Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q

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x
        
        QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the quarterly period ended March 31, 2008ORo
        
        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For 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. Employerincorporation or organization)
        Identification No.)500 Spruce Tree Centre1600 University Avenue WestSt. 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)



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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. YesxNoo



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 filero
        Accelerated fileroNon-accelerated filero
(Do not check if a smaller reporting company)
        Smaller reporting companyx




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




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 April 30, 2008Common Stock, $0.01 par value per share
        
        3,927,806 shares








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IMAGE SENSING SYSTEMS, INC.



TABLE OF CONTENTS



Page No.PART I.
        FINANCIAL INFORMATION
        3Item 1.
        Financial Statements
        3Condensed Consolidated Balance Sheets
        3Condensed Consolidated Statements of Income
        4Condensed Consolidated Statements of Cash Flows
        5Notes To Condensed Consolidated Financial Statements
        6Item 2.
        Managements Discussion and Analysis of Financial Condition and Results of Operations
        10Item 3.
        Quantitative and Qualitative Disclosures About Market Risk
        17Item 4T.
        Controls and Procedures
        17PART II.
        OTHER INFORMATION
        18Item 1.
        Legal Proceedings
        18Item 1A.
        Risk Factors
        18Item 2.
        Unregistered Sales of Equity Securities and Use of Proceeds
        18Item 3.
        Defaults Upon Senior Securities
        18Item 4.
        Submission of Matters to a Vote of Security Holders
        18Item 5.
        Other Information
        18Item 6.
        Exhibits
        19SIGNATURES
        20EXHIBIT INDEX
        21






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Table of Contents

PART I. FINANCIAL INFORMATION



Item 1.    Financial Statements



Image Sensing Systems, Inc.

Condensed Consolidated Balance Sheets

(in thousands)



March 31,2008
        
        December 31,2007(Unaudited)
        
        (Note)AssetsCurrent assets:Cash and cash equivalents
        
        $
        3,085
        
        $
        5,613Restricted cash
        
        
        3,474
        
        
        5,263Accounts receivable, net
        
        
        5,273
        
        
        4,997Inventories
        
        
        1,888
        
        
        1,579Prepaid expenses
        
        
        350
        
        
        228Deferred income taxes
        
        
        142
        
        
        142Total current assets
        
        
        14,212
        
        
        17,822Property and equipment, net
        
        
        639
        
        
        700Long-term investments, net
        
        
        5,199
        
        
        Deferred income taxes
        
        
        1,826
        
        
        1,676Goodwill and intangible assets
        
        
        9,948
        
        
        10,140Total assets
        
        $
        31,824
        
        $
        30,338Liabilities and Shareholders EquityCurrent liabilities:Accounts payable
        
        $
        821
        
        $
        816Bank debt
        
        
        5,000
        
        
        5,000Accrued compensation
        
        
        559
        
        
        703Accrued warranty and other
        
        
        536
        
        
        510Income taxes payable
        
        
        524
        
        
        Total current liabilities
        
        
        7,440
        
        
        7,029Income taxes payable
        
        
        150
        
        
        84Shareholders equity:Common stock
        
        
        39
        
        
        39Additional paid-in capital
        
        
        11,077
        
        
        11,004Accumulated other comprehensive income
        
        
        41
        
        
        161Retained earnings
        
        
        13,077
        
        
        12,02124,234
        
        
        23,225Total liabilities and shareholders equity
        
        $
        31,824
        
        $
        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.



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Image Sensing Systems, Inc.

Condensed Consolidated Statements of Income

(Unaudited)

(in thousands, except per share data)



Three-Month Periods EndedMarch 31,2008
        
        2007Revenue:International sales
        
        $
        1,355
        
        $
        353North American sales
        
        
        1,625
        
        
        Royalties
        
        
        2,892
        
        
        2,2915,872
        
        
        2,644Costs of revenue:International sales
        
        
        608
        
        
        127North American sales
        
        
        594
        
        
        1,202
        
        
        127Gross profit
        
        
        4,670
        
        
        2,517Operating expenses:Selling, marketing and product support
        
        
        1,333
        
        
        685General and administrative
        
        
        888
        
        
        570Research and development
        
        
        701
        
        
        594Amortization of intangible assets
        
        
        192
        
        
        3,114
        
        
        1,849Income from operations
        
        
        1,556
        
        
        668Other income, net
        
        
        41
        
        
        138Income before income taxes
        
        
        1,597
        
        
        806Income taxes
        
        
        541
        
        
        250Net income
        
        $
        1,056
        
        $
        556Net income per common share:Basic
        
        $
        0.27
        
        $
        0.15Diluted
        
        $
        0.26
        
        $
        0.14Weighted average number of common shares outstanding:Basic
        
        
        3,928
        
        
        3,774Diluted
        
        
        4,026
        
        
        3,888






See accompanying notes.



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Image Sensing Systems, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)



Three-Month Periods EndedMarch 31,2008
        
        2007Operating activities:Net income
        
        $
        1,056
        
        $
        556Adjustments to reconcile net income to net cash provided by (used in) operating activitiesDepreciation and amortization
        
        
        290
        
        
        57Stock option expense
        
        
        73
        
        
        29Change in operating assets and liabilities
        
        
        (249
        )
        
        (722
        )Net cash provided by (used in) operating activities
        
        
        1,170
        
        
        (80
        )Investing activities:Net (purchases) disposals of property and equipment
        
        
        (37
        )
        
        4Net (purchases) sales of investments
        
        
        (5,450
        )
        
        1,000Net cash provided by (used in) investing activities
        
        
        (5,487
        )
        
        1,004Financing activities:Proceeds from exercise of stock options
        
        
        
        
        
        30Cash released from restriction
        
        
        1,789
        
        
        Net cash provided by financing activities
        
        
        1,789
        
        
        30Increase (decrease) in cash and cash equivalents
        
        
        (2,528
        )
        
        954Cash and cash equivalents, beginning of period
        
        
        5,613
        
        
        11,626Cash and cash equivalents, end of period
        
        $
        3,085
        
        $
        12,580






See accompanying notes.






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IMAGE SENSING SYSTEMS, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

March 31, 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 period ended March 31, 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 March 31, 2008, we held $5.5 million (par value) of investments comprised of auction rate securities (ARS) with maturity dates ranging from 2031 to 2047. 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, meaning that there was not enough demand to sell all of the securities that holders desired to sell at auction. The immediate effect of a failed auction is that such 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.



At March 31, 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 primarily based on(a) a discounted cash flow model with factors including tax status, credit quality, duration, insurance swaps, levels of federal guarantees and likelihood of redemption and (b) estimates of observable market data for similar securities (when available). Based on this analysis, we recorded an unrealized loss of $251,000 ($166,000 net of tax) related to our ARS investments and have classified the investments as long-term on our balance sheet as of March 31, 2008. We believe this unrealized loss is primarily attributable to the limited liquidity of these investments, and it is our intent to hold these investments long enough to avoid realizing any significant loss.
Nonetheless, if uncertainties in the credit and capital market 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.



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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.).



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



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 endedMarch 31, 2007Total revenue
        
        $
        3,844Net income
        
        
        141Net income per share:Basic
        
        $
        0.04Diluted
        
        $
        0.03




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):



March 31, 2008
        
        December 31, 2007Developed technology (8 year life)
        
        $
        3,900
        
        $
        3,900Trade names (5 year life)
        
        
        1,200
        
        
        1,200Other intangibles (5 year life)
        
        
        200
        
        
        200Less:  Accumulated amortization
        
        
        (243
        )
        
        (51
        )Total identifiable intangible assets, net
        
        $
        5,057
        
        $
        5,249






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



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 periods ended March 31, 2008 and 2007 (in thousands, except per share data):



2008
        
        2007Numerator:Net income
        
        $
        1,056
        
        $
        556Denominator:Shares used in basic net income per common share calculation
        
        
        3,928
        
        
        3,774Effect of diluted securities:Employee and director stock options
        
        
        98
        
        
        114Shares used in diluted net income per common share calculations
        
        
        4,026
        
        
        3,888Basic net income per common share
        
        $
        0.27
        
        $
        0.15Diluted net income per common share
        
        $
        0.26
        
        $
        0.14




Note F: Stock-based Compensation



We recorded $73,000 and $29,000 of stock-based compensation in general and administrative expense for the three-month periods ended March 31, 2008 and 2007, respectively. Options to purchase 44,000 shares, at a weighted average exercise price of $12.37, and options to purchase 75,000 shares, at a weighted average exercise price of $14.19, were granted during the three-month periods ended March 31, 2008 and 2007, respectively. As of March 31, 2008, $830,000 of total unrecognized compensation expense related to non-vested stock option awards is expected to be recognized over a weighted average period of 3.0 years.



We used the Black-Scholes option pricing model to determine the weighted average fair value of options during the three-month periods ended March 31, 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 March 31, 2008, we had 78,200 shares available for grants under the 2005 Stock Incentive Plan.



The following table summarizes information about the stock options outstanding at March 31, 2007:



Options Outstanding
        
        Options ExercisableRange ofExercise Price
        
        NumberOutstanding
        
        Weighted AverageRemaining Contractual Life
        
        Weighted AverageExercise Price
        
        NumberExercisable
        
        Weighted AverageExercise Price$  1.301.99
        
        71,100
        
        4.0 years
        
        $  1.34
        
        71,100
        
        $  1.342.002.99
        
        52,200
        
        1.7 years
        
        2.38
        
        52,200
        
        2.383.003.99
        
        38,933
        
        4.5 years
        
        3.15
        
        38,933
        
        3.157.007.99
        
        16,000
        
        1.1 years
        
        7.77
        
        16,000
        
        7.7712.0012.99
        
        62,000
        
        6.7 years
        
        12.44
        
        6,000
        
        12.6114.0014.99
        
        75,000
        
        4.8 years
        
        14.19
        
        18,750
        
        14.1915.0015.99
        
        19,000
        
        2.7 years
        
        15.70
        
        
        
        16.0016.99
        
        15,000
        
        5.1 years
        
        16.00
        
        
        
        17.0017.99
        
        32,000
        
        4.7 years
        
        17.50
        
        
        
        381,233
        
        4.2 years
        
        8.92
        
        202,983
        
        3.98






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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 table sets forth selected unaudited
financial information for the Companys reportable segments for the three month period ended March 31, 2008
(in thousands):



Autoscope
        
        RTMS
        
        TotalRevenue
        
        $
        4,063
        
        $
        1,809
        
        $
        5,872Depreciation
        
        
        72
        
        
        26
        
        
        98Amortization of intangible assets
        
        
        
        
        
        192
        
        
        192Income before income taxes
        
        
        1,334
        
        
        263
        
        
        1,597Capital expenditures
        
        
        37
        
        
        
        
        
        37Total assets
        
        
        21,275
        
        
        10,549
        
        
        31,824




Note H: New Accounting Pronouncements:



In September 2006, the 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 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 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 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 157 impacted our disclosures surrounding our long-term investments.



On February 15, 2007, the FASB issued FASB Statement No. 159,The Fair Value Option for Financial Assets and Financial Liabilities  Including an Amendment of FASB Statement No. 115 (SFAS 159).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 159 permits all entities to choose to measure eligible items at fair value at specified election dates. SFAS 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.



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



Overview



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



Autoscope systems are sold to distributors and end users of traffic management products in North America, the Caribbean and Latin America by Econolite Control Products, Inc., or Econolite, our exclusive licensee in these regions. We sell RTMS systems to distributors and end users in North America. We also sell both Autoscope and RTMS 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 former EIS business 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.






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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.




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 and expires in June 2011. 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 Econolite 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.



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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).



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 Period
Ended March 31,
        
        Quarter Over Quarter2008
        
        2007
        
        ChangeInternational sales
        
        23.1
        %
        13.4
        %
        283.9
        %North American sales
        
        27.7
        
        
        
        n/mRoyalties
        
        49.2
        
        86.6
        
        26.2Total revenue
        
        100.0
        
        100.0
        
        122.1Gross profit - international sales
        
        55.1
        
        64.0
        
        230.5Gross profit  North American sales
        
        63.4
        
        
        
        n/mGross profit  royalties
        
        100.0
        
        100.0
        
        Selling, marketing and product support expenses
        
        22.7
        
        25.9
        
        94.6General and administrative expenses
        
        15.1
        
        21.6
        
        55.8Research and development expenses
        
        11.9
        
        22.5
        
        18.0Amortization of intangible assets
        
        3.3
        
        
        
        n/mIncome from operations
        
        26.5
        
        25.3
        
        132.9Other income, net
        
        0.7
        
        5.2
        
        (70.3
        )Income taxes
        
        9.2
        
        9.5
        
        116.4Net income
        
        18.0
        
        21.0
        
        89.9




Total revenue increased to $5.9 million in the first quarter of 2008 from $2.6 million in the first quarter of 2007. Royalty revenue for the first quarter of 2008 increased to $2.9 million, or 49.2% of revenue, from $2.3 million, or 86.6% of revenue, in 2007. The increase in royalty revenue in 2008 resulted primarily from a similar increase in sales volume of Autoscope products by Econolite. International sales for 2008 increased to $1.4 million, or 23.1% of revenue, from $353,000, or 13.4% of revenue, in 2007. The 283.9% increase in international sales was due primarily to increasing acceptance of Autoscope Terra products in European and Asian markets, including several orders that were significantly above our average order size, as well as the sales of the newly added RTMS product line. North American sales were 27.7% of revenue and reflect the addition of the RTMS product line.



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Gross profit margins on international sales for the first quarter of 2008 were 55.1%, down from 64.0% in the comparable quarter of 2007, due to higher manufacturing costs and a shift in sales mix to lower margin products. Gross profit margins on North American sales for the first quarter were 63.4%.



Operating expenses increased to $3.1 million for the first quarter of 2008 from $1.8 million for the comparable period in 2007, a 68.4% increase. The primary reason for the increase was the addition of operating expenses from the former EIS business acquired in December 2007, which currently has a run rate of approximately $600,000 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 included headcount additions for sales and product support, and in general and administrative, which included increased stock option expense and higher fees for professional services. 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 operating expense
categories, except amortization of intangible assets, to increase in absolute dollars over the remaining three quarters of 2008 as compared to the first quarter.



Income from operations in the first quarter of 2008 was $1.6 million, or 26.5% of revenue, compared to $668,000, or 25.3% of revenue, in the comparable quarter in 2007, an increase of 132.9%. The increase resulted primarily from the growth in all revenue categories, which were offset in part by increased operating expenses as described above.



Other income, net, decreased to $41,000 in the first quarter of 2008 from $138,000 in the comparable quarter of 2007 as a result of lower cash balances and interest expense incurred on bank debt.



Income tax expense was $541,000 or 33.9% of pretax income in the first quarter of 2008, compared to $250,000 or 31.0% of pretax income in the comparable quarter of 2007. The increase in the effective rate was due primarily to there being no tax-exempt interest income in 2008 versus significant amounts in 2007. We anticipate that the effective tax rate for the year will remain in the 30-35% range.



Net income was $1.1 million in the first quarter of 2008, an 89.9% increase, compared to $556,000 in the comparable quarter of 2007 due to the factors discussed above.



Liquidity and Capital Resources



At March 31, 2008, we had $3.1 million in cash and cash equivalents, $3.5 million in restricted cash and $5.2 million in long-term investments, compared to $5.6 million in cash and cash equivalents, $5.3 million in restricted cash and $-0- 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 $1.2 million in the first quarter of 2008, compared to net cash used of $80,000 in 2007. The primary reason for the change was the incremental net income increase in 2008 and payables growth in 2008 as opposed to a decrease in 2007. We purchased $5.5 million in investments, net of redemptions, in 2008 as opposed to selling $1.0 million in investments, net of purchases, in 2007.



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At March 31, 2008, we held $5.5 million (par value) of investments comprised of auction rate securities, or ARS, with maturity dates ranging from 2031 to 2047. 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 such 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.



At March 31, 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 primarily based on (a) a discounted cash flow model with factors including tax status, credit quality, duration, insurance swaps, levels of federal guarantees and likelihood of redemption and (b) estimates of observable market data for similar securities (when available). Based on this analysis, we recorded an unrealized loss of $251,000 ($166,000 net of tax) related to our ARS investments and have classified the investments as long-term on our balance sheet as of March 31, 2008. We believe this unrealized loss is primarily attributable to the limited liquidity of these investments, and it is our intent to hold these investments long enough to avoid realizing any significant loss. Nonetheless, if uncertainties in the
credit and capital market 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. We do not believe we need access to these funds for operational purposes for the foreseeable future.



On May 1, 2008, we entered into a new 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 to Associated Bank. 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 March 31, 2008, along with the restricted cash that is now unencumbered as of May 1, 2008, 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.



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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.



New Accounting Pronouncements



In September 2006, the 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 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 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 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 157 impacted our disclosures surrounding our long-term investments.



On February 15, 2007, the FASB issued FASB Statement No. 159,The Fair Value Option for Financial Assets and Financial Liabilities  Including an Amendment of FASB Statement No. 115 (SFAS 159).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 159 permits all entities to choose to measure eligible items at fair value at specified election dates. SFAS 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.



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 discussed 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;



        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.



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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 March 31, 2008, we held $5.5 million (par value) of investments comprised of ARS with maturity dates ranging from 2031 to 2047. 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 such 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.



At March 31, 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 primarily based on (a) a discounted cash flow model with factors including tax status, credit quality, duration, insurance swaps, levels of federal guarantees and likelihood of redemption and (b) estimates of observable market data for similar securities (when available). Based on this analysis, we recorded an unrealized loss of $251,000 ($166,000 net of tax) related to our ARS investments and have classified the investments as long-term on our balance sheet as of March 31, 2008. We believe this unrealized loss is primarily attributable to the limited liquidity of these investments, and it is our intent to hold these investments long enough to avoid realizing any significant loss. Nonetheless, if uncertainties in the
credit and capital market 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. We do not believe we need access to these funds for operational purposes for the foreseeable future.



Item 4T.   Controls and Procedures



Evaluation of Disclosure Controls and Procedures



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



Changes in Internal Control Over Financial Reporting



During the fiscal quarter covered by this report, there 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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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 a risk factor in our Annual Report on Form 10-K for the year ended December 31, 2007. However, we do not believe that this update has materially changed the type or magnitude of the risks we face in comparison to the disclosure provided in our Annual Report on Form 10-K for 2007.



As of March 31, 2008, we had $5.5 million invested in ARS. Since mid-February 2008, the auctions for these securities have failed, which adversely affects their liquidity. In May 2008, we recorded an unrealized loss of $251,000 ($166,000 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 March 31, 2008, we held $5.5 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. Liquidity for these securities has been provided by an auction process that resets the applicable interest rate at pre-determined intervals, usually every 28 to 35 days. 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 May 2008, based on an analysis of our ARS portfolio, we determined there was an unrealized loss of $251,000 ($166,000 net of tax). 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.



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



Item 5.    Other Information



None.



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Item 6.    Exhibits



The following exhibits are filed as part of this quarterly report on Form 10-Q for the quarterly period ended March 31, 2008:





Exhibit

Number
        Description




10.1
        Loan Agreement dated May 1, 2008 by and between Image Sensing Systems, Inc. (the Company) and Associated Bank, National Association (Associated Bank) (incorporated by reference to Exhibit 10.19 to the Companys Registration Statement on Form S-1 filed with the Securities and Exchange Commission on May 12, 2008 (Registration Statement)).




10.2
        Security Agreement dated May 1, 2008 by and between the Company and Associated Bank (incorporated by reference to Exhibit 10.20 to the Registration Statement).




10.3
        Promissory Note (Line of Credit) dated May 1, 2008 in the original principal amount of $5,000,000 issued by the Company to Associated Bank (incorporated by reference to Exhibit 10.21 to the Registration Statement).




10.4
        Promissory Note (Loan) dated May 1, 2008 in the original principal amount of $3,000,000 issued by the Company to Associated Bank (incorporated by reference to Exhibit 10.22 to the Registration Statement).




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.






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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:  May 14, 2008
        
        
        /s/ Kenneth R. AubreyKenneth R. AubreyPresident and Chief Executive Officer(principal executive officer)




Dated:  May 14, 2008
        
        
        /s/ Gregory R.L. SmithGregory R.L. SmithChief Financial Officer(principal financial and accounting officer)






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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.




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