity and Capital Resources

At September
30, 2008, we had $7.7 million in cash and cash equivalents and $5.0 million in
restricted long-term investments, compared to $5.6 million in cash and cash
equivalents, $5.3 million in restricted cash and $-0- in investments at
December 31, 2007. As discussed below, our investments are auction rate
securities and are not currently liquid.

Net cash
provided by operating activities was $3.3 million in the first nine months of
2008, compared to $650,000 in 2007. The primary reasons for the change were the
incremental net income increase in 2008 and significant increases in
depreciation and amortization in 2008 over 2007. We purchased $5.4 million in
investments, net of redemptions, in 2008 as opposed to selling $2.1 million in
investments, net of purchases, in 2007. We also repaid $1.0 million in debt in
2008.

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At September
30, 2008, we held $5.4 million (par value) of investments comprised of auction
rate securities, or ARS, with maturity dates ranging from 2031 to 2047, which
were purchased from UBS ($4.0 million) and Credit Suisse ($1.4 million). All
our ARS held are AAA/Aaa rated, with substantially all collateralized by
student loans guaranteed by the U.S. government under the Federal Family
Education Loan Program. Until February 2008, the auction rate securities market
was highly liquid. Since mid-February 2008, a substantial number of auctions
have failed. The immediate effect of a failed auction is that holders cannot
sell the securities at auction. In the case of a failed auction, with respect
to the ARS held by us, the ARS are deemed not currently liquid. In the case of
funds invested by us in ARS which are the subject of a failed auction, we may
not be able to access the funds in the near term without a loss of principal
unless a future auction on these investments is successful or the issuer calls
the security pursuant to a mandatory tender or redemption prior to maturity.

In the third
quarter of 2008, both UBS and Credit Suisse announced settlement offers with
governmental authorities in which the banks agreed to repurchase the ARS from
their clients at par. Based on the information made available from the banks,
we believe that the repurchases of our ARS will be completed by the end of
January 2009. While we believe that the repurchases are highly probable to
occur, we have determined the proper accounting for these investments is to
continue to consider them long-term and temporarily impaired until such repurchases
are completed.

At September
30, 2008, there was insufficient observable ARS market information available to
determine the fair value of our investments. Therefore, we estimated fair value
by using broker quotes. Based on this analysis, we recorded an unrealized loss
of $449,000 in other comprehensive income ($297,000 net of tax) related to our
ARS investments. The ARS investments are pledged as collateral as described
below.

Credit Suisse
purchased the $1.4 million of ARS held in our account at par in November 2008.

In May 2008,
we entered into a financing arrangement with Associated Bank, National
Association, or Associated Bank, which replaced our loan agreements with Wells
Fargo Bank, N.A., including fully repaying those loans. Under the arrangement
with Associated Bank, we entered into a revolving line of credit and a term
loan. 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 Associated Bank. Advances on the line of credit cannot
exceed a borrowing base determined under a formula which is a percentage of the
amounts of ARS and receivables. The line of credit currently has $2.0 million
in borrowings outstanding and matures on May 1, 2011. The term loan is for
$3.0 million and has a fixed annual interest rate of 6.75%. Repayment on
the term loan is in equal monthly principal installments over a 36-month
period. As collateral, Associated Bank has a first priority security interest
in all of our assets, and we have pledged $5.4 million in ARS. As a result of
the new financing arrangement with Associated Bank, our restricted cash is no
longer restricted; however, our ARS investments are now restricted as pledged
to Associated Bank.

We believe
that cash and cash equivalents on hand at September 30, 2008, along with our
$5.0 million revolving line of credit and cash provided by operating activities
will satisfy our projected working capital needs, investing activities and
other cash requirements for the foreseeable future.

In conjunction
with our EIS asset purchase, the sellers have an earn-out arrangement over
approximately three years. 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. Earn-out payments generally are due within three months of the end of an
earn-out period. The first earn-out period runs from December 6, 2007 to
December 31, 2008. Thus, if any earn-out payment is due for this period, it
would be paid by March 31, 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.

Critical Accounting Policies

Our
significant accounting policies are described in Note 1 to the consolidated
financial statements included in our Annual Report on Form 10-K for the year
ended December 31, 2007. The accounting policies used in preparing our interim
2008 consolidated financial statements are the same as those described in our
Annual Report.

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New and Recently Adopted Accounting
Pronouncements

In September
2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157,
Fair
Value Measurements. SFAS No. 157 defines fair value,
establishes a framework for measuring fair value and expands disclosures about
fair value measurement but does not require any new fair value measurements.
SFAS No. 157 is effective for financial statements issued for fiscal years
beginning after November 15, 2007 and interim periods within those fiscal years.
However, on February 12, 2008, the FASB issued proposed FSP FAS 157-2 which
delayed the effective date of SFAS No. 157 for all nonfinancial assets and
nonfinancial liabilities, except those
that are recognized or disclosed at fair value in the financial statements on a
recurring basis (at least annually). This FSP partially defers the effective
date of SFAS No. 157 to fiscal years beginning after November 15, 2008,
and interim periods within those fiscal years for items within the scope of this
FSP. Effective for 2008, we have adopted SFAS No. 157 except as it applies
to those nonfinancial assets and nonfinancial liabilities as noted in proposed
FSP FAS 157-2. The partial adoption of SFAS No. 157 impacted our disclosures
surrounding our restricted long-term investments.

On February
15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities  Including an Amendment of FASB Statement
No. 115. This standard permits an entity to choose to measure
many financial instruments and certain other items at fair value. The fair
value option established by SFAS No. 159 permits all entities to choose to
measure eligible items at fair value at specified election dates. SFAS
No. 159 is effective for the Company as of January 1, 2008. The impact of
adopting this pronouncement had no effect on our consolidated financial
statements because we did not elect the fair value option for any financial
assets or liabilities.

In December
2007, the 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 prospectively to business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15, 2008. Earlier
adoption is prohibited. SFAS No. 141(R) will impact us if we complete an
acquisition after the effective date.

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 with those fiscal years, beginning on or
after December 15, 2008. Earlier adoption is prohibited. We are currently
assessing the potential impact that the adoption of SFAS No. 160 will have
on our financial statements.

In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities  an amendment of FASB Statement
No. 133. SFAS No. 161 requires enhanced disclosures about
an entitys derivative and hedging activities and is effective for financial
statements issued for fiscal years beginning after November 15, 2008. We
are currently assessing the impact of SFAS No. 161 on our disclosures.

In April 2008,
the FASB issued FASB Staff Position (FSP) FAS 142-3, Determination of the Useful Life of
Intangible Assets, to provide guidance for determining the useful
life of recognized intangible assets and to improve consistency between the
period of expected cash flows used to measure the fair value of a recognized
intangible asset and the useful life of the intangible asset as determined
under SFAS No. 142, Goodwill and Other Intangible Assets. The
FSP requires that an entity consider its own historical experience in renewing
or extending similar arrangements. However, the entity must adjust that
experience based on entity-specific factors under SFAS No. 142. FSP FAS
142-3 is effective for fiscal years and interim periods that begin after
November 15, 2008. The Company intends to adopt FSP FAS 142-3 effective January
1, 2009 and to apply its provisions prospectively to recognized intangible
assets acquired after that date. The Company has periodically purchased
recognized intangible assets and is in the process of evaluating the impact
that the adoption of FSP FAS 142-3 will have on its financial statements.

In May 2008,
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 SECs approval 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.

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.

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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;                                                                                                                      
| |   |                                                                                                                                                                                          
| |  | 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 a 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, 2007.

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

The Companys
foreign sales and results of operations are subject to the impact of foreign
currency fluctuations. The Company has not hedged its exposure to translation
gains and losses. A 10% adverse change in foreign currency rates would not have
a material effect on the Companys results of operations or financial position.

At September
30, 2008, we held $5.4 million (par value) of investments comprised of auction
rate securities, or ARS, with maturity dates ranging from 2031 to 2047, which
were purchased from UBS ($4.0 million) and Credit Suisse ($1.4 million). All
our ARS held are AAA/Aaa rated, with substantially all collateralized by
student loans guaranteed by the U.S. government under the Federal Family
Education Loan Program. Until February 2008, the auction rate securities market
was highly liquid. Since mid-February 2008, a substantial number of auctions
have failed. The immediate effect of a failed auction is that holders cannot
sell the securities at auction. In the case of a failed auction, with respect
to the ARS held by us, the ARS are deemed not currently liquid. In the case of
funds invested by us in ARS which are the subject of a failed auction, we may
not be able to access the funds in the near term without a loss of principal
unless a future auction on these investments is successful or the issuer calls
the security pursuant to a mandatory tender or redemption prior to maturity.

15

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Table of Contents

In the third
quarter of 2008, both UBS and Credit Suisse announced settlement offers with
governmental authorities in which the banks agreed to repurchase the ARS from
their clients at par. Based on the information made available from the banks,
we believe that the repurchases of our ARS will be completed by the end of
January 2009. While we believe that the repurchases are highly probable to
occur, we have determined the proper accounting for these investments is to
continue to consider them long-term and temporarily impaired until such
repurchases are completed.

At September
30, 2008, there was insufficient observable ARS market information available to
determine the fair value of our investments. Therefore, we estimated fair value
by using broker quotes. Based on this analysis, we recorded an unrealized loss
of $449,000 in other comprehensive income ($297,000 net of tax) related to our
ARS investments. The ARS investments are pledged as collateral for our bank
debt.

Credit Suisse
purchased the $1.4 million of ARS held in our account at par in November 2008.

|        |                        
|------- | -----------------------
|Item 4. | 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 has been 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, 2007. 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.

The following updates the section entitled
Item 1A.Risk Factors in our Annual Report on Form 10-K for the year ended
December 31, 2007.

As of September 30,
2008, we had $5.4 million invested in ARS. Since mid-February 2008, the
auctions for these securities have failed, which adversely affects their
liquidity. As of September 30, 2008, we have recorded an unrealized loss of
$449,000 ($297,000 net of tax) due to a determination of a temporary impairment
to the value of our ARS. If we must record other-than-temporary impairment
charges on our ARS or recognize a loss on their disposition, our financial
condition would be adversely affected.

At September
30, 2008, we held $5.4 million (par value) of investments comprised of ARS. All
of our ARS held are AAA/Aaa rated, with substantially all collateralized by
student loans guaranteed by the U.S. government under the Federal Family
Education Loan Program. Until mid-February 2008, the auction rate securities
market was highly liquid. Since mid-February 2008, a substantial number of
auctions have failed. In the case of a failed auction, with respect to the ARS
held by us, the ARS are deemed not currently liquid. In the case of funds
invested by us in ARS which are the subject of a failed auction, we may not be
able to access the funds in the near term without a loss of principal unless a
future auction on these investments is successful or the issuer calls the
security pursuant to a mandatory tender or redemption prior to maturity. In the
third quarter of 2008, both UBS and Credit Suisse announced settlement offers
with governmental authorities in which the banks agreed to repurchase the ARS
from their clients at par. Based on the information made available from the
banks, we believe that the repurchases of our ARS will be completed by the end
of January 2009. While we believe that the repurchases are highly probable to
occur, we have determined the proper accounting for these investments is to
continue to consider them long-term and record unrealized gains and losses
based on their fair value until such repurchases are completed. At September
30, 2008, there was insufficient observable ARS market information available to
determine the fair value of our investments. Therefore, we estimated fair value
by using broker quotes. Based on this analysis, we recorded an unrealized loss
of $449,000 in other comprehensive income ($297,000 net of tax) related to our
ARS investments. The ARS investments are pledged as collateral for our bank
debt. We cannot predict whether future auctions related to our ARS will be
successful. If uncertainties in the credit and capital markets continue, if
these markets further deteriorate, or if we no longer have the ability to hold
these investments, we may be required to recognize other-than-temporary
impairment charges on our ARS or a loss on the disposition of our ARS, which would
have an adverse effect on our financial condition.

If governmental
entities elect not to use our products due to budgetary constraints, including
budgetary constraints caused by decreasing tax revenues, project delays or
other reasons, our revenue may fluctuate severely or be substantially
diminished.

Autoscope and
RTMS systems are sold primarily to governmental entities for use in traffic
control projects using advanced technologies. We expect that we will continue
to rely substantially on revenue and royalties from sales of Autoscope and RTMS
systems to governmental entities. In addition to normal business risks, it
often takes considerable time before governmental traffic control projects are
developed to the point at which a purchase of Autoscope and RTMS systems would
be made, and a purchase of our products also may be subject to a time-consuming
approval process. Additionally, governmental budgets and plans may change
without warning. Other risks of selling to governmental entities include dependence
on appropriations and administrative allocation of funds, changes in
governmental procurement legislation and regulations and other policies that
may reflect political developments, significant changes in contract scheduling,
intense competition for government business and termination of purchase
decisions for the convenience of the governmental entity. Substantial delays in
purchase decisions by governmental entities, or governmental budgetary
constraints, including budgetary constraints cause by decreasing tax revenues,
could cause our revenue and income to drop substantially or to fluctuate
significantly between fiscal periods.

17

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Amounts recorded for goodwill could be
adversely impacted by current market conditions.

As disclosed
in our Annual Report on Form 10-K for the year ending December 31, 2007, we
perform our annual impairment test of goodwill in December of each year or
whenever an impairment indicator arises, and we test our long-lived assets for
impairment when indicators of impairment are present. Our recorded goodwill
relates to our Hong Kong-based subsidiary, Flow Traffic Ltd., and certain
assets purchased from EIS. The impairment test requires us to estimate the fair
value of our subsidiary and then compare it to the carrying value of the
subsidiary. If the carrying value exceeds the fair value, further analysis is
performed to determine if there is an impairment loss. We estimate the fair
value by using the income approach, where fair value is dependent on the
present value of future economic benefits to be derived from ownership of Flow
Traffic. The future economic benefits are significantly dependent on future
revenue growth. No impairment of goodwill was recorded as of December 31, 2007
and 2006. If Flow Traffic and the EIS assets do not provide the future economic
benefits we project, the fair value of these assets may become impaired, and we
would need to record an impairment loss. Fair market valuation requires
assumptions and estimates of many critical factors, including revenue and
market growth, operating cash flows, market multiples and discount rates. As
general market conditions have deteriorated, our Flow Traffic subsidiary and
the EIS assets could experience a decline in the fair market value, which could
adversely affect the results of the impairment testing that will be performed
in December and could potentially lead to a future impairment charge.

Difficult and
volatile conditions in the capital, credit and commodities markets and in the
overall economy could materially adversely affect our financial position,
results of operations and cash flows, and we do not know if these conditions
will improve in the near future.

Our financial
position, results of operations and cash flows could be materially adversely
affected by difficult conditions and significant volatility in the capital,
credit and commodities markets and in the overall worldwide economy. These
factors, combined with declining business and consumer confidence and increased
unemployment, have precipitated a worldwide economic slowdown and fears of a
possible recession. The impact, if any, that these factors might have on us and
our business is uncertain and cannot be estimated at this time. Item 1A of our
Annual Report on Form 10-K for the year ended December 31, 2007 discusses some
of the principal risks inherent in our business. Current economic conditions
have accentuated each of these risks and magnified their potential effect on us
and our business. The difficult conditions in these markets and the overall
economy affect our business in a number of ways. For example:

| |   |                                                                                                                                                                                                                                                                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Although we
 believe we have sufficient liquidity under our financing arrangement with
 Associated Bank to run our business, under extreme market conditions, there
 can be no assurance that such funds would be available or sufficient, and, in
 such a case, we may not be able to successfully obtain additional financing
 on favorable terms, or at all.
| |   |                                                                                                                                                                                                                                                                                                                                                                
| |  | Recent
 market volatility has exerted downward pressure on our stock price, which may
 make it more difficult for us to raise additional capital in the future.                                                                                                                                                                                                
| |   |                                                                                                                                                                                                                                                                                                                                                                
| |  | Economic
 conditions could result in customers in our markets experiencing financial
 difficulties or electing to limit spending because of the declining economy
 which may result, for example, in declining tax revenue for our customers
 that are governmental entities, which in turn could result in decreased sales
 and earnings for us.              

We do not know
if market conditions or the state of the overall economy will improve in the
near future or when any improvement will occur.

|        |                                                             
|------- | ------------------------------------------------------------
|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

None.

18

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Table of Contents

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

On May 12,
2008, we filed a Registration Statement on Form S-1 for an offering by us of
our shares of common stock, and we have received a comment letter from the
Securities and Exchange Commission (SEC) on our Form S-1 Registration
Statement.

On November 5,
2008, we requested the SEC to withdraw the filing because of ongoing adverse
market conditions.

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

The following
exhibits are filed as part of this quarterly report on Form 10-Q for the
quarterly period ended September 30, 2008:

|                |  |                                                                                                      
|--------------- |  | -----------------------------------------------------------------------------------------------------
|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.

19

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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.                            | 
|                          |  |                                                         | 
|                          |  | By:                                                     | 
|                          |  |                                                         | 
|Dated:
 November 13, 2008 |  | /s/ Kenneth
 R. Aubrey                                  | 
|                          |  |                                                         | 
|                          |  | Kenneth R.
 Aubrey                                      | 
|                          |  | President
 and Chief Executive Officer                  | 
|                          |  | (principal
 executive officer)                          | 
|                          |  |                                                         | 
|Dated:
 November 13, 2008 |  | /s/ Gregory
 R.L. Smith                                 | 
|                          |  |                                                         | 
|                          |  | Gregory R.L.
 Smith                                     | 
|                          |  | Chief
 Financial Officer                                | 
|                          |  | (principal
 financial and principal accounting officer) | 

20

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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.

21

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