**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 
| **(Mark****One)** |
|-------------------|
| **ý**        | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**For the quarterly period ended September 30,2005**

 

**OR**

 
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|-------|------------|----------------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom                   to                   **

 

**Commission file number:  001-08762**

 

**ITERIS, INC.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                     | ** ** | **95-2588496**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **1515 South Manchester Avenue  Anaheim, California**            | ** ** | **92802**                             |
| (Address of principal  executive office)                         |       | (Zip Code)                            |
|                                                             |       |                                  |
| **(714)****774-5000**                                            |
| (Registrant’s telephone  number, including area code)       |

 

 

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

 

**Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”) during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.**

 

**Yes  ****ý****   No  ****o**

 

**Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).**

 

**Yes  ****o****   No  ****ý**

 

**Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).**

 

**Yes  ****o****   No  ****ý**

 

As of November 8, 2005, the registrant had 28,546,170shares of common stock outstanding.

 

 

----

 

**ITERIS, INC.**

**Quarterly Report on Form 10-Q**

**For the Three and Six MonthsEnded September 30, 2005**

 

**Table of Contents**

 
| **PART I.**  | **FINANCIAL  INFORMATION**                                                                                                          | ** ** |
|-------------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|
|              |                                                                                                                                |       |
| **ITEM  1.**      | **FINANCIAL  STATEMENTS**                                                                                                           | ** ** |
|              |                                                                                                                                |       |
| ** **        | **UNAUDITED CONDENSED  CONSOLIDATED BALANCE SHEETS AT SEPTEMBER 30, 2005 AND MARCH 31, 2005**                             | ** ** |
| ** **        | ** **                                                                                                                          | ** ** |
| ** **        | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED SEPTEMBER 30,  2005 AND 2004** | ** ** |
|              |                                                                                                                                |       |
| ** **        | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED SEPTEMBER 30,  2005 AND 2004**           | ** ** |
|              |                                                                                                                                |       |
| ** **        | **NOTES TO UNAUDITED CONDENSED  CONSOLIDATED FINANCIAL STATEMENTS**                                                                 | ** ** |
|              |                                                                                                                                |       |
| **ITEM 2.**       | **MANAGEMENT’S DISCUSSION  AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                                     | ** ** |
|              |                                                                                                                                |       |
| ** **        | **RISK  FACTORS**                                                                                                                   | ** ** |
|              |                                                                                                                                |       |
| **ITEM 3.**       | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                                                     | ** ** |
|              |                                                                                                                                |       |
| **ITEM 4.**       | **CONTROLS AND  PROCEDURES**                                                                                                        | ** ** |
|              |                                                                                                                                |       |
| **PART II.** | **OTHER INFORMATION**                                                                                                               | ** ** |
|              |                                                                                                                                |       |
| **ITEM 1.**       | **LEGAL PROCEEDINGS**                                                                                                               | ** ** |
|              |                                                                                                                                |       |
| **ITEM 2.**       | **UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**                                                                    | ** ** |
|              |                                                                                                                                |       |
| **ITEM 3.**       | **DEFAULTS  UPON SENIOR SECURITIES**                                                                                                | ** ** |
|              |                                                                                                                                |       |
| **ITEM 4.**       | **SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS**                                                                            | ** ** |
|              |                                                                                                                                |       |
| **ITEM 5.**       | **OTHER INFORMATION**                                                                                                               | ** ** |
|              |                                                                                                                                |       |
| **ITEM  6.**      | **EXHIBITS**                                                                                                                        | ** ** |

 

Unless otherwiseindicated in this report, the “Company,” “we,” “us” and “our” collectivelyrefer to Iteris, Inc. (formerly known as Iteris Holdings, Inc. andOdetics, Inc.) and its subsidiary, Meyer, Mohaddes Associates, Inc.

 

AutoVueTM, IterisTM and VantageTM are among thetrademarks of Iteris, Inc.  Anyother trademarks or trade names mentioned herein are the property of theirrespective owners.

 

2

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**PART I.FINANCIAL INFORMATION**

**ITEM1.  FINANCIAL STATEMENTS**

 

**ITERIS, INC.**

**UNAUDITED CONDENSED CONSOLIDATEDBALANCE SHEETS**

**(In thousands, except per share amounts)**

 
| ** **                                                                                                                                                                                                                                                                                                                                                                     | ** ** | **September 30, 2005** | ** ** | **March 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                                                                                                                                                                     |       |                        |       |                     |       |
| Current  assets:                                                                                                                                                                                                                                                                                                                                                               |       |                        |       |                     |       |
| Cash                                                                                                                                                                                                                                                                                                                                                                           | ** ** | **$**                       | **—** |                     | $          | 46 |   |
| Trade  accounts receivable, net of allowance for doubtful accounts of $423 and $239  at September 30, 2005 and March 31, 2005, respectively                                                                                                                                                                                                                          | ** ** | **8,883**                   |       | 8,866                    |       |
| Costs and  estimated earnings in excess of billings on uncompleted contracts                                                                                                                                                                                                                                                                                                   | ** ** | **2,568**                   |       | 2,086                    |       |
| Inventories,  net of reserve for inventory obsolescence of $613 and $514 at September 30,  2005 and March 31, 2005, respectively                                       | ** ** | **3,003**                   |       | 4,344                    |       |
| Deferred  income taxes                                                                                                                                                                                                                                                                                                                                                         | ** ** | **221**                     |       | 101                      |       |
| Prepaid  expenses and other current assets                                                                                                                                                                                                                                                                                                                           | ** ** | **627**                     |       | 384                      |       |
| Total  current assets                                                                                                                                                                                                                                                                                                                                                          | ** ** | **15,302**                  |       | 15,827                   |       |
| Property and  equipment, net                                                                                                                                                                                                                                                                                                                                                   | ** ** | **1,154**                   |       | 1,103                    |       |
| Deferred  income taxes                                                                                                                                                                                                                                                                                                                                                         | ** ** | **628**                     |       | 559                      |       |
| Intangible  assets, net of accumulated amortization of $187 and $114 at September 30,  2005 and March 31, 2005, respectively                                                                                                                                                                                                                                         | ** ** | **625**                     |       | 698                      |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                                                       | ** ** | **27,774**                  |       | 27,774                   |       |
| Other assets                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **560**                     |       | 695                      |       |
| Total assets                                                                                                                                                                                                                                                                                                                                                                   | ** ** | **$**                       | **46,043** |                     | $          | 46,656 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                                                 | ** ** | ** **                  |       | ** **               | ** ** |
| Current  liabilities:                                                                                                                                                                                                                                                                                                                                                          |       |                        |       |                     |       |
| Trade  accounts payable                                                                                                                                                                                                                                                                                                                                              | ** ** | **$**                       | **3,101**  |                     | $          | 3,936 |   |
| Accrued  payroll and related expenses                                                                                                                                                                                                                                                                                                                                          | ** ** | **3,022**                   |       | 3,007                    |       |
| Accrued  liabilities                                                                                                                                                                                                                                                                                                                                                           | ** ** | **1,098**                   |       | 790                      |       |
| Billings in  excess of costs and estimated earnings on uncompleted contracts                                                                                                                                                                                                                                                                                                   | ** ** | **991**                     |       | 944                      |       |
| Revolving  line of credit                                                                                                                                                                                                                                                                                                                        | ** ** | **1,711**                   |       | 945                      |       |
| Current  portion of long-term debt                                                                                                                                                                                                                                                                                                                                             | ** ** | **3,378**                   |       | 4,008                    |       |
| Total  current liabilities                                                                                                                                                                                                                                                                                                                                                     | ** ** | **13,301**                  |       | 13,630                   |       |
| Non-current  payroll related liability                                                                                                                                                                                                                                                                                                                | ** ** | **173**                     |       | 330                      |       |
| Deferred  compensation plan liability                                                                                                                                                                                                                                                                                                                                          | ** ** | **850**                     |       | 772                      |       |
| Deferred  gain on sale of building                                                                                                                                                                                                                                                                                                                                             | ** ** | **591**                     |       | 733                      |       |
| Long-term debt  and capital lease obligation                                                                                                                                                                                                                                                                                                                                   | ** ** | **1,292**                   |       | 1,319                    |       |
| Convertible  debentures, net                                                                                                                                                                                                                                                                                                                                                   | ** ** | **9,100**                   |       | 8,996                    |       |
| Total  liabilities                                                                                                                                                                                                                                                                                                                                                             | ** ** | **25,307**                  |       | 25,780                   |       |
| Commitments  and contingencies                                                                                                                                                                                                                                                                                                                                                 |       |                        |       |                     |       |
| Redeemable  common stock, 1,219 shares issued and outstanding at September 30, 2005 and  March 31, 2005                                                                                                                                                                                                                                                              | ** ** | **3,414**                   |       | 3,414                    |       |
| Stockholders’  equity:                                                                                                                                                                                                                                                                                                                                                    |       |                        |       |                     |       |
| Preferred  stock, $1.00 par value, 2,000 shares authorized, none issued and outstanding  at September 30, 2005 and March 31, 2005                                                                                                                                                                                                                                    | ** ** | **—**                  |       | —                   |       |
| Common  stock, $0.10 par value, 50,000 shares authorized, 27,266 and 27,090 shares  issued and outstanding at September 30, 2005 and March 31, 2005,  respectively                                                                                                                                                                                                   | ** ** | **2,727**                   |       | 2,709                    |       |
| Additional  paid-in capital                                                                                                                                                                                                                                                                                                                                                    | ** ** | **126,632**                 |       | 126,534                  |       |
| Deferred  stock-based compensation                                                                                                                                                                                                                                                                                                                                             | ** ** | **(300**                    | **)**      | (925                     | )          |
| Common stock  held in trust, 311 shares at September 30, 2005 and March 31, 2005                                                                                                                                                                                                                                                                                     | ** ** | **(374**                    | **)**      | (374                     | )          |
| Treasury  stock                                                                                                                                                                                                                                                                                                                                                      | ** ** | **(1**                      | **)**      | (1                       | )          |
| Notes  receivable from employees                                                                                                                                                                                                                                                                                                                                               | ** ** | **(45**                     | **)**      | (45                      | )          |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                                                                           | ** ** | **(111,317**                | **)**      | (110,436                 | )          |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                                                                                               | ** ** | **17,322**                  |       | 17,462                   |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                                                                                                                                                                                               | ** ** | **$**                       | **46,043** |                     | $          | 46,656 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

3

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**ITERIS, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except pershare amounts)**

 
| ** **                                                      | ** ** | **Three Months Ended  September 30,** | ** **  | **Six Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------|-------------|------------------------------------------|------------|
| ** **                                                      | ** ** | **2005**                                   | ** **  | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales  and contract revenues:                               |       |                                       |        |                                     |       |   |   |   |   |
| Net sales                                                       | ** ** | **$**                                      | **7,975**   |                                     | $          | 7,651 | ** ** | **$** | **15,500** |   | $ | 14,554 |   |
| Contract  revenues                                              | ** ** | **4,740**                                  |        | 4,109                                    |       | **9,294** |   | 8,647 |   |
| Total net  sales and contract revenues                          | ** ** | **12,715**                                 |        | 11,760                                   |       | **24,794** |   | 23,201 |   |
|                                                            |       |                                       |        |                                     |       |   |   |   |   |
| Costs and  expenses:                                            |       |                                       |        |                                     |       |   |   |   |   |
| Cost of  sales                                                  | ** ** | **4,227**                                  |        | 4,332                                    |       | **7,973** |   | 7,878 |   |
| Cost of  contract revenues                                      | ** ** | **2,970**                                  |        | 2,733                                    | ** ** | **5,869** |   | 5,679 |   |
| Gross profit                                                    | ** ** | **5,518**                                  |        | 4,695                                    | ** ** | **10,952** |   | 9,644 |   |
| Operating  expenses:                                            | ** ** | ** **                                 |        |                                     | ** ** | ** ** |   |   |   |
| Selling,  general and administrative                            | ** ** | **3,950**                                  |        | 3,201                                    | ** ** | **7,639** |   | 6,801 |   |
| Research and  development                                       | ** ** | **1,324**                                  |        | 871                                      | ** ** | **3,023** |   | 1,664 |   |
| Stock-based  compensation                                       | ** ** | **258**                                    | ** **  | **—**                               | ** ** | **523** | ** ** | **—** | ** ** |
| Acquired  in-process research and development                   | ** ** | **—**                                 | ** **  | 115                                      | ** ** | **—** | ** ** | 115 | ** ** |
| Deferred  compensation plan                                     | ** ** | **16**                                     | ** **  | **—**                               | ** ** | **78** | ** ** | **—** | ** ** |
| Amortization  of intangible assets                              | ** ** | **36**                                     | ** **  | 34                                       | ** ** | **73** | ** ** | 34 | ** ** |
| Total  operating expenses                                       | ** ** | **5,584**                                  |        | 4,221                                    | ** ** | **11,336** |   | 8,614 |   |
| Operating  income (loss)                                        | ** ** | **(66**                                    | **) ** | 474                                      | ** ** | **(384** | **) ** | 1,030 |   |
| Non-operating  income (expense):                                |       |                                       |        |                                     |       |   | ** ** |   |   |
| Other  income, net                                              | ** ** | **86**                                     |        | 57                                       | ** ** | **38** |   | 980 |   |
| Interest  expense, net                                          | ** ** | **(358**                                   | **)**       | (470                                     | )          | **(710** | **)** | (540 | ) |
| Income  (loss) before income taxes and   minority interest | ** ** | **(338**                                   | **)**       | 61                                       |       | **(1,056** | **)** | 1,470 |   |
| Income tax  (expense) benefit                                   |       | **183**                                    |        | —                                   |       | **175** | ** ** | (75 | ) |
| Minority  interest in earnings of subsidiary                    | ** ** | —                                     |        | (65                                      | )          | — |   | (433 | ) |
| Net income  (loss)                                              | ** ** | **$**                                      | **(155**    | **)**                                    | $          | (4 | )  | **$** | **(881** | **)** | $ | 962 |   |
|                                                            |       |                                       |        |                                     |       |   | ** ** |   |   |
| Earnings  (loss) per common share:                              |       |                                       |        |                                     |       |   | ** ** |   |   |
| Basic                                                           | ** ** | **$**                                      | **(0.01**   | **) **                              | $          | 0.00 | ** ** | **$** | **(0.03** | **) ** | $ | 0.04 |   |
| Diluted                                                         | ** ** | **$**                                      | **(0.01**   | **) **                              | $          | 0.00 | ** ** | **$** | **(0.03** | **) ** | $ | 0.04 |   |
| Weighted  average common shares outstanding:                    |       |                                       |        |                                     |       |   | ** ** |   |   |
| Basic                                                           | ** ** | **28,106**                                 |        | 25,685                                   | ** ** | **28,084** |   | 23,938 |   |
| Diluted                                                         | ** ** | **28,106**                                 |        | 25,685                                   | ** ** | **28,084** |   | 25,328 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

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**ITERIS,INC.UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                                           | ** ** | **Six Months Ended  September 30,** | ** **  |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------------|-------------|
| ** **                                                                                           | ** ** | **2005**                                 | ** **  | **2004** | ** ** |
| **Cash  flows from operating activities**                                                            | ** ** | ** **                               | ** **  | ** ** | ** ** |
| Net income  (loss)                                                                                   | ** ** | **$**                                    | **(881**    | **)** | $ | 962 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                     | ** **  |   |   |
| Depreciation  and amortization                                                                       | ** ** | **335**                                  | ** **  | 429 |   |
| Write-off of  in-process research and development                                                    | ** ** | **—**                               | ** **  | 115 |   |
| Minority  interest in earnings of subsidiary                                                         | ** ** | **—**                               | ** **  | 433 |   |
| Amortization  of deferred gain on sale–leaseback transaction                                    | ** ** | **(142**                                 | **)**       | (432 | ) |
| Amortization  of intangible assets                                                                   | ** ** | **73**                                   | ** **  | 34 |   |
| Amortization  of debt discount                                                                       | ** ** | **104**                                  | ** **  | 78 |   |
| Amortization  of deferred financing costs                                                            | ** ** | **69**                                   | ** **  | 44 |   |
| Stock-based  compensation                                                                            | ** ** | **523**                                  | ** **  | — |   |
| Change in  deferred tax assets                                                                       | ** ** | **(189**                                 | **) ** | — |   |
| Changes in  operating assets and liabilities:                                                        |       |                                     | ** **  |   |   |
| Accounts  receivable                                                                                 | ** ** | **(17**                                  | **)**       | (602 | ) |
| Net costs  and estimated earnings in excess of billings                                              | ** ** | **(435**                                 | **)**       | 237 |   |
| Inventories                                                                                          | ** ** | **1,341**                                | ** **  | (204 | ) |
| Prepaid  expenses and other assets                                                                   | ** ** | **(177**                                 | **)**       | (148 | ) |
| Accounts  payable and accrued expenses                                                               | ** ** | **(563**                                 | **) ** | (1,079 | ) |
| Deferred  revenue                                                                                    | ** ** | **—**                               | ** **  | (226 | ) |
| Net cash  provided by (used in) operating activities                                                 | ** ** | **41**                                   | ** **  | (359 | ) |
|                                                                                                 |       |                                     | ** **  |   |   |
| **Cash  flows from investing activities**                                                            |       |                                     | ** **  |   |   |
| Purchases of  property and equipment                                                                 | ** ** | **(386**                                 | **)**       | (299 | ) |
|                                                                                                 |       |                                     | ** **  |   |   |
| **Cash  flows from financing activities**                                                            |       |                                     | ** **  |   |   |
| Proceeds  from borrowings on line of credit, net                                                     | ** ** | **766**                                  | ** **  | 1,294 |   |
| Proceeds  from long-term debt                                                                        | ** ** | **—**                               | ** **  | 5,000 |   |
| Payments on  long-term debt and capital lease obligations                                            | ** ** | **(657**                                 | **)**       | (490 | ) |
| Costs from  issuance of common stock                                                                 | ** ** | **—**                               | ** **  | (99 | ) |
| Proceeds  from issuance of convertible debentures                                                    | ** ** | **—**                               | ** **  | 9,479 |   |
| Purchase of  Iteris Subsidiary Series A preferred stock                                         | ** ** | **—**                               | ** **  | (17,543 | ) |
| Proceeds  from stock option and warrant exercises                                                    | ** ** | **190**                                  | ** **  | 499 |   |
| Net cash  provided by (used in) financing activities                                                 | ** ** | **299**                                  | ** **  | (1,860 | ) |
| Decrease in  cash                                                                                    | ** ** | **(46**                                  | **)**       | (2,518 | ) |
| Cash at  beginning of period                                                                         | ** ** | **46**                                   | ** **  | 2,612 |   |
| Cash at end  of period                                                                               | ** ** | **$**                                    | **—**  | ** ** | $ | 94 |   |
|                                                                                                 |       |                                     | ** **  |   |   |
| **Supplemental  cash flow information:**                                                             |       |                                     | ** **  |   |   |
| Cash paid  during the period:                                                                        |       |                                     | ** **  |   |   |
| Interest                                                                                             | ** ** | **$**                                    | **528**     | ** ** | $ | 310 |   |
| Income taxes                                                                                         | ** ** | **44**                                   | ** **  | 614 |   |
| **Supplemental  schedule of non-cash investing and financing activities:**                      |       |                                     | ** **  |   |   |
| Acquisition  of minority interest of the Iteris Subsidiary                                           | ** ** | ** **                               | ** **  |   |   |
| Intangible  assets                                                                                   | ** ** | **—**                               | ** **  | 652 |   |
| Goodwill                                                                                             | ** ** | **—**                               | ** **  | 11,297 |   |
| Issuance of  warrants in connection with Debenture and Warrant Purchase Agreement                    | ** ** | **—**                               | ** **  | 1,100 |   |
| Fair value  of warrants issued in settlement of liabilities                                          | ** ** | **$**                                    | **28**      | ** ** | $ | — |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

5

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**ITERIS,INC.**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**September 30,2005**

 

**1.  Description of Business andSummary of Significant Accounting Policies**

 

**Description of Business**

 

Iteris, Inc., formerly known as IterisHoldings, Inc. (“Iteris” or the “Company”), is a leading provider ofoutdoor machine vision systems and sensors that optimize the flow of trafficand enhance driver safety. Using proprietary software and IntelligentTransportation Systems (“ITS”) industry expertise, the Company provides videosensor systems, transportation management and traveler information systems andother engineering consulting services to the ITS industry. The ITS industry iscomprised of companies applying a variety of technologies to enable the safeand efficient movement of people and goods. The Company uses its outdoor imagerecognition software expertise to develop proprietary algorithms for videosensor systems that improve vehicle safety and the flow of traffic. Using itsknowledge of the ITS industry, the Company designs and implementstransportation management systems that help public agencies reduce trafficcongestion and provide greater access to traveler information.  The Company was originally incorporated in Delawarein 1987 as Odetics, Inc. and in September 2003 changed its name toIteris Holdings, Inc. to reflect its focus on the ITS industry and itscapital structure at that time.  On October 22,2004, the Company completed a merger with its majority-owned subsidiary, Iteris, Inc.(the “Iteris Subsidiary”), and officially changed its corporate name fromIteris Holdings, Inc. to Iteris, Inc.

 

# **Basisof 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 Form 10-Qand Article 10 of SEC Regulation S-X. In the opinion of management, theaccompanying unaudited condensed consolidated financial statements contain alladjustments, consisting of normal recurring adjustments, necessary to presentfairly the consolidated financial position of the Company as of September 30,2005, the consolidated results of operations for the three and six monthperiods ended September 30, 2005, and 2004, and the consolidated cashflows for the six month periods ended September 30, 2005, and 2004.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 six month periods ended September 30, 2005, 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, 2005, which was filed with the SEC on July 14, 2005.

 

# **Useof Estimates**

#  

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 anddisclosures of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer 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 usedin cost-plus contracts, contract reserves and estimates of future cash flowsused to assess the recoverability of long-lived assets, the valuation of debtand equity instruments and the realization of goodwill.

 

# **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 thedate revenue is recognized, the significant uncertainties concerning the salehave been resolved.

 

Contract revenues arederived primarily from long-term contracts with governmental agencies.  Contract revenues include costs incurred plusa portion of estimated fees or profits determined on the percentage ofcompletion method of accounting based on the relationship of costs incurred todate to total estimated costs.  Anyanticipated losses on contracts are charged to earnings when identified.  Changes in job performance and estimatedprofitability, including those arising from contract penalty provisions andfinal contract settlements, may result in revisions to costs and revenues andare recognized in the period in which the revisions are determined.  Profit incentives are included in revenuewhen their realization is reasonably assured.

 

In addition to productand contract revenue, the Company derives revenue from technology access fees,the provision of specific non-recurring contract engineering services androyalties.  Technology access feerevenues are recognized evenly over the period in which they are earned.  Non-recurring contract engineering revenuesare recognized in the period in which the related services are performed.  Royalty revenues are recorded in the periodin which the royalty is earned, based on unit sales of the Company’sproducts.  Technology access feerevenues, contract engineering revenues and royalty revenues are included innet sales in the accompanying condensed consolidated statements of operations.

 

6

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

 

# **Concentrationof Credit Risk**

#  

Accounts receivable arederived from revenues earned from customers located throughout North Americaand Europe.  The Company generally doesnot require collateral or other security from customers. Collectibility of receivablebalances is estimated through review of invoices outstanding greater than acertain period of time and ongoing credit evaluations of customers’ financialcondition.  Reserves are maintained forpotential credit losses, and such losses have historically been within management’sexpectations.

 

**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.  The fair value of convertible debenturesapproximates carrying value because the effective interest rate, taking intoaccount recorded debt discounts, approximates current market rates.  The fair value of redeemable common stockapproximates carrying value since these shares are not freely tradable in anypublic markets.  If the redeemable sharesbecome freely tradable, the fair value of such shares may differ from thecarrying value based on the value of the shares as determined in the publicequity markets.

 

# **Inventories**

#  

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

 

**Property and Equipment**

 

Property and equipment are recorded at costand are depreciated principally by the double declining balance method over theestimated useful life ranging from three to eight years.   Leasehold improvements are depreciated overthe term of the related lease or the estimated useful life of the improvement,whichever is shorter.

 

**Goodwill and Long-Lived Assets**

 

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 142, *Goodwill and IntangibleAssets*(“SFAS 142”), goodwill is tested for impairment at thereporting unit level (operating segment or one level below an operatingsegment) on an annual basis in the Company’s fourth fiscal quarter or morefrequently if indicators of impairment exist, of which none have beenidentified.  The performance of the testinvolves a two-step process.  The firststep of the impairment test involves comparing the fair value of the Company’sreporting units with each respective reporting unit’s carrying amount,including goodwill.  The fair value ofreporting units is generally determined using the income approach.  If the carrying amount of a reporting unitexceeds the reporting unit’s fair value, the second step of the goodwillimpairment test is performed to determine the amount of any impairmentloss.  The second step of the goodwillimpairment test involves comparing the implied fair value of the reporting unit’sgoodwill with the carrying amount of that 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 areperformed to determine whether the carrying value of assets is impaired, basedon a comparison to undiscounted expected 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 using adiscount rate based upon the Company’s weighted average cost of capitaladjusted for risks associated with the related operations.  Impairment is based on the excess of thecarrying 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.* Under the liability method, deferred taxes are determined based on thetemporary differences between the financial statement and tax bases of assetsand liabilities using enacted tax rates. A valuation allowance is recorded when it is more likely than not thatall or a portion of the deferred tax assets will not be realized.

 

7

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**Stock-Based Compensation**

 

The Company accounts forstock-based employee compensation arrangements in accordance with AccountingPrinciples Board (“APB”) Opinion No. 25, *Accountingfor Stock-Issued to Employees*(“APB 25”) and relatedinterpretations, and complies with the disclosure-only provisions of SFAS No. 123,*Accounting for Stock-Based Compensation*(“SFAS123”), and SFAS No. 148, *Accounting for Stock-BasedCompensation – Transition and Disclosure* (“SFAS 148”).  Under APB 25, compensation cost is recognizedbased on the difference, if any, on the date of the grant between the fairvalue of the Company’s stock and the amount the employee must pay to acquirethe stock.

 

In accordance with the requirements of thedisclosure-only alternative of SFAS 123 and SFAS 148, set forth below are theassumptions used and the pro forma statement of operations data of the Company,which gives effect to valuing stock-based awards to employees using theBlack-Scholes option pricing model instead of the guidelines provided by APB25.  Among other factors, theBlack-Scholes model considers the expected life of the option and the expectedvolatility of the Company’s stock price in arriving at an option valuation.

 

The per share fair valueof stock options granted in connection with stock option plans has beenestimated with the following weighted average assumptions:

 
| ** **                  | ** ** | **Three and Six Months  Ended  September 30,** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
|                        |       |                                                |       |   |   |
| Dividend  rate              | ** ** | **0.0**                                             |       | 0.0 |   |
| Expected  life – years | ** ** | **7.0**                                             |       | 7.0 |   |
| Risk-free  interest rate    | ** ** | **5.5**                                             |       | 4.5 |   |
| Volatility  of common stock | ** ** | **0.5**                                             |       | 0.4 |   |

 

For purposes of pro formadisclosures, the estimated fair value of stock options is amortized to expenseover the vesting period of the options. The Company’s pro forma information isas follows:

 
| ** **                                                                              | ** ** | **Three Months Ended  September 30,**   | ** **  | **Six Months Ended  September 30,** | ** **  |
|-----------------------------------------------------------------------------------------|------------|----------------------------------------------|-------------|------------------------------------------|-------------|
| ** **                                                                              | ** ** | **2005**                                     | ** **  | **2004**                                 | ** **  | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                              | ** ** | **(In thousands, except per share amounts)** | ** **  |
| Net income (loss) – as reported                                                    | ** ** | **$**                                        | **(155**    | **)**                                    | $           | (4 | )  | **$** | **(881** | **) ** | $ | 962 |   |
| Add: Stock-based  compensation expense included in net income (loss) – as reported |       | **258**                                      |        | —                                   |        | **523** | ** ** | — |   |
| Deduct:  Stock-based compensation expense under fair value method                       | ** ** | **(364**                                     | **) ** | (86                                      | **) ** | **(735** | **) ** | (172 | )  |
| Net income (loss) – pro forma                                                      | ** ** | **$**                                        | **(261**    | **)**                                    | $           | (90 | )  | **$** | **(1,093** | **) ** | $ | 790 |   |
|                                                                                    |       |                                         |        |                                     |        |   |   |   |   |
| Basic and  diluted earnings (loss) per share – as reported                         | ** ** | **$**                                        | **(0.01**   | **) **                              | $           | 0.00 | ** ** | **$** | **(0.03** | **) ** | $ | 0.04 |   |
| Basic and diluted earnings (loss) per share  – pro forma                           | ** ** | **$**                                        | **(0.01**   | **) **                              | $           | 0.00 | ** ** | **$** | **(0.04** | **) ** | $ | 0.03 |   |

 

**Research and Development Expenditures**

 

Research and developmentexpenditures are charged to expense in the period incurred.

 

**Shipping and Handling Costs**

 

Shipping and handlingcosts are included in cost of sales in the period during which products ship.

 

**Warranty**

 

Unless otherwise stated,the Company provides a one to three year warranty from the original invoicedate on all products, materials and workmanship.  Products sold to certain original equipmentmanufacturer (“OEM”) customers sometimes carry longer warranties. Defectiveproducts will be either repaired or replaced, generally at the Company’soption, upon meeting certain criteria. The Company accrues a provision for theestimated costs that may be incurred for product warranties relating to aproduct as a component of cost of sales at the time revenue for that product isrecognized.  The accrued warrantyprovision is included within accrued expenses on the accompanying condensedconsolidated balance sheets.

 

8

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**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 costsare charged to expense as incurred.

 

**Reclassifications**

** **

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

 

**Recent Accounting Pronouncements**

 

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151, *InventoryCosts* (“SFAS 151”), which clarifies the accounting for abnormalamounts of idle facility expense, freight, handling costs and wastedmaterial.  SFAS 151 will be effective forinventory costs incurred during fiscal years beginning after June 15,2005.  Management does not believe theadoption of SFAS 151 will have a material impact on the Company’s financialstatements.

 

On December 16, 2004, the FASB issued SFASNo.123 (revised 2004), *Share-Based Payment*(“SFAS 123R”), which replaces SFAS 123, supersedes APB 25, and amends SFASNo. 95, *Statement of Cash Flows*.  Generally, the approach in SFAS 123R issimilar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values (i.e., pro forma disclosure is no longeran alternative to financial statement recognition).  In accordance with SEC Release No. 33-8568,SFAS 123R will be effective for the Company beginning April 1, 2006.  The Company is currently assessing the impactof SFAS 123R.  As of the date of thisfiling, no decisions have been made as to whether the Company will apply themodified prospective or retrospective transition method of application;therefore, the effect of adoption cannot be determined at this time.

 

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections* (“SFAS 154”). SFAS154 requires retroactive application of a voluntary change in accountingprinciple to prior period financial statements unless it is impracticable. SFAS154 also requires that a change in method of depreciation, amortization, ordepletion for long-lived, non-financial assets be accounted for as a change inaccounting estimate that is affected by a change in accounting principle. SFAS154 replaces APB Opinion No. 20, *Accounting Changes*,and SFAS No. 3, *Reporting Accounting Changes in InterimFinancial Statements*.  TheCompany is required to adopt the provisions of SFAS 154 in its fiscal yearending March 31, 2007.  Management ispresently evaluating what effect the adoption of the provisions of SFAS 154will have on the Company’s consolidated financial statements.

 

**2.   Supplemental FinancialInformation**

 

**Inventories**

 

The following tablepresents details of the Company’s inventories:

 
| ** **              | ** ** | **September 30,** | ** ** | **March 31,** | ** ** |
|-------------------------|------------|------------------------|------------|--------------------|------------|
| ** **              | ** ** | **2005**               | ** ** | **2005**           | ** ** |
| ** **              | ** ** | **(In thousands)**     | ** ** |
| Materials  and supplies | ** ** | **$**                  | **2,220**  |               | $          | 3,204 |   |
| Work in  process        | ** ** | **453**                |       | 558                |       |
| Finished  goods         | ** ** | **330**                |       | 582                |       |
| ** **              |       | **$**                  | **3,003**  |               | $          | 4,344 |   |

 

**Goodwill and Identifiable Intangible Assets**

 

The followingtable sets forth the Company’s intangible assets that are subject to amortization:

 
| ** **                                  | ** ** | **September 30, 2005** | ** ** | **March 31, 2005**       | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                  | ** ** | **(In thousands)**          | ** ** |
| Intangible  assets subject to amortization: |       |                        |       |                          |       |   |   |   |   |
| Developed  technology                       | ** ** | **$**                       | **495**    | ** **                    | **$**      | **(130** | **)** | $ | 495 |   | $ | (78 | ) |
| Patents                                     | ** ** | **317**                     | ** ** | **(57**                       | **)**      | 317 |   | (36 | ) |
| Total                                       | ** ** | **$**                       | **812**    | ** **                    | **$**      | **(187** | **)** | $ | 812 |   | $ | (114 | ) |

 

Amortization expense for intangible assets subject to amortization was$36,000 and $73,000 for the three and six month periods ended September 30,2005, respectively, and $34,000 for both the three and six month periods ended September 30,2004. Future estimated amortization expense for the remainder of the currentfiscal year, the next four fiscal years and thereafter is as follows:

 
| **Year Ending  March 31:** | ** ** | ** ** | ** ** |
|---------------------------------|------------|------------|------------|
| **(In thousands)**              | ** ** | ** ** | ** ** |
| Remainder of  2006              |       | $          | 74         |   |
| 2007                            |       | 147        |       |
| 2008                            |       | 147        |       |
| 2009                            |       | 147        |       |
| 2010                            |       | 58         |       |
| Thereafter                      |       | 52         |       |
|                            |       | $          | 625        |   |

 

9

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At September 30, 2005, goodwill of $27.8 million was comprised of$18.0 million associated with the October 2004 merger of the IterisSubsidiary (Note 3); $9.6 million associated with the acquisitions of theRockwell International Transportation Systems Group, Meyer Mohaddes Associatesand the Viggen Systems Consulting Group; and $200,000 associated with thepurchase of the assets of Mil-Lektron, a complementary product to the Company’sVantage video detection business.

 

**Warranty Reserve Activity**

 

The following table presents activity in accrued warrantyobligations:

 
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                          | ** ** | **(In thousands)**                         | ** ** |
| Balance at  beginning of period     | ** ** | **$**                                      | **342**    |                                     | $          | 190 | ** ** | **$** | **326** |   | $ | 204 |   |
| Additions  charged to cost of sales | ** ** | **190**                                    |       | 385                                      | ** ** | **265** |   | 429 |   |
| Warranty  claims                    | ** ** | **(91**                                    | **)**      | (175                                     | )          | **(150** | **)** | (233 | ) |
|                                |       |                                       |       |                                     |       |   |   |   |   |
| Balance at  end of period           | ** ** | **$**                                      | **441**    |                                     | $          | 400 | ** ** | **$** | **441** |   | $ | 400 |   |

 

**Earnings (Loss) Per Share**

 

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

 
| ** **                                                   | ** ** | **Three Months Ended  September 30,**   | ** ** | **Six Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                                     | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                   | ** ** | ** **                                   | ** ** |                                     |       |   |   | ** ** | ** ** |   |   |   |   |
| Net income  (loss)                                           | ** ** | **$**                                        | **(155**   | **)**                                    | $          | (4 | ) | **$** | **(881** | ) | $ | 962 |   |
|                                                         | ** ** | ** **                                   | ** ** |                                     |       | ** ** |   |   |   |
| Denominator:                                                 | ** ** | ** **                                   |       |                                     |       | ** ** |   |   |   |
| Weighted  average common shares used in basic computation    | ** ** | **28,106**                                   | ** ** | 25,685                                   |       | **28,084** | ** ** | 23,938 |   |
| Dilutive  stock options                                      |       | —                                       |       | —                                   |       | — |   | 557 |   |
| Dilutive  warrants                                           |       | —                                       |       | —                                   |       | — |   | 833 |   |
| Weighted  average common shares used in dilutive computation | ** ** | **28,106**                                   | ** ** | 25,685                                   | ** ** | **28,084** |   | 25,328 |   |
|                                                         | ** ** | ** **                                   | ** ** |                                     |       | ** ** |   |   |   |
| Basic and  diluted earnings (loss) per share                 | ** ** | **$**                                        | **(0.01**  | **) **                              | $          | 0.00 | ** ** | **$** | **(0.03** | )  | $ | 0.04 |   |

 

The following shares wereexcluded from the computation of diluted earnings (loss) per share as theireffect would have been antidilutive:

 
| ** **              | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **              | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **              | ** ** | **(In   thousands)**                  | ** ** |
| Stock  options          | ** ** | **4,299**                                  | ** ** | 556                                      |       | **4,093** |   | — |   |
| Warrants                | ** ** | **983**                                    |       | 829                                      |       | **872** |   | — |   |
| Convertible  debentures | ** ** | **2,729**                                  | ** ** | 2,798                                    |       | **2,729** | ** ** | — |   |

 

10

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**3.  Merger of the Company and theIteris Subsidiary**

 

On May 28, 2004, in order to simplify theCompany’s capital structure and facilitate the merger of the Iteris Subsidiaryinto the Company, the Company completed the purchase of all of the outstandingshares of the Series A preferred stock of the Iteris Subsidiary (the “Series Apreferred stock”), which were held by DaimlerChrysler Ventures GmbH (“DCV”) andHockenheim Investment Pte. Ltd. (“Hockenheim”), at a purchase price of $5.61per share or an aggregate purchase price of approximately $17.5 million incash.  The purchase price represented thestated redemption value of the Series A preferred stock.  The purchase of the shares was financedprimarily with a $10.1 million convertible debenture financing completed in May 2004with a group of accredited investors, in addition to a $5.0 million seniorcredit facility arranged through a bank and $2.4 million in cash (Note 4).  Inaddition, the Company acquired all of the 547,893 shares of common stock of theIteris Subsidiary held by DCV in exchange for the issuance of 1,219,445 shares(the “Exchange Shares”) of the Company’s Class A common stock (now knownas the Company’s common stock), which was valued at $3.4 million at the date ofissuance. The fair value of the Company’s common stock issued in thetransaction was based on the quoted market price of the Company’s common stockon the OTC Bulletin Board averaged over a five-day period. The purchase andexchange of the shares were made pursuant to a Stock Purchase and ExchangeAgreement dated March 31, 2004, by and among the Company, the IterisSubsidiary, DCV and Hockenheim (the “Purchase and Exchange Agreement”).

 

On June 30, 2004, the Company and certainminority stockholders of the Iteris Subsidiary (including certain officers anddirectors) entered into an exchange agreement whereby an aggregate of 1,319,541shares of common stock of the Iteris Subsidiary were exchanged for 2,639,082shares of the Company’s newly issued common stock valued at $8.6 million at thedate of issuance. The fair value of the Company’s stock issued in thetransaction was based on the quoted market price of the Company’s common stockon the OTC Bulletin Board averaged over a five-day period. The effect of thisexchange was to reduce the residual minority interest in the Iteris Subsidiaryto 8.1%.

 

On October 22, 2004,the Iteris Subsidiary was merged into the Company. The remaining 8.1% minorityinterest in the Iteris Subsidiary (consisting of 1,228,981 shares of common stockof the Iteris Subsidiary) was converted to 2,457,962 shares of the Company’scommon stock valued at $7.6 million at the merger date. Immediately followingthe merger, the Company converted all of its outstanding Class B commonstock (921,917 shares) into 1,014,108 shares of its common stock (formerlydesignated as Class A common stock). The exchange ratio used in conversionwas determined by the Company’s Board of Directors.  The fair value of the Company’s common stockissued in the transaction was based on the quoted market price of the Company’scommon stock on the OTC Bulletin Board averaged over a five-day period. In October 2004,the Company also amended its certificate of incorporation to (a) changethe voting rights of its Class A common stock from one-tenth to one voteper share, (b) remove the ability to issue any further shares of Class Bcommon stock, and (c) rename its Class A common stock to commonstock. As a result, the Company currently has only one class of common stockoutstanding, the common stock.

 

In connection with themerger, the Company assumed all outstanding options and warrants to purchaseshares of common stock of the Iteris Subsidiary that were outstandingimmediately prior to the merger, whether vested or unvested, together with theIteris Subsidiary’s 1998 Stock Incentive Plan (the “Option Plan”). Each suchoption and warrant assumed by the Company shall continue to have, and besubject to, the same terms and conditions as were applicable immediately priorto the merger, provided that (A) such option or warrant shall beexercisable for that number of whole shares of the Company’s common stock equalto the product of the number of shares of the Company’s common stock that wereissuable upon exercise of such assumed option or warrant immediately prior tothe merger multiplied by two (2) (the “Exchange Ratio”) rounded down tothe nearest whole number of shares and (B) the per share exercise pricefor the shares of the Company’s common stock issuable upon exercise of suchassumed option or warrant is equal to the quotient determined by dividing theexercise price per share at which such option or warrant was exercisableimmediately prior to the merger by the Exchange Ratio (rounded up to thenearest whole cent).  As a result,options and warrants to purchase approximately 3.1 million shares and327,000 shares, respectively, of common stock of the Iteris Subsidiary assumedin the merger became options and warrants to purchase approximately6.1 million and 655,000 shares of common stock of the Company,respectively. The weighted-average exercise prices of the assumed options andwarrants were $1.09 and $2.32, respectively.  Stock-based compensation expense of $11.3million was recorded in connection with the assumption and exchange of vestedIteris Subsidiary stock options for stock options immediately exercisable intothe Company’s common stock based on the difference between the fair marketvalue of the Company’s common stock on the October 22, 2004, merger dateand the exercise price of the modified stock option. Additionally, the Companyrecorded approximately $1.4 million in deferred compensation related to theassumption of unvested stock options to purchase common stock of the IterisSubsidiary. Deferred compensation is being amortized to stock-basedcompensation expense as the options vest. The Company also recorded $1.1 million of goodwill and additionalpaid-in-capital in connection with the 655,000 vested warrants assumed in themerger and acquisition of the Iteris Subsidiary.  The $1.1 million value was based on thedifference between the fair market value of the Company’s common stock on the October 22,2004, merger date and the modified exercise price of the assumed warrantawards.

 

The excess of the purchase price over the proportionateamount of minority interest acquired was allocated to acquired intangibleassets based on the estimated fair values with the residual allocated togoodwill. Accordingly, the Company recorded goodwill of $18.0 million, whichrepresents the excess of the purchase price over the fair value of theproportionate identifiable net assets acquired. The estimated fair value of theintangible assets was determined using the income method and discounting futureexpected returns. The estimated useful life for each of the acquired intangibleassets is provided below:

 
| Patents               | ** ** | 7 years | ** ** |
|-----------------------|------------|---------|------------|
| Developed  technology |       | 5 years |       |

 

11

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The following table summarizes fair values of the assets acquired andliabilities assumed and the allocation of the purchase price at the date ofacquisition (in thousands):

 
| Acquisition costs:                                           | ** ** | ** ** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|
| Issuance of  common stock                                    |       | $          | 18,617     |   |
| Assumption  of Iteris Subsidiary warrants                    |       | 1,114      |       |
| Purchase of  Iteris Subsidiary Series A preferred stock |       | 17,543     |       |
| Acquisition  costs                                           |       | 80         |       |
| Total  acquisition costs                                     |       | $          | 37,354     |   |
|                                                         |       |       |       |
| Purchase  price allocation:                                  |       |       |       |
| Fair value  of 41% of Iteris Subsidiary                      |       |       |       |
| Patents                                                      |       | $          | 318        |   |
| Developed  technology                                        |       | 495        |       |
| Acquired  in-process research and development                |       | 140        |       |
| Deferred tax  liabilities                                    |       | (360       | )          |
| Reduction of  minority interest                              |       | 18,794     |       |
| Goodwill  (not deductible for tax purposes)                  |       | 17,967     |       |
| Total  purchase price allocation                             |       | $          | 37,354     |   |

 

On October 22, 2004, in connection with theCompany’s merger with the Iteris Subsidiary, the Chief Executive Officer of theIteris Subsidiary, Mr. Jack Johnson, was promoted to President and ChiefExecutive Officer of the Company, replacing Mr. Gregory Miner. This mergertriggered certain obligations under the Company’s change-in-control agreementwith Mr. Miner. Accordingly, the Company recorded approximately $807,000in severance expense, which included $57,000 for related payroll taxes, as acharge to earnings for the year ended March 31, 2005.  The severance amount is being paid to Mr. Minerin bi-weekly installments over a 30 month period that began in October 2004.Mr. Miner is not required to render any services to the Company inconnection with this agreement.

 

**4.  Revolving Line of Credit andLong-Term Debt**

 

**RevolvingLine of Credit**

 

On May 28, 2004, theIteris Subsidiary entered into a line of credit agreement with a bank, whichexpired on August 1, 2005, and provides for a maximum available creditline of $5.0 million. The bank verbally agreed to extend the term of this lineof credit arrangement while a new arrangement is negotiated, as discussedfurther below.  The Company assumed thisline of credit in October 2004. Under the terms of this agreement, theCompany may borrow against its eligible accounts receivable and the value ofits eligible inventory, as defined in the credit agreement. Interest onborrowed amounts is payable monthly at the current stated prime rate.  Additionally, the Company is obligated to payan unused line fee of 0.25% per annum applied to the amount by which themaximum credit amount exceeds the average daily principal balance during thepreceding month.

 

There are nomonthly collateral management fees and no pre-payment or early terminationfees. On September 30, 2005, the available credit under this line ofcredit agreement was $4.7 million, of which $3.0 million was unused.

 

**Long-TermDebt**

 

Long-term debt consistsof the following:

 
| ** **                   | ** ** | **September 30** | ** ** | **March 31,** | ** ** |
|------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                   | ** ** | **2005**              | ** ** | **2005**           | ** ** |
| ** **                   | ** ** | **(In thousands)**    | ** ** |
|                         |       |                  |       |
| Convertible  debentures, net |       | $                     | 9,100      |               | $          | 8,996 |   |
| Bank term  note              |       | 3,333                 |       | 3,958              |       |
| Promissory  note to landlord |       | 1,292                 |       | 1,292              |       |
| 4% note  payable             |       | 45                    |       | 67                 |       |
| Capital  lease obligation    | ** ** | **—**            |       | 10                 |       |
|                         |       | 13,770                |       | 14,323             |       |
| Less current  portion        |       | (3,378                | )          | (4,008             | )          |
|                         |       | $                     | 10,392     |               | $          | 10,315 |   |

 

*Convertible Debentures, Net.*  In order to finance the purchase of theIteris Subsidiary Series A preferred stock (Note 3), the Company enteredinto a Debenture and Warrant Purchase Agreement dated May 19, 2004, with agroup of accredited investors, which included certain officers of the Company,pursuant to which the Company sold and issued subordinated convertibledebentures in the aggregate original principal amount of $10.1 million.  In connection with the issuance of thedebentures, the Company issued warrants to purchase an aggregate of 639,847shares of its common stock, the value of which was recorded as a debt discountagainst the face amount of the debentures on the date of issuance and is beingamortized to interest expense over the term of the convertible debentures.

 

12

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The debentures are due infull on May 19, 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 19,2007, until May 18, 2008, the debentures may be redeemed by the Company,at its option, at 120% of the principal amount; and from May 19, 2008,until the maturity date, the debentures may be redeemed at 110% of theprincipal amount.  As of September 30,2005, $250,000 of convertible debentures had been converted into 69,252 sharesof common stock leaving $9.9 million of the originally issued convertibledebentures outstanding at September 30, 2005.

 

*Bank Term Note.*  Concurrent with the issuance of theconvertible debentures, the Iteris Subsidiary entered into a $5.0 million termnote payable with a bank. This note was assumed by the Company in October 2004.  The proceeds from the note were used topurchase the Series A preferred stock of the Iteris Subsidiary (Note 3).The note is due on May 27, 2008, and provides for monthly principalpayments of approximately $104,000. Interest accrues at the current stated prime rate plus 0.25% (7.00% at September 30,2005).

 

Both the term notepayable and the line of credit are held by one bank under the same creditagreement and are secured by substantially all of the assets of theCompany.  At June 30, 2005 and March 31,2005, the Company failed to meet certain financial covenants under the creditagreement.  On August 3, 2005, thebank waived its right of default regarding the covenant violations for thequarter ended June 30, 2005 only; and on May 12, 2005, the bankwaived its right of default regarding the covenant violations for the quarterended March 31, 2005 only.  TheCompany is currently renegotiating the entire credit facility, which expired onAugust 1, 2005, with a new facility comprised of a modified line of creditand a modified term note.  The bankverbally agreed to extend the term of the credit agreement and not call any ofthe debt under the credit agreement until a new arrangement is negotiated.  Because the bank did not waive its defaultrights for a period of at least 12 months and because the Company has notentered into a definitive agreement for a modified credit agreement, the entirebalance of the bank term note is presented as a current liability in theaccompanying condensed consolidated balance sheets.

 

*Promissory Note to Landlord.*  The Company has a $1.3 million unsecuredpromissory note payable to its landlord. Under the terms of the note agreement, interest is payable quarterly andaccrues at a rate of prime plus 2.0% (8.75% at September 30, 2005).  Beginning on October 1, 2006, theCompany is required to make four equal quarterly payments of principal andaccrued interest.  All outstandingaccrued interest and principal becomes payable in full on July 2, 2007.

 

*4% Note Payable.*  On October 9, 2003, the Company enteredinto a $126,000 unsecured note payable agreement to settle trade payables.  The note is secured by the equipment relatedto the payable. The note bears interest at 4.0%, is payable in monthlyinstallments of $4,000 for 36 months and becomes payable in full on October 20,2006.

 

Scheduled aggregatematurities of long-term debt principal as of September 30, 2005 were asfollows:

 
| **Year Ending March 31,** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|
| **(In thousands)**             | ** ** | ** ** | ** ** |
| Remainder of  2006             |       | $          | 648        |   |
| 2007                           |       | 1,918      |       |
| 2008                           |       | 1,896      |       |
| 2009                           |       | 208        |       |
| 2010                           |       | 9,850      |       |
|                           |       | $          | 14,520     |   |
|                                |            |            |            |  |  |

 

**5.  Commitments and Contingencies**

 

**Litigation**

 

On June 29, 2004, asupplier to Mariner Networks, Inc., the Company’s former subsidiary, fileda complaint in Orange County Superior Court against the Company allegingvarious breaches of written contract claims arising out of alleged purchaseorders.  The plaintiff in this lawsuitseeks monetary damages aggregating approximately $850,000 plus attorney feesand related costs.  Discovery hascommenced with respect to this matter, but no trial date has been set.  Settlement discussions are currently pendingat this time, but there can be no assurance that this lawsuit will be settledin a timely manner or for a reasonable amount. The Company believes that the ultimate resolution of this claim will nothave a material impact on the Company’s financial position, results ofoperations or cash flows and, accordingly, has not recorded any amounts in theaccompanying condensed consolidated financial statements in connection withthis matter.

 

In June 2004, theCompany received $949,000 as part of a settlement between RockwellInternational and the Michigan Department of Transportation, pursuant to whichthe Company was a third party beneficiary. This amount is reflected in other income in the condensed consolidatedstatement of operations for the six month period ended September 30, 2004.

 

13

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From time to time, the Company has beeninvolved in litigation relating to claims arising out of its operations in thenormal course of business. The Company currently is not a party to any legalproceedings except as described above, the adverse outcome of which, inmanagement’s opinion, individually or in the aggregate, would have a materialadverse effect on its consolidated results of operations, financial position orcash flows.

 

**Operating Lease Commitments**

 

The Company has lease commitments for facilities invarious locations throughout the United States. Future commitments under thesenon-cancelable operating leases at September 30, 2005, including the leasefor the Company’s Anaheim facilities were as follows:

 
| **Fiscal year ending March 31,**                                                                                                                                                                                                                                                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| **(In  thousands)**                                                                                                                                                                                                                                                                                   | ** ** | ** ** | ** ** | ** ** |
| Remainder of  2006                                                                                                                                                                                                                                                                                    | ** ** | **$**      | **689**    | ** ** |
| 2007                                                                                                                                                                                                                                                                              | ** ** | **1,255**  | ** ** |
| 2008                                                                                                                                                                                                                                                                              | ** ** | **769**    | ** ** |
| 2009                                                                                                                                                                                                                                                                              | ** ** | **91**     | ** ** |
| Thereafter                                                                                                                                                                                                                                                                                            | ** ** | **128**    | ** ** |
| Total                                                 | ** ** | **$**      | **2,932**  | ** ** |
|                                                                                                                                                                                                                                                                                                       |            |            |            |  |  |

 

**6.  Business Segment Information**

 

The Company currentlyoperates in three reportable segments: Roadway Sensors, Automotive Sensors andTransportation Systems.  The RoadwaySensors segment includes the Company’s Vantage vehicle detection systems fortraffic intersection control and certain highway traffic data collectionapplications.  The Automotive Sensorssegment includes AutoVue and is comprised of all activities related to lanedeparture warning systems for vehicle safety. The Transportation Systems segment includes transportation engineeringand consulting services and the development of transportation management andtraveler information systems for the ITS industry. The accounting policies ofthe reportable segments are the same as those described in the summary ofsignificant accounting policies except that certain expenses, such as interest,amortization of certain intangibles and certain corporate expenses are notallocated to the segments. In addition, certain assets including cash and cashequivalents, deferred taxes and certain long-lived and intangible assets arenot allocated to the segments.  Thereportable segments are each managed separately because they manufacture anddistribute distinct products or provide services with different processes.  All segment revenues are derived fromexternal customers.

 

The following table sets forth selected unaudited financialinformation for the Company’s reportable segments for the three and six monthperiods ended September 30, 2005 and 2004:

 
| ** **                                         | ** ** | **Roadway  Sensors** | ** ** | **Automotive  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |   |
|----------------------------------------------------|------------|----------------------|------------|-------------------------|------------|-----------------------------|------------|-----------|------------|--------|
| ** **                                         | ** ** | **(In thousands)**   | ** ** |                    |
| **Three  Months Ended September 30, 2005**    |       |                 |       |                    |       |                        |       |      |       |   |
| Product  revenue from external customers           |       | $                    | 5,798      |                    | $          | 1,472                       | ** ** | **$**     | **—** |   | $ | 7,270 |   |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 705                     |       | 4,740                       |       | 5,445     |       |   |
| Depreciation  and amortization                     |       | 33                   |       | 48                      |       | 68                          |       | 149       |       |   |
| Segment  income (loss)                             |       | 878                  |       | (608                    | )          | 600                         |       | 870       |       |   |
|                                               |       |                 |       |                    |       |                        |       |      |       |   |
| **Three  Months Ended September 30, 2004**    |       |                 |       |                    |       |                        |       |      |       |   |
| Product  revenue from external customers           |       | $                    | 6,025      |                    | $          | 889                         |       | $         | —     |   | $ | 6,914 |   |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 737                     |       | 4,109                       |       | 4,846     |       |   |
| Depreciation  and amortization                     |       | 29                   |       | 28                      |       | 102                         |       | 159       |       |   |
| Segment  income (loss)                             |       | 1,186                |       | (456                    | )          | 239                         |       | 969       |       |   |
|                                               |       |                 |       |                    |       |                        |       |      |       |   |
| **Six  Months Ended September 30, 2005**      |       |                 |       |                    |       |                        |       |      |       |
| Product  revenue from external customers           |       | $                    | 11,145     |                    | $          | 3,199                       | ** ** | **$**     | **—** |   | $ | 14,344 |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 1,156                   |       | 9,294                       |       | 10,450    |       |
| Depreciation  and amortization                     |       | 63                   |       | 82                      |       | 151                         |       | 296       |       |
| Segment  income (loss)                             |       | 1,663                |       | (1,308                  | )          | 1,096                       |       | 1,451     |       |
|                                               |       |                 |       |                    |       |                        |       |      |       |
| **Six  Months Ended September 30, 2004**      |       |                 |       |                    |       |                        |       |      |       |
| Product  revenue from external customers           |       | $                    | 11,243     |                    | $          | 1,672                       |       | $         | —     |   | $ | 12,915 |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 1,639                   |       | 8,647                       |       | 10,286    |       |
| Depreciation  and amortization                     |       | 55                   |       | 54                      |       | 193                         |       | 302       |       |
| Segment  income (loss)                             |       | 1,997                |       | (694                    | )          | 536                         |       | 1,839     |       |
|                                                    |            |                      |            |                         |            |                             |            |           |            |        |  |  |  |  |  |  |  |  |

 

14

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The following tablereconciles segment income (loss) to consolidated income (loss) before incometaxes and minority interest:

 
| ** **                                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                               | ** ** | **(In thousands)**                         | ** ** |
| Total income  for reportable segments                    | ** ** | **$**                                      | **870**    |                                     | $          | 969 | ** ** | **$** | **1,451** |   | $ | 1,839 |   |
| Unallocated  amounts:                                    |       |                                       |       |                                     |       |   |   |   |   |
| Corporate  expenses and other income, net                | ** ** | **(850**                                   | **)**      | (438                                     | )          | **(1,797** | **)** | 171 |   |
| Interest  expense, net                                   | ** ** | **(358**                                   | **)**      | (470                                     | )          | **(710** | **)** | (540 | ) |
| Income  (loss) before income taxes and minority interest |       | **$**                                      | **(338**   | **)**                                    | $          | 61 |   | **$** | **(1,056** | **)** | $ | 1,470 |   |

 

15

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

 

*This report, including the following discussion and analysis, containsforward-looking statements (within the meaning of the Private SecuritiesLitigation Reform Act of 1995) that are based on our current expectations,estimates and projections about our business and our industry, and reflectmanagement’s beliefs and certain assumptions made by us based upon informationavailable to us as of the date of this report. When used in this report and theinformation incorporated herein by reference, the words “expect(s),” “feel(s),”“believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s)” andsimilar expressions or variations of these words are intended to identifyforward-looking statements. These forward-looking statements include but arenot limited to statements regarding our anticipated sales, revenue, expenses,profits, capital needs, competition, development plans, backlog andmanufacturing capabilities, the practical market applications 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 which could cause actual results todiffer materially from those projected. You should not place undue reliance onthese forward-looking statements that speak only as of the date hereof. Weundertake no obligation to republish revised forward-looking statements to reflectevents or circumstances after the date hereof or to reflect the occurrence ofunanticipated events. We encourage you to carefully review and consider thevarious disclosures made by us which describe certain factors which couldaffect our business, including in* “*Risk Factors” set forth**below, before deciding to invest in our company or to maintain orincrease your investment. We undertake no obligation to revise or updatepublicly any forward-looking statement for any reason.*

 

**Overview**

 

We area leading provider of outdoor machine vision systems and sensors that optimizethe flow of traffic and enhance driver safety. Using our proprietary softwareand Intelligent Transportation Systems (“ITS”) industry expertise, we providevideo sensor systems and transportation management systems and travelerinformation and other engineering services to the ITS industry. We use ouroutdoor image recognition software expertise to develop proprietary algorithmsfor video sensor systems that improve vehicle safety and the flow of traffic.Using our knowledge of the ITS industry, we design and implement transportationmanagement systems that help public agencies reduce traffic congestion andprovide greater access to traveler information.

 

OurVantage product is a video vehicle sensing system that detects the presence ofvehicles on roadways.  Vantage systemsare used at signalized intersections to enable a more efficient allocation ofgreen signal time and are also used for incident detection and highway trafficdata collection applications. We sell and distribute our Vantage productsprimarily to commercial customers and municipal agencies.

 

OurAutoVue Lane Departure Warning (“LDW”) systems consist of a small windshieldmounted sensor that uses proprietary software to detect and warn drivers ofunintended lane departures. Approximately 18,000 production AutoVue units havebeen sold for truck platforms in the North American and European markets.  Our AutoVue LDW systems are currently offeredas an option on certain Mercedes, MAN, Freightliner and Internationaltrucks.  In September 2003, weentered into an agreement with Valeo Schalter and Sensuren GmbH (“Valeo”),which granted Valeo the exclusive right to sell and manufacture our AutoVue LDWsystems to the worldwide passenger car market in exchange for royalty paymentsfor each AutoVue LDW unit sold.  To date,royalty payments from Valeo have not been significant.  Pursuant to this agreement, we also providespecific contract engineering services, technical marketing and sales supportto Valeo to enable the launch of our LDW technology on three Infinitiplatforms, the FX, M and Q, where the device is offered as part of thetechnology option package.  Valeo iscurrently in negotiations to provide our LDW system to other passenger caroriginal equipment manufacturers (“OEMs”); however, we cannot assure you thatsuch negotiations will be successful.  Weplan to provide technical marketing and sales support to Valeo in our effortsto win new OEM customers for the passenger car market as well as contractengineering services related to the possible launch of new Infiniti platformsthat include our LDW system.  We believethat AutoVue is a broad sensor platform that, through additional softwaredevelopment, may be expanded to incorporate additional safety and conveniencefeatures.

 

Our transportation managementsystems business includes transportation engineering and consulting servicesfocused on the planning, design, development and implementation ofsoftware-based systems that integrate sensors, video surveillance, computersand advanced communications equipment to enable public agencies to monitor,control and direct traffic flow, assist in the quick dispatch of emergencycrews and distribute real-time information about traffic conditions.  Our services include planning and otherengineering for the implementation of transportation infrastructure and relatedcommunications systems, analysis and study related to goods movement andcommercial vehicle operations, and parking systems designs.  These services and systems are sold to local,state and national transportation agencies in the United States.  Our transportation management systemsbusiness is largely dependent upon governmental funding and budgetary issues.  The Federal Highway Bill was passed in August2005, which provides for a significant increase in transportation funding overthe next six years.  Historically therehave been significant delays between the passage of funding bills and theallocation of related funding to specific contracts.  Accordingly, we cannot currently predict theimpact that the passage of this bill will have on our transportation managementsystems business.  

 

Wecurrently operate in three reportable segments: Roadway Sensors, AutomotiveSensors and Transportation Systems. The Roadway Sensors segment includes ourVantage vehicle detection systems for traffic intersection control,incident detection and certain highway traffic data collectionapplications.  The Automotive Sensorssegment is comprised of all activities related to our AutoVue LDW systems forvehicle safety. The Transportation Systems segment includes transportationengineering and consulting services and the development of transportationmanagement and traveler information systems for the ITS industry.

 

16

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**Merger with Iteris Subsidiary**

 

Duringour fiscal year ended March 31, 2005, we completed the merger of ourIteris Subsidiary into us.  This mergerincluded the following transactions:

 

• In May 2004,we repurchased all of the outstanding shares of Series A preferred stockof the Iteris Subsidiary for an aggregate purchase price of approximately $17.5million in cash, and we purchased 548,000 shares of the Iteris Subsidiarycommon stock from DaimlerChrysler Ventures GmbH (“DCV”) in consideration forthe issuance of 1.2 million shares of our common stock.  We financed the purchase price for the IterisSubsidiary Series A preferred stock through the issuance of convertibledebentures in the original principal amount of $10.1 million, a $5.0 millionterm note payable to our bank and $2.4 million in cash.

 

• In June 2004,we issued 2.6 million shares of our common stock valued at $8.6 million at thedate of issuance in exchange for an aggregate of 1.3 million shares of commonstock of the Iteris Subsidiary, which had the effect of reducing the residualminority interest in our Iteris Subsidiary to 8.1%.

 

• In October 2004,we merged the Iteris Subsidiary into us and the remaining minority interest inthe Iteris Subsidiary (consisting of 1.2 million shares of common stock of theIteris Subsidiary) was converted to 2.5 million shares of our common stockvalued at $7.6 million at the merger date. Immediately following the merger, we converted all of our outstanding Class Bcommon stock (922,000 shares) into 1.0 million shares of our common stock(formerly designated as Class A common stock).  In connection with this merger, we alsoassumed all of the outstanding options and warrants to purchase common stock ofthe Iteris Subsidiary, which aggregated 6.1 million and 655,000 shares,respectively, of our common stock.

 

• In October 2004,we amended our certificate of incorporation to (a) change the votingrights of our Class A common stock from one-tenth to one vote per share, (b) removethe ability to issue any further shares of Class B common stock, and (c) renameour Class A common stock to common stock. As a result, we currently haveonly one class of common stock outstanding, the common stock.

 

**Critical Accounting Policies andEstimates**

 

Management’s Discussion and Analysis of FinancialConditions and Results of Operations is based on our unaudited condensedconsolidated financial statements included herein, which have been prepared inaccordance with U.S generally accepted accounting principles. The preparationof these financial statements requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities andrelated disclosures of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. On an ongoing basis, we evaluate these estimates andassumptions, including those related to the collectibility of accounts receivable,the valuation of inventories and the recoverability of long-lived assets andgoodwill. We base these estimates on historical experience and on various otherfactors that we believe to be reasonable under the circumstances, the resultsof which form the basis for making judgments about the carrying values ofassets and liabilities that are not readily apparent from other sources. Theseestimates and assumptions by their nature involve risks and uncertainties, andmay prove to be inaccurate. In the event that any of our estimates orassumptions are inaccurate in any material respect, it could have a materialadverse effect on our reported amounts of assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.

 

The following critical accounting policies affectour more significant judgments and estimates used in the preparation of ourunaudited condensed consolidated financial statements.

 

*Revenue Recognition*.  We record product revenues and related costsof sales upon transfer of title, which is generally upon shipment or, ifrequired, upon acceptance by the customer, provided that we believecollectibility of the net sales amount is reasonably assured.  Accordingly, at the date revenue isrecognized, the significant uncertainties concerning the sale have beenresolved.

 

Contract revenues are derived primarily from long-term contracts withgovernmental agencies.  Contract revenuesinclude costs incurred plus a portion of estimated fees or profits determinedusing the percentage of completion method of accounting based on therelationship of costs incurred to total estimated costs.  Any anticipated losses on contracts arecharged to earnings when identified. Changes in job performance and estimated profitability, including thosearising from contract penalty provisions and final contract settlements, mayresult in revisions to recognized costs and revenues and are recognized in theperiod in which the revisions are determined. Profit incentives are included in revenue when their realization isreasonably assured.

 

17

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In addition to product and contract revenues, wederive revenue from technology access fees, the provision of specificnon-recurring contract engineering services related to our AutoVue LDW system,and royalties related to unit sales of our AutoVue LDW systems by our strategicpartner Valeo to the passenger car market. Technology access fee revenues arerecognized evenly over the period in which they are earned.  Non-recurring contract engineering revenuesare recognized in the period in which the related services are performed.  Royalty revenues are recorded based on unitsales of our products by Valeo and are recognized in the period in which suchsales occur.  Technology access feerevenues, contract engineering revenues and royalty revenues are included innet sales in the accompanying condensed consolidated statements of operations.

 

Revenues from follow-on service and support, for which we chargeseparately, are recorded in the period in which the services are performed.

 

*Accounts Receivable*.  We estimate the collectibility of customerreceivables on an ongoing basis by periodically reviewing invoices outstandinggreater than a certain period of time. We have recorded reserves for receivables deemed to be at risk forcollection as well as a general reserve based on our historical collectionsexperience.  A considerable amount ofjudgment is required in assessing the ultimate realization of tradereceivables, including the current credit-worthiness of each customer.  If the financial condition of our customersdeteriorates, resulting in an impairment of their ability to make requiredpayments, additional allowances may be required that could adversely affect ouroperating results.

 

*Inventory*. Inventories consist offinished goods, work-in-process and raw materials and are stated at the lowerof cost or market.  We provide reservesfor potentially excess and obsolete inventory. In assessing the ultimaterealization of inventories, we make judgments as to future demand requirementsand compare that with the current or committed inventory levels.  Reserves are established for inventory levelsthat exceed future demand.  It ispossible that reserves over and above those already established may be requiredin the future if market conditions for our products deteriorate.

 

*Goodwill*.  Goodwill is tested for impairment annually inthe fourth fiscal quarter at the reporting unit level unless a change incircumstances indicates that more frequent impairment analysis is required.  Impairment, if any, is measured based on theestimated fair value of the reporting units with the recorded goodwill.  Fair value is determined by using the incomeapproach methodology of valuation which utilizes discounted cash flows.  Significant management judgment is requiredin the forecasts of future operating results that are used in the discountedcash flow method of valuation.  Inestimating future cash flows, we generally use the financial assumptions in ourcurrent budget and our current strategic plan, subject to modification as considerednecessary, including sales and expense growth rates and the discount rates weestimate to represent our cost of funds. It is possible, however, that the plans and estimates used may beincorrect.  If our actual results, or theplans and estimates used in future impairment analyses, are lower than theoriginal estimates used to assess the recoverability of goodwill, we couldincur impairment charges.

 

*Warranty.*  Unless otherwise stated, we provide a one tothree year warranty from the original invoice date on all products, materialsand workmanship.  Defective products areeither repaired or replaced, at our option, upon meeting certain criteria.  We accrue a provision for the estimated coststhat may be incurred for product warranties relating to a product as acomponent of cost of sales at the time revenue for that product isrecognized.  The accrued warrantyprovision is included within accrued expenses on the accompanying condensedconsolidated balance sheets.  Should ouractual experience of warranty returns be higher than anticipated, additionalwarranty reserves may be required, which may adversely affect our operatingresults.

 

*Taxes.*We recorded a valuation allowance to reduce our deferred taxassets to amounts that we believe are more likely than not to be realized.Realization of deferred tax assets (such as net operating loss carryforwards)is dependent on future taxable earnings and is therefore uncertain. On aquarterly basis, we assess the likelihood that our deferred tax asset balancewill be recovered from future taxable income. To the extent we believe thatrecovery is not likely, we establish a valuation allowance against our deferredtax asset, increasing our income tax expense in the period such determinationis made.

 

On an interim basis, we estimate what our anticipated annual effectivetax rate will be and record a quarterly income tax provision in accordance withthis anticipated rate. As the fiscal year progresses, we refine our estimatesbased upon actual events and earnings during the year. This estimation processcan result in significant changes to our expected effective tax rate. When thisoccurs, we adjust the income tax provision during the quarter in which thechange in estimate occurs so that the year-to-date provision reflects theexpected annual rate. The changes described in the preceding sentence and therecording of valuation allowances may create fluctuations in our overalleffective tax rate from quarter to quarter.

 

18

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**Results of Operations**

 

Thefollowing table sets forth certain statement of operations data as a percentageof total net sales and contract revenues for the periods indicated. Thefollowing table should be read in conjunction with Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

 
| ** **                                               | ** ** | **Three Months  Ended  September 30,** | ** ** | **Six Months  Ended  September 30,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                    | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales and contract  revenues:                        |       |                                        |       |                                      |       |   |   |   |   |
| Net sales                                                |       | **62.7**                                    | **%**      | 65.1                                      | %          | **62.5** | **%** | 62.7 | % |
| Contract revenues                                        |       | **37.3**                                    | ** ** | 34.9                                      |       | **37.5** | ** ** | 37.3 |   |
| Total net sales and  contract revenues                   |       | **100.0**                                   | **%**      | 100.0                                     | %          | **100.0** | **%** | 100.0 | % |
| Costs and expenses:                                      |       | ** **                                  | ** ** |                                      |       | ** ** | ** ** |   |   |
| Cost of net sales                                        |       | **33.2**                                    | ** ** | 36.8                                      |       | **32.2** | ** ** | 34.0 |   |
| Cost of contract revenues                                |       | **23.4**                                    | ** ** | 23.2                                      |       | **23.7** | ** ** | 24.5 |   |
| Gross profit                                             |       | **43.4**                                    | ** ** | 39.9                                      |       | **44.2** | ** ** | 41.6 |   |
| Operating expenses:                                      |       | ** **                                  | ** ** |                                      |       | ** ** | ** ** |   |   |
| Selling, general and  administrative                     |       | **31.1**                                    | ** ** | 27.2                                      |       | **30.8** | ** ** | 29.3 |   |
| Research and development                                 |       | **10.4**                                    | ** ** | 7.4                                       |       | **12.2** | ** ** | 7.2 |   |
| Stock-based compensation                                 |       | **2.0**                                     | ** ** | —                                    |       | **2.1** | ** ** | — |   |
| Acquired in-process  research and development            |       | **—**                                  | ** ** | 1.0                                       |       | **—** | ** ** | 0.5 |   |
| Deferred compensation plan                               |       | **0.1**                                     | ** ** | —                                    |       | **0.3** | ** ** | — |   |
| Amortization of intangible  assets                       |       | **0.3**                                     | ** ** | 0.3                                       |       | **0.3** | ** ** | 0.l |   |
| Total operating expenses                                 |       | **43.9**                                    | ** ** | 35.9                                      |       | **45.7** | ** ** | 37.1 |   |
| Operating income (loss)                                  |       | **(0.5**                                    | **)**      | 4.0                                       |       | **(1.5** | **)** | 4.4 |   |
| Non-operating income  (expense):                         |       | ** **                                  | ** ** |                                      |       | ** ** | ** ** |   |   |
| Other income, net                                        |       | **0.7**                                     | ** ** | 0.5                                       |       | **0.1** | ** ** | 4.2 |   |
| Interest expense, net                                    |       | **(2.8**                                    | **)**      | (4.0                                      | )          | **(2.9** | **)** | (2.3 | ) |
| Income (loss) before income  taxes and minority interest |       | **(2.6**                                    | **)**      | 0.5                                       |       | **(4.3** | **)** | 6.3 |   |
| Income tax (expense)  benefit                            |       | **1.4**                                     | ** ** | —                                    |       | **0.7** | ** ** | (0.3 | ) |
| Minority interest in  earnings of subsidiary             |       | **—**                                  | ** ** | (0.5                                      | )          | **—** | ** ** | (1.9 | ) |
| Net income (loss)                                        |       | **(1.2**                                    | **)%**     | 0.0                                       | %          | **(3.6** | **)%** | 4.1 | % |

 

**Analysis of Quarterly Results ofOperations**

 

*NetSales and Contract Revenues*.  Net sales consist principallyof sales of our Vantage video detection systems and AutoVue LDW systems, aswell as technology access fees, contract engineering revenue and royaltyrevenue generated from AutoVue related activities.  Contract revenueconsists principally of revenue derived from systems integration and ITSconsulting services with federal, state, county and municipal agencies. Wecurrently have a diverse customer base with our largest customer constituting 13.2%of total net sales and contract revenues in the three months ended September 30,2005 and 12.2% of total net sales and contract revenues in the six months endedSeptember 30, 2005.

 

Total net sales andcontract revenues increased 8.1% and 6.9% to $12.7 million and $24.8 millionfor the three and six months ended September 30, 2005, respectively,compared to $11.8 million and $23.2 million in the corresponding periods in theprior fiscal year. These increases were a result of increased net sales of ourAutoVue products and services and increased contract revenues, as discussedbelow.

 

Net sales increased 4.2%to $8.0 million and 6.5% to $15.5 million for the three and six months ended September 30,2005, respectively, compared to $7.7 million and $14.6 million in thecorresponding periods in the prior fiscal year. The increase in net salesprimarily reflected an increase in the unit sales of our AutoVue LDWsystems.  Net sales from AutoVue products increased 62.5% and 88.2% in thethree and six month periods ended September 30, 2005, respectively,compared to the corresponding periods in the prior year. The increase in salesof AutoVue products was principally related to increased unit sales of LDWsystems in the European and North American commercial heavy truck markets.Overall sales of AutoVue products and services, which also include technologyaccess fees, contract engineering revenue and royalty revenue, increased 33.9% inthe current quarter to $2.2 million and 31.5% to $4.4 million for the six monthperiod compared to $1.6 million and $3.3 million in the corresponding periodsin the prior fiscal year.

 

The increased sales ofour AutoVue products and services were slightly offset by a 3.8% and 0.9%decrease in Vantage video detection systems sales in the three and six monthperiods ended September 30, 2005, respectively, compared to thecorresponding periods in the prior fiscal year. In unit terms, Vantage salesgrowth continues to increase primarily due to increased market adoption ofvideo-based detection technologies for traffic intersection management andour ability to obtain additional contracts with state departments oftransportation.   The effects ofincreased unit shipments of Vantage products was more than offset by decreasedaverage selling prices due to the changeover to new lower priced units.  The majority of Vantage sales are generatedin North America.

 

Contract revenuesincreased 15.4% to $4.7 million and 7.5% to $9.3 million in the three and sixmonths ended September 30, 2005, respectively, compared to $4.1 millionand $8.6 million in the corresponding periods in the prior fiscal year. Theincrease in contract revenues was fueled by increased activity in theCalifornia market.  Contract revenuesreflect a broad range of fixed price and cost plus fixed fee contracts forengineering study and design, systems integration and systemimplementation.  Contract revenues are dependent upon the continuedavailability of funding on both the state and federal levels from the variousdepartments of transportation.  All of our contract revenue is currentlyderived from work performed in North America.

 

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*GrossProfit*.  Total gross profit increased 17.5% to $5.5million for the three months ended September 30, 2005 compared to $4.7million in the corresponding period of the prior fiscal year and 13.6% to $11.0million for the six months ended September 30, 2005 compared to $9.6million in the corresponding period of the prior fiscal year.  Total gross profit as a percent of net salesand contract revenues increased to 43.4% and to 44.2% for the three and sixmonth periods ended September 30, 2005, respectively, compared to 39.9%and 41.6% in corresponding periods in the prior fiscal year.

 

Gross profit as apercentage of net sales was 47.0% for the three months ended September 30,2005 compared to 43.4% in the corresponding period of the prior fiscal year and48.6% for the six months ended September 30, 2005 compared to 45.9% in thecorresponding period of the prior fiscal year.  The increase in grossprofit as a percentage of net sales for both the three and six month periodsended September 30, 2005 was primarily a result of increased marginsrelated to the Vantage business as a result of reduced product support costsand lower materials costs on newer product offerings.

 

Gross profit as a percentof contract revenues increased to 37.3% for the three months ended September 30,2005 compared to 33.5% in the corresponding period of the prior fiscal year and36.9% for the six months ended September 30, 2005 compared to 34.3% in thecorresponding period of the prior fiscal year.  We recognize contractrevenues and related gross profit using percentage of completion contractaccounting and the underlying mix of contract activity affects the relatedgross profit recognized in any given year.  The increase in the three andsix month periods ended September 30, 2005 reflects a mix of higher margincontracts in the period as compared to the corresponding periods of the priorfiscal year.

 

*Selling,General and Administrative Expense*.  Selling, generaland administrative expense increased 23.4% to $3.9 million (or 31.1% of totalnet sales and contract revenues) in the three months ended September 30,2005 compared to $3.2 million (or 27.2% of total net sales and contractrevenues) in the corresponding period of the prior fiscal year and increased 12.3%to $7.6 million (or 30.8% of total net sales and contract revenues) in the sixmonths ended September 30, 2005 compared to $6.8 million (or 29.3% oftotal net sales and contract revenues) in the corresponding period of the priorfiscal year.

 

The increase in selling,general and administrative expenses for the three and six months ended September 30,2005 was principally related to increased auditing and accounting fees incurredby the Company as a direct result of the restatement of the Company’s March 31,2005, financial statements issued in July 2005 as well as additional consultingfees incurred by the Company related to preparation for Sarbanes-Oxleycompliance.  All expenses related to the2004 financial statement restatements were incurred during the six month periodended September 30, 2005, and we do not anticipate any future chargesrated to this matter. Additionally, on September 30, 2005, we determinedthat we will not be required to comply with Section 404 of theSarbanes-Oxley Act until our fiscal year ending March 31, 2007 at theearliest.  As a result, we expect areduced level of consulting expenses related to our Sarbanes-Oxley Section 404implementation efforts through the remainder of the current fiscal year.

 

*Researchand Development Expense*.  Research and developmentexpense increased 52.0% to $1.3 million (or 10.4% of total net sales andcontract revenues) in the three months ended September 30, 2005 comparedto $871,000 (or 7.4% of total net sales and contract revenues) in thecorresponding period of the prior fiscal year and increased 81.7% to $3.0million (or 12.2% of total net sales and contract revenues) in the six monthsended September 30, 2005 compared to $1.7 million (or 7.2% of total netsales and contract revenues) in the corresponding period of the prior fiscalyear.

 

The increase in researchand development expense in the three and six month periods reflects increasedspending on development of AutoVue and Vantage products.  AutoVue productdevelopment has primarily related to the development of our next generation LDWunit for the heavy truck market and was largely focused on re-engineering andqualification of a new imager.  In October 2005,the next generation LDW unit was approved for production by our largest truckcustomer and shipments are expected to begin in our fiscal third quarter.Although the AutoVue development team must qualify the new unit for use by eachadditional heavy truck customer, we believe the time and cost of futurequalifications should decrease as additional heavy truck customers adopt thisnew unit.  Vantage product developmentprimarily reflects activities for product line extensions to support newcommunications platforms and to accommodate new camera designs.

 

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

 

*Stock-BasedCompensation Expense.* On October 22, 2004, we recorded$1.4 million in deferred compensation expense related to the unvested IterisSubsidiary stock options assumed in connection with the merger between us and theIteris Subsidiary. This amount is being amortized to stock-based compensationexpense as the options vest. During the three and six month periods ended September 30,2005, non-cash charges of $258,000 and $523,000, respectively, were recordedfor stock-based compensation expense based on the vesting of the assumedoptions. Because the merger occurred in October 2004, no such expense wasrecorded in the corresponding periods of the prior fiscal year.

 

*DeferredCompensation Plan Expense.*  During the three and sixmonth periods ended September 30, 2005, non-cash charges of $16,000 and$78,000, respectively, were recorded by the Company related to the appreciationin value of 310,510 shares of our common stock held in trust by our deferredcompensation savings plan.  Noappreciation in value was recorded in the corresponding periods of the priorfiscal year.  We intend to amend thisplan in the near future to prohibit diversification of any shares of our commonstock held in the plan, which we believe will prevent any future deferredcompensation charges or other impact on our consolidated financial statementsas a result of changes in the value of our common stock held in this plan.

 

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*OtherIncome, Net*.  Other income, net reflects the following:

 
| ** **                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                     | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                     | ** ** | **(In thousands)**                         | ** ** |
| Gain on  settlement of lawsuit |       | **$**                                      | **—** | ** **                               | $          | — |   | **$** | **—** | ** ** | $ | 949 |   |
| Other                          |       | **86**                                     | ** ** | 57                                       |       | **38** | ** ** | 31 |   |
| Other  income, net             |       | **$**                                      | **86**     | ** **                               | $          | 57 |   | **$** | **38** | ** ** | $ | 980 |   |

 

Other income, net for thethree and six month periods ended September 30, 2005 primarily reflects$86,000 of income recorded in connection with the final earnout payment made tous by FEI-Zyfer in connection with the sale of Zyfer, Inc. in May of2003.  Other income, net for the six monthsended September 30, 2004 primarily reflects a $949,000 gain recognized onthe settlement of litigation between Rockwell International and the MichiganDepartment of Transportation in which we were a third party beneficiary.

 

*InterestExpense, Net.*  Interest expense, net reflects the net ofinterest expense and interest income as follows:

 
| ** **                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                              | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                              | ** ** | **(in thousands)**                         | ** ** |
| Interest  expense                       |       | **$**                                      | **(272**   | **)**                                    | $          | (387 | ) | **$** | **(537** | **)** | $ | (418 | ) |
| Amortization  of deferred finance costs |       | **(34**                                    | **)**      | (33                                      | )          | **(69** | **)** | (44 | ) |
| Amortization  of debt discount          |       | **(52**                                    | **)**      | (50                                      | )          | **(104** | **)** | (78 | ) |
| Interest  expense, net                  |       | **$**                                      | **(358**   | **)**                                    | $          | (470 | ) | **$** | **(710** | **)** | $ | (540 | ) |

 

Interest expensedecreased 23.8% for the three month period ended September 30, 2005compared to the corresponding period in the prior fiscal year as a result of alower level of bank borrowings in the current year.  Interest expense increased 31.5% for the sixmonths ended September 30, 2005 compared to the corresponding period inthe prior fiscal year.  This increase waslargely due to additional interest expense incurred related to the $5.0 millionterm debt entered into by the Iteris Subsidiary on May 28, 2004 (which we assumedin October 2004), interest expense related to the $10.1 millionconvertible debentures issued by us on May 19, 2004, and the amortizationof debt discounts and deferredfinancing costs associated with the issuance of the convertibledebentures and related warrants.

 

*IncomeTaxes*.  During the three and six month periods ended September 30,2005, we recognized an income tax benefit of $183,000 and $175,000,respectively, as compared to $0 and $75,000 of income tax expense in thecorresponding three and six month periods of the prior fiscal year,respectively.  The tax benefit recordedin the three and six month periods ended September 30, 2005 primarilyreflects a reduction in the valuation allowance recorded against our deferredtax assets as a result of changes in estimates of the future realizability ofthese assets.  As a result, totaldeferred tax assets on our consolidated balance sheet increased from $660,000at March 31, 2005 to $849,000 at September 30, 2005.  In the future, we may continue to recordsimilar adjustments to our deferred tax asset valuation allowance as ourestimates are updated.  We anticipate thiswill likely cause our future effective tax rate in any given period tofluctuate significantly from prior effective tax rates, estimated effective taxrates and statutory tax rates.

 

*MinorityInterest in Earnings of Subsidiary*.  Minority interestin earnings of subsidiary represents the minority stockholders’ share of theIteris Subsidiary’s net income or loss combined with the accretion of theredemption preference of the Iteris Subsidiary’s Series A preferredstock.  The decrease in minority interest to $0 in the three and six monthperiods ended September 30, 2005 from $65,000 and $433,000 in the threeand six month periods ended September 30, 2004, respectively, was theresult of the merger of the Iteris Subsidiary into us on October 22, 2004.

 

**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 ofequity securities. We currently rely on cash flows from operations andborrowings on a line of credit facility to fund our operations, which webelieve to be sufficient to fund our operations for at least the next twelvemonths.  However, should

 

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a shortfalloccur, we believe we could obtain additional funds through additionalborrowings or the sale of equity securities. At September 30, 2005, we had $2.0 million in working capital,which included borrowings of $1.7 million on our revolving line of credit andno cash.  This compares to working capitalof $2.2 million, $46,000 in cash and an outstanding revolving line of creditbalance of $945,000 at March 31, 2005. Our operations provided $41,000 of cash during the six month periodended September 30, 2005, primarily as a result of planned decreases ininventory to a level more in line with target inventory levels, offset by a netdecrease in accounts payable and accrued expenses and an increase in net costs andestimated earnings in excess of billings on uncompleted contracts.  During the six months ended September 30,2004, we used $359,000 of cash in operating activities.  This was primarily due to $1.5 million incash outflows associated with accounts payable, accrued liabilities andprepayments, offset by net income, which included the receipt of $949,000related to a legal settlement between Rockwell International and the MichiganDepartment of Transportation to which we were a third party beneficiary, $433,000of income attributable to minority stockholders and $585,000 in depreciationand amortization.

 

Our investing activities for the six month periods ended September 30,2005, and 2004, consisted entirely of purchases of property and equipment,which aggregated $386,000 and $299,000, respectively.

 

Cash provided by financing activities was $299,000 inthe six month period ended September 30, 2005, which was the result of netborrowings of $109,000 and cash inflows of $190,000 from the exercise ofoutstanding stock options and warrants to purchase our common stock.  During the six month period ended September 30,2004, financing activities used $1.9 million of cash, which was comprised ofnet cash outflows of approximately $2.4 million related to the mergeractivities described more fully above under the caption “Merger with IterisSubsidiary” and in Note 3 to the accompanying condensed consolidated financialstatements, partially offset by $499,000 in proceeds from the exercise of stockoptions and warrants to purchase our common stock.

 

*Borrowings*

 

The following table summarizes our borrowings andlong-term debt as of September 30, 2005 (in thousands):

 
| Convertible  debentures      |   | **$** | 9,100  |   |
|------------------------------|--------|-------|--------|--------|
| Bank term  note              |   | 3,333 |   |
| Promissory  note to landlord |   | 1,292 |   |
| 4% note  payable             |   | 45    |   |
| Revolving  line of credit    |   | 1,711 |   |
|                         |   | $     | 15,481 |   |

 

Our revolving line of credit agreement, which expiredon August 1, 2005, and which has been verbally extended by the bank untila new arrangement is negotiated, provides for borrowings of up to $5.0 millionsubject to a borrowing formula based upon qualified accounts receivable andinventories as defined in the credit agreement. At September 30, 2005, we had $4.7 million available under therevolving line of credit, of which $3.0 million was unused.

 

As discussed in Note 4 to the accompanying condensedconsolidated financial statements, we failed to meet certain financialcovenants under the credit agreement with our primary bank in each of the twoprior fiscal quarters.  This creditagreement governs the bank term note as well as our revolving line of creditfacility.  On August 3, 2005, and May 12,2005, the bank waived its rights of default regarding these covenant violationsfor the quarterly periods ended June 30, 2005, and March 31, 2005,only.  The bank verbally agreed to extendthe term of the credit agreement and not call any of the debt under theagreement until a new arrangement is negotiated.  We believe the combination of availableborrowings on our line of credit and our internally generated cash flows willbe sufficient to enable us to execute our operating plans and meet ourobligations on a timely basis for at least the next twelve months.

 

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**Contractual Obligations**

 

Our contractual obligations are as follows at September 30, 2005:

 
| ** **              | ** ** | **Payments Due by Period** | ** ** |
|-------------------------|------------|----------------------------|------------|
| ** **              | ** ** | **2006**                   | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **              | ** ** | **(In thousands)**         | ** ** |
| Lines of  credit        |       | $                          | 1,711      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,711 |   |
| Notes  payable          |       | 648                        |       | 1,918 |   | 1,896 |   | 208 |   | — |   | — |   | 4,670 |   |
| Convertible  debentures |       | —                     |       | — |   | — |   | — |   | 9,850 |   | — |   | 9,850 |   |
| Operating  leases       |       | 689                        |       | 1,255 |   | 769 |   | 91 |   | 85 |   | 43 |   | 2,932 |   |
| Total                   |       | $                          | 3,048      |   | $ | 3,173 |   | $ | 2,665 |   | $ | 299 |   | $ | 9,935 |   | $ | 43 |   | $ | 19,163 |   |

 

**Recent Accounting Pronouncements**

 

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151, *InventoryCosts* (“SFAS 151”), which clarifies the accounting for abnormalamounts of idle facility expense, freight, handling costs, and wastedmaterial.  SFAS 151 will be effective forinventory costs incurred during fiscal years beginning after June 15, 2005.  We do not believe the adoption of SFAS 151will have a material impact on our financial statements.

 

On December 16, 2004, the FASB issued SFASNo.123 (revised 2004), *Share-Based Payment*(“SFAS 123R”), which replaces SFAS 123, supersedes APB 25, and amends SFASNo. 95, *Statement of Cash Flows*.  Generally, the approach in SFAS 123R issimilar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values (i.e., pro forma disclosure is no longeran alternative to financial statement recognition).  In accordance with SEC Release No. 33-8568,SFAS 123R will be effective for us beginning April 1, 2006.  We are currently assessing the impact of SFAS123R.  As of the date of this filing, wehave not yet concluded as to whether we will apply the modified prospective orretrospective transition method of application; therefore, the effect ofadoption cannot be determined at this time.

 

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections* (“SFAS 154”). SFAS154 requires retroactive application of a voluntary change in accountingprinciple to prior period financial statements unless it is impracticable. SFAS154 also requires that a change in method of depreciation, amortization, ordepletion for long-lived, non-financial assets be accounted for as a change inaccounting estimate that is affected by a change in accounting principle. SFAS154 replaces APB Opinion No. 20, *Accounting Changes*,and SFAS No. 3, *Reporting Accounting Changes in InterimFinancial Statements*.  We arerequired to adopt the provisions of SFAS 154 in our fiscal year ending March31, 2007, and are presently evaluating what effect the adoption of theprovisions of SFAS 154 will have on our consolidated financial statements.

 

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**RISKFACTORS**

 

*Our business is subject to a number of risks, some of whichare discussed below.  Other risks arepresented elsewhere in this report and in our other filings with the SEC.  You should consider the following riskscarefully in addition to the other information contained in this report and ourother filings with the SEC, including our subsequent reports on Forms 10-Q and 8-K,before deciding to buy, sell or hold our common stock. The risks anduncertainties described below are not the only ones facing our company.  Additional risks and uncertainties notpresently known to us or that we currently deem immaterial may also affect ourbusiness operations.  If any of theserisks actually occurs, our business, financial condition or results ofoperations could be seriously harmed.  Inthat event, the market price for our common stock could decline and you maylose all or part of your investment.*

 

**We Have Experienced Substantial Losses And May Continue ToExperience Losses For The Foreseeable Future.**  Weexperienced net losses from continuing operations of $11.3 million, $1.9million and $5.3 million in the years ended March 31, 2005, 2004 and 2003,respectively.  While we have divested allof our other business units and merged with our Iteris Subsidiary, we cannotassure you that our efforts to downsize our operations or reduce our operatingexpenses will improve our financial performance, or that we will be able toachieve profitability on a quarterly or annual basis in the future. Most of ourexpenses are fixed in advance. As such, we generally are unable to reduce ourexpenses significantly in the short-term to compensate for any unexpected delayor decrease in anticipated revenues. As a result, we may continue to experienceoperating losses and net losses, which would make it difficult to fund ouroperations and achieve our business plan, and could cause the market price ofour common stock to decline.

 

**Our Line of Credit Has Expired And We May Need To Raise AdditionalCapital In The Future, Which May Not Be Available On Terms Acceptable ToUs, Or At All.**  We have generated significant net losses andoperating losses in recent periods, and have experienced volatility in our cashflows from operations ranging from positive cash flows from operations of$858,000 in the year ended March 31, 2005, to negative cash flows fromoperations of $718,000 and $4.8 million in the years ended March 31, 2004,and 2003, respectively.  While wecompleted a $10.1 million convertible debenture financing and our IterisSubsidiary closed a $5.0 million term loan in May 2004, the majorityof the proceeds from such financings were used to purchase the Series Apreferred stock of our Iteris Subsidiary held by outside investors.

 

Our line of credit with our bank expired on August 1,2005.  As further described in Note 4 tothe condensed consolidated financial statements, we also failed to meet certaindebt covenants under our credit agreement with our bank.  At September 30, 2005, we had $3.3million in term debt and $1.7 million in revolving credit outstanding inconnection with this credit agreement. Although we are currently in negotiations to restructure this creditfacility, we cannot assure you that we will be able to complete thisrestructuring or obtain a replacement facility under acceptable terms, on atimely basis or at all.

 

We may need to raise additional capital in the nearfuture to fund our operations or to repay indebtedness.  Such additional capital may be raised throughbank borrowings, or other debt or equity financings.  We cannot assure you that any additionalcapital will be available on a timely basis, on acceptable terms, or at all,and such additional financing may result in further dilution to ourstockholders.

 

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

 

•                  ourability to successfully negotiate a new credit arrangement with our bank;

 

•                  ourability to control costs;

 

•                  marketacceptance of our products and the overall level of sales of our products;

 

•                  ourability to generate net income;

 

•                  increasedresearch and development funding;

 

•                  increasedsales and marketing expenses;

 

•                  technologicaladvancements and our competitors’ response to our products;

 

•                  capitalimprovements to new and existing facilities;

 

•                  potential acquisitions of businesses andproduct lines;

 

•                  our relationships with customers andsuppliers; and

 

•                  general economic conditions, including theeffects of the current economic slowdown and international conflicts.

 

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If our capital requirements are materially differentfrom those currently planned, we may need additional capital sooner thananticipated. If additional funds are raised through the issuance of equity orconvertible debt securities, the percentage ownership of our stockholders willbe reduced and such securities may have rights, preferences and privilegessenior to our common stock. Additional financing may not be available onfavorable terms or at all. If adequate funds are not available or are notavailable on acceptable terms, we may be unable to continue our operations as planned,develop or enhance our products, expand our sales and marketing programs, takeadvantage of future opportunities or respond to competitive pressures.

 

**If Our Internal Controls Over FinancialReporting Do Not Comply With The Requirements Of The Sarbanes-Oxley Act, OurBusiness And Stock Price Could Be Adversely Affected.**Alongwith our independent registered public accounting firm we will be evaluatingthe effectiveness of our internal controls over financial reporting to complywith Section 404 of the Sarbanes-Oxley Act of 2002.  Section 404 currently requires us toevaluate the effectiveness of our internal controls over financial reporting atthe end of each fiscal year beginning in our next fiscal year ending March 31,2007 at the earliest, and to include a management report assessing theeffectiveness of our internal controls over financial reporting in all annualreports beginning with our Annual Report on Form 10-K for the fiscal yearending March 31, 2007 at the earliest. Section 404 also requires our independent accountant to attest to,and report on, management’s assessment of our internal controls over financialreporting.

 

Our management, including our CEO and CFO, does notexpect that our internal controls over financial reporting will prevent allerror and all fraud.  A control system,no matter how well designed and operated, can provide only reasonable, notabsolute, assurance that the control system’s objectives will be met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs.  Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, within the company havebeen, or will be detected.  Theseinherent limitations include the realities that judgments in decision-makingcan be faulty and that breakdowns can occur because of simple error ormistake.  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 any system of controls is basedin part on certain assumptions about the likelihood of future events, and wecannot assure you that any design will succeed in achieving its stated goalsunder all potential future conditions. Over time, controls may become inadequate because of changes inconditions or deterioration in the degree of compliance with policies orprocedures.  Because of the inherentlimitations in a cost-effective control system, misstatements due to error orfraud 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.  We cannot assure youthat we or our independent registered public accounting firm will not identifyadditional material weaknesses in our internal controls.  A material weakness is a control deficiency,or combination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. Based on our evaluation, ourmanagement has concluded that, as of March 31, 2004, our internal controlover financial reporting was not effective due to the existence of one materialweakness. If our internal controls over financial reporting are notconsidered adequate, we may experience a loss of public confidence, which couldhave an adverse effect on our business and our stock price.

 

**We May Experience Production Gaps OrDelays In the Transition To Our Next Generation LDW System And Have ExhaustedComponent Supplies For Our Legacy AutoVue LDW Systems, Which Could MateriallyAnd Adversely Impact Our Sales And Financial Results And The UltimateAcceptance Of AutoVue.** We are in the process of transitioning to production of a nextgeneration LDW system and have run out of certain components used in themanufacture of our AutoVue LDW units sold to the heavy truck market.  Although we have qualified our nextgeneration system with our largest customer, we must continue to qualify thenew system with our other customers.  Asa result, we could experience a gap or delay in production as we transition tothis next generation system.  In somecases, such gaps or delays may be driven by customer transition issues.  Additionally, it is possible that we could experienceunforeseen quality control issues as we ramp up to full production of our nextgeneration LDW system.  Should any suchdelay or disruption occur in transitioning to production of our next generationLDW system, our sales will likely be materially and adversely affected.

 

**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 significantportion of our sales were derived from contracts with governmental agencies,either as a general contractor, subcontractor or supplier. Government contractsrepresented approximately 37.4%, 48.2% and 53.8% of our total net sales andcontract revenues for the years ended March 31, 2005, 2004, and 2003,respectively. We anticipate that revenue from government contracts willcontinue to increase in the near future. Government business is, in general,subject to special risks and challenges, including:

 

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•                  long purchase cycles or approval processes;

 

•                  competitive bidding and qualificationrequirements;

 

•                  the impact of international conflicts;

 

•                  performance bond requirements;

 

•                  changes in government policies and politicalagendas;

 

•                  delays in funding, budgetary constraints andcut-backs; and

 

•                  milestone requirements and liquidated damageprovisions 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.  Thesefixed price contracts require us to estimate the total project cost based onpreliminary projections of the project’s requirements.  The financial viability of any given projectdepends in large part on our ability to estimate these costs accurately andcomplete the project on a timely basis. In the event our costs on these projects exceed the fixed contractual amount,we will be required to bear the excess costs. Such additional costs would adversely affect our financial condition andresults of operations.  Moreover, certainof our government contracts are subject to termination or renegotiation at theconvenience of the government, which could result in a large decline in our netsales in any given quarter.  Ourinability to address any of the foregoing concerns or the loss or renegotiationof any material government contract could seriously harm our business,financial condition and results of operations.

 

**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.  As such, the future success and broad marketacceptance of our AutoVue technologies in the passenger car market will dependupon Valeo’s ability to manufacture, market and sell our technologies, and toconvince more OEM passenger car manufacturers to adopt our technologies.  IfValeo does not devote considerable resources and aggressively pursueopportunities, our expansion into the passenger car market could be adverselyaffected.  

 

**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 may not be able to introduce anynew products or any enhancements to our existing products on a timely basis, orat all. In addition, the introduction of any new products could adverselyaffect the sales of certain of our existing products. Our future success willalso depend in part on the success of several products including our AutoVueLDW system.

 

We believe that we must continue to make substantialinvestments to support ongoing research and development in order to remaincompetitive. We need to continue to develop and introduce new products thatincorporate the latest technological advancements in outdoor image processinghardware, software and camera technologies in response to evolving customerrequirements. Our business and results of operations could be adverselyaffected if we do not anticipate or respond adequately to technologicaldevelopments or changing customer requirements. We cannot assure you that anysuch investments in research and development will lead to any correspondingincrease 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 and achieve manufacturingefficiencies, the perceived advantages of our new products over traditionalproducts and the marketing capabilities of our independent distributors andstrategic partners, including Valeo's ability to expand sales of AutoVue in thepassenger car market. The success of our AutoVue system will also depend inpart on the success of the automotive vehicles that incorporate our technology,as well as the success of optional equipment that OEMs bundle with ourtechnologies.

 

Our business and results of operations could also beseriously harmed by any significant delays in our new product development.Certain of our new products could contain undetected design faults and softwareerrors or “bugs” when first released by us, despite our testing. We may notdiscover these faults or errors until after a product has been installed andused by our customers. Any faults or errors in our existing products or in anynew products may cause delays in product introduction and shipments, require designmodifications or harm customer relationships, any of which could adverselyaffect our business and competitive position.

 

**An Economic Slowdown And Related Uncertainties Could Adversely ImpactThe Demand For Our Products.**  Concerns about inflation, decreasedconsumer confidence, reduced corporate profits and capital spending, and recentinternational conflicts and terrorist and military actions have resulted in adownturn in worldwide economic conditions, particularly in the United States.  These unfavorable economic conditions mayhave a negative impact on customer orders, cancellations and rescheduling ofbacklog. In addition, recent political and social turmoil related tointernational conflicts and terrorist acts can be expected to put furtherpressure on economic conditions in the U.S. and worldwide.  These political, social and economicconditions make it extremely difficult for our customers, our suppliers and usto accurately forecast and plan future business activities.  If such conditions continue or worsen, ourbusiness, financial condition and results of operations will likely bematerially and adversely affected.

 

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**Our Quarterly Operating ResultsFluctuate As A Result Of Many Factors. Therefore, We May Fail To Meet OrExceed The Expectations Of Securities Analysts And Investors, Which Could CauseOur Stock Price To Decline.**  Our quarterly revenues andoperating results have fluctuated and are likely to continue to vary fromquarter to quarter due to a number of factors, many of which are not within ourcontrol. Factors that could affect our revenues include, among others, thefollowing:

 

•                  our ability to raise additional capital;

 

•                  our ability to control costs;

 

•                  international conflicts and acts ofterrorism;

 

•                  our ability to develop, introduce, patent,market and gain market acceptance of new products, applications and productenhancements in a timely manner, or at all;

 

•                  the size, timing, rescheduling orcancellation of significant customer orders;

 

•                  the introduction of new products bycompetitors;

 

•                  the availability of components used in themanufacture of our products;

 

•                  changes in our pricing policies and thepricing policies of our suppliers and competitors, pricing concessions on volumesales, as well as increased price competition in general;

 

•                  the long lead times associated withgovernment contracts or required by vehicle manufacturers;

 

•                  delays in the allocation of funds to state andlocal agencies from the U.S. government transportation bill;

 

•                  our success in expanding and implementing oursales and marketing programs;

 

•                  the effects of technological changes in ourtarget markets;

 

•                  our relatively small level of backlog at anygiven time;

 

•                  seasonality due to winter weather conditions;

 

•                  the mix of our sales;

 

•                  deferrals of customer orders in anticipationof new products, applications or product enhancements;

 

•                  risks and uncertainties associated with ourinternational business;

 

•                  currency fluctuations and our ability to getcurrency out of certain foreign countries; and

 

•                  general economic and political conditions.

 

Due to all of the factors listed above as well asother unforeseen factors, our future operating results could be below theexpectations of securities analysts or investors.  If that happens, the trading price of ourcommon stock could decline. As a result of these quarterly variations, youshould not rely on quarter-to-quarter comparisons of our operating results asan indication of our future performance.

 

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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 astechnologies mature;

 

•                  changes in customer requirements;

 

•                  frequent new product introductions andenhancements; and

 

•                  evolving industry standards and changes inthe regulatory environment.

 

Our future success will depend upon our ability toanticipate and adapt to changes in technology and industry standards, and toeffectively develop, introduce, market and gain broad acceptance of new productsand product enhancements incorporating the latest technological advancements.

 

**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 numerous othercompanies in our target markets including, but not limited to, large,multinational corporations and many smaller regional engineering firms. Weexpect such competition to increase due to technological advancements, industryconsolidations and reduced barriers to entry. Increased competition is likelyto result in price reductions, reduced gross margins and loss of market share,any of which could seriously harm our business, financial condition and resultsof operations. Many of our competitors have far greater name recognition andgreater financial, technological, marketing and customer service resources thanwe do. This may allow them to respond more quickly to new or emergingtechnologies and changes in customer requirements. It may also allow them todevote greater resources to the development, promotion, sale and support oftheir products than we can. Recent consolidations of end users, distributorsand manufacturers in our target markets have exacerbated this problem. As aresult of the foregoing factors, we may not be able to compete effectively inour target markets and competitive pressures could adversely affect ourbusiness, financial condition and results of operations.

 

**We May Be Unable To Attract And Retain Key Personnel, Which CouldSeriously Harm Our Business.**  Due to the specialized natureof our business, we are highly dependent on the continued service of ourexecutive officers and other key management, engineering and technicalpersonnel.  The loss of any of ourexecutive officers or key members of management could adversely affect ourbusiness, financial condition or results of operations.  Our success will also depend in large partupon our ability to continue to attract, retain and motivate qualifiedengineering and other highly skilled technical personnel. Competition foremployees, particularly development engineers, is intense.  We may not be able to continue to attract andretain sufficient numbers 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.

 

**We May Not Be Able To Adequately Protect Or Enforce Our IntellectualProperty Rights, Which Could Harm Our Competitive Position.**  If weare not able to adequately protect or enforce the proprietary aspects of ourtechnology, competitors could be able to access our proprietary technology andour business, financial condition and results of operations will likely beseriously harmed. We currently attempt to protect our technology through acombination of patent, copyright, trademark and trade secret laws, employee andthird party nondisclosure agreements and similar means. Despite our efforts,other parties may attempt to disclose, obtain or use our technologies orsystems. Our competitors may also be able to independently develop productsthat are substantially equivalent or superior to our products or design aroundour patents. In addition, the laws of some foreign countries do not protect ourproprietary rights as fully as do the laws of the United States. As a result,we may not be able to protect our proprietary rights adequately in the UnitedStates or abroad.

 

From time to time, we have received notices thatclaim we have infringed upon the intellectual property of others. Even if theseclaims are not valid, they could subject us to significant costs. We haveengaged in litigation in the past, and litigation may be necessary in thefuture to enforce our intellectual property rights or to determine the validityand scope of the proprietary rights of others. Litigation may also be necessaryto defend against claims of infringement or invalidity by others. An adverseoutcome in litigation or any similar proceedings could subject us tosignificant liabilities to third parties, require us to license disputed rightsfrom others or require us to cease marketing or using certain products ortechnologies. We may not be able to obtain any licenses on terms acceptable tous, or at all. We also may have to indemnify certain customers or strategicpartners if it is determined that we have infringed upon or misappropriatedanother party’s intellectual property. Any of these results could adverselyaffect our business, financial condition and results of operations. Inaddition, the cost of addressing any intellectual property litigation claim, includinglegal fees and expenses, and the diversion of management’s attention andresources, regardless of whether the claim is valid, could be significant andcould seriously harm our business, financial condition and results ofoperations.

 

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**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 and improve cashflow;

 

•                  our ability to raise additional capital;

 

•                  shortages announced by suppliers;

 

•                  announcements of technological innovations ornew products or applications by our competitors, customers or us;

 

•                  acquisitions of businesses, products ortechnologies;

 

•                  the impact of any litigation;

 

•                  changes in investor perceptions;

 

•                  changes in earnings estimates or investmentrecommendations by securities analysts; and

 

•                  international conflicts, political unrest andacts of terrorism.

 

The stock market in general has recently experiencedvolatility, which has particularly affected the market prices of equitysecurities 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 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 businessand the diversion of our resources and management’s attention;

 

•                  the failure to retain or integrate keyacquired personnel;

 

•                  the challenge of assimilating diversebusiness 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 duplicativeservices;

 

•                  the incurrence of unforeseen obligations orliabilities;

 

•                  potential impairment of relationships withemployees or customers as a result of changes in management; and

 

•                  increased interest expense and amortizationof acquired intangible assets.

 

Ourcompetitors are also soliciting potential acquisition candidates, which couldboth increase the price of any acquisition targets and decrease the number ofattractive companies available for acquisition. Acquisitions may alsomaterially and adversely affect our operating results due to large write-offs,contingent liabilities, substantial depreciation, deferred compensation chargesor intangible asset amortization, or other adverse tax or accountingconsequences. We cannot assure you that we will be able to identify orconsummate any additional acquisitions, successfully integrate any acquisitionsor realize the benefits anticipated from any acquisition.

 

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**Our International Business Operations May Be Threatened By ManyFactors That Are Outside Of Our Control.**  Wecurrently market our AutoVue and Vantage products internationally and weanticipate that our international operations will expand in the near future.International business operations are subject to various inherent risksincluding, among others:

 

•                  currency fluctuations and restrictions;

 

•                  political, social and economic instability;

 

•                  reduced protection for intellectual propertyrights in some countries;

 

•                  unexpected changes in regulatoryrequirements, tariffs and other trade barriers or restrictions;

 

•                  the burdens of compliance with a wide varietyof foreign laws and more restrictive labor laws and obligations;

 

•                  longer accounts receivable payment cycles;

 

•                  difficulties in managing and staffinginternational operations;

 

•                  potentially adverse tax consequences; and

 

•                  import and export license requirements andrestrictions of the United States and each other country in which we operate.

 

All of our international sales are denominated inU.S. dollars. As a result, an increase in the relative value of the dollarcould make our products more expensive and potentially less price competitivein international markets. We do not engage in any transactions as a hedge againstrisks of loss due to foreign currency fluctuations.

 

Any of the factors mentioned above may adverselyaffect our future international sales and, consequently, affect our business,financial condition and operating results. Furthermore, as we increase ourinternational sales, our total revenues may also be affected to a greaterextent by seasonal fluctuations resulting from lower sales that typically occurduring the summer months in Europe and other parts of the world.

 

**We Could Experience Negative FinancialImpacts Arising From Developments In Contingencies Created Under Our PreviousStructure Or By Former Subsidiaries.**  Although we divested ourselves of allbusiness units, with the exception of our Iteris business, from time to time wecould experience unforeseen developments in contingencies related to our formersubsidiaries.  In particular, we arepresently party to a lawsuit brought against Mariner Networks, Inc., oneof our former subsidiaries (refer to Note 5 to the condensed consolidated financialstatements).  We are also presentlyundergoing a sales tax audit in the state of California covering periods andtransactions related to our former subsidiaries.  The outcome of this lawsuit and sales taxaudit are presently uncertain.  Although weare not aware of any other material contingencies, it is possible that other matterscould be brought against us in connection with activities related to formersubsidiaries and that such matters could materially and adversely affect ourfinancial results and cash flows.

 

**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 September 30, 2005, our officersand directors owned approximately 16% of the outstanding shares of our commonstock (and approximately 25% of our common stock when including options,warrants and other convertible securities held by them which are currently exercisableor convertible or will become exercisable or convertible within 60 daysafter September 30, 2005). As a result of their stock ownership, ourmanagement will be able to significantly 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 Anti-Takeover Provisions May Affect The Price Of OurCommon Stock And Discourage A Third Party From Acquiring Us.** Certain provisions of our certificate of incorporation and ourstockholder rights plan could make it difficult for a third party to acquireus, even though an acquisition might be beneficial to our stockholders. Suchprovisions could limit the price that investors might be willing to pay in thefuture for shares of our common stock. Under the terms of our certificate ofincorporation, our Board of Directors is authorized to issue, withoutstockholder approval, up to 2,000,000 shares of preferred stock with voting,conversion and other rights and preferences superior to those of our commonstock. Our future issuance of preferred stock could be used to discourage anunsolicited acquisition proposal. In addition, in March 1998, we adopted astockholder rights plan and declared a dividend of preferred stock purchaserights to our stockholders. We amended this plan in May 2004. In the eventa third party acquires more than 15% of the outstanding voting control of ourcompany or 15% of our outstanding common stock, the holders of these rightswill be able to purchase the junior participating preferred stock at asubstantial discount off of the then current market price. The exercise ofthese rights and purchase of a significant amount of stock at below marketprices could cause substantial dilution to a particular acquirer and discouragethe acquirer from pursuing our company. The mere existence of a stockholderrights plan often delays or makes a merger, tender offer or proxy contest moredifficult.

 

30

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**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

Our exposure to interest rate risk is limited to ourline of credit. Our line of credit bears interest based on the prevailing primerate (6.75% at September 30, 2005). A 10% increase in the interest rate onour line of credit (from 6.75% to 7.43%) would not have a material impact onour financial position, operating results or cash flows. In addition, webelieve that the carrying value of our outstanding debt approximates fairvalue.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rule 13a-15(f).Under the supervision and with the participation of our management, includingour principal executive officer and principal financial officer, we conductedan evaluation of the effectiveness of our internal control over financialreporting and concluded that our disclosure controls and procedures wereeffective in timely alerting them to the material information involvingtransactions occurring in the normal course of business relating to us requiredto be included in the reports we file or submit under the Securities ExchangeAct of 1934, as amended.  We did,however, conclude that as of March 31, 2004, we had a material weakness relatedto the administration and proper accounting for certain types of contracts andagreements.

 

A material weakness is acontrol deficiency, or combination of control deficiencies, that results inmore than a remote likelihood that a material misstatement of the annual orinterim financial statements will not be prevented or detected.  The material weakness described above resultedin improper accounting treatment for the Iteris Subsidiary’s DeferredCompensation Savings Plan. The material weakness resulted in the restatement ofour audited consolidated financial statements for the year ended March 31,2004, with respect to deferred compensation expense and compensation savingsplan liabilities.

 

Management has responded to the aboveidentified material weakness by performing additional accounting, financialanalysis and managerial review of procedures in order to ensure that thefinancial information contained in our quarterly report on Form 10-Q isreliable. In January 2005, we hired a controller to supplement our accountingand finance department and have held regular disclosure committee meetings toimprove communication regarding the Company’s operations including contractadministration.  Except as set forthabove, during the most recent completed fiscal quarter covered by this report,there has been no change in our internal controls over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f) under the SecuritiesExchange Act of 1934) that has materially affected, or is reasonably likely tomaterially affect, our internal controls over financial reporting.

 

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**PART II. OTHER INFORMATION**

 

**ITEM1.  LEGAL PROCEEDINGS**

 

The information set forth under Note 5 of Notes toUnaudited Condensed Consolidated Financial Statements, included in Part I,Item I of this report, is incorporated herein by reference.

 

**ITEM 2.  UNREGISTERED SALES OFEQUITY SECURITIES AND USE OF PROCEEDS**

 

None.

 

# **ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**ITEM 4.  SUBMISSION OF MATTERS TOA VOTE OF SECURITY HOLDERS**

 

In connection with our Annual Meeting ofStockholders, held on September 16, 2005, the following proxies weretabulated representing 17,613,251 shares of our common stock or 61.9% of theoutstanding shares:

 

**Proposal I**: **Election of the Board of Directors**

 
| **Director Nominee**      | ** ** | **Total Vote for Each  Director** | ** ** | **Total Vote Withheld from Each  Director** | ** ** |
|---------------------------|------------|-----------------------------------|------------|---------------------------------------------|------------|
| Kevin C.  Daly, Ph.D.     |       | 17,500,963                        |       | 112,288                                     |       |
| Gary  Hernandez           |       | 17,500,963                        |       | 112,288                                     |       |
| Jack Johnson              |       | 17,500,519                        |       | 112,732                                     |       |
| Dr. Hartmut  Marwitz |       | 17,500,963                        |       | 112,288                                     |       |
| Gregory A.  Miner         |       | 17,487,071                        |       | 126,180                                     |       |
| John W.  Seazholtz        |       | 17,500,963                        |       | 112,288                                     |       |
| Joel Slutzky              |       | 17,497,217                        |       | 116,034                                     |       |
| Thomas L.  Thomas         |       | 17,500,963                        |       | 112,288                                     |       |
| Paul E.  Wright           |       | 17,500,963                        |       | 112,288                                     |       |

 

**Proposal II:  To approve the amendment of the Bylaws tochange the size of the Board of Directors to not less than seven members normore than eleven members, with the exact number to be set at eleven directorsuntil changed within the foregoing limits by resolution of the Board or thestockholders.**

 
| ** **  | ** ** | **Common Stock** | ** ** |
|-------------|------------|------------------|------------|
| **For**     |       | 17,456,363       |       |
| **Against** |       | 142,916          |       |
| **Abstain** |       | 13,972           |       |

 

**Proposal III: The ratification ofMcGladrey & Pullen, LLP as the Company’s independent auditors for thefiscal year ending March 31, 2006.**

 
| ** **  | ** ** | **Common Stock** | ** ** |
|-------------|------------|------------------|------------|
| **For**     |       | 17,426,194       |       |
| **Against** |       | 148,586          |       |
| **Abstain** |       | 38,471           |       |

 

**ITEM5.  OTHER INFORMATION**

 

None.

 

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**ITEM 6.  EXHIBITS**

 

Thefollowing exhibits are filed herewith or are incorporated by reference to thelocation 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                     |       | 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*                     |
| * *                | * *   | * *                                                                                                                                                                                                                         | * *   | * *                                                                                                                                                                       |
| 3.3                     |       | 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*             |
| * *                | * *   | * *                                                                                                                                                                                                                         | * *   | * *                                                                                                                                                                       |
| 3.4                     |       | 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* |
| * *                | * *   | * *                                                                                                                                                                                                                         | * *   | * *                                                                                                                                                                       |
| 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*               |
| * *                | * *   | * *                                                                                                                                                                                                                         | * *   | * *                                                                                                                                                                       |
| 4.2                     |       | Amended and Restated Rights Agreement, dated as of May 10, 2004,  by and between the registrant and U.S. Stock Transfer Corporation, including  exhibits thereto                                                            | * *   | *Exhibit 99.1 to the registrant’s  Registration Statement on Form 8-A/A as filed with the SEC on June 18,  2004*                                           |
|                    |       |                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                       |
| 10.1+                   |       | Cooperative Agreement for Development, Manufacture, Marketing and  Sale of Products to the Class 1 and Class 2 Vehicle Markets Incorporating  Iteris' LDWS Technology between the Company and Valeo Schalter and Sensoren  GmbH. | * *   | *Exhibit 10.1 to the registrant's Quarterly Report  on Form 10-Q for the quarter ended June 30, 2004 as filed with the SEC on  August 16, 2004*                                |
| * *                | * *   | * *                                                                                                                                                                                                                         | * *   | * *                                                                                                                                                                       |
| 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 Financial 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*                                                                                                                                                               |

----

+ Confidential treatment has been requested for certain confidentialportions of this exhibit pursuant to Rule 24b-2 of the Securities Exchange Actof 1934, as amended.  In accordance withRule 24b-2, these confidential portions have been omitted from the exhibit andfiled separately with the SEC.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
| Dated: November 9, 2005 | ITERIS, INC. |
|------------------------------|--------------|
|                         | (Registrant) |
|                         |         |
|                         | By           | /s/ JACK JOHNSON |   |
|                         |         | Jack Johnson |
|                         |         | 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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