Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-Q**

 

**(Mark****One)**
| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                  |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                     |
| ** ** | ** ** | **For the quarterly period ended December 31,  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:  001-08762**

** **

**ITERIS, INC.**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                             | ** ** | **95-2588496**      |
|------------------------------------------|------------|---------------------|
| (State or other jurisdiction of          |       | (I.R.S. Employer    |
| incorporation or organization)           |       | Identification No.) |
|                                     |       |                |
| **1700 Carnegie Avenue, Suite 100** | ** ** | ** **          |
| **Santa Ana, California**                | ** ** | **92705**           |
| (Address of principal executive office)  |       | (Zip Code)          |

 

**(949)**270-9400

**(Registrant’stelephone number, including area code)**

** **

(Formername, former address and former fiscal year, if changed since last report)

 

**Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934, as amended (the “Exchange Act”), during the preceding 12 months (or forsuch 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 registrantis a large accelerated filer, an accelerated filer, a non-accelerated filer, ora smaller reporting company. See definitions of “large accelerated filer,” “acceleratedfiler,” 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** |

 

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

** **

**Yes **o No x

** **

As of February 4,2009, the registrant had 34,186,756 shares of common stock outstanding.

 

 

 

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Tableof Contents

 

**ITERIS, INC.**

**Quarterly Reporton Form 10-QFor the Three and Nine Months Ended December 31, 2008**

** **

**Table of Contents**

** **
| **PART I.**  | ** ** | **FINANCIAL INFORMATION**                                                                                                      | ** ** | **3**      |
|-------------------|------------|--------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|              |       |                                                                                                                           |       |       |
| **ITEM 1.**       | ** ** | **FINANCIAL STATEMENTS**                                                                                                       | ** ** | **3**      |
|              |       |                                                                                                                           |       |       |
| ** **        | ** ** | **CONDENSED CONSOLIDATED  BALANCE SHEETS AT DECEMBER 31, 2008 AND MARCH 31, 2008**                                        | ** ** | **3**      |
| ** **        | ** ** | ** **                                                                                                                     | ** ** | ** ** |
| ** **        | ** ** | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED  DECEMBER 31, 2008 AND 2007** | ** ** | **4**      |
|              |       |                                                                                                                           |       |       |
| ** **        | ** ** | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED DECEMBER 31,  2008 AND 2007**           | ** ** | **5**      |
|              |       |                                                                                                                           |       |       |
| ** **        | ** ** | **NOTES TO  UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**                                                            | ** ** | **6**      |
|              |       |                                                                                                                           |       |       |
| **ITEM 2.**       | ** ** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                                | ** ** | **16**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 3.**       | ** ** | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                                                | ** ** | **23**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 4T.**      | ** ** | **CONTROLS AND  PROCEDURES**                                                                                                   | ** ** | **24**     |
|              |       |                                                                                                                           |       |       |
| **PART II.** | ** ** | **OTHER INFORMATION**                                                                                                          | ** ** | **24**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 1.**       | ** ** | **LEGAL PROCEEDINGS**                                                                                                          | ** ** | **24**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 1A.**      | ** ** | **RISK FACTORS**                                                                                                               | ** ** | **24**     |
| ** **        | ** ** | ** **                                                                                                                     | ** ** | ** ** |
| **ITEM 2.**       | ** ** | **UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**                                                               | ** ** | **33**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 3.**       | ** ** | **DEFAULTS UPON  SENIOR SECURITIES**                                                                                           | ** ** | **33**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 4.**       | ** ** | **SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS**                                                                       | ** ** | **33**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 5.**       | ** ** | **OTHER INFORMATION**                                                                                                          | ** ** | **33**     |
|              |       |                                                                                                                           |       |       |
| **ITEM 6.**       | ** ** | **EXHIBITS**                                                                                                                   | ** ** | **34**     |

 

Unless otherwise indicated in this report,the “Company,” “we,” “us” and “our” refer to Iteris, Inc. and ourwholly-owned subsidiary, Iteris Europe, GmbH.

 

AutoVue®, Iteris®, Vantage®, VersiCamTM,EdgeConnectTM, RZ4 AdvancedTM and Safety DirectTM are among the trademarks ofIteris, Inc. Any other trademarks or trade names mentioned herein are theproperty of their respective owners.

 

2

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**Table of Contents**

 

**PART I. FINANCIALINFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS**

** **

**ITERIS,INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Inthousands, except par value amounts)**

 
| ** **                                                                                                                                                                 | ** ** | **December 31,  2008** | ** ** | **March 31,  2008** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(unaudited)**             | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                                                                 |       |                        |       |                     |       |
| Current assets:                                                                                                                                                            |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                                                                                  | ** ** | **$**                       | **5,975**  |                     | $          | 421 |   |
| Trade accounts receivable, net of allowance  for doubtful accounts of $782 and $1,020 at December 31, 2008 and  March 31, 2008, respectively                     | ** ** | **12,850**                  |       | 13,108                   |       |
| Costs and estimated earnings in excess of  billings on uncompleted contracts                                                                                               | ** ** | **3,369**                   |       | 5,351                    |       |
| Inventories, net of reserve for inventory  obsolescence of $968 and $819 at December 31, 2008 and March 31,  2008, respectively                                  | ** ** | **4,997**                   |       | 4,226                    |       |
| Deferred income taxes                                                                                                                                                      | ** ** | **841**                     |       | 2,541                    |       |
| Prepaid expenses and other current assets                                                                                                                                  | ** ** | **292**                     |       | 371                      |       |
| Total current assets                                                                                                                                                       | ** ** | **28,234**                  |       | 26,018                   |       |
| Property and equipment, net                                                                                                                                                | ** ** | **3,428**                   |       | 3,467                    |       |
| Deferred income taxes                                                                                                                                                      | ** ** | **7,807**                   |       | 7,807                    |       |
| Intangible assets, net                                                                                                                                                     | ** ** | **147**                     |       | 257                      |       |
| Goodwill                                                                                                                                                                   | ** ** | **27,774**                  |       | 27,774                   |       |
| Other assets                                                                                                                                                               | ** ** | **211**                     |       | 322                      |       |
| Total assets                                                                                                                                                               | ** ** | **$**                       | **67,691** |                     | $          | 65,645 |   |
|                                                                                                                                                                       |       |                        |       |                     |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                             | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Current liabilities:                                                                                                                                                       |       |                        |       |                     |       |
| Trade accounts payable                                                                                                                                                     | ** ** | **$**                       | **3,272**  |                     | $          | 3,902 |   |
| Accrued payroll and related expenses                                                                                                                                       | ** ** | **3,291**                   |       | 3,825                    |       |
| Accrued liabilities                                                                                                                                                        | ** ** | **1,873**                   |       | 1,973                    |       |
| Billings in excess of costs and estimated  earnings on uncompleted contracts                                                                                               | ** ** | **1,790**                   |       | 1,126                    |       |
| Current portion of long-term debt                                                                                                                                          | ** ** | **2,191**                   |       | 244                      |       |
| Total current liabilities                                                                                                                                                  | ** ** | **12,417**                  |       | 11,070                   |       |
| Deferred rent                                                                                                                                                              | ** ** | **1,752**                   |       | 1,956                    |       |
| Unrecognized tax benefits                                                                                                                                                  | ** ** | **1,098**                   |       | 1,381                    |       |
| Other non-current liabilities                                                                                                                                              | ** ** | **37**                      |       | 461                      |       |
| Long-term debt                                                                                                                                                             | ** ** | **5,114**                   |       | 7,566                    |       |
| Total liabilities                                                                                                                                                          | ** ** | **20,418**                  |       | 22,434                   |       |
| Commitments and contingencies                                                                                                                                              |       |                        |       |                     |       |
| Stockholders’ equity:                                                                                                                                                 |       |                        |       |                     |       |
| Preferred stock, $1.00 par value, 2,000  shares authorized, none issued and outstanding at December 31, 2008 and  March 31, 2008                                 |       | —                      |       | —                   |       |
| Common stock, $0.10 par value, 70,000  shares authorized, 34,182 and 33,420 shares issued and outstanding at December 31,  2008 and March 31, 2008, respectively | ** ** | **3,418**                   |       | 3,342                    |       |
| Additional paid-in capital                                                                                                                                                 | ** ** | **136,887**                 |       | 135,516                  |       |
| Common stock held in trust, 24 and 167  shares at December 31, 2008 and March 31, 2008, respectively                                                             | ** ** | **(31**                     | **)**      | (202                     | )          |
| Accumulated deficit                                                                                                                                                        | ** ** | **(93,025**                 | **)**      | (95,499                  | )          |
| Accumulated other comprehensive income                                                                                                                                     | ** ** | **24**                      |       | 54                       |       |
| Total stockholders’ equity                                                                                                                                            | ** ** | **47,273**                  |       | 43,211                   |       |
| Total liabilities and stockholders’ equity                                                                                                                            | ** ** | **$**                       | **67,691** |                     | $          | 65,645 |   |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

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**ITERIS, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per shareamounts)**

 
| ** **                                | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                | ** ** | **2008**                                            | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net sales and contract revenues:          |       |                                                |       |                                               |       |   |   |   |   |
| Net sales                                 | ** ** | **$**                                               | **9,083**  |                                               | $          | 9,176 | ** ** | **$** | **30,687** |   | $ | 30,215 |   |
| Contract revenues                         | ** ** | **7,379**                                           |       | 6,187                                              | ** ** | **22,283** |   | 17,881 |   |
| Total net sales and contract revenues     | ** ** | **16,462**                                          |       | 15,363                                             | ** ** | **52,970** |   | 48,096 |   |
|                                      |       |                                                |       |                                               |       |   |   |   |   |
| Costs of net sales and contract revenues: |       |                                                |       |                                               |       |   |   |   |   |
| Cost of net sales(a)                      | ** ** | **4,890**                                           |       | 4,631                                              | ** ** | **16,043** |   | 15,302 |   |
| Cost of contract revenues(a)              | ** ** | **5,068**                                           |       | 4,232                                              | ** ** | **14,796** |   | 11,938 |   |
| Gross profit                              | ** ** | **6,504**                                           |       | 6,500                                              | ** ** | **22,131** |   | 20,856 |   |
| Operating expenses:                       |       |                                                |       |                                               |       |   |   |   |   |
| Selling, general and administrative(a)    | ** ** | **4,385**                                           |       | 4,331                                              | ** ** | **14,193** |   | 13,119 |   |
| Research and development(a)               | ** ** | **848**                                             |       | 1,002                                              | ** ** | **3,180** |   | 2,623 |   |
| Amortization of intangible assets         | ** ** | **37**                                              |       | 37                                                 | ** ** | **110** |   | 110 |   |
| Total operating expenses                  | ** ** | **5,270**                                           |       | 5,370                                              | ** ** | **17,483** |   | 15,852 |   |
| Operating income                          | ** ** | **1,234**                                           |       | 1,130                                              | ** ** | **4,648** |   | 5,004 |   |
| Non-operating income (expense):           |       |                                                |       |                                               |       |   |   |   |   |
| Other income, net                         | ** ** | **63**                                              |       | (3                                                 | **)**      | **90** |   | 41 |   |
| Interest expense, net                     | ** ** | **(141**                                            | **)**      | (314                                               | **)**      | **(537** | **)** | (1,046 | ) |
| Income before income taxes                | ** ** | **1,156**                                           | ** ** | 813                                                | ** ** | **4,201** | ** ** | 3,999 |   |
| Income tax benefit (provision)            | ** ** | **(415**                                            | **)**      | 141                                                | ** ** | **(1,727** | **)** | 221 |   |
| Net income                                | ** ** | **$**                                               | **741**    |                                               | $          | 954 | ** ** | **$** | **2,474** |   | $ | 4,220 |   |
|                                      |       |                                                |       |                                               |       |   |   |   |   |
| Earnings per share:                       |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                     | ** ** | **$**                                               | **0.02**   |                                               | $          | 0.03 | ** ** | **$** | **0.07** |   | $ | 0.13 |   |
| Diluted                                   | ** ** | **$**                                               | **0.02**   |                                               | $          | 0.03 | ** ** | **$** | **0.07** |   | $ | 0.12 |   |
| Weighted average shares outstanding:      |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                     | ** ** | **34,120**                                          |       | 32,914                                             | ** ** | **33,895** |   | 32,568 |   |
| Diluted                                   | ** ** | **34,358**                                          |       | 35,256                                             | ** ** | **34,752** |   | 34,674 |   |

 

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| (a) Includes stock-based compensation  expense as follows: |       |   |   |   |       |    |       |   |    |
|-----------------------------------------------------------------|------------|--------|--------|--------|------------|---------|------------|--------|---------|
| Cost of net sales                                               | ** ** | **$**  | **2**  |   | $          | 1       | ** ** | **$**  | **7**   |   | $ | 3 |   |
| Cost of contract revenues                                       | ** ** | **10** |   | 3      | ** ** | **30**  |       | 9      |    |
| Selling, general and administrative                             | ** ** | **75** |   | 77     | ** ** | **228** |       | 190    |    |
| Research and development                                        | ** ** | **5**  |   | 1      | ** ** | **15**  |       | 5      |    |
| Total                                                           | ** ** | **$**  | **92** |   | $          | 82      | ** ** | **$**  | **280** |   | $ | 207 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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** **

**ITERIS, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(In thousands)**

 
| ** **                                                                         | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2008**                                           | ** ** | **2007** | ** ** |
| **Cash flows from operating activities**                       |       |                                               |       |   |   |
| Net income                                                                         | ** ** | **$**                                              | **2,474**  |   | $ | 4,220 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                               |       |   |   |
| Change in deferred tax assets                                                      | ** ** | **1,700**                                          |       | (229 | ) |
| Depreciation and amortization of property  and equipment                           | ** ** | **755**                                            |       | 443 |   |
| Stock-based compensation expense                                                   | ** ** | **280**                                            |       | 207 |   |
| Amortization of debt discount                                                      | ** ** | **166**                                            |       | 155 |   |
| Amortization of intangible assets                                                  | ** ** | **110**                                            |       | 110 |   |
| Amortization of deferred financing costs                                           | ** ** | **110**                                            |       | 104 |   |
| Amortization of deferred gain on  sale—leaseback transaction                  |       | —                                             |       | (165 | ) |
| Changes in operating assets and  liabilities:                                      |       |                                               |       |   |   |
| Accounts receivable                                                                | ** ** | **258**                                            |       | (1,114 | ) |
| Net costs and estimated earnings in excess  of billings                            | ** ** | **2,646**                                          |       | (1,108 | ) |
| Inventories                                                                        | ** ** | **(771**                                           | **)**      | 1,979 |   |
| Prepaid expenses and other assets                                                  | ** ** | **80**                                             |       | (166 | ) |
| Accounts payable and accrued liabilities                                           | ** ** | **(1,778**                                         | **)**      | 928 |   |
| Net cash provided by operating activities                                          | ** ** | **6,030**                                          |       | 5,364 |   |
|                                                                               |       |                                               |       |   |   |
| **Cash flows from investing activities**                                           |       |                                               |       |   |   |
| Purchases of property and equipment                                                | ** ** | **(716**                                           | **)**      | (455 | ) |
|                                                                               |       |                                               |       |   |   |
| **Cash flows from financing activities**                                           |       |                                               |       |   |   |
| Proceeds from stock option and warrant  exercises                                  | ** ** | **911**                                            |       | 1,325 |   |
| Borrowings on long-term debt                                                       | ** ** | **5,073**                                          |       | — |   |
| Payments on long-term debt                                                         | ** ** | **(5,744**                                         | **)**      | (1,727 | ) |
| Net payments on line of credit                                                     |       | —                                             |       | (3,816 | ) |
| Change in checks drawn in excess of  available bank balances                       |       | —                                             |       | (47 | ) |
| Net cash provided by (used in) financing  activities                               | ** ** | **240**                                            |       | (4,265 | ) |
| Increase in cash                                                                   | ** ** | **5,554**                                          |       | 644 |   |
| Cash at beginning of period                                                        | ** ** | **421**                                            |       | 35 |   |
| Cash at end of period                                                              | ** ** | **$**                                              | **5,975**  |   | $ | 679 |   |
|                                                                               |       |                                               |       |   |   |
| **Supplemental cash flow information:**                                            | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Cash paid during the period:                                                       |       |                                               |       |   |   |
| Interest                                                                           | ** ** | **$**                                              | **435**    |   | $ | 825 |   |
| Income taxes                                                                       | ** ** | **404**                                            |       | 48 |   |
| ** **                                                                         | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| **Supplemental schedule of non-cash  investing and financing activities:**    | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Fair value of common stock issued in  settlement of liabilities                    | ** ** | **$**                                              | **427**    |   | $ | 350 |   |
| Conversion of redeemable common stock to  common stock                             |       | —                                             |       | 3,414 |   |
| Lease incentives in connection with new  headquarters lease                        |       | —                                             |       | 1,772 |   |
| Write-off of notes receivable from  employees                                      |       | —                                             |       | (5 | ) |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

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**ITERIS,INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2008**

** **

**1. Description of Business and Summary of Significant Accounting Policies**

 

**Description of Business**

 

Iteris, Inc. is a leader in the traffic management market focusedon the development and application of advanced technologies that reduce trafficcongestion and improve the safety of surface transportation systems infrastructure.By combining outdoor image processing, traffic engineering and informationtechnology, the Company offers a broad range of Intelligent TransportationSystems (“ITS”) and driver safety solutions to customers worldwide. As an addedbenefit, the Company’s products and services minimize the environmental impactof traffic congestion. The Company was originally incorporated in Delaware in1987.

 

**Basis of Presentation**

 

The unaudited condensed consolidated financialstatements of the Company have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Securities and Exchange Commission (“SEC”)Form 10-Q and Article 10 of SEC Regulation S-X. In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements contain all adjustments, consisting of normal recurring adjustments,necessary to present fairly the consolidated financial position of the Companyas of December 31, 2008, the consolidated results of operations for thethree and nine months ended December 31, 2008 and 2007, and theconsolidated cash flows for the nine months ended December 31, 2008 and2007. Certain information and footnote disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States (“U.S. GAAP”) have been condensed or omitted pursuant tothe rules and regulations of the SEC. The results of operations for thethree and nine months ended December 31, 2008 are not necessarilyindicative of those to be expected for the entire year. The accompanyingunaudited condensed consolidated financial statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the yearended March 31, 2008, which was filed with the SEC on June 12, 2008.

 

# **Use ofEstimates**

#  

The preparation of consolidated financial statementsin conformity with U.S. GAAP requires management to make certain estimates andassumptions that affect the reported amounts of assets and liabilities,disclosures of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates. Significantestimates made in the preparation of the consolidated financial statementsinclude the allowance for doubtful accounts, deferred tax assets, inventory andwarranty reserves, costs to complete long-term contracts, overhead rates used incost-plus contracts, contract reserves and estimates of future cash flows usedto assess the recoverability of long-lived assets, the valuation of debt andequity instruments and the realization of goodwill.

 

**Reclassifications**

** **

Certain amounts in theprior period financial statements have been reclassified to conform withcurrent year presentation.

 

# **RevenueRecognition**

#  

Product revenues andrelated costs of sales are recognized upon the transfer of title, whichgenerally occurs upon shipment or, if required, upon acceptance by thecustomer, provided that the Company believes collectibility of the net salesamount is probable. Accordingly, at the date revenue is recognized, thesignificant uncertainties concerning the sale have been resolved.

 

Contract revenues arederived primarily from long-term contracts with governmental agencies. Contractrevenues include costs incurred plus a portion of estimated fees or profitsdetermined on the percentage of completion method of accounting based on therelationship of costs incurred to date to total estimated costs. Anyanticipated losses on contracts are charged to earnings when identified.Changes in job performance and estimated profitability, including those arisingfrom contract penalty provisions and final contract settlements, may result inrevisions to costs and revenues and are recognized in the period in which therevisions are determined. Profit incentives are included in revenue when theirrealization is reasonably assured.

 

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In addition to productand contract revenue, the Company derives revenue from the provision ofspecific non-recurring contract engineering services and royalties.Non-recurring contract engineering revenues are recognized in the period inwhich the related services are performed. Royalty revenues are recorded in theperiod in which the royalty is earned based on unit sales of the Company’sproducts.  Non-recurring contractengineering revenues and royalty revenues are included in net sales in theaccompanying condensed consolidated statements of operations.

 

Revenues from follow-onservice and support, for which the Company charges separately, are recorded inthe period in which the services are performed.

 

**Concentration of Credit Risk**

 

Accounts receivable areprimarily derived from revenues earned from customers located throughout NorthAmerica and Europe. The Company generally does not require collateral or othersecurity from customers. Collectibility of receivable balances is estimatedthrough review of invoices outstanding greater than a certain period of timeand ongoing credit evaluations of customers’ financial condition. Reserves aremaintained for potential credit losses, and such losses have historically beenwithin management’s expectations.

 

**Fair Values of Financial Instruments**

 

The fair values of cash and cash equivalents,receivables, inventories, accounts payable and accrued expenses approximatecarrying value because of the short period of time to maturity. The fair valuesof line of credit agreements and long-term debt approximate carrying valuebecause the related rates of interest approximate current market rates. Thefair value of convertible debentures approximates carrying value because theeffective interest rate, taking into account recorded debt discounts,approximates current market rates.

 

# **Inventories**

#  

Inventories are stated at the lower of cost ormarket. Cost is determined using the first-in, first-out method.

 

**Property and Equipment**

 

Property and equipment are recorded at cost and aregenerally depreciated using the straight-line method over the estimated usefullife ranging from three to eight years. Leasehold improvements are depreciatedover the term of the related lease or the estimated useful life of theimprovement, whichever is shorter.

 

**Goodwill and Long-Lived Assets**

 

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 142, *Goodwill and IntangibleAssets*, goodwill is tested for impairment on an annual basis in theCompany’s fourth fiscal quarter or more frequently if indicators of impairmentexist, of which none have been identified. The performance of the test involvesa two-step process. The first step of the impairment test involves comparingthe fair value of the Company’s reporting units with each respective reportingunit’s carrying amount, including goodwill. The Company determines the fairvalue of reporting units using the income approach. If the carrying amount of areporting unit exceeds the reporting unit’s fair value, the second step of thegoodwill impairment test is performed to determine the amount of any impairmentloss. The second step of the goodwill impairment test involves comparing theimplied fair value of the reporting unit’s goodwill with the carrying amount ofthat goodwill.

 

The Company evaluates long-lived assets forimpairment in accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets,* which requiresimpairment evaluation on long-lived assets used in operations when indicatorsof impairment are present. Reviews are performed to determine whether thecarrying value of assets is impaired, based on a comparison to undiscountedexpected future cash flows. If this comparison indicates that there isimpairment, the impaired asset is written down to fair value, which istypically calculated using discounted expected future cash flows and a discountrate based upon the Company’s weighted average cost of capital adjusted forrisks associated with the related operations. Impairment is based on the excessof the carrying amount over the fair value of those assets.

 

**Income Taxes**

 

The Company utilizes the liability method ofaccounting for income taxes as set forth in SFAS No. 109, *Accounting for Income Taxes*(“SFAS 109”)*.*Underthe liability method, deferred taxes are determined based on the temporarydifferences between the financial statement and tax bases of assets andliabilities using enacted tax rates. A valuation allowance is recorded when itis more likely than not that all or a portion of the deferred tax assets willnot be realized.

 

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**Stock-BasedCompensation**

 

Effective April 1,2006, the Company adopted SFAS No. 123 (revised 2004), *Share-Based Payment* (“SFAS 123R”), which requires allstock-based payments, including grants of employee stock options, to berecognized in the statement of operations as an expense, based on their grantdate fair values with such fair values amortized over the requisite serviceperiod. The Company elected to use the modified prospective transition methodfor transition to SFAS 123R. Under the modified prospective method, SFAS 123Rapplies to all awards granted or modified after the date of adoption. Inaddition, under the modified prospective method, compensation expense isrecognized for all stock-based compensation awards granted prior to but not yetvested as of April 1, 2006, based on grant-date fair values estimated inaccordance with the original provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*.

 

The fair value of theCompany’s common stock option awards is estimated on the grant date using theBlack-Scholes-Merton (“BSM”) option-pricing formula. Expected volatility isbased on the historical volatility of the Company’s stock price. The expectedlife of options granted subsequent to the adoption of SFAS 123R is derivedbased on the historical life of the Company’s options. The risk-free interestrate for periods within the expected life of the option is based on the U.S.Treasury interest rates in effect at the time of grant.

 

**Research and Development Expenditures**

 

Research and development expenditures are charged toexpense in the period in which they are incurred.

 

**Shipping and Handling Costs**

 

Shipping and handling costs are included in cost ofsales in the period during which products ship.

 

**Sales Taxes**

 

Sales taxes are presented on a net basis (excludedfrom net sales and contract revenues) in the unaudited condensed consolidatedstatements of operations.

 

**Warranty**

 

The Company generally provides a one to three yearwarranty from the original invoice date on all products, materials andworkmanship. Products sold to certain original equipment manufacturer (“OEM”)customers sometimes carry longer warranties. Defective products will be eitherrepaired or replaced, generally at the Company’s option, upon meeting certaincriteria. The Company accrues a provision for the estimated costs that may beincurred for product warranties relating to a product as a component of cost ofsales at the time revenue for that product is recognized. The accrued warranty provisionis included within accrued expenses on the accompanying condensed consolidatedbalance sheets.

 

**Repair and Maintenance Costs**

 

The Company incurs repairand maintenance costs in the normal course of business. Should the activityresult in a permanent improvement to one of the Company’s leased facilities,the cost is capitalized as a leasehold improvement and amortized over itsuseful life or the remainder of the lease period, whichever is shorter.Non-permanent repair and maintenance costs are charged to expense as incurred.

 

**Other Comprehensive Income**

 

The only component of accumulated othercomprehensive income is foreign currency translation adjustments.

 

**Recent Accounting Pronouncements**

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value, and expands disclosure about fair valuemeasurements. SFAS 157 does not require any new fair value measurements; ratherit specifies valuation methods to be applied when fair value measurements arerequired under existing or future accounting pronouncements. SFAS 157 iseffective for fiscal years beginning after November 15, 2007 and interimperiods within those

 

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fiscalyears. In February 2008, the FASB issued FASB Staff Position (“FSP”)157-2, *Effective Date of FASB Statement No. 157*(“FSP 157-2”), which delays the effective date of SFAS 157 for non-financialassets and liabilities to fiscal years beginning after November 15, 2008.Generally, SFAS 157 will be applied prospectively. With respect to financialassets and liabilities, the Company adopted SFAS 157 in the first quarter offiscal 2009. There was no material impact on the consolidated financialstatements. The Company is currently evaluating the impact of SFAS 157 and FSP157-2 with respect to its non-financial assets and liabilities and expects toadopt SFAS 157 and FSP 157-2 with respect to these assets and liabilities inthe first quarter of its fiscal year ending March 31, 2010.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities — including an amendment of FASB Statement No. 115 (“SFAS159”).* SFAS 159 allows an entity the irrevocable option to electfair value for the initial and subsequent measurement of certain financialassets and liabilities on a contract-by-contract basis. Subsequent changes infair value of these financial assets and liabilities would be recognized inearnings when they occur. SFAS 159 is effective for fiscal years beginningafter November 15, 2007 with earlier adoption permitted under specialrules. The adoption of SFAS 159 did not have a material impact on theconsolidated financial statements of the Company.

 

InDecember 2007, the FASB issued SFAS No. 141R, *Business Combinations* (“SFAS 141R”). SFAS 141Restablishes principles and requirements for how the acquirer of a businessrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in theacquiree. The statement also provides guidance for recognizing and measuringthe goodwill acquired in the business combination and determines whatinformation to disclose to enable users of financial statements to evaluate thenature and financial effects of the business combination. SFAS 141R is effectivefor financial statements issued for fiscal years beginning after December 15,2008. The nature and magnitude of the specific effects of adopting SFAS 141Rwill depend upon the nature, terms and size of any acquisitions the Company mayconsummate after the effective date of the Company’s adoption of SFAS 141R  (April 1, 2009).

 

In May 2008, theFASB issued SFAS No. 162, *TheHierarchy of Generally Accepted Accounting Principles* (“SFAS 162”).SFAS 162 identifies the sources of accounting principles to be used in thepreparation of financial statements of nongovernmental entities that arepresented in conformity with U.S. GAAP. SFAS 162 is effective60 days following the SEC approval of the Public Company AccountingOversight Board amendments to AU Section 411, *The Meaning of Present Fairly in Conformity with Generally AcceptedAccounting Principles.* The Company currently adheres to thehierarchy of U.S. GAAP as presented in SFAS 162, and adoption is notexpected to have a material impact on its consolidated financial statements.

 

InJune 2008, the FASB issued Emerging Issues Task Force (“EITF”) Issue No. 07-5,*Determining Whether an Instrument (or EmbeddedFeature) Is Indexed to an Entity’s Own Stock* (“EITF 07-5”). EITF07-5 clarifies how to determine whether certain instruments or features wereindexed to an entity’s own stock under EITF Issue No. 01-6, *The Meaning of “Indexed to a Company’s Own Stock,”*(“EITF01-6”) and provides guidance to determine what accounting literature may applyto a particular equity linked instrument or feature. EITF 07-5 will becomeeffective for financial statements issued for fiscal years beginning after December 15,2008, and interim periods within those fiscal years, and must be applied to allinstruments outstanding on the date of adoption. The Company is currentlyevaluating the impact of EITF 07-5, and has not yet determined the effect, ifany, of its adoption on the Company’s consolidated financial statements.

 

**2. Supplemental Financial Information**

 

**Inventories**

 

The following tablepresents details of the Company’s inventories:

 
| ** **                       | ** ** | **December 31,  2008** | ** **      | **March 31,  2008** | ** ** |
|----------------------------------|------------|-----------------------------|-----------------|--------------------------|------------|
| ** **                       | ** ** | **(In thousands)**     | ** **      |
| Materials and supplies | ** ** | **$**                       | ** 4,152** | ** **               | $          |  3,031 | ** ** |
| Work in process                  | ** ** | **16**                      |            | 345                      |       |
| Finished goods                   | ** ** | **829**                     |            | 850                      |       |
| ** **                       |       | **$**                       | **4,997**       |                     | $          | 4,226 |   |

 

**IntangibleAssets**

 
|                 | ** ** | **December 31, 2008** |       | **March 31, 2008**  |       |
|----------------------|------------|---------------------------------|------------|-------------------------------|------------|
|                 | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** |   |
|                 | ** ** | **(In thousands)**         |       |
| Developed technology | ** ** | **$**                           | **495**    | ** **                    | **$**      | **(457** | **)** | $ | 495 |   | $ | (381 | ) |
| Patents              | ** ** | **317**                         | ** ** | **(208**                      | **)**      | 317 |   | (174 | ) |
| Total                | ** ** | **$**                           | **812**    | ** **                    | **$**      | **(665** | **)** | $ | 812 |   | $ | (555 | ) |

 

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Amortizationexpense for intangible assets subject to amortization was $37,000 and $110,000for the three and nine months ended December 31, 2008, respectively, and$37,000 and $110,000 for the three and nine months ended December 31,2007, respectively.  Future estimatedamortization expense for the remainder of the current fiscal year and the nextthree fiscal years is as follows:

 
| **Fiscal Year Ending March 31:** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| Remainder of 2009                                    |       | $          | 37         |   |
| 2010                                                 |       | 58         |       |
| 2011                                                 |       | 46         |       |
| 2012                                                 |       | 6          |       |
|                                                 |       | $          | 147        |   |

 

**Warranty Reserve Activity**

 

The following table presents activity in accrued warrantyobligations:

 

 
|                               | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** |       |
|------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
|                               | ** ** | **2008**                                            | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** |   |
|                               | ** ** | **(In thousands)**                             |       |
| Balance at beginning of period     | ** ** | **$**                                               | **557**    |                                               | $          | 489 | ** ** | **$** | **494** |   | $ | 520 |   |
| Additions charged to cost of sales | ** ** | **74**                                              |       | 109                                                | ** ** | **258** |   | 253 |   |
| Warranty claims                    | ** ** | **(75**                                             | **)**      | (74                                                | )          | **(196** | **)** | (249 | ) |
| Balance at end of period           | ** ** | **$**                                               | **556**    |                                               | $          | 524 | ** ** | **$** | **556** |   | $ | 524 |   |

 

**Earnings Per Share**

 

The following table setsforth the computation of basic and diluted earnings per share:

 
|                                                         |       | **Three Months Ended  December 31,**                   |       | **Nine Months Ended  December 31,** |       |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
|                                                         |       | **2008**                                                              | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** |   |
|                                                         |       | **(In thousands, except per share amounts)** |       |
| Numerator:                                                   |       |                                                                  |       |                                               |       |   |   |   |   |
| Net  income                                                  | ** ** | **$**                                                                 | **741**    |                                               | $          | 954 | ** ** | **$** | **2,474** |   | $ | 4,220 |   |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Denominator:                                                 |       |                                                                  |       |                                               |       |   |   |   |   |
| Weighted  average common shares used in basic computation    | ** ** | **34,120**                                                            |       | 32,914                                             | ** ** | **33,895** |   | 32,568 |   |
| Dilutive  stock options                                      | ** ** | **238**                                                               |       | 2,329                                              | ** ** | **853** |   | 2,086 |   |
| Dilutive  warrants                                           |       | **—**                                                            |       | 13                                                 | ** ** | **4** |   | 20 |   |
| Weighted  average common shares used in dilutive computation | ** ** | **34,358**                                                            |       | 35,256                                             | ** ** | **34,752** |   | 34,674 |   |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Earnings  per share:                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Basic                                                        | ** ** | **$**                                                                 | **0.02**   |                                               | $          | 0.03 | ** ** | **$** | **0.07** |   | $ | 0.13 |   |
| Diluted                                                      | ** ** | **$**                                                                 | **0.02**   |                                               | $          | 0.03 | ** ** | **$** | **0.07** |   | $ | 0.12 |   |

 

The following shares wereexcluded from the computation of diluted earnings per share as their effectwould have been anti-dilutive:

 
| ** **             | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **             | ** ** | **2008**                                            | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **             | ** ** | **(In thousands)**                             | ** ** |
| Stock options          | ** ** | **2,184**                                           |       | 355                                                | ** ** | **1,245** |   | 552 |   |
| Warrants               | ** ** | **1,165**                                           |       | 1,150                                              | ** ** | **1,155** |   | 1,177 |   |
| Convertible debentures | ** ** | **623**                                             |       | 2,729                                              | ** ** | **1,639** |   | 2,729 |   |

 

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**3.Revolving Line of Credit and Long-Term Debt**

 

**RevolvingLine of Credit**

 

Prior to October 16,2008, the Company had a credit facility with a bank that provided for line ofcredit borrowings of up to $10.0 million. Under this credit facility, theCompany could borrow against its eligible accounts receivable and eligibleinventory, as defined in the credit agreement. Interest on borrowed amountsunder the line of credit was payable monthly at the current stated prime rateplus 1.00%. Additionally, the Company was obligated to pay an unused line feeof 0.25% per annum applied to the amount by which the maximum credit amountexceeded the average daily principal balance during the preceding month. Thecredit facility required $2,000 in monthly collateral management fees andincluded an early termination fee equal to 2% of the total facility during thefirst year of the agreement and 1% of the total facility in the second year ofthe agreement. The credit facility was secured by substantially all of theassets of the Company. This credit facility expired on October 15, 2008.

 

Effective October 16,2008, the Company entered into a new $19.5 million credit facility with adifferent bank which replaced the Company’s existing credit facility.  This new credit facility provides for atwo-year revolving line of credit with borrowings of up to $12.0 million and a$7.5 million 48-month term note (discussed below).  Interest on borrowed amounts under therevolving line of credit will be payable monthly at a rate equal to the currentstated prime rate up to the current stated prime rate plus 0.50%, depending onaggregate deposit balances maintained at the bank in relation to the total loancommitment under the credit facility (3.75% at December 31, 2008).  The Company is obligated to pay an unusedline fee of 0.25% per annum applied to the average unused portion of the $12.0million revolving line of credit during the preceding month.  The revolving line of credit does not containany early termination fees and is secured by substantially all of the assets ofthe Company. As of December 31, 2008, no amounts were borrowed under the revolvingline of credit portion of the facility. As part of this new credit facility,the Company may also borrow up to $7.5 million in the form of a 48-monthterm note to retire its convertible debentures as discussed below under “Long-TermDebt — Bank Term Notes”.

 

**Long-TermDebt**

 

The Company’s long-termdebt consists of the following:

 
| ** **                            | ** ** | **December 31,  2008** | ** ** | **March 31,  2008** | ** ** |
|---------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                            | ** ** | **(In thousands)**     | ** ** |
| Convertible debentures, net |       | **$**                       | **2,232**  |                     | $          | 7,566 |   |
| Bank term notes                       | ** ** | **5,073**                   |       | 210                      |       |
| Other                                 |       | —                      |       | 34                       |       |
| ** **                            |       | **7,305**                   |       | 7,810                    | ** ** |
| Less current portion                  | ** ** | **(2,191**                  | **)**      | (244                     | )          |
| ** **                            |       | **$**                       | **5,114**  |                     | $          | 7,566 |   |

 

*Convertible Debentures, Net.*InMay 2004, the Company sold and issued subordinated convertible debenturesin the aggregate original principal amount of $10.1 million. In connection withthe issuance of the debentures, the Company issued warrants to purchase anaggregate of 639,847 shares of its common stock, the value of which wasrecorded as a debt discount against the face amount of the debentures on thedate of issuance and is being amortized to interest expense over the term ofthe convertible debentures.

 

The debentures are due infull on May 18, 2009, provide for 6.0% annual interest, payable quarterly,and are convertible into the Company’s common stock at an initial conversionprice of $3.61 per share, subject to certain adjustments, including adjustmentsfor dilutive issuances. From May 19, 2008 until the maturity date, theCompany may redeem the debentures at 110% of the principal amount. As of December 31,2008, $250,000 of debentures had been converted into 69,252 shares of theCompany’s common stock.

 

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Additionally, as of December 31,2008, the Company had retired $7.6 million of its outstanding debentures, atthe holders’ request, using $2.1 million in cash and $5.07 million financedunder the Company’s new bank term note, which is described below under thecaption “Bank Term Notes.”  In January 2009,the Company paid $1.47 million to retire an additional $1.5 million ofdebentures, at the holders’ request, leaving $750,000 of debenturesoutstanding. The $1.47 million was also financed under the Company’s new bankterm note. In accordance with SFAS No. 6, *Classificationsof Short-Term Obligations Expected to Be Refinanced*, the Company hasclassified the long-term portion of the debentures financed under the new termnote subsequent to December 31, 2008 as long-term debt in the accompanyingcondensed consolidated balance sheet.

 

*Bank Term Notes.*InOctober 2004, the Company entered into a $5.0 million term note payablewith a bank. The note was due on May 27, 2008, and provided for monthlyprincipal payments of approximately $104,000. The final payment against this term note was made in June 2008.

 

Effective October 16,2008, the Company entered into a new $19.5 million credit facility with adifferent bank, as described above. Under this new credit facility, the Company may borrow up to $7.5million in the form of a 48-month term note to retire all outstandingconvertible debentures.  Principalpayments under this term note are required to be repaid in 48 monthlyinstallments commencing on June 1, 2009. Interest on the term note will be payable monthly at a rate equal to thecurrent stated prime rate plus 0.50% up to the current stated prime rate plus1.00%, depending on aggregate deposit balances maintained at the bank inrelation to the total loan commitment under the credit facility (4.25% at December 31,2008).  The Company paid an upfront loancommitment fee of $28,000 for the term note. The term note contains no earlytermination fees and, along with the new revolving line of credit under thesame credit agreement (above), is secured by substantially all of the assets ofthe Company. As of December 31, 2008, $5.07 million had been borrowedagainst this term note to repay debentures. In January 2009, an additional $1.47 million was borrowed for thesame purpose; increasing the total amount borrowed under the term note to $6.5million as of February 6, 2009.

 

On February 4, 2009 the Company entered into anAmended and Restated Loan and Security Agreement with its current senior lenderwhich supersedes the agreements entered into on October 16, 2008 in theirentirety. The October 16, 2008 documents were amended and restated toclarify the meaning of certain ambiguities and remove non-applicablelanguage.  No modifications were made toany significant provisions related to the overall amount of the creditfacility, interest rate calculations, or any financial or non-financialcovenant.

 

Scheduled aggregatematurities of long-term debt principal as of December 31, 2008, were asfollows:

 
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| 2009                                                 | ** ** | **$**      | **—** | ** ** |
| 2010                                                 | ** ** | **2,620**  | ** ** |
| 2011                                                 | ** ** | **2,144**  | ** ** |
| 2012                                                 | ** ** | **2,144**  | ** ** |
| 2013                                                 | ** ** | **415**    | ** ** |
| Thereafter                                           |       | —     |       |
| ** **                                           | ** ** | **7,323**  | ** ** |
| Less: unamortized debt discount                      | ** ** | **(18**    | **)**      |
| ** **                                           | ** ** | **$**      | **7,305**  | ** ** |

 

**4. Commitments and Contingencies**

 

**Litigation and Other Contingencies**

 

From time to time, the Company has been involved inlitigation relating to claims arising out of its operations in the normalcourse of business. The Company currently is not a party to any such legalproceedings, the adverse outcome of which, in management’s opinion,individually or in the aggregate, would have a material adverse effect on itsconsolidated results of operations, financial position or cash flows.

 

Furthermore, from time to time, the Company hasexperienced unforeseen developments in contingencies related to its formersubsidiaries. For example, the Company has been the subject of a number ofroutine tax audits for time periods and jurisdictions related to the businessesof its former subsidiaries, some of which are still in process. Although thedevelopment and ultimate outcome of these and other unforeseen matters cannotbe predicted with any certainty, management does not believe that the Companyis presently involved in any matters related to its former subsidiaries thatwould have a material adverse effect on the Company’s consolidated results ofoperations, financial position or cash flows.

 

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**Operating Lease Commitments**

 

The Company has lease commitments for facilities invarious locations throughout the United States. Future commitments under thesenon-cancelable operating leases at December 31, 2008 were as follows:

 
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| Remainder of 2009                                    | ** ** | **$**      | **812**    | ** ** |
| 2010                                                 | ** ** | **1,661**  | ** ** |
| 2011                                                 | ** ** | **1,444**  | ** ** |
| 2012                                                 | ** ** | **1,365**  | ** ** |
| 2013                                                 | ** ** | **1,380**  | ** ** |
| Thereafter                                           | ** ** | **2,460**  | ** ** |
| Total                                                | ** ** | **$**      | **9,122**  | ** ** |

 

The Company previouslysubleased office space to MAXxess Systems, Inc. (“MAXxess”), a formersubsidiary of the Company that was sold by the Company in September 2003and is currently owned by an investor group that includes four of the Company’sdirectors, one of whom is the Chief Executive Officer of MAXxess. At December 31,2008, MAXxess owed the Company an aggregate of $274,000 related to thissublease, which terminated in September 2007, and certain relatedancillary services that were previously provided by the Company toMAXxess.  Although the Company has fullyreserved for amounts owed to it by MAXxess under the terms of this sublease, theCompany plans to continue to pursue full payment of any and all amounts duefrom MAXxess, but cannot assure that MAXxess will be able to make suchpayments.

 

**Inventory Purchase Commitments**

 

At December 31, 2008, the Company had firm commitments to purchaseinventory in the amount of approximately $2.5 million during the next threefiscal quarters.

 

**5. Stock-Based Compensation**

 

Under the Company’s 2007Omnibus Incentive Plan (the “2007 Plan”), options to purchase shares of theCompany’s unissued common stock may be granted to the Company’s employees,officers, consultants and directors at exercise prices which are equal to orgreater than the fair market value of the Company’s common stock on the date ofgrant. Options expire no more than ten years after the date of grant andgenerally vest at the rate of 25% on each of the first four anniversaries ofthe grant date. The 2007 Plan also allows for the issuance of stockappreciation rights, restricted stock, restricted stock units and otherstock-based awards. New shares are issued to satisfy stock option exercises andshare issuances under the 2007 Plan. As of December 31, 2008, options topurchase an aggregate of 404,000 shares of common stock were outstanding underthe 2007 Plan.

 

The Company’s 1997 StockIncentive Plan (the “1997 Plan”) terminated in September 2007; however,all stock options outstanding under the 1997 Plan will remain outstandingpursuant to the terms of such stock options. As of December 31, 2008,options to purchase approximately 1.3 million shares of the Company’s commonstock were outstanding under the 1997 Plan.

 

In connection with the October 2004merger of the Company and its previously majority-owned subsidiary, Iteris Inc.(the “Iteris Subsidiary”), the Company assumed the 1998 Stock Incentive Plan ofthe Iteris Subsidiary (the “1998 Plan”) and all outstanding options grantedthereunder. As of December 31, 2008, options to purchase approximately 1.8million shares of the Company’s common stock were outstanding under the 1998Plan. The 1998 Plan has been terminated and no further options may be grantedunder the 1998 Plan.

 

Certain options grantedunder the 2007 Plan, the 1997 Plan and the 1998 Plan (collectively, the “Plans”)provide for accelerated vesting of unvested options in the event of a change incontrol under certain circumstances. These change-in-control provisions meetthe criteria of a performance condition under SFAS 123R.

 

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A summary of activity inthe Plans for the nine months ended December 31, 2008 is as follows:

 
| ** **                                                                     | ** ** | **Options**                                                         | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                     | ** ** | **(In thousands, except number of years)** | ** ** |
| Options outstanding at March 31, 2008                                     |       | 4,524                                                               |       | $                                      | 1.83       |                                                             | 3.7        |                           |       |   |
| Granted                                                                        |       | 30                                                                  |       | 2.10                                   |       | N/A                                                              |       |                           |       |
| Exercised                                                                      |       | (762                                                                | )          | 1.20                                   |       | N/A                                                              |       |                           |       |
| Forfeited                                                                      |       | (18                                                                 | )          | 2.59                                   |       | N/A                                                              |       |                           |       |
| Expired                                                                        |       | (303                                                                | )          | 2.53                                   |       | N/A                                                              |       |                           |       |
| Options outstanding at December 31, 2008                                  |       | 3,471                                                               |       | $                                      | 1.91       |                                                             | 4.1        |                           | $          | 1,781 |   |
| Vested and expected to vest at December 31, 2008                          |       | 3,381                                                               |       | $                                      | 1.90       |                                                             | 4.0        |                           | $          | 1,781 |   |
| Options exercisable at December 31, 2008                                  |       | 2,949                                                               |       | $                                      | 1.82       |                                                             | 3.4        |                           | $          | 1,781 |   |
| Options exercisable at December 31, 2008 pursuant to a  change-in-control |       | 3,471                                                               |       | $                                      | 1.91       |                                                             | 4.1        |                           | $          | 1,781 |   |

 

At December 31,2008, there were 446,000 shares of common stock available for grant under the2007 Plan.

 

For the nine months endedDecember 31, 2008 and 2007, the Company received $911,000 and $1.2million, respectively, in cash from the exercise of stock options. Totalstock-based compensation expense was $92,000 and $280,000 for the three andnine months ended December 31, 2008, respectively, and $82,000 and$207,000 for the three and nine months ended December 31, 2007,respectively.  No income tax benefit wasrealized from activity in the Plans during the nine months ended December 31,2008 and 2007.

 

At December 31,2008, there was $960,000 of total unrecognized compensation expense related tounvested stock options. This expense is expected to be recognized over aweighted-average period of approximately 3.1 years.

 

A summary of the grantdate fair value and intrinsic value information is as follows:

 
| ** **                                        | ** ** | **Three Months  Ended December 31,**                   | ** ** | **Nine Months  Ended December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                                              | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                        | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Weighted average grant  date fair value per share | ** ** | **$**                                                                 | **—** |                                               | $          | 1.82 | ** ** | **$** | **1.50** |   | $ | 1.81 |   |
| Intrinsic value of options  exercised             | ** ** | **$**                                                                 | **16**     |                                               | $          | 650 | ** ** | **$** | **770** |   | $ | 2,297 |   |

 

**6. Business Segment Information**

 

The Company currentlyoperates in three reportable segments: Roadway Sensors, Vehicle Sensors andTransportation Systems. The Roadway Sensors segment includes the Company’sVantage and VersiCam vehicle detection systems for trafficintersection control, incident detection and certain highway traffic datacollection applications. The Vehicle Sensors segment includes AutoVue and iscomprised of all activities related to vehicle safety. The TransportationSystems segment includes transportation engineering and consulting services andthe development of transportation management and traveler information systemsfor the ITS industry. The accounting policies of the reportable segments arethe same as those described in the summary of significant accounting policiesexcept that certain expenses, such as interest, amortization of certainintangibles, and certain corporate expenses are not allocated to thesegments.  The reportable segments areeach managed separately because they manufacture and distribute distinctproducts or provide services with different processes. All segment revenues arederived from external customers.

 

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The following table setsforth selected unaudited financial information for the Company’s reportablesegments for the three and nine months ended December 31, 2008 and 2007:

 
| ** **                                    | ** ** | **Roadway  Sensors**    | ** ** | **Vehicle  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|----------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                    | ** ** | **(In thousands)** | ** ** |
| **Three Months Ended December 31, 2008** |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 6,291      |                 | $          | 2,477                       |       | $         | —     |   | $ | 8,768 |   |
| Service and other revenue                     |       | —                  |       | 315                  |       | 7,379                       |       | 7,694     |       |
| Stock-based compensation                      |       | 8                       |       | 12                   |       | 13                          |       | 33        |       |
| Depreciation and amortization                 |       | 48                      |       | 32                   |       | 65                          |       | 145       |       |
| Segment income                                |       | 773                     |       | 105                  |       | 425                         |       | 1,303     |       |
|                                          |       |                    |       |                 |       |                        |       |      |       |
| **Three Months Ended December 31, 2007** |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 6,432      |                 | $          | 2,281                       | ** ** | **$**     | **—** |   | $ | 8,713 |   |
| Service and other revenue                     |       | —                  |       | 463                  |       | 6,187                       |       | 6,650     |       |
| Stock-based compensation                      |       | 3                       |       | 10                   |       | 6                           |       | 19        |       |
| Depreciation and amortization                 |       | 26                      |       | 32                   |       | 39                          |       | 97        |       |
| Segment income                                |       | 929                     |       | 167                  |       | 449                         |       | 1,545     |       |
|                                          |       |                    |       |                 |       |                        |       |      |       |
| **Nine Months Ended December 31, 2008**  |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 21,334     |                 | $          | 8,380                       | ** ** | $         | **—** |   | $ | 29,714 |   |
| Service and other revenue                     |       | —                  |       | 973                  |       | 22,283                      |       | 23,256    |       |
| Stock-based compensation                      |       | 24                      |       | 36                   |       | 39                          |       | 99        |       |
| Depreciation and amortization                 |       | 144                     |       | 105                  |       | 185                         |       | 434       |       |
| Segment income                                |       | 2,887                   |       | 552                  |       | 1,569                       |       | 5,008     |       |
|                                          |       |                    |       |                 |       |                        |       |      |       |
| **Nine Months Ended December 31, 2007**  |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 21,273     |                 | $          | 7,630                       | ** ** | **$**     | **—** |   | $ | 28,903 |   |
| Service and other revenue                     |       | —                  |       | 1,312                |       | 17,881                      |       | 19,193    |       |
| Stock-based compensation                      |       | 13                      |       | 34                   |       | 19                          |       | 66        |       |
| Depreciation and amortization                 |       | 79                      |       | 98                   |       | 105                         |       | 282       |       |
| Segment income                                |       | 3,725                   |       | 439                  |       | 1,426                       |       | 5,590     |       |

 

The following tablereconciles segment income to consolidated income before income taxes:

 
| ** **                            | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                            | ** ** | **2008**                                            | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                            | ** ** | **(In thousands)**                             | ** ** |
| Total income for  reportable segments | ** ** | **$**                                               | **1,303**  |                                               | $          | 1,545 | ** ** | **$** | **5,008** |   | $ | 5,590 |   |
| Unallocated amounts:                  |       |                                                |       |                                               |       |   |   |   |   |
| Corporate expenses                    | ** ** | **(69**                                             | **)**      | (415                                               | )          | **(360** | **)** | (586 | ) |
| Other income, net                     | ** ** | **63**                                              |       | (3                                                 | )          | **90** | ** ** | 41 |   |
| Interest expense, net                 | ** ** | **(141**                                            | **)**      | (314                                               | )          | **(537** | **)** | (1,046 | ) |
| Income before income taxes            | ** ** | **$**                                               | **1,156**  |                                               | $          | 813 |   | **$** | **4,201** | ** ** | $ | 3,999 |   |

 

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| **ITEM 2.** | ** ** | **MANAGEMENT’S DISCUSSION  AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-------------|------------|-------------------------------------------------------------------------------------------------|

** **

*This report, including the followingdiscussion and analysis, contains forward-looking statements (within themeaning of the Private Securities Litigation Reform Act of 1995) that are basedon our current expectations, estimates and projections about our business andour industry, and reflect management’s beliefs and certain assumptions made byus based upon information available to us as of the date of this report. Whenused in this report and the information incorporated herein by reference, thewords “expect(s),” “feel(s),” “believe(s),” “should,” “will,” “may,” “anticipate(s),”“estimate(s)” and similar expressions or variations of these words are intendedto identify forward-looking statements. These forward-looking statementsinclude but are not limited to statements regarding our anticipated sales,revenue, expenses, profits, capital needs, competition, development plans,backlog and manufacturing capabilities, the applications for and acceptance ofour products and services, and the status of our facilities and productdevelopment. These statements are not guarantees of future performance and aresubject to certain risks and uncertainties that could cause our actual resultsto differ materially from those projected. You should not place undue relianceon these forward-looking statements that speak only as of the date hereof. Weundertake no obligation to republish revised forward-looking statements toreflect events or circumstances after the date hereof or to reflect theoccurrence of unanticipated events. We encourage you to carefully review andconsider the various disclosures made by us which describe certain factorswhich could affect our business, including in* “*Risk Factors” set forth in Part II, Item 1A of this report, beforedeciding to invest in our company or to maintain or increase your investment.We undertake no obligation to revise or update publicly any forward-lookingstatement for any reason.*

 

**Overview**

 

We are a leader in the traffic management market focused on thedevelopment and application of advanced technologies that reduce trafficcongestion and improve the safety of surface transportation systemsinfrastructure. As an added benefit, our products and services minimize theenvironmental impact of traffic congestion. By combining outdoor imageprocessing, traffic engineering and information technology, we offer a broadrange of Intelligent Transportation Systems and driver safety solutions tocustomers worldwide.the environmental

 

We currently operate in three reportable segments: Roadway Sensors,Vehicle Sensors, and Transportation Systems. The Roadway Sensors segmentincludes our Vantage and VersiCam vehicle detection systems for trafficintersection control, incident detection and certain highway traffic datacollection applications. The Vehicle Sensors segment includes our AutoVue LaneDeparture Warning (“LDW”) system and is comprised of all activities related tovehicle safety. The Transportation Systems segment includes transportationengineering and consulting services, and the development of transportationmanagement and traveler information systems for the ITS industry.

 

Our Vantage product line uses advanced image processing technology tocapture and analyze video images through sophisticated algorithms, enablingvehicle detection and transmission of both video images and data using a widerange of communication technologies. Vantage video detection systems detect vehicle presence, count, speed,occupancy, and other traffic data used in traffic management systems.  This gives traffic managers the ability tomitigate roadway congestion by modifying traffic signal timing or detectingincidents quickly.  VersiCam, ourintegrated camera and processor video detection system, which was introduced inApril of 2008, is a cost-efficient video detection system for smallerintersections that require only a few detection points.  Vantage video detection systems have beendeployed by hundreds of agencies and are currently sold through a network ofindependent dealers in the United States, Asia, Latin America, Europe and theMiddle East.

 

Our Vehicle Sensors segment addresses the leading cause of roadwayfatalities:  rear-end, lane change, androadway departure accidents.  Accordingto the National Highway Traffic Safety Administration, these three crash typesresult in about 27,500 of the U.S.’s 42,000 annual traffic fatalities andcontribute to a considerable economic loss due to injuries, property damage,and decreased productivity.

 

We developed the world’s first production LDW system and offer a provensystem that is available as an OEM option in passenger cars and as an OEM andaftermarket option on heavy trucks worldwide. The AutoVue LDW system utilizes video detection images to detect when avehicle begins to drift toward an unintended lane change.  When this occurs, the unit automaticallyemits a distinctive rumble strip or other audible warning sound, alerting thedriver to make a correction.  To date, wehave sold approximately 67,000 LDW systems into the heavy truck market inEurope, North America and Asia.  Our LDWsystems are currently qualified as an option on certain heavy trucks, includingMercedes-Benz, MAN, Iveco, DAF, Scania, Freightliner and FUSO, as well asNeoplan and MAN luxury bus and coach lines. In North America, our LDW systemsare sold primarily to truck fleets, and to date, 71 U.S. heavy truck fleetshave selected our LDW systems, with a combined fleet size estimated at 56,000vehicles.  Additionally, we have licensedour LDW technology to our strategic partner, Valeo Schalter and Sensuren GmbH,an independent automotive supplier (“Valeo”), resulting in sales to date ofapproximately 69,000 LDW systems for passenger cars.

 

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In addition to our LDW systems, we have expanded our Vehicle Sensorsportfolio in August 2008 with newly developed technologies such as radarbased Forward Collision Warning (“FCW”) and Blind Spot Warning (“BSW”) systemsfor the North American truck market.  Wealso introduced Safety Direct in March 2008, which is a system thatreports real-time driver performance data captured by our LDW system and thathas the ability to relay this information directly to fleet operators throughintegration with the truck’s existing fleet communications system.  We offer the FCW and BSW features through theresale of Delphi’s radar based systems, for which we are the exclusive NorthAmerican dealer, while Safety-Direct was internally developed. These newproducts, together with the AutoVue LDW system, combine to create a broad suiteof active safety driver assistance features that help to reduce the number ofmotor vehicle crashes and the severity of crash-related injuries.

 

Our Transportation Systems segment includes transportation engineeringand consulting services focused on the planning, design, development andimplementation of software-based systems that integrate sensors, videosurveillance, computers, and advanced communications equipment to enable publicagencies to monitor, control, and direct traffic flow, assist in the quickdispatch of emergency crews and distribute real-time information about trafficconditions. Our services include planning, design, and implementation ofsurface transportation infrastructure systems. We perform analysis and studygoods movement, commercial vehicle operations, travel demand forecasting, andsystems engineering, and identify mitigation measures to reduce trafficcongestion. These services and systems are primarily sold to local, state, andnational transportation agencies in the United States. Our transportationmanagement systems business is largely dependent upon governmental funding andbudgetary issues. The Federal Highway Bill that was passed in August 2005provided for a significant increase in transportation funding. We believe therecent expansion of our transportation management systems business was due inpart to the passage of the Federal Highway Bill, combined with increasedtransportation funds available at state and local agencies throughout thecountry.  The 2005 Federal Highway Billis set to expire in September 2009. At this point in time, the impact on future contract revenues as aresult of the recently introduced federal stimulus package and any potentialdelays in the passage of future transportation bills cannot be determined.

 

**CriticalAccounting Policies and Estimates**

 

Management’s Discussion and Analysis of Financial Condition and Resultsof Operations is based on our unaudited condensed consolidated financialstatements included herein, which have been prepared in accordance withaccounting principles generally accepted in the United States, or U.S. GAAP.The preparation of these financial statements requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and related disclosures of contingent assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. On an ongoing basis, we evaluate theseestimates and assumptions, including those related to the collectibility ofaccounts receivable, the valuation of inventories, the recoverability oflong-lived assets and goodwill, the realizability of deferred tax assets,accounting for stock-based compensation, the valuation of equity instruments,warranty reserves and other contingencies. We base these estimates on ourhistorical experience and on various other factors that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. These estimates and assumptions bytheir nature involve risks and uncertainties, and may prove to be inaccurate.In the event that any of our estimates or assumptions are inaccurate in anymaterial respect, it could have a material adverse effect on our reportedassets and liabilities at the date of the financial statements and our reportedrevenues and expenses during the reporting period.

 

The accounting policies that affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements are those relating to revenue recognition, accountsreceivable, inventory, goodwill, warranty, income taxes, and stock-basedcompensation.  These policies aredescribed in further detail in our Annual Report on Form 10-K for thefiscal year ended March 31, 2008. There have been no significant changes in our critical accountingpolicies and estimates during the nine months ended December 31, 2008 ascompared to what was previously disclosed in our Annual Report on Form 10-Kfor the fiscal year ended March 31, 2008.

 

**RecentAccounting Pronouncements**

 

In September 2006, the Financial Accounting Standards Board, orFASB, issued Statement of Financial Accounting Standards, or SFAS, No. 157,*Fair Value Measurements*, or SFAS 157,which defines fair value, establishes a framework for measuring fair value, andexpands disclosure about fair value measurements. SFAS 157 does not require anynew fair value measurements; rather it specifies valuation methods to beapplied when fair value measurements are required under existing or futureaccounting pronouncements. SFAS 157 is effective for fiscal years beginningafter November 15, 2007 and interim 

 

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periods within those fiscal years. In February 2008, the FASBissued FSP 157-2, *Effective Date of FASB Statement No. *157,or FSP 157-2, which delays the effective date of SFAS 157 for non-financialassets and liabilities to fiscal years beginning after November 15, 2008.Generally, SFAS 157 will be applied prospectively. With respect to financialassets and liabilities, we adopted SFAS 157 in the first quarter of fiscal2009. There was no material impact on our consolidated financial statements. Weare currently evaluating the impact of SFAS 157 and FSP 157-2 with respect toour non-financial assets and liabilities and expect to adopt SFAS 157 and FSP157-2 with respect to these assets and liabilities in the first quarter of ourfiscal year ending March 31, 2010.

 

In February 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 statement allows an entity theirrevocable option to elect fair value for the initial and subsequentmeasurement of certain financial assets and liabilities on acontract-by-contract basis. Subsequent changes in fair value of these financialassets and liabilities would be recognized in earnings when they occur. Thisstatement is effective for fiscal years beginning after November 15, 2007with earlier adoption permitted under special rules. The adoption of thisstatement did not have a material impact on our consolidated financialstatements.

 

In December 2007, the FASB issued SFAS No. 141R, *Business Combinations*, or SFAS 141R. SFAS 141Restablishes principles and requirements for how the acquirer of a businessrecognizes and measures in its financial statements the identifiable assetsacquired, the liabilities assumed, and any noncontrolling interest in theacquiree. The statement also provides guidance for recognizing and measuringthe goodwill acquired in the business combination and determines whatinformation to disclose to enable users of financial statements to evaluate thenature and financial effects of the business combination. SFAS 141R iseffective for financial statements issued for fiscal years beginning after December 15,2008. The nature and magnitude of the specific effects of adopting SFAS 141Rwill depend upon the nature, terms and size of any acquisitions we may consummateafter the effective date of the Company’s adoption on April 1, 2009.

 

InMay 2008, the FASB issued SFAS No. 162, *The Hierarchy of Generally Accepted AccountingPrinciples,* or SFAS 162. SFAS 162 identifies the sourcesof accounting principles to be used in the preparation of financial statementsof nongovernmental entities that are presented in conformity with U.S.GAAP. SFAS 162 is effective 60 days following the Securities andExchange Commission approval of the Public Company Accounting Oversight Boardamendments to AU Section 411, *TheMeaning of Present Fairly in Conformity with Generally Accepted AccountingPrinciples.* We currently adhere to the hierarchy of U.S. GAAP aspresented in SFAS 162, and adoption is not expected to have a material impacton our consolidated financial statements.

 

In June 2008, the FASB issued Emerging Issues Task Force Issue No. 07-5,*Determining Whether an Instrument (or EmbeddedFeature) Is Indexed to an Entity’s Own Stock*, or EITF 07-5. EITF07-5 clarifies how to determine whether certain instruments or features wereindexed to an entity’s own stock under EITF Issue No. 01-6, *The Meaning of “Indexed to a Company’s Own Stock,”* andprovides guidance to determine what accounting literature may apply to aparticular equity linked instrument or feature. EITF 07-5 will become effectivefor financial statements issued for fiscal years beginning after December 15,2008, and interim periods within those fiscal years, and must be applied to allinstruments outstanding on the date of adoption. We are currently evaluatingthe impact of EITF 07-5, and have not yet determined the effect, if any, of itsadoption on our consolidated financial statements.

 

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**Resultsof Operations**

 

The following table sets forth certain statement of operations data asa percentage of total net sales and contract revenues for the periodsindicated.

 
| ** **                                 | ** ** | **Three Months  Ended December 31,** | ** ** | **Nine Months  Ended December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                 | ** ** | **2008**                                            | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net sales  and contract revenues:          |       |                                                |       |                                               |       |   |   |   |   |
| Net sales                                  | ** ** | **55.2**                                            | **%**      | 59.7                                               | %          | **57.9** | **%** | 62.8 | % |
| Contract  revenues                         | ** ** | **44.8**                                            | ** ** | 40.3                                               |       | **42.1** | ** ** | 37.2 |   |
| Total net  sales and contract revenues     | ** ** | **100.0**                                           | **%**      | 100.0                                              | %          | **100.0** | **%** | 100.0 | % |
| Costs of net  sales and contract revenues: |       |                                                | ** ** |                                               |       |   | ** ** |   |   |
| Cost of net  sales                         | ** ** | **29.7**                                            | ** ** | 30.2                                               | ** ** | **30.3** | ** ** | 31.8 |   |
| Cost of  contract revenues                 | ** ** | **30.8**                                            | ** ** | 27.5                                               | ** ** | **27.9** | ** ** | 24.8 |   |
| Gross profit                               | ** ** | **39.5**                                            | ** ** | 42.3                                               | ** ** | **41.8** | ** ** | 43.4 |   |
| Operating  expenses:                       |       |                                                | ** ** |                                               |       |   | ** ** |   |   |
| Selling,  general and administrative       | ** ** | **26.7**                                            | ** ** | 28.3                                               | ** ** | **26.8** | ** ** | 27.3 |   |
| Research and  development                  | ** ** | **5.1**                                             | ** ** | 6.5                                                | ** ** | **6.0** | ** ** | 5.5 |   |
| Amortization  of intangible assets         | ** ** | **0.2**                                             | ** ** | 0.2                                                | ** ** | **0.2** | ** ** | 0.2 |   |
| Total  operating expenses                  | ** ** | **32.0**                                            | ** ** | 35.0                                               | ** ** | **33.0** | ** ** | 33.0 |   |
| Operating income                           | ** ** | **7.5**                                             | ** ** | 7.3                                                | ** ** | **8.8** | ** ** | 10.4 |   |
| Non-operating  income (expense):           |       |                                                | ** ** |                                               |       |   | ** ** |   |   |
| Other  income, net                         | ** ** | **0.4**                                             | ** ** | (0.0                                               | )          | **0.2** | ** ** | 0.1 |   |
| Interest  expense, net                     | ** ** | **(0.9**                                            | **)**      | (2.0                                               | )          | **(1.0** | **)** | (2.2 | ) |
| Income  before income taxes                | ** ** | **7.0**                                             | ** ** | 5.3                                                |       | **8.0** | ** ** | 8.3 |   |
| Income tax  benefit (provision)            | ** ** | **(2.5**                                            | **)**      | 0.9                                                |       | **(3.3** | **)** | 0.5 |   |
| Net income                                 | ** ** | **4.5**                                             | **%**      | 6.2                                                | %          | **4.7** | **%** | 8.8 | % |

 

**Analysisof Quarterly Results of Operations**

 

*Net Sales and Contract Revenues*. Net sales are comprised of Roadway Sensors sales, which are derived from salesof our Vantage and VersiCam video detection systems, and Vehicle Sensor sales,which are derived from sales of our active vehicle safety products, contractengineering revenue from Valeo, and royalty revenue generated from sales of LDWsystems, by our partner Valeo, to the passenger car market.  Contractrevenues consist entirely of Transportation Systems revenues, which aregenerated from systems integration and ITS consulting services with federal,state, county, and municipal agencies. We currently have a relatively diverse customerbase with no customer representing greater than 10% of total net sales andcontract revenues in the three and nine months ended December 31, 2008,respectively.

 

Total net sales and contract revenues increased 7.2% to $16.5 millionand 10.1% to $53.0 million for the three and nine months ended December 31,2008, respectively, compared to $15.4 million and $48.1 million in thecorresponding periods of the prior fiscal year. The increase was primarilydriven by higher contract revenues partially offset by a decrease in netRoadway Sensor revenues, as discussed below.

 

Net sales decreased 1.0% to $9.1 million and increased 1.6% to $30.7million for the three and nine months ended December 31, 2008,respectively, compared to $9.2 million and $30.2 million in the correspondingperiods of the prior fiscal year.

 

Roadway Sensors net sales decreased 2.2% to $6.3 million compared to$6.4 million for the three months ended December 31, 2008 and wererelatively flat for the nine months ended December 31, 2008 compared tothe         corresponding periods of theprior fiscal year mainly due to reduced and delayed spending on infrastructureprojects as a result of the decline in commercial and residential construction,as well as local government budgetary pressures.  We expect these factors may continue toadversely impact our Roadway Sensors net sales for at least the next few fiscalquarters.

 

Vehicle Sensors net sales increased 1.7% to $2.8 million and 4.6% to$9.4 million for the three and nine months ended December 31, 2008,respectively, versus $2.7 million and $8.9 million in the corresponding periodsof the prior fiscal year. This increase was primarily a result of a slightincrease in unit sales in the North American truck market, which was offset inpart by lower unit sales of our LDW systems to European and Asian OEMs. Sales of

 

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LDW systems to the heavy truck market increased 8.6% to $2.5 millionand 9.8% to $8.4 million for the three and nine month periods ended December 31,2008, when compared to the corresponding periods in the prior fiscal year. Wemay continue to experience either relatively flat or decreased sales to the NorthAmerican heavy truck market and in sales to our European and Asian OEMscustomers in our next few fiscal quarters as a result of an overall decline innew truck sales in the U.S, Europe and Asia, the general slowdown in the U.S.credit markets and weakness in overall global economy. Also included in VehicleSensors net sales are revenues from contract engineering services and royaltyrevenues in the passenger car market that are derived from our strategic relationshipwith Valeo, which aggregated $315,000 and $973,000 for the three and ninemonths ended December 31, 2008, respectively, compared to $463,000 and $1.3million in the corresponding periods of the prior fiscal year. We expectcontract engineering revenues to remain relatively stable for the foreseeablefuture.

 

Contract revenues increased 19.3% to $7.4 million and 24.6% to $22.3million for the three and nine months ended December 31, 2008,respectively, compared to $6.2 million and $17.9 million in the correspondingperiods of the prior fiscal year. This increase was largely a result ofincreased sales and marketing activity across the country. In response to thisgrowth, we have slightly increased our Transportation Systems staff in the ninemonths ended December 31, 2008.  Webelieve the ability of our Transportation Systems business to grow andsuccessfully win and service new contracts will be highly dependent upon ourcontinued success in recruiting and retaining qualified personnel. Weanticipate that our contract revenues will continue to increase for the balanceof fiscal 2009, largely as a result of significant new contracts awarded to usduring the first six months of fiscal 2009. All of our contract revenues are derived from work performed in NorthAmerica under a broad range of fixed price and cost plus fixed fee contracts.

 

 It is conceivable that, as aresult of the continued deterioration of economic conditions in the U.S., thedecline in residential and commercial construction, the tightening of thecredit markets, and the expiration of the 2005 Federal Highway Bill in September of2009, government funding for certain traffic initiatives and roadwayimprovement projects could be delayed or diverted to focus on other budgetaryneeds.  Should this occur, it is likelythat future domestic Roadway Sensors net sales and Transportation Systemcontract revenues and backlog would be adversely affected.

 

*Gross Profit*. Total gross profit was flat for the three months ended December 31, 2008and increased 6.1% to $22.1 million for the nine months ended December 31,2008, respectively, as compared to $6.5 million and $20.9 million in thecorresponding periods of the prior fiscal year. Total gross profit as a percentof net sales and contract revenues decreased to 39.5% and 41.8% for the three andnine months ended December 31, 2008, respectively, as compared to 42.3%and 43.4% in the corresponding periods of the prior fiscal year.

 

Gross profit as a percent of net sales was 46.2% and 47.7% for thethree and nine months ended December 31, 2008, respectively, compared to49.5% and 49.4% in the corresponding periods of the prior fiscal year. Thisdecrease in gross profit as a percent of net sales was a result of decreasedgross profit in both Roadway Sensors and Vehicle Sensors and was primarily drivenby customer mix.  Roadway Sensors netsales have been weighted more toward dealer than direct sales in fiscal 2009while Vehicle Sensors net sales have been weighted more toward OEMs thanafter-market sales in fiscal 2009. We generally enjoy higher gross margins ondirect and OEM sales when compared to dealer and aftermarket sales. Weanticipate that this mix will remain relatively constant for the remainder offiscal 2009. Gross profit as a percent of net sales generally fluctuates in anyspecific quarter based on customer mix. Gross profit as a percent of net saleshas fluctuated over the last eleven quarters from a high of 50.0% in the firstquarter of fiscal 2009 to a low of 43.2% reported in the second quarter offiscal 2007.

 

Gross profit as a percent of contract revenues was 31.3% and 33.6% forthe three and nine months ended December 31, 2008, respectively, comparedto 31.6% and 33.2% in the corresponding periods of the prior fiscal year. Werecognize contract revenues and related gross profit using percentage ofcompletion contract accounting and the underlying mix of contract activityaffects the related gross profit recognized in any given period.  The slight change in gross profit as apercent of contract revenues for the three and nine months ended December 31,2008 reflects a contract mix weighted more toward contract revenues, whichgenerally carry lower margins than our net sales, particularly if they requiresub-contractor participation.

 

*Selling, General and Administrative Expense*. Selling, general and administrative expense increased 1.2% to $4.4 million (or26.6% of total net sales and contract revenues) and increased 7.5% to $14.2million (or 26.8% of total net sales and contract revenues) in the three andnine months ended December 31, 2008, respectively, compared to $4.3million (or 28.2% of total net sales and contract revenues) and $13.2 million(or 27.4% of total net sales and contract revenues) in the correspondingperiods of the prior fiscal year.  Theseincreases for the nine month period were largely attributable to higher sellingexpenses in our Transportation Systems segment, as a result of a shift in laborresources from project related activities to sales and marketing efforts, aimedat capturing additional contract backlog, and as a result, TransportationSystems sales & marketing expense increased to $2.1 million during the ninemonths ended December 31, 2008 compared to $1.3 million for the sameperiod in the prior year.

 

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*Research and Development Expense*. Research and development expense decreased 15.4% to $848,000 (or 5.2% of totalnet sales and contract revenues) and increased 21.2% to $3.2 million (or 6.0%of total net sales and contract revenues) in the three and nine months ended December 31,2008, respectively, compared to $1.0 million (or 6.5% of total net sales andcontract revenues) and $2.6 million (or 5.5% of total net sales and contractrevenues) in the corresponding periods of the prior fiscal year. Research anddevelopment expense decreased in the third quarter mainly because many of theCompany’s expenditures to bring new products to market were incurred it itsfirst two fiscal quarters. The increase for the nine month period was primarilydue to increased research and development activities in Roadway Sensors aimedat accelerating the time to market of certain new products.  We believe research and development activitiesare crucial to our ability to continue to be a leader in our markets, and weexpect our expenditures in this area to continue to run at an increased level,compared to the prior year, for the remainder of fiscal 2009.

 

For competitive reasons, we closely guard the confidentiality ofspecific development projects.

 

*Interest Expense, Net.* Interest expense, net includes the following:

 
| ** **                             | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                             | ** ** | **2008**                                            | ** ** | **2007**                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                             | ** ** | **(in thousands)**                             | ** ** |
| Interest expense                       | ** ** | **$**                                               | **(106**   | **)**                                              | $          | (228 | ) | **$** | **(366** | **)** | $ | (787 | ) |
| Amortization of debt discount          | ** ** | **(21**                                             | **)**      | (51                                                | )          | **(103** | **)** | (155 | ) |
| Amortization of deferred finance costs | ** ** | **(14**                                             | **)**      | (35                                                | )          | **(68** | **)** | (104 | ) |
| Interest expense, net                  | ** ** | **$**                                               | **(141**   | **)**                                              | $          | (314 | ) | **$** | **(537** | **)** | $ | (1,046 | ) |

 

Interest expense decreased for the three and nine months ended December 31,2008 compared to the corresponding period in the prior fiscal year as a resultof an overall lower level of borrowings in the current periods and as a resultof the early retirement of certain of the Company’s convertible debentures.

 

*Income Taxes*. During the three and nine months ended December 31, 2008, we recognizedincome tax expense of $415,000 and $1.7 million, respectively, as compared toincome tax benefits of $141,000 and $221,000 in the three and nine months endedDecember 31, 2007, respectively. The increase in income tax expense and our effective tax rate in thecurrent year periods was primarily due to the reduction of the valuationallowance recorded against our deferred tax assets in the prior year periods asa result of changes in our estimates of the future realizability of theseassets.  We analyze our tax estimatesquarterly, and should those estimates result in an increase in future taxableincome, we may continue to reduce our deferred tax asset valuation allowance,which totaled approximately $8.0 million at December 31, 2008. This couldcause our future overall effective tax rate in any given period to fluctuatefrom prior effective tax rates, estimated annual effective tax rates andstatutory tax rates.

 

**Liquidityand Capital Resources**

 

*Cash Flows*

 

We have historically financed our operations with a combination of cashflows from operations, borrowings under credit facilities and the sale of debtand equity securities. We currently rely on cash flows from operations andborrowings on a line of credit facility to fund our operations. At December 31,2008, we had $15.8 million in working capital, no borrowings on our $12.0million working capital line of credit and $6.0 million in cash and cashequivalents. This compares to working capital of $14.9 million at March 31,2008, which included no borrowings on our line of credit and $421,000 in cashand cash equivalents.

 

Our operating activities provided $6.0 million in cash during the ninemonths ended December 31, 2008, primarily as a result of net incomegenerated during the period and the usage of deferred tax assets.  We expect to continue to utilize our deferredtax assets to significantly reduce cash tax payments in future quarters.  Accounts receivable decreased during the ninemonths ended December 31, 2008 by $258,000 primarily due to decreasedsales and the timing of invoicing and collections for all segments.  Net unbilled accounts receivable alsodecreased by $2.0 million during the nine months ended December 31, 2008as a result of the timing of invoicing in Transportation Systems.  Inventories increased by $771,000 as a resultof flat product sales, the introduction of new products by Roadway Sensors andthe acquisition of certain components because they have been discontinued bythe manufacturer.  We expect inventoriesto slightly increase for the remainder of fiscal 2009.

 

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Our investing activities for the nine months ended December 31,2008 and 2007 consisted entirely of purchases of property and equipment, whichaggregated $716,000 and $455,000, respectively.

 

Cash provided by financing activities was $240,000 in the nine monthsended December 31, 2008, which was primarily the result of $911,000 inproceeds from the exercise of outstanding stock options to purchase our commonstock and borrowings of $5.1 million pursuant to the Company’s term note,offset by $5.8 million used to redeem convertible debentures. During the ninemonths ended December 31, 2007, financing activities used $4.3 million ofcash, which was the result of $5.6 million in net payments against borrowings,partially offset by $1.3 million in proceeds from the exercise of outstandingstock options and warrants to purchase our common stock.

 

*Borrowings*

 

The following table summarizes our borrowings andlong-term debt:

 
| ** **                  | ** ** | **At December 31,  2008** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|
| ** **                  | ** ** | **(In thousands)**             | ** ** |
| Convertible debentures, net |       | $                                   | 2,232      |   |
| Bank term note              |       | 5,073                               |       |
|                        |       | $                                   | 7,305      |   |

 

Until October 15,2008, we had a credit facility with Silicon Valley Bank that provided for lineof credit borrowings of up to $10.0 million. Under this credit facility, we could borrow against eligible accountsreceivable and eligible inventory, as defined in the credit agreement. Intereston borrowed amounts under the line of credit was payable monthly at the currentstated prime rate plus 1.00%. Additionally, we were obligated to pay an unusedline fee of 0.25% per annum applied to the amount by which the maximum creditamount exceeded the average daily principal balance during the preceding month.The credit facility required $2,000 in monthly collateral management fees andincluded an early termination fee equal to 2% of the total facility during thefirst year of the agreement and 1% of the total facility in the second year ofthe agreement. The credit facility was secured by substantially all of ourassets. This credit facility expired on October 15, 2008.

 

Effective October 16,2008, we entered into a new $19.5 million credit facility with California Bank &Trust, which replaced our $10.0 million facility with Silicon Valley Bank.  This new credit facility provides for a $12.0million, two-year, revolving line of credit and a term note of up to $7.5million as discussed below.  Interest onborrowed amounts under the revolving line will be payable monthly at a rateequal to the current stated prime rate up to the current stated prime rate plus0.50%, depending on aggregate deposit balances maintained at the bank inrelation to the total loan commitment under the credit facility. We areobligated to pay an unused line fee of 0.25% per annum applied to the averageunused portion of the $12.0 million revolving line of credit during thepreceding month. No amounts were borrowed under the $12.0 million revolvingline of credit as of December 31, 2008.

 

Additionally, as part ofthis new credit facility and in connection with the early retirement of $7.0million of our convertible debentures, we have borrowed $6.5 million ($5.07million in October 2008 and $1.47 million in January 2009) and mayborrow up to another $1.0 million in the form of a $7.5 million 48-month term noteto retire all outstanding debentures. Principal payments under this term noteare required to be repaid in 48 monthly installments commencing on June 1,2009. Interest on the term note will be payable monthly at a rate equal to thecurrent stated prime rate plus 0.50% up to the current stated prime rate plus1.00%, depending on aggregate deposit balances maintained at the bank inrelation to the total loan commitment under the credit facility.  In October 2008, we paid an upfront loancommitment fee of $28,000 in connection with the term note portion of thecredit facility.  The new credit facilitycontains no early termination fees and is secured by substantially all of ourassets.

 

On February 4, 2009 we entered into anAmended and Restated Loan and Security Agreement with California Bank &Trust which supersedes the agreements entered into on October 16, 2008 intheir entirety. The October 16, 2008 documents were amended and restatedto clarify the meaning of certain ambiguities and remove non-applicablelanguage.  No modifications were made toany significant provisions related to the overall amount of the creditfacility, interest rate calculations, or any financial or non-financialcovenant.

 

We believe that the cash generated from ouroperations, together with funds available under our credit facility, will besufficient to fund our operations for at least the next twelve months. However,should a shortfall occur, we may need to raise additional funds through otherdebt or equity financings.

 

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**Contractual Obligations**

 

Our contractual obligations at December 31, 2008, updated toreflect the early retirement and refinancing of convertible debentures in January 2009,were as follows:

 
| ** **             | ** ** | **Payments Due by Fiscal Year** | ** ** |
|------------------------|------------|-----------------------------------------------------|------------|
| ** **             | ** ** | **2009**                                            | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **2013** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **             | ** ** | **(In thousands)**                             | ** ** |
| Term note payable      |       | $                                                   | —     |   | $ | 1,870 |   | $ | 2,144 |   | $ | 2,144 |   | $ | 415 |   | $ | — |   | $ | 6,573 |   |
| Convertible debentures |       | —                                              |       | 750 |   | — |   | — |   | — |   | — |   | 750 |   |
| Operating leases       |       | 812                                                 |       | 1,661 |   | 1,444 |   | 1,365 |   | 1,380 |   | 2,460 |   | 9,122 |   |
| Total                  |       | $                                                   | 812        |   | $ | 4,281 |   | $ | 3,588 |   | $ | 3,509 |   | $ | 1,795 |   | $ | 2,460 |   | $ | 16,445 |   |

 

At December 31, 2008, we had firm commitments to purchaseinventory in the amount of $2.5 million during our next three fiscal quarters.

 

**Off Balance Sheet Arrangements**

 

In May 2004, weissued subordinated convertible debentures in an aggregate original principalamount of $10.1 million. These debentures are due in full on May 18,2009 and are convertible into shares of our common stock at an initialconversion price of $3.61 per share. To date, all but $750,000 of thesedebentures have been retired. Because these debentures are conventionallyconvertible, we have not separately accounted for the conversion feature and,accordingly, no separate amounts are presented in our condensed consolidatedfinancial statements in connection with this conversion feature.

 

At December 31, 2008, outstanding warrants to purchase an aggregateof 246,250 shares of our common stock at an exercise price of $3.25 per sharewere callable by us if the closing sales price of our common stock for 20consecutive days is equal to or greater than two times the exercise price ofthe warrants. Outstanding warrants to purchase an aggregate of75,000 shares of our common stock at an exercise price of $5.00 per sharewere callable by us if the price of our common stock for 20 consecutivedays is equal to or greater than one and a half times the exercise price of thewarrants.

 

In connection with warrants to purchase 246,250 shares of our commonstock at an exercise price of $3.25 per share, we are a party to a registrationrights agreement that contains provisions under which we could be subjected toliquidated damages should we fail to maintain effective registration statementsfor the underlying shares of common stock. These warrants have been accountedfor within equity in our condensed consolidated balance sheets in accordancewith Emerging Issues Task Force Issue 00-19, *Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock*, and, accordingly, no liabilities have beenrecorded in connection therewith. As of the date of this filing, no liquidateddamages are payable under the provisions of the registration rights agreementassociated with these warrants.

 

**Seasonality**

 

We have historically experienced, and expect to continue to experience,seasonality, particularly with respect to our Roadway Sensors net sales in thethird and fourth fiscal quarters due to a reduction in road construction orrepairs during the winter months in many markets as a result of inclementweather conditions.

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Our exposure to interest rate risk is limitedto our line of credit and our new bank term note. Our line of credit bearsinterest equal to the prevailing prime rate (3.25% at December 31, 2008)plus 0% to 1.0%. We do not believe that a 10% increase in the interest rate onour line of credit or term note (from 3.25% to 3.58%) would have a materialimpact on our financial position, operating results or cash flows. In addition,we believe that the carrying value of our outstanding debt under our creditfacility approximates fair value.

 

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**ITEM 4T. CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures, as such term isdefined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based uponthat evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures are effective to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms and are effective in ensuring that information required to be disclosedby us in the reports that we file or submit under the Exchange Act isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. In designing and evaluating the disclosurecontrols and procedures, our management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives. Ourmanagement necessarily applied its judgment in evaluating the cost-benefitrelationship of such controls and procedures.

 

**Changesin Internal Controls**

 

During the fiscal quarter covered by this report, there has been nochange in our internal controls over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934) that has materiallyaffected, or is reasonably likely to materially affect, our internal controlsover financial reporting.

 

**PART II. OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

The information set forth under the heading “Litigation and OtherContingencies” in Note 4 of Notes to Unaudited Condensed Consolidated FinancialStatements, included in Part I, Item I of this report, is incorporatedherein by reference.

 

**ITEM 1A.****                    RISK FACTORS**

 

*Our business is subject to a numberof risks, some of which are discussed below. Other risks are presented elsewherein this report and in the information incorporated by reference into thisreport. You should consider the following risks carefully in addition to theother information contained in this report and our other filings with the SEC,including our annual report on Form 10-K and subsequent reports on Forms10-Q and 8-K, before deciding to buy, sell, or hold our common stock. The risksand uncertainties described below are not the only ones facing our company.Additional risks and uncertainties not presently known to us or that wecurrently deem immaterial may also affect our business operations. If any ofthese risks actually occurs, our business, financial condition, or results ofoperations could be seriously harmed. In that event, the market price for our commonstock could decline and you may lose all or part of your investment.*

 

**THE ECONOMIC SLOWDOWN IS LEADING TO REDUCED OR DELAYED GOVERNMENTFUNDING FOR TRANSPORTATION INFRASTRUCTURE PROJECTS, AND INITIATIVES ANDDECREASED AVAILABILITY OF FINANCIAL CAPITAL FOR OUR CUSTOMERS, WHICH COULD HAVEAN ADVERSE IMPACT ON OUR NET SALES AND CONTRACT REVENUES. **Decreased consumer confidence, thefailure of certain financial institutions and businesses, concerns about theavailability and cost of credit, and reduced corporate profits and capitalspending have resulted in a downturn in worldwide economic conditions, as wellas budgetary shortfalls increasingly present at all levels of government. Theseunfavorable economic conditions have had a negative impact on customer ordersand government funding of infrastructure projects incorporating our productsand services. Such concerns may result in cancellations and rescheduling ofbacklog. In addition, the recent decline in the U.S. real estate market,particularly in new home and commercial construction, has adversely impactednew road construction and has resulted in and may continue to result in flat orslightly declining Roadway Sensor and Vehicle Sensor net sales and could impactTransportation Systems contract revenues. Any of the foregoing economicconditions make it extremely difficult for our customers, our suppliers and usto accurately forecast and plan future business activities. If such conditionscontinue or worsen, our business, financial condition and results of operationscould be materially and adversely affected.

 

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**CURRENT BUDGETARY CONSTRAINTS ANDTHE SIGNIFICANT MILITARY OPERATIONS IN THE MIDDLE EAST OR ELSEWHERE MAY IMPACTGOVERNMENT FUNDING OR CONSUMER SPENDING, CAUSING A DECLINE IN OUR REVENUES.**Inthe near term, the funding of U.S. military operations in the Middle East orelsewhere may cause disruptions in funding of government contracts. Sincemilitary operations of such magnitude are not routinely included in U.S.defense budgets, supplemental legislative funding actions are often required tofinance such operations. Even when such legislation is enacted, it may not beadequate for ongoing operations, causing other government resources to betemporarily or permanently diverted. Since a significant portion of our salesare derived from contracts with government agencies, such diversion of fundscould produce interruptions in funding or delays in receipt of our contracts,causing disruptions and adversely effecting our revenue and operations.

 

**WE DEPEND ON GOVERNMENT CONTRACTS AND SUBCONTRACTS, AND BECAUSE MANY OFOUR GOVERNMENT CONTRACTS ARE FIXED PRICE CONTRACTS, HIGHER THAN ANTICIPATEDCOSTS WILL REDUCE OUR PROFIT AND COULD ADVERSELY IMPACT OUR OPERATING RESULTS.**A significant portion of our sales are derived from contracts withgovernmental agencies, either as a general contractor, subcontractor orsupplier. Government contracts represented approximately 38.1%, 37.8% and 38.3%of our total net sales and contract revenues for the years ended March 31,2008, 2007 and 2006, respectively. We anticipate that revenue from governmentcontracts will continue to remain a significant portion of our net sales andcontract revenues. Government business is, in general, subject to special risksand challenges, including:

 
| · |   | long purchase cycles or approval processes;                                                                                                                                                                              |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                     |
| · |   | competitive bidding and qualification  requirements;                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                     |
| · |   | the impact of international conflicts;                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                     |
| · |   | delays in funding, including delays in the  allocation of funds to state and local agencies from the U.S. federal  government as a result of the expiration of the 2005 Federal Highway Bill in  September of 2009; |
|   |   |                                                                                                                                                                                                                     |
| · |   | performance bond requirements;                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                     |
| · |   | changes in government policies and  political agendas;                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                     |
| · |   | other government budgetary constraints,  cut-backs, delays or reallocation of government funding;                                                                                                                        |
|   |   |                                                                                                                                                                                                                     |
| · |   | milestone requirements and liquidated  damage provisions for failure to meet contract milestones.                                                                                                                        |

 

In addition, a large number of our governmentcontracts are fixed price contracts. As a result, we may not be able to recoverany cost overruns we may incur. These fixed price contracts require us toestimate the total project cost based on preliminary projections of the project’srequirements. The financial viability of any given project depends in largepart on our ability to estimate these costs accurately and complete the projecton a timely basis. In the event our costs on these projects exceed the fixedcontractual amount, we will be required to bear the excess costs. Suchadditional costs would adversely affect our financial condition and results ofoperations. Moreover, certain of our government contracts are subject totermination or renegotiation at the convenience of the government, which couldresult in a large decline in our net sales and contract revenues in any givenquarter. Our inability to address any of the foregoing concerns or the loss orrenegotiation of any material government contract could seriously harm ourbusiness, financial condition and results of operations.

 

**WE MAY EXPERIENCE PRODUCTION GAPS THAT COULD MATERIALLY ANDADVERSELY IMPACT OUR SALES AND FINANCIAL RESULTS AND THE ULTIMATE ACCEPTANCE OFOUR PRODUCTS.**It is possible that we could experienceunforeseen quality control issues or part shortages as we adjust production tomeet current demand for our products. We have historically used singlesuppliers for certain of our components in our AutoVue and Vantage products.Should any such delay or disruption occur, our future sales will likely bematerially and adversely affected. Additionally, we rely heavily on selectcontract manufacturers to produce many of our products. Although we believe ourcontract manufacturers have sufficient capacity to meet our productionschedules for the foreseeable future and we believe we could find alternativecontract manufacturing sources if necessary, we could experience a productiongap if for any reason our contract manufacturers were unable to meet ourproduction requirements.

 

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**WE MAY BE UNABLE TO ATTRACT AND RETAIN KEY PERSONNEL, WHICH COULDSERIOUSLY HARM OUR BUSINESS.**Due to the specialized nature ofour business, we are highly dependent on the continued service of our executiveofficers and other key management, engineering and technical personnel. Theloss of Abbas Mohaddes, our Chief Executive Officer, or any of the otherexecutive officers or key members of management could adversely affect ourbusiness, financial condition, or results of operations. Our success will alsodepend in large part upon our ability to continue to attract, retain andmotivate qualified engineering and other highly skilled technical personnel. Inparticular, the future success of our Transportation Systems segment willdepend on our ability to hire additional qualified engineers and planners.Competition for qualified employees, particularly development engineers, isintense. We may not be able to continue to attract and retain sufficientnumbers of such highly skilled employees. Our inability to attract and retainadditional key employees or the loss of one or more of our current keyemployees could adversely affect our business, financial condition and resultsof operations.

 

**THE MARKETS IN WHICH WE OPERATE ARE HIGHLY COMPETITIVE AND HAVE MANYMORE ESTABLISHED COMPETITORS, WHICH COULD ADVERSELY AFFECT OUR SALES OR THEMARKET ACCEPTANCE OF OUR PRODUCTS.**We compete with numerousother companies in our target markets including, but not limited to, large,multinational corporations, which include tier one automotive suppliers, andmany smaller regional engineering firms. We expect such competition to increasedue to technological advancements, industry consolidations and reduced barriersto entry. Increased competition is likely to result in price reductions,reduced gross margins and loss of market share, any of which could seriouslyharm our business, financial condition and results of operations. In fiscal 2007,we began to experience more competition in our Roadway Sensors segment as theDepartment of Transportation in one of our largest sales territories moved to amulti-source contracting environment from one in which we were the solesupplier. In addition, one of the other developers of LDW systems was acquiredby a large multinational organization during fiscal 2009. This new competitorcould be more aggressive in both the passenger car and heavy truck markets, asa result of its greater access to resources and reputation in the market.Additional new competitors may enter this market in the future. Furthermore,awareness of LDW technology is increasing and other market players areattempting to develop competing technologies, which may contain improvements oradded features beyond those offered by our LDW systems. Additionally, from timeto time, we may be required to re-compete for LDW business from our maincustomer base of heavy truck OEMs. These OEMs could make a supplier changebased on price, product performance or available features. Should ourcompetition be successful, this could erode our ability to successfully marketand sell our LDW systems to new and existing customers.

 

Many of our competitors have far greater namerecognition and greater financial, technological, marketing, and customerservice resources than we do. This may allow them to respond more quickly tonew or emerging technologies and changes in customer requirements. It may alsoallow them to devote greater resources to the development, promotion, sale andsupport of their products than we can. Recent consolidations of end users,distributors and manufacturers in our target markets have exacerbated thisproblem. As a result of the foregoing factors, we may not be able to competeeffectively in our target markets and competitive pressures could adverselyaffect our business, financial condition and results of operations.

 

**IF WE ARE UNABLE TO DEVELOP AND INTRODUCE NEW PRODUCTS AND PRODUCTENHANCEMENTS SUCCESSFULLY AND IN A COST-EFFECTIVE AND TIMELY MANNER, OR AREUNABLE TO ACHIEVE MARKET ACCEPTANCE OF OUR NEW PRODUCTS, OUR OPERATING RESULTSWOULD BE ADVERSELY AFFECTED.**We believe our revenue growthand future operating results will depend on our ability to complete developmentof new products and enhancements, introduce these products in a timely,cost-effective manner, achieve broad market acceptance of these products andenhancements, and reduce our product costs. We cannot guarantee the success ofthese products and we may not be able to introduce any new products or anyenhancements to our existing products on a timely basis, or at all. Inaddition, the introduction of any new products could adversely affect the salesof certain of our existing products.

 

We believe that we must continue to makesubstantial investments to support ongoing research and development in order toremain competitive. We need to continue to develop and introduce new productsthat incorporate the latest technological advancements in outdoor imageprocessing hardware, software and camera technologies in response to evolvingcustomer requirements. We cannot assure you that we will be able to adequatelymanage product transition issues. Our business and results of operations couldbe adversely affected if we do not anticipate or respond adequately totechnological developments or changing customer requirements or if we cannotadequately manage inventory issues typically related to new product transitionsand introductions. We cannot assure you that any such investments in researchand development will lead to any corresponding increase in revenue.

 

Market acceptance of our new products dependsupon many factors, including our ability to accurately predict marketrequirements and evolving industry standards, our ability to resolve technicalchallenges in a timely and cost-effective manner, qualify any new products withOEMs and achieve manufacturing efficiencies, the perceived advantages of ournew products over traditional products and the marketing capabilities of our independentdistributors and strategic partners, including Valeo’s ability to expand salesof AutoVue in the passenger car market. The success of our AutoVue system willalso depend in part on the success of the automotive vehicles that incorporateour technology, as well as the success of optional equipment that OEMs bundlewith our technologies.

 

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Certain of the components used in our Vantageand AutoVue products may need to be re-engineered in the next 12 to 36 monthsas the industry is moving towards a standard of using lead-free components. Wecannot assure you as to the timing of the adoption of this new standard or ourability to successfully redesign our products to incorporate compliantcomponents and gain market acceptance of such redesigned products. In addition,if the standard is adopted earlier than anticipated we may experience ashortage of Vantage and AutoVue products as a result of potential scarcity oflead-free components.

 

Our business and results of operations couldalso be seriously harmed by any significant delays in our new productdevelopment. Certain of our new products could contain undetected design faultsand software errors or “bugs” when first released by us, despite our testing.We may not discover these faults or errors until after a product has beeninstalled and used by our customers. Any faults or errors in our existingproducts or in any new products may cause delays in product introduction andshipments, require design modifications or harm customer relationships, any ofwhich could adversely affect our business and competitive position.

 

**NEW ENVIRONMENTAL REGULATIONS MAY RESULTIN A DECLINE IN OUR VEHICLE SENSORS NET SALES.**From time to time, environmental regulationsare enacted, which can significantly increase the cost of manufacturing newvehicles as well as the cost of maintenance of existing vehicles and truckfleets.  As a result, we could experiencea decline in sales of our Vehicle Sensors products as truck and vehiclemanufacturers and fleet operators attempt to control their costs.

 

**WE MAY ENGAGE IN ACQUISITIONS OF COMPANIES OR TECHNOLOGIES THAT MAY REQUIREUS TO UNDERTAKE SIGNIFICANT CAPITAL INFUSIONS AND COULD RESULT IN DISRUPTIONSOF OUR BUSINESS AND DIVERSION OF RESOURCES AND MANAGEMENT ATTENTION.**Wehave historically acquired, and may in the future acquire, complementarybusinesses, products, and technologies. Acquisitions may require significantcapital infusions and, in general, acquisitions also involve a number ofspecial risks, including:

 
| · |   | potential disruption of our ongoing  business and the diversion of our resources and management’s attention;                                                             |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                          |
| · |   | the failure to retain or integrate key  acquired personnel;                                                                                                                   |
|   |   |                                                                                                                                                                          |
| · |   | the challenge of assimilating diverse  business cultures, and the difficulties in integrating the operations,  technologies and information system of the acquired companies; |
|   |   |                                                                                                                                                                          |
| · |   | increased costs to improve managerial,  operational, financial and administrative systems and to eliminate  duplicative services;                                             |
|   |   |                                                                                                                                                                          |
| · |   | the incurrence of unforeseen obligations or  liabilities;                                                                                                                     |
|   |   |                                                                                                                                                                          |
| · |   | potential impairment of relationships with  employees or customers as a result of changes in management; and                                                                  |
|   |   |                                                                                                                                                                          |
| · |   | increased interest expense and amortization  of acquired intangible assets.                                                                                                   |

 

Our competitors are also soliciting potentialacquisition candidates, which could both increase the price of any acquisitiontargets and decrease the number of attractive companies available foracquisition. Acquisitions may also materially and adversely affect ouroperating results due to large write-offs, contingent liabilities, substantialdepreciation, deferred compensation charges or intangible asset amortization,or other adverse tax or accounting consequences. We cannot assure you that wewill be able to identify or consummate any additional acquisitions,successfully integrate any acquisitions or realize the benefits anticipatedfrom any acquisition.

 

**WE DEPEND UPON VALEO TO MARKET OUR AUTOVUE TECHNOLOGIES FOR THE OEMPASSENGER CAR MARKET.**We have granted Valeo the exclusiveright to sell and manufacture our AutoVue LDW system to the worldwide passengercar market in exchange for royalty payments for each AutoVue unit sold. Assuch, the future success and broad market acceptance of our AutoVuetechnologies in the passenger car market will depend upon Valeo’s ability tomanufacture market and sell our technologies, and to convince more OEMpassenger car manufacturers to adopt our technologies.  To date, we have not generated significantroyalties from Valeo’s efforts and have only been designed into one car OEMproduct line.  If Valeo does not devoteconsiderable resources and aggressively pursue opportunities, our expansioninto the passenger car market could be adversely affected.

 

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**IF WE DO NOT KEEP PACE WITH RAPID TECHNOLOGICAL CHANGES AND EVOLVINGINDUSTRY STANDARDS, WE WILL NOT BE ABLE TO REMAIN COMPETITIVE AND THERE WILL BENO DEMAND FOR OUR PRODUCTS.**Our markets are in generalcharacterized by the following factors:

 
| · |   | rapid technological advances;                                                 |
|--------|--------|-------------------------------------------------------------------------------|
|   |   |                                                                          |
| · |   | downward price pressure in the marketplace  as technologies mature;           |
|   |   |                                                                          |
| · |   | changes in customer requirements;                                             |
|   |   |                                                                          |
| · |   | additional qualification requirements  related to new products or components; |
|   |   |                                                                          |
| · |   | frequent new product introductions and  enhancements;                         |
|   |   |                                                                          |
| · |   | inventory issues related to transition to  new or enhanced models; and        |
|   |   |                                                                          |
| · |   | evolving industry standards and changes in  the regulatory environment.       |

 

Our future success will depend upon ourability to anticipate and adapt to changes in technology and industrystandards, and to effectively develop, introduce, market and gain broadacceptance of new products and product enhancements incorporating the latesttechnological advancements. In particular, our LDW system is incorporated intoautomobiles and trucks that face significant technological changes in eachmodel year and among different vehicle models. Accordingly, we must adapt ourtechnology from time to time to function with such changes.

 

**OUR INTERNATIONAL BUSINESS OPERATIONS MAY BE THREATENED BY MANYFACTORS THAT ARE OUTSIDE OF OUR CONTROL.**We currently marketour AutoVue and Vantage products internationally and we anticipate that ourinternational operations will expand in the near future. International businessoperations are subject to various inherent risks including, among others:

 
| · |   | currency fluctuations and restrictions;                                                                                   |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                      |
| · |   | political, social and economic instability;                                                                               |
|   |   |                                                                                                                      |
| · |   | longer accounts receivable payment cycles;                                                                                |
|   |   |                                                                                                                      |
| · |   | import and export license requirements and  restrictions of the United States and each other country in which we operate; |
|   |   |                                                                                                                      |
| · |   | unexpected changes in regulatory  requirements, tariffs and other trade barriers or restrictions;                         |
|   |   |                                                                                                                      |
| · |   | the burdens of compliance with a wide  variety of foreign laws and more restrictive labor laws and obligations;           |
|   |   |                                                                                                                      |
| · |   | difficulties in managing and staffing  international operations;                                                          |
|   |   |                                                                                                                      |
| · |   | potentially adverse tax consequences; and                                                                                 |
|   |   |                                                                                                                      |
| · |   | reduced protection for intellectual  property rights in some countries.                                                   |

 

All of our international sales aredenominated in U.S. dollars. As a result, an increase in the relative value ofthe dollar could make our products more expensive and potentially less pricecompetitive in international markets. We do not engage in any transactions as ahedge against risks of loss due to foreign currency fluctuations.

 

Any of the factors mentioned above mayadversely affect our future international sales and, consequently, affect ourbusiness, financial condition and operating results. Furthermore, as weincrease our international sales, our total revenues may also be affected to agreater extent by seasonal fluctuations resulting from lower sales thattypically occur during the summer months in Europe and other parts of theworld.

 

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**IF OURINTERNAL CONTROLS OVER FINANCIAL REPORTING DO NOT COMPLY WITH THE REQUIREMENTSOF THE SARBANES-OXLEY ACT, OUR BUSINESS AND STOCK PRICE COULD BE ADVERSELYAFFECTED. **Section 404of the Sarbanes-Oxley Act of 2002 currently requires us to evaluate theeffectiveness of our internal controls over financial reporting at the end ofeach fiscal year and to include a management report assessing the effectivenessof our internal controls over financial reporting in all annual reports. Section 404also requires our independent registered public accounting firm to attest to,and report on, management’s assessment of our internal controls over financialreporting beginning with our fiscal year ending March 31, 2010. We may notbe able to complete the work required for such attestation on a timely basis,and even if we timely complete such requirements, our independent auditors maystill conclude that our internal controls over financial reporting are noteffective.

 

Our management, including our CEO and CFO,does not expect that our internal controls over financial reporting willprevent all errors and all fraud. A control system, no matter how well designedand operated, can provide only reasonable, not absolute, assurance that thecontrol system’s objectives will be met. Further, the design of a controlsystem must reflect the fact that there are resource constraints, and thebenefits of controls must be considered relative to their costs. Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within Iteris have been or will be detected. These inherent limitationsinclude the realities that judgments in decision-making can be faulty and thatbreakdowns can occur because of simple error or mistake. Controls can also becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of the controls. The design of anysystem of controls is based in part on certain assumptions about the likelihoodof future events, and we cannot assure you that any design will succeed inachieving its stated goals under all potential future conditions. Over time,our controls may become inadequate because of changes in conditions ordeterioration in the degree of compliance with policies or procedures. Becauseof the inherent limitations in a cost-effective control system, misstatementsdue to error or fraud may occur and not be detected.

 

As of March 31, 2005, we became aware ofa material weakness in our internal controls related to the accounting for theconsolidation of our deferred compensation savings plan and certain contractadministration. Based on our evaluation, our management concluded that, as of March 31,2004, our internal control over financial reporting was not effective due tothe existence of one material weakness. The weakness was immediately corrected.We cannot assure you that we or our independent registered public accountingfirm will not identify additional material weaknesses in our internal controls.A material weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected. If our internal controls over financial reporting arenot considered adequate, we may experience a loss of public confidence, whichcould have an adverse effect on our business and our stock price.

 

**WE MAY NEED TO RAISE ADDITIONAL CAPITAL IN THE FUTURE, WHICH MAY NOTBE AVAILABLE ON TERMS ACCEPTABLE TO US, OR AT ALL. **Until recently, we havehistorically generated significant net losses and operating losses, and haveexperienced volatility in our cash flows from operations ranging from positivecash flows from operations of $7.6 million in the fiscal year ended March 31,2008 to negative cash flows from operations of $2.0 million in the fiscal yearended March 31, 2007. Although we entered into a new $19.5 million creditfacility, effective October 2008, should we have an event of default,which includes, among other things, a failure to meet certain financialcovenants and a material adverse change in the business, the bank could chooseto limit or take away our ability to borrow these or any funds.  Should this occur, or if the credit marketsfurther tighten, we may need or choose to raise additional capital to refinancethe remaining debentures, pursue acquisitions or to expand our operations.

 

At December 31,2008, we had $6.0 million of cash and cash equivalents and our entire $12.0million line of credit to fund our operations. We may need to raise additionalcapital in the near future to fund our operations or to repay indebtedness.Such additional capital may be raised through bank borrowings, or other debt orequity financings. We cannot assure you that any additional capital will beavailable on a timely basis, on acceptable terms, or at all, and suchadditional financing may result in further dilution to our stockholders.

 

Our capital requirements will depend on manyfactors, including, but not limited to:

 
| · |   | market acceptance of our products and  product enhancements, and the overall level of sales of our products; |
|--------|--------|--------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                         |
| · |   | our ability to control costs;                                                                                |
|   |   |                                                                                                         |
| · |   | the supply of key components for our  products;                                                              |
|   |   |                                                                                                         |
| · |   | our ability to increase revenue and net  income;                                                             |
|   |   |                                                                                                         |
| · |   | increased research and development expenses  and sales and marketing expenses;                               |

 

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| · |   | our need to respond to technological  advancements and our competitors’ introductions of new products or  technologies;     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                             |
| · |   | capital improvements to new and existing  facilities and enhancements to our infrastructure and systems;                         |
|   |   |                                                                                                                             |
| · |   | potential acquisitions of businesses and  product lines;                                                                         |
|   |   |                                                                                                                             |
| · |   | our relationships with customers and  suppliers;                                                                                 |
|   |   |                                                                                                                             |
| · |   | government budgets, political agendas and  other funding issues, including potential delays in government contract  awards;      |
|   |   |                                                                                                                             |
| · |   | our ability to successfully negotiate credit  arrangements with our bank and repay our subordinated convertible debentures;  and |
|   |   |                                                                                                                             |
| · |   | general economic conditions, including the  effects of the current economic slowdown and international conflicts.                |

 

If our capital requirements are materiallydifferent from those currently planned, we may need additional capital soonerthan anticipated. If additional funds are raised through the issuance of equityor convertible debt securities, the percentage ownership of our stockholderswill be reduced and such securities may have rights, preferences and privilegessenior to our common stock. Additional financing may not be available onfavorable terms, on a timely basis, or at all. If adequate funds are notavailable or are not available on acceptable terms, we may be unable tocontinue our operations as planned, develop or enhance our products, expand oursales and marketing programs, take advantage of future opportunities or respondto competitive pressures.

 

**OUR QUARTERLY OPERATING RESULTS FLUCTUATE AS A RESULT OF MANY FACTORS.THEREFORE, WE MAY FAIL TO MEET OR EXCEED THE EXPECTATIONS OF SECURITIESANALYSTS AND INVESTORS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE.**Ourquarterly revenues and operating results have fluctuated and are likely tocontinue to vary from quarter to quarter due to a number of factors, many ofwhich are not within our control. Factors that could affect our revenuesinclude, among others, the following:

 
| · |   | changes in our pricing policies and the  pricing policies of our suppliers and competitors, pricing concessions on  volume sales, as well as increased price competition in general; |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                 |
| · |   | the long lead times associated with  government contracts or required by vehicle manufacturers;                                                                                      |
|   |   |                                                                                                                                                                                 |
| · |   | the size, timing, rescheduling or  cancellation of significant customer orders;                                                                                                      |
|   |   |                                                                                                                                                                                 |
| · |   | delays in government contracts and funding  from time to time and budgetary constraints at the federal, state and local  levels;                                                     |
|   |   |                                                                                                                                                                                 |
| · |   | declines in new home construction and  related road and other infrastructure construction;                                                                                           |
|   |   |                                                                                                                                                                                 |
| · |   | our ability to control costs;                                                                                                                                                        |
|   |   |                                                                                                                                                                                 |
| · |   | our ability to raise additional capital;                                                                                                                                             |
|   |   |                                                                                                                                                                                 |
| · |   | the mix of our products and services sold  in a quarter, which mix has varied and is expected to continue to vary from  time to time;                                                |
|   |   |                                                                                                                                                                                 |
| · |   | seasonality due to winter weather  conditions;                                                                                                                                       |
|   |   |                                                                                                                                                                                 |
| · |   | international conflicts and acts of  terrorism;                                                                                                                                      |
|   |   |                                                                                                                                                                                 |
| · |   | our ability to develop, introduce, patent,  market and gain market acceptance of new products, applications and product  enhancements in a timely manner, or at all;                 |
|   |   |                                                                                                                                                                                 |
| · |   | market acceptance of the products  incorporating our technologies and products;                                                                                                      |

 

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| · |   | the introduction of new products by  competitors;                                                    |
|--------|--------|------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                 |
| · |   | the availability and cost of components  used in the manufacture of our products;                    |
|   |   |                                                                                                 |
| · |   | our success in expanding and implementing  our sales and marketing programs;                         |
|   |   |                                                                                                 |
| · |   | the effects of technological changes in our  target markets;                                         |
|   |   |                                                                                                 |
| · |   | the amount of our backlog at any given  time;                                                        |
|   |   |                                                                                                 |
| · |   | the nature of our government contracts;                                                              |
|   |   |                                                                                                 |
| · |   | deferrals of customer orders in  anticipation of new products, applications or product enhancements; |
|   |   |                                                                                                 |
| · |   | risks and uncertainties associated with our  international business;                                 |
|   |   |                                                                                                 |
| · |   | currency fluctuations and our ability to  get currency out of certain foreign countries; and         |
|   |   |                                                                                                 |
| · |   | general economic and political conditions.                                                           |

 

Due to all of the factors listed above aswell as other unforeseen factors, our future operating results could be belowthe expectations of securities analysts or investors. If that happens, thetrading price of our common stock could decline. As a result of these quarterlyvariations, you should not rely on quarter-to-quarter comparisons of ouroperating results as an indication of our future performance.

 

**WE HAVEEXPERIENCED GROWTH IN RECENT PERIODS. IF WE FAIL TO MANAGE OUR GROWTHEFFECTIVELY, WE MAY BE UNABLE TO EXECUTE OUR BUSINESS PLAN AND MAY EXPERIENCEFUTURE WEAKNESSES IN OUR INTERNAL CONTROLS.**We have expandedour overall business. In order to achieve our business objectives, we will needto continue to expand our business and add additional qualified personnel. Suchexpansion has placed and is expected to continue to place, a significant strainon our managerial, administrative, operational, financial and other resources.If we are unable to successfully manage our growth, our business, financialcondition and results of operations will be adversely affected.

 

**WE MAY NOT BE ABLE TO ADEQUATELY PROTECT OR ENFORCE OURINTELLECTUAL PROPERTY RIGHTS, WHICH COULD HARM OUR COMPETITIVE POSITION.**If we are not able to adequately protect or enforce the proprietaryaspects of our technology, competitors could be able to access our proprietarytechnology and our business, financial condition and results of operations willlikely be seriously harmed. We currently attempt to protect our technologythrough a combination of patent, copyright, trademark and trade secret laws,employee and third party nondisclosure agreements and similar means. Despiteour efforts, other parties may attempt to disclose, obtain or use ourtechnologies or systems. Our competitors may also be able to independentlydevelop products that are substantially equivalent or superior to our productsor design around our patents. In addition, the laws of some foreign countriesdo not protect our proprietary rights as fully as do the laws of the UnitedStates. As a result, we may not be able to protect our proprietary rightsadequately in the United States or abroad.

 

Litigation may be necessary in the future to enforce our intellectualproperty rights or to determine the validity and scope of the proprietaryrights of others. Litigation may also be necessary to defend against claims ofinfringement or invalidity by others. An adverse outcome in litigation or anysimilar proceedings could subject us to significant liabilities to thirdparties, require us to license disputed rights from others or require us tocease marketing or using certain products or technologies. We may not be ableto obtain any licenses on terms acceptable to us, or at all. We also may haveto indemnify certain customers or strategic partners if it is determined thatwe have infringed upon or misappropriated another party’s intellectualproperty. Any of these results could adversely affect our business, financialcondition and results of operations. In addition, the cost of addressing anyintellectual property litigation claim, including legal fees and expenses, andthe diversion of management’s attention and resources, regardless of whetherthe claim is valid, could be significant and could seriously harm our business,financial condition and results of operations.

 

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**WE HAVEHISTORICALLY EXPERIENCED SUBSTANTIAL LOSSES AND MAY EXPERIENCE LOSSES INTHE FUTURE.**Although we have achieved net income in our pastthree fiscal years, we experienced a net loss of $11.3 million in the yearended March 31, 2005 and significant net losses in prior years. We cannotassure you that we will be able to sustain or improve our financialperformance, or that we will be able to continue to achieve profitability on aquarterly or annual basis in the future. Most of our expenses are fixed inadvance. As such, we generally are unable to reduce our expenses significantlyin the short-term to compensate for any unexpected delay or decrease inanticipated revenues. As a result, we may continue to experience operatinglosses and net losses, which would make it difficult to fund our operations andachieve our business plan, and could cause the market price of our common stockto decline.

 

**THE TRADING PRICE OF OUR COMMON STOCK IS HIGHLY VOLATILE.**Thetrading price of our common stock has been subject to wide fluctuations in thepast. Since January 2000, our Class A common stock (now known as ourcommon stock) has traded at prices as low as $0.45 per share and as high as$29.44 per share. The market price of our common stock could continue tofluctuate in the future in response to various factors, including, but notlimited to:

 
| · |   | quarterly variations in operating results;                                                                       |
|--------|--------|------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                             |
| · |   | our ability to control costs, improve cash  flow and sustain profitability;                                      |
|   |   |                                                                                                             |
| · |   | our ability to raise additional capital;                                                                         |
|   |   |                                                                                                             |
| · |   | shortages announced by suppliers;                                                                                |
|   |   |                                                                                                             |
| · |   | announcements of technological innovations  or new products or applications by our competitors, customers or us; |
|   |   |                                                                                                             |
| · |   | transitions to new products or product  enhancements;                                                            |
|   |   |                                                                                                             |
| · |   | acquisitions of businesses, products or  technologies;                                                           |
|   |   |                                                                                                             |
| · |   | the impact of any litigation;                                                                                    |
|   |   |                                                                                                             |
| · |   | changes in investor perceptions;                                                                                 |
|   |   |                                                                                                             |
| · |   | government funding, political agendas and  other budgetary constraints;                                          |
|   |   |                                                                                                             |
| · |   | changes in earnings estimates or investment  recommendations by securities analysts; and                         |
|   |   |                                                                                                             |
| · |   | international conflicts, political unrest  and acts of terrorism.                                                |

 

The stock market in general has from time totime experienced volatility, which has often affected the market prices ofequity securities of many technology companies. This volatility has often beenunrelated to the operating performance of these companies. These broad marketfluctuations may adversely affect the market price of our common stock. In thepast, companies that have experienced volatility in the market price of theirsecurities have been the subject of securities class action litigation. If wewere to become the subject of a class action lawsuit, it could result insubstantial losses and divert management’s attention and resources from othermatters.

 

**WE COULD EXPERIENCE NEGATIVE FINANCIAL IMPACTS ARISING FROMDEVELOPMENTS IN CONTINGENCIES CREATED UNDER OUR PREVIOUS STRUCTURE OR BY FORMERSUBSIDIARIES.**Although we divested ourselves of all businessunits prior to October 2004, with the exception of our Iteris business,from time to time we could experience unforeseen developments in contingenciesrelated to our former subsidiaries. For example, in July 2006 we enteredinto a settlement agreement in connection with a lawsuit brought againstMariner Networks, Inc., one of our former subsidiaries, by one of Mariner’ssuppliers, pursuant to which we issued 88,912 shares of our common stock tothis supplier (valued at $213,000 as of the date of issuance), paid thissupplier $125,000 on October 20, 2006 and are required to pay anadditional $350,000 in 36 equal monthly installments of $9,700 through October 2009.Although we are not aware of any other material contingencies, it is possibleother matters could be brought against us in connection with activities relatedto former subsidiaries and that such matters could materially and adverselyaffect our financial results and cash flows.

 

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**SOME OF OUR DIRECTORS, OFFICERS AND THEIR AFFILIATES CAN CONTROL THEOUTCOME OF MATTERS THAT REQUIRE THE APPROVAL OF OUR STOCKHOLDERS, ANDACCORDINGLY WE WILL NOT BE ABLE TO ENGAGE IN CERTAIN TRANSACTIONS WITHOUT THEIRAPPROVAL.**As of December 31, 2008, our officers anddirectors beneficially owned approximately 11% of the outstanding shares of ourcommon stock (and approximately 15% of our common stock when including options,warrants and other convertible securities held by them which are currentlyexercisable or convertible or will become exercisable or convertible within60 days after December 31, 2008). As a result of their stockownership, our management will be able to influence the election of ourdirectors and the outcome of corporate actions requiring stockholder approval,such as mergers and acquisitions, regardless of how our other stockholders mayvote. This concentration of voting control may have a significant effect indelaying, deferring or preventing a change in our management or change incontrol and may adversely affect the voting or other rights of other holders ofcommon stock.

 

**CERTAIN PROVISIONS OF THECOMPANY’S CHARTER DOCUMENTS MAY DISCOURAGE A THIRD PARTY FROM ACQUIRING USAND MAY ADVERSELY AFFECT THE PRICE OF OUR COMMON STOCK.**Certainprovisions of our certificate of incorporation could make it difficult for a thirdparty to acquire us, even though an acquisition might be beneficial to ourstockholders. Such provisions could limit the price that investors might bewilling to pay in the future for shares of our common stock. Under the terms ofour certificate of incorporation, our Board of Directors is authorized toissue, without stockholder approval, up to 2,000,000 shares of preferred stockwith voting, conversion and other rights and preferences superior to those ofour common stock. Our future issuance of preferred stock also could be used toeffect a shareholder rights plan which could discourage an unsolicitedacquisition proposal.

 

**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**

 

One of our executive officers, James S.Miele, has entered into a trading plan pursuant to Rule 10b5-1(c)(1) ofthe Securities Exchange Act of 1934, as amended, which covers an aggregate of40,000 shares of our common stock not to be sold at a price below $2.75. Theoptions shares are set to expire on September 26, 2011.

 

On February 4, 2009 the Company enteredinto an Amended and Restated Loan and Security Agreement with California Bank& Trust which supersedes the agreements entered into on October 16,2008 in their entirety. The Amended and Restated Loan and Security Agreement isincluded as an exhibit with the filing (Exhibit 10.1).  The October 16, 2008 documents wereamended and restated to clarify the meaning of certain ambiguities and removenon-applicable language.  Nomodifications were made to any significant provisions related to the overallamount of the credit facility, interest rate calculations, or any financial ornon-financial covenant.

 

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**ITEM 6. EXHIBITS**

 

The following exhibits are filed herewith or are incorporatedby reference to the location indicated.

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                         | ** ** | **Where Located**                                                                                                                                                         |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Amended and Restated Certificate of Incorporation of the registrant                                                                                                                     | * *   | *Exhibit 3.1 to the registrant’s Current Report on Form 8-K  as filed with the SEC on October 28, 2004*                                                    |
| * *            | * *   | * *                                                                                                                                                                                | * *   | * *                                                                                                                                                                       |
| 3.2                 |       | Certificate of Amendment to Amended and Restated Certificate of  Incorporation filed September 26, 2007                                                                            | * *   | *Exhibit 3.2 to the registrant’s Quarterly Report on  Form 10-Q for the quarter ended September 30, 2007 as filed with  the SEC on November 13, 2007* |
| * *            | * *   | * *                                                                                                                                                                                | * *   | * *                                                                                                                                                                       |
| 3.3                 |       | Bylaws of registrant, as amended                                                                                                                                                        | * *   | *Exhibit 4.2 to the registrant’s Registration Statement on  Form S-1 (Reg. No. 033-67932) as filed with the SEC on July 6,  1993*                     |
| * *            | * *   | * *                                                                                                                                                                                | * *   | * *                                                                                                                                                                       |
| 3.4                 |       | Certificates of Amendment to Bylaws of the registrant dated  April 24, 1998 and August 10, 2001                                                                               | * *   | *Exhibit 3.4 to the registrant’s Annual Report on  Form 10-K/A for the year ended March 31, 2003 as filed with the SEC  on July 29, 2003*             |
| * *            | * *   | * *                                                                                                                                                                                | * *   | * *                                                                                                                                                                       |
| 3.5                 |       | Certificate of Amendment to Bylaws of registrant dated  September 9, 2004                                                                                                          | * *   | *Exhibit 3.1 to the registrant’s Quarterly Report on  Form 10-Q for the quarter ended September 30, 2004 as filed with  the SEC on November 15, 2004* |
|                |       |                                                                                                                                                                                    |       |                                                                                                                                                                           |
| 3.6                 |       | Certificate of Amendment to Bylaws of registrant dated  September 16, 2005                                                                                                         | * *   | *Exhibit 3.5 to the registrant’s Annual Report on Form 10-K  for the year ended March 31, 2007 as filed with the SEC on June 21,  2007*               |
|                |       |                                                                                                                                                                                    |       |                                                                                                                                                                           |
| 3.7                 |       | Certificate of Amendment to Bylaws of registrant dated  December 7, 2007                                                                                                           | * *   | *Exhibit 3.1 to the registrant’s Current Report on Form 8-K  as filed with the SEC on December 13, 2007*                                                   |
|                |       |                                                                                                                                                                                    |       |                                                                                                                                                                           |
| 4.1                 |       | Specimen of Common Stock Certificate                                                                                                                                                    | * *   | *Exhibit 4.1 to the registrant’s Amendment No. 1 to the  Registration Statement on Form 8-A as filed with the SEC on  December 8, 2004*               |
|                |       |                                                                                                                                                                                    |       |                                                                                                                                                                           |
| 10.1                |       | Amended and Restated Loan and Security Agreement on February 4, 2009  by and between California Bank & Trust and the registrant                                                     | * *   | *Filed herewith*                                                                                                                                                               |
|                |       |                                                                                                                                                                                    | * *   | * *                                                                                                                                                                       |
| 10.2                |       | Debenture Redemption Agreement, dated October 17, 2008, by and  between the registrant and certain affiliates of Bryant R. Riley                                                        | * *   | *Filed herewith*                                                                                                                                                               |
|                |       |                                                                                                                                                                                    | * *   | * *                                                                                                                                                                       |
| 10.3                |       | Debenture Redemption Agreement, dated October 27, 2008, by and  between the registrant and each of Lloyd I. Miller, III, Lloyd I. Miller  Trust A-4, Milfam I, L.P. and Milfam II, L.P. | * *   | *Filed herewith*                                                                                                                                                               |
|                |       |                                                                                                                                                                                    | * *   | * *                                                                                                                                                                       |
| 10.4                |       | Debenture Redemption Agreement, dated January 9, 2009, by and between  the registrant and each of Irvin Kessler and Provident Premier Master Fund  Ltd.                                 | * *   | *Filed herewith*                                                                                                                                                               |
|                |       |                                                                                                                                                                                    |       |                                                                                                                                                                           |
| 31.1                |       | Certification of the Principal Executive Officer, as required  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                           | * *   | *Filed herewith*                                                                                                                                                               |
| * *            | * *   | * *                                                                                                                                                                                | * *   | * *                                                                                                                                                                       |
| 31.2                |       | Certification of the Principal Financial and Accounting Officer, as  required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                            | * *   | *Filed herewith*                                                                                                                                                               |
| * *            | * *   | * *                                                                                                                                                                                | * *   | * *                                                                                                                                                                       |
| 32.1                |       | Certification of the Chief Executive Officer, as required pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                                                               | * *   | *Filed herewith*                                                                                                                                                               |
| * *            | * *   | * *                                                                                                                                                                                | * *   | * *                                                                                                                                                                       |
| 32.2                |       | Certification of the Chief Financial Officer, as required pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                                                               | * *   | *Filed herewith*                                                                                                                                                               |

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
| Dated: February 12 , 2009 | ITERIS, INC. |
|--------------------------------|--------------|
|                           | (Registrant) |
|                           |         |
|                           | By           | /S/ ABBAS MOHADDES |
|                           |         | Abbas Mohaddes |
|                           |         | Chief Executive Officer |
|                           |         | (Principal Executive Officer) |
|                           |         |   |
|                           |         |   |
|                           | By           | /S/ JAMES S. MIELE |
|                           |         | James S. Miele |
|                           |         | Chief Financial Officer |
|                           |         | (Principal Financial and Accounting Officer) |

 

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