** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

** **

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**Form 10-Q**

** **
| **(Mark****One)**                                           |
|-------------------------------------------------------------|
| ** **                                                  | ** ** | ** ** |
| **x**                                                       | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13  OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
| ** **                                                  | ** ** | ** ** |
| **For the quarterly period ended September 30,  2007** |
| ** **                                                  | ** ** | ** ** |
| **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.**

(Exactname of registrant as specified in its charter)

 

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

 

**(949)**270-9400

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

** **

**1515 S. Manchester Ave., Anaheim, CA  92802 (Former address)**

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

 

**Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934, as amended (the “Exchange Act”), during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.**

** **

**Yes **x  No o

** **

**Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):**

** **

**Large acceleratedfiler  **o                                                Acceleratedfiler  o                                 Non-acceleratedfiler  x

** **

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

** **

**Yes **o No x

** **

As of November 7,2007, the registrant had 33,005,398 shares of common stock outstanding.

 

 

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**ITERIS, INC.**

**Quarterly Reporton Form 10-QFor the Three and Six Months Ended September 30, 2007**

** **

**Table of Contents**

** **
| **PART I.**  | ** ** | **FINANCIAL INFORMATION**                                                                                                           | ** ** | ** ** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|              |       |                                                                                                                                |       |       |
| **ITEM 1.**       | ** ** | **FINANCIAL STATEMENTS**                                                                                                            | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **CONDENSED CONSOLIDATED  BALANCE SHEETS AT SEPTEMBER 30, 2007 AND MARCH 31, 2007**                                       | ** ** | ** ** |
| ** **        | ** ** | ** **                                                                                                                          | ** ** | ** ** |
| ** **        | ** ** | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED SEPTEMBER 30,  2007 AND 2006** | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED SEPTEMBER 30,  2007 AND 2006**           | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **NOTES TO UNAUDITED CONDENSED  CONSOLIDATED FINANCIAL STATEMENTS**                                                                 | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| **ITEM 2.**       | ** ** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**                                     | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| **ITEM 3.**       | ** ** | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                                                     | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| **ITEM 4.**       | ** ** | **CONTROLS AND  PROCEDURES**                                                                                                        | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| **PART II.** | ** ** | **OTHER INFORMATION**                                                                                                               | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| **ITEM 1.**       | ** ** | **LEGAL PROCEEDINGS**                                                                                                               | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| **ITEM 1A.**      | ** ** | **RISK FACTORS**                                                                                                                    | ** ** | ** ** |
| ** **        | ** ** | ** **                                                                                                                          | ** ** | ** ** |
| **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 otherwise indicated in this report,the “Company,” “we,” “us” and “our” collectively refer to Iteris, Inc. andits former subsidiary, Meyer, Mohaddes Associates, Inc., which wasdissolved effective April 2006.

 

AutoVue®, Iteris®, Vantage® and eAccessTM are among the trademarks of Iteris, Inc.Any other trademarks or trade names mentioned herein are the property of theirrespective owners.

 

2

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**PART I. FINANCIALINFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS**

** **

**ITERIS,INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(Inthousands, except per share amounts)**

** **
| ** **                                                                                                                                                                                           | ** ** | **September 30,  2007** | ** ** | **March 31,  2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                                           | ** ** | **(unaudited)**              | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                                                                                           |       |                         |       |                     |       |
| Current  assets:                                                                                                                                                                                     |       |                         |       |                     |       |
| Cash and  cash equivalents                                                                                                                                                                           | ** ** | **$**                        | **55**     |                     | $          | 35 |   |
| Trade accounts  receivable, net of allowance for doubtful accounts of $758 and $664 at September 30,  2007 and March 31, 2007, respectively                                                | ** ** | **13,193**                   | ** ** | 11,493                   |       |
| Costs and  estimated earnings in excess of billings on uncompleted contracts                                                                                                                         | ** ** | **5,344**                    | ** ** | 3,689                    |       |
| Inventories,  net of reserve for inventory obsolescence of $842 and $844 at September 30,  2007 and March 31, 2007, respectively                                                           | ** ** | **4,846**                    | ** ** | 6,379                    |       |
| Deferred  income taxes                                                                                                                                                                               | ** ** | **582**                      | ** ** | 494                      |       |
| Prepaid  expenses and other current assets                                                                                                                                                           | ** ** | **509**                      | ** ** | 385                      |       |
| Total  current assets                                                                                                                                                                                | ** ** | **24,529**                   | ** ** | 22,475                   |       |
| Property and  equipment, net                                                                                                                                                                         | ** ** | **3,486**                    | ** ** | 1,712                    |       |
| Deferred  income taxes                                                                                                                                                                               | ** ** | **2,612**                    | ** ** | 2,533                    |       |
| Intangible  assets, net                                                                                                                                                                              | ** ** | **331**                      | ** ** | 404                      |       |
| Goodwill                                                                                                                                                                                             | ** ** | **27,774**                   | ** ** | 27,774                   |       |
| Other assets                                                                                                                                                                                         | ** ** | **411**                      | ** ** | 352                      |       |
| Total assets                                                                                                                                                                                         | ** ** | **$**                        | **59,143** | ** **               | $          | 55,250 |   |
|                                                                                                                                                                                                 |       |                         | ** ** |                     |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                       | ** ** | ** **                   | ** ** | ** **               | ** ** |
| Current  liabilities:                                                                                                                                                                                |       |                         | ** ** |                     |       |
| Trade  accounts payable                                                                                                                                                                              | ** ** | **$**                        | **3,533**  | ** **               | $          | 3,542 |   |
| Accrued  payroll and related expenses                                                                                                                                                                | ** ** | **3,284**                    | ** ** | 3,527                    |       |
| Accrued  liabilities                                                                                                                                                                                 | ** ** | **2,262**                    | ** ** | 1,618                    |       |
| Billings in  excess of costs and estimated earnings on uncompleted contracts                                                                                                                         | ** ** | **1,121**                    | ** ** | 847                      |       |
| Revolving  line of credit                                                                                                                                                                            | ** ** | **2,521**                    | ** ** | 4,015                    |       |
| Current  portion of long-term debt                                                                                                                                                                   | ** ** | **986**                      | ** ** | 1,947                    |       |
| Total  current liabilities                                                                                                                                                                           | ** ** | **13,707**                   | ** ** | 15,496                   |       |
| Deferred  rent                                                                                                                                                                                       | ** ** | **1,842**                    | ** ** | —                   |       |
| Deferred  compensation plan liability                                                                                                                                                                | ** ** | **379**                      | ** ** | 730                      |       |
| Other  non-current liabilities                                                                                                                                                                       | ** ** | **119**                      | ** ** | 163                      |       |
| Long-term  debt                                                                                                                                                                                      | ** ** | **9,528**                    | ** ** | 9,760                    |       |
| Total  liabilities                                                                                                                                                                                   | ** ** | **25,575**                   | ** ** | 26,149                   |       |
| Commitments  and contingencies                                                                                                                                                                       |       |                         | ** ** |                     |       |
| Redeemable  common stock, none issued and outstanding at September 30, 2007 and  1,219 shares issued and outstanding at March 31, 2007                                                     | ** ** | **—**                   | ** ** | 3,414                    |       |
| Stockholders’  equity:                                                                                                                                                                          |       |                         | ** ** |                     |       |
| Preferred  stock, $1.00 par value, 2,000 shares authorized, none issued and outstanding  at September 30, 2007 and March 31, 2007                                                          | ** ** | **—**                   | ** ** | —                   |       |
| Common  stock, $0.10 par value, 70,000 and 50,000 shares authorized, 32,945 and  30,601 shares issued or issuable and outstanding, at September 30, 2007  and March 31, 2007, respectively | ** ** | **3,315**                    | ** ** | 3,060                    |       |
| Additional  paid-in capital                                                                                                                                                                          | ** ** | **134,822**                  | ** ** | 130,425                  |       |
| Common stock  held in trust, 167 and 311 shares at September 30, 2007 and March 31,  2007, respectively                                                                                    | ** ** | **(202**                     | **)**      | (374                     | )          |
| Notes  receivable from employees                                                                                                                                                                     | ** ** | **—**                   | ** ** | (5                       | )          |
| Accumulated  deficit                                                                                                                                                                                 | ** ** | **(104,396**                 | **)**      | (107,438                 | )          |
| Accumulated  other comprehensive income                                                                                                                                                              | ** ** | **29**                       | ** ** | 19                       |       |
| Total  stockholders’ equity                                                                                                                                                                     | ** ** | **33,568**                   | ** ** | 25,687                   |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                     | ** ** | **$**                        | **59,143** | ** **               | $          | 55,250 |   |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

3

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**ITERIS, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
| ** **                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net sales  and contract revenues:          |       |                                                 |       |                                               |       |   |   |   |   |
| Net sales                                  | ** ** | **$**                                                | **10,795** | ** **                                         | $          | 9,323 |   | **$** | **21,039** | ** ** | $ | 17,923 |   |
| Contract  revenues                         | ** ** | **6,181**                                            | ** ** | 5,143                                              |       | **11,694** | ** ** | 10,359 |   |
| Total net  sales and contract revenues     | ** ** | **16,976**                                           | ** ** | 14,466                                             |       | **32,733** | ** ** | 28,282 |   |
|                                       |       |                                                 | ** ** |                                               |       |   | ** ** |   |   |
| Costs of net  sales and contract revenues: |       |                                                 | ** ** |                                               |       |   | ** ** |   |   |
| Cost of net  sales(a)                      | ** ** | **5,496**                                            | ** ** | 5,296                                              |       | **10,671** | ** ** | 10,054 |   |
| Cost of  contract revenues(a)              | ** ** | **4,218**                                            | ** ** | 3,213                                              |       | **7,706** | ** ** | 6,552 |   |
| Gross profit                               | ** ** | **7,262**                                            | ** ** | 5,957                                              |       | **14,356** | ** ** | 11,676 |   |
| Operating  expenses:                       |       |                                                 | ** ** |                                               |       |   | ** ** |   |   |
| Selling,  general and administrative(a)    | ** ** | **4,321**                                            | ** ** | 3,985                                              |       | **8,779** | ** ** | 7,986 |   |
| Research and  development(a)               | ** ** | **627**                                              | ** ** | 771                                                |       | **1,621** | ** ** | 1,774 |   |
| Deferred  compensation plan                | ** ** | **(22**                                              | **)**      | 34                                                 |       | **9** | ** ** | (32 | ) |
| Amortization  of intangible assets         | ** ** | **36**                                               | ** ** | 37                                                 |       | **73** | ** ** | 73 |   |
| Total  operating expenses                  | ** ** | **4,962**                                            | ** ** | 4,827                                              |       | **10,482** | ** ** | 9,801 |   |
| Operating  income                          | ** ** | **2,300**                                            | ** ** | 1,130                                              |       | **3,874** | ** ** | 1,875 |   |
| Non-operating  income (expense):           |       |                                                 | ** ** |                                               |       |   | ** ** |   |   |
| Other income  (expense), net               | ** ** | **25**                                               | ** ** | 45                                                 |       | **44** | ** ** | (645 | ) |
| Interest  expense, net                     | ** ** | **(369**                                             | **)**      | (424                                               | )          | **(732** | **)** | (810 | ) |
| Income  before income taxes                | ** ** | **1,956**                                            | ** ** | 751                                                |       | **3,186** | ** ** | 420 |   |
| Income tax  benefit (provision)            | ** ** | **214**                                              | ** ** | (19                                                | )          | **80** | ** ** | 591 |   |
| Net income                                 | ** ** | **$**                                                | **2,170**  | ** **                                         | $          | 732 |   | **$** | **3,266** | ** ** | $ | 1,011 |   |
|                                       |       |                                                 | ** ** |                                               |       |   | ** ** |   |   |
| Earnings per  share:                       |       |                                                 | ** ** |                                               |       |   | ** ** |   |   |
| Basic                                      | ** ** | **$**                                                | **0.07**   | ** **                                         | $          | 0.03 |   | **$** | **0.10** | ** ** | $ | 0.04 |   |
| Diluted                                    | ** ** | **$**                                                | **0.06**   | ** **                                         | $          | 0.02 |   | **$** | **0.09** | ** ** | $ | 0.03 |   |
| Weighted  average shares outstanding:      |       |                                                 | ** ** |                                               |       |   | ** ** |   |   |
| Basic                                      | ** ** | **32,702**                                           | ** ** | 28,882                                             |       | **32,396** | ** ** | 28,637 |   |
| Diluted                                    | ** ** | **34,518**                                           | ** ** | 33,020                                             |       | **34,383** | ** ** | 32,694 |   |

 

----

| (a) Includes  stock-based compensation expense as follows: |       |   |   |   |       |    |       |   |    |
|-----------------------------------------------------------------|------------|--------|--------|--------|------------|---------|------------|--------|---------|
| Cost of net  sales                                              | ** ** | **$**  | **1**  |   | $          | 4       | ** ** | **$**  | **2**   |   | $ | 9 |   |
| Cost of  contract revenues                                      | ** ** | **3**  |   | 19     | ** ** | **6**   |       | 48     |    |
| Selling,  general and administrative expense                    | ** ** | **54** |   | 5      | ** ** | **113** |       | 59     |    |
| Research and  development expense                               | ** ** | **1**  |   | 46     | ** ** | **4**   |       | 58     |    |
| Total                                                           | ** ** | **$**  | **59** |   | $          | 74      | ** ** | **$**  | **125** |   | $ | 174 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

4

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**ITERIS, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(In thousands)**

** **
| ** **                                                                         | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                         | ** ** | **2007**                                           | ** ** | **2006** | ** ** |
| **Cash flows from operating activities**                       |       |                                               |       |   |   |
| Net income                                                                         | ** ** | **$**                                              | **3,266**  | ** ** | $ | 1,011 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                                               | ** ** |   |   |
| Change in  deferred tax assets                                                     | ** ** | **(167**                                           | **)**      | (628 | ) |
| Depreciation  and amortization of property and equipment                           | ** ** | **291**                                            | ** ** | 278 |   |
| Stock-based  compensation expense                                                  | ** ** | **125**                                            | ** ** | 174 |   |
| Amortization  of deferred gain on sale—leaseback transaction                  | ** ** | **(165**                                           | **)**      | (142 | ) |
| Amortization  of debt discount                                                     | ** ** | **104**                                            | ** ** | 104 |   |
| Amortization  of intangible assets                                                 | ** ** | **73**                                             | ** ** | 73 |   |
| Amortization  of deferred financing costs                                          | ** ** | **69**                                             | ** ** | 69 |   |
| Issuance of  warrants for services                                                 | ** ** | **—**                                         | ** ** | 21 |   |
| Changes in  operating assets and liabilities:                                      |       |                                               | ** ** |   |   |
| Accounts  receivable                                                               | ** ** | **(1,700**                                         | **)**      | (1,036 | ) |
| Net costs  and estimated earnings in excess of billings                            | ** ** | **(1,381**                                         | **)**      | (388 | ) |
| Inventories                                                                        | ** ** | **1,533**                                          | ** ** | (1,978 | ) |
| Prepaid  expenses and other assets                                                 | ** ** | **(252**                                           | **)**      | (158 | ) |
| Accounts  payable and accrued liabilities                                          | ** ** | **225**                                            | ** ** | 2,735 |   |
| Net cash  provided by operating activities                                         | ** ** | **2,021**                                          | ** ** | 135 |   |
|                                                                               |       |                                               | ** ** |   |   |
| **Cash  flows from investing activities**                                          |       |                                               | ** ** |   |   |
| Purchases of  property and equipment                                               | ** ** | **(293**                                           | **)**      | (240 | ) |
|                                                                               |       |                                               | ** ** |   |   |
| **Cash  flows from financing activities**                                          |       |                                               | ** ** |   |   |
| Net payments  on line of credit                                                    | ** ** | **(1,494**                                         | **)**      | (2,085 | ) |
| Payments on  long-term debt                                                        | ** ** | **(1,297**                                         | **)**      | (666 | ) |
| Change in  checks drawn in excess of available bank balances                       | ** ** | **143**                                            | ** ** | 81 |   |
| Proceeds  from stock option and warrant exercises                                  | ** ** | **940**                                            | ** ** | 2,663 |   |
| Net cash  used in financing activities                                             | ** ** | **(1,708**                                         | **)**      | (7 | ) |
| Increase  (decrease) in cash                                                       | ** ** | **20**                                             | ** ** | (112 | ) |
| Cash at  beginning of period                                                       | ** ** | **35**                                             | ** ** | 131 |   |
| Cash at end  of period                                                             | ** ** | **$**                                              | **55**     | ** ** | $ | 19 |   |
|                                                                               |       |                                               | ** ** |   |   |
| **Supplemental  cash flow information:**                                           | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Cash paid  during the period:                                                      |       |                                               | ** ** |   |   |
| Interest                                                                           | ** ** | **$**                                              | **590**    | ** ** | $ | 637 |   |
| Income taxes                                                                       | ** ** | **48**                                             | ** ** | — |   |
| ** **                                                                         | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| **Supplemental  schedule of non-cash investing and financing activities:**    | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Conversion  of redeemable common stock to common stock                             | ** ** | **$**                                              | **3,414**  | ** ** | $ | — |   |
| Lease  incentives in connection with new headquarters lease                        | ** ** | **1,772**                                          | ** ** | — |   |
| Fair value  of common stock issued in settlement of liabilities                    | ** ** | **350**                                            | ** ** | 213 |   |
| Write-off of  notes receivable from employees                                      | ** ** | **(5**                                             | **)**      | — |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

5

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**ITERIS, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**September 30,2007**

** **

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

 

**Description of Business**

 

Iteris, Inc. is a leader in the trafficmanagement market and focuses on the development and application of advancedtechnologies that reduce traffic congestion, minimize the environmental impactof traffic congestion and improve the safety of surface transportation systems.By combining outdoor image processing, traffic engineering and informationtechnology, the Company offers a broad range of Intelligent TransportationSystems and driver safety solutions to customers worldwide. The Company wasoriginally incorporated in Delaware in 1987. On October 22, 2004, theCompany 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.

 

**Basis of Presentation**

 

The unaudited condensed consolidatedfinancial statements of the Company have been prepared in accordance withaccounting principles generally accepted in the United States for interimfinancial information and with the instructions to Securities and ExchangeCommission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. Inthe opinion of management, the accompanying unaudited condensed consolidatedfinancial statements contain all adjustments, consisting of normal recurringadjustments, necessary to present fairly the consolidated financial position ofthe Company as of September 30, 2007, the consolidated results ofoperations for the three and six months ended September 30, 2007 and 2006,and the consolidated cash flows for the six months ended September 30,2007 and 2006. Certain information and footnote disclosures normally includedin financial statements prepared in accordance with accounting principlesgenerally accepted in the United States (“U.S. GAAP”) have been condensed oromitted pursuant to the rules and regulations of the SEC. The results ofoperations for the three and six months ended September 30, 2007 are notnecessarily indicative of those to be expected for the entire year. Theaccompanying unaudited condensed consolidated financial statements should beread in conjunction with the Company’s Annual Report on Form 10-K for theyear ended March 31, 2007, which was filed with the SEC on June 21,2007.

 

# **Use ofEstimates**

#  

The preparation of consolidated financialstatements in conformity with U.S. GAAP requires management to make certain estimatesand assumptions that affect the reported amounts of assets and liabilities,disclosures of contingent assets and liabilities at the date of the financialstatements, and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates. Significantestimates made in the preparation of the consolidated financial statementsinclude the allowance for doubtful accounts, deferred tax assets, inventory andwarranty reserves, costs to complete long-term contracts, overhead rates 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.

 

**Reclassifications**

** **

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

 

# **RevenueRecognition**

#  

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

 

6

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

 

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 fee revenues are recognized evenly over the periodin which they are earned. Non-recurring contract engineering revenues arerecognized in the period in which the related services are performed. Royaltyrevenues are recorded in the period in which the royalty is earned, based onunit sales of the Company’s products. Technology access fee revenues, contractengineering revenues and royalty revenues are included in net sales in theaccompanying condensed consolidated statements of operations.

 

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

 

**Concentration of Credit Risk**

 

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

 

**Fair Values of Financial Instruments**

 

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

 

# **Inventories**

#  

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

 

**Property and Equipment**

 

Property and equipment are recorded at costand are generally depreciated using the straight-line method over the estimateduseful life ranging from three to eight years. Leasehold improvements aredepreciated over the term of the related lease or the estimated useful life ofthe improvement, whichever is shorter.

 

**Goodwill and Long-Lived Assets**

 

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

 

7

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

 

**Income Taxes**

 

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

 

## **Stock-Based Compensation**

##  

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

 

**Research and Development Expenditures**

 

Research and development expenditures arecharged to expense in the period in which they are incurred.

 

**Shipping and Handling Costs**

 

Shipping and handling costs are included incost of sales in the period during which products ship.

 

**Sales Taxes**

 

Sales taxes are presented on a net basis(excluded from net sales and contract revenues) in the unaudited condensedconsolidated statements of operations.

 

**Warranty**

 

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

 

**Repair and Maintenance Costs**

 

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

 

**Other Comprehensive Income**

 

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

 

8

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**Recent Accounting Pronouncements**

 

In July 2006, theFinancial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*(“FIN 48”). FIN 48 applies to all tax positions accounted for under SFAS 109,and defines the confidence level that a tax position must meet in order to berecognized in the financial statements. The interpretation requires that thetax effects of a position be recognized only if it is “more-likely-than-not” tobe sustained by the taxing authority as of the reporting date. If a taxposition is not considered “more-likely-than-not” to be sustained then nobenefits of the position are to be recognized. FIN 48 requires additionaldisclosures and is effective as of the beginning of the first fiscal yearbeginning after December 15, 2006. As further discussed in Note 4, theCompany adopted FIN 48 effective April 1, 2007.

 

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements* (“SFAS 157”),which defines fair value, establishes a framework for measuring fair value, andexpands disclosure about fair value measurements. SFAS 157 does not require anynew fair value measurements; rather it specifies valuation methods to beapplied when fair value measurements are required under existing or futureaccounting pronouncements. SFAS 157 is effective for fiscal years beginningafter November 15, 2007 and interim periods within those fiscal years.Early application of the statement is encouraged. Generally, this statementwill be applied prospectively. The Company is currently evaluating the impactof SFAS 157 and expects to adopt SFAS 157 in the first quarter of its fiscalyear ending March 31, 2009.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities — Including an Amendment of FASB Statement No. 115*(“SFAS 159”). SFAS 159 permits entities to choose to measure many financialinstruments and certain other items at fair value. Unrealized gains and losseson items for which the fair value option has been elected will be recognized inearnings at each subsequent reporting date. SFAS 159 is effective for financialstatements issued for fiscal years beginning after November 15, 2007. TheCompany is evaluating the impact that the adoption of SFAS 159 will have on itsresults of operations and financial condition and expects to adopt SFAS 159 inits fiscal year ending March 31, 2009.

 

**2. Supplemental Financial Information**

 

**Inventories**

 

The following tablepresents details of the Company’s inventories:

 
| ** **              | ** ** | **September 30,  2007** | ** ** | **March 31,  2007** | ** ** |
|-------------------------|------------|------------------------------|------------|--------------------------|------------|
| ** **              | ** ** | **(In thousands)**      | ** ** |
| Materials  and supplies | ** ** | **$**                        | **3,838**  |                     | $          | 4,705 |   |
| Work in  process        | ** ** | **195**                      |       | 366                      |       |
| Finished  goods         | ** ** | **813**                      |       | 1,308                    |       |
| ** **              |       | **$**                        | **4,846**  |                     | $          | 6,379 |   |

 

**Intangible Assets**

 
| ** **            | ** ** | **September 30, 2007** | ** ** | **March 31, 2007**  | ** ** |
|-----------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **            | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **            | ** ** | **(In thousands)**     | ** ** |
| Developed  technology | ** ** | **$**                       | **495**    | ** **                    | **$**      | **(331** | **)** | $ | 495 |   | $ | (280 | ) |
| Patents               | ** ** | **317**                     | ** ** | **(150**                      | **)**      | 317 |   | (128 | ) |
| Total                 | ** ** | **$**                       | **812**    | ** **                    | **$**      | **(481** | **)** | $ | 812 |   | $ | (408 | ) |

 

9

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Amortization expense for intangible assets subject to amortization was$36,000 and $73,000 for the three and six months ended September 30, 2007,respectively, and $37,000 and $73,000 for the three and six months ended September 30,2006, respectively. Future estimated amortization expense for the remainder ofthe current fiscal year and the next four fiscal years is as follows:

 
| **Fiscal Year Ending March 31:** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| 2008                                                 |       | $          | 74         |   |
| 2009                                                 |       | 147        |       |
| 2010                                                 |       | 58         |       |
| 2011                                                 |       | 46         |       |
| 2012                                                 |       | 6          |       |
|                                                 |       | $          | 331        |   |

 

**Warranty Reserve Activity**

 

The following table presents activity in accrued warrantyobligations:

 
| ** **                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                          | ** ** | **(In thousands)**                              | ** ** |
| Balance at  beginning of period     | ** ** | **$**                                                | **569**    |                                               | $          | 590 | ** ** | **$** | **520** |   | $ | 519 |   |
| Additions  charged to cost of sales | ** ** | **45**                                               |       | 155                                                | ** ** | **144** |   | 290 |   |
| Warranty  claims                    | ** ** | **(125**                                             | **)**      | (66                                                | )          | **(175** | **)** | (130 | ) |
| Balance at  end of period           | ** ** | **$**                                                | **489**    |                                               | $          | 679 | ** ** | **$** | **489** |   | $ | 679 |   |

 

**Earnings Per Share**

 

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

 
| ** **                                                   | ** ** | **Three Months Ended  September 30,**                  | ** ** | **Six Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                                              | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                   |       |                                                                  |       |                                               |       |   |   |   |   |
| Net income                                                   | ** ** | **$**                                                                 | **2,170**  |                                               | $          | 732 | ** ** | **$** | **3,266** |   | $ | 1,011 |   |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Denominator:                                                 |       |                                                                  |       |                                               |       |   |   |   |   |
| Weighted average common shares used in  basic computation    | ** ** | **32,702**                                                            |       | 28,882                                             | ** ** | **32,396** |   | 28,637 |   |
| Dilutive stock options                                       | ** ** | **1,798**                                                             |       | 3,550                                              | ** ** | **1,963** |   | 3,484 |   |
| Dilutive warrants                                            | ** ** | **18**                                                                |       | 588                                                | ** ** | **24** |   | 573 |   |
| Weighted average common shares used in dilutive  computation | ** ** | **34,518**                                                            |       | 33,020                                             | ** ** | **34,383** |   | 32,694 |   |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Earnings per share:                                          |       |                                                                  |       |                                               |       |   |   |   |   |
| Basic                                                        | ** ** | **$**                                                                 | **0.07**   |                                               | $          | 0.03 | ** ** | **$** | **0.10** |   | $ | 0.04 |   |
| Diluted                                                      | ** ** | **$**                                                                 | **0.06**   |                                               | $          | 0.02 | ** ** | **$** | **0.09** |   | $ | 0.03 |   |

 

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

 
| ** **              | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(In thousands)**                              | ** ** |
| Stock  options          | ** ** | **632**                                              |       | 568                                                | ** ** | **650** |   | 547 |   |
| Warrants                | ** ** | **1,190**                                            |       | 1,200                                              | ** ** | **1,190** |   | 1,290 |   |
| Convertible  debentures | ** ** | **2,729**                                            |       | 2,729                                              | ** ** | **2,729** |   | 2,729 |   |

 

10

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**3. Revolving Line of Credit and Long-TermDebt**

 

**RevolvingLine of Credit**

 

In October 2006, theCompany entered into a two-year credit facility with a bank. At September 30,2007, the facility provided for combined line of credit and bank term noteborrowings of up to $8.0 million. Under the credit facility, the Company mayborrow against its eligible accounts receivable and eligible inventory, asdefined in the credit agreement. Line of credit interest on borrowed amounts ispayable monthly at the current stated prime rate plus 1.25% (9.00% at September 30,2007). Additionally, the Company is obligated to pay an unused line fee of0.25% per annum applied to the amount by which the maximum credit amountexceeds the average daily principal balance during the preceding month. Thecredit facility requires $2,000 in monthly collateral management fees andincludes an early termination fee equal to 2% of the total facility during thefirst year of the agreement and 1% of the total facility in the second year ofthe agreement. The credit facility is secured by substantially all of theassets of the Company.

 

In October 2007, theCompany and its bank amended the credit facility to allow for borrowings on theline of credit of up to $10.0 million, adjust the interest rate on the line ofcredit to the current stated prime rate plus 1.00%, and fix the annual interestrate on the bank term note at 8.75%. The Company paid a commitment fee of$50,000 in connection with amending the credit facility.

 

On September 30,2007, the available credit under the credit facility was $8.0 million, of which$4.5 million was unused.

 

**Long-TermDebt**

 

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

 
| ** **                   | ** ** | **September 30,  2007** | ** ** | **March 31,  2007** | ** ** |
|------------------------------|------------|------------------------------|------------|--------------------------|------------|
| ** **                   | ** ** | **(In thousands)**      | ** ** |
| ** **                   | ** ** | ** **                   | ** ** | ** **               | ** ** |
| Convertible  debentures, net | ** ** | **$**                        | **9,514**  |                     | $          | 9,410 |   |
| Bank term  note              | ** ** | **944**                      |       | 1,573                    |       |
| Promissory  note to landlord | ** ** | **—**                   |       | 646                      |       |
| Other                        | ** ** | **56**                       |       | 78                       |       |
| ** **                   |       | **10,514**                   |       | 11,707                   |       |
| Less current  portion        | ** ** | **(986**                     | **)**      | (1,947                   | )          |
| ** **                   |       | **$**                        | **9,528**  |                     | $          | 9,760 |   |

 

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

 

The debentures are due infull on May 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, 2008, until the maturity date, theCompany may redeem the debentures at 110% of the principal amount. As of September 30,2007, $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, 2007.

 

*Bank Term Note.*InOctober 2004, the Company entered into a $5.0 million term note payablewith a bank. The note was due on May 27, 2008, and provided for monthlyprincipal payments of approximately $104,000. In October 2006, the termnote was assumed by the Company’s new bank as part of the Company’s $8.0million credit facility. The new term note is also due on May 27, 2008 andprovides for monthly principal payments of approximately $104,000. At September 30,2007, interest accrued under the new term note at the current stated prime rateplus 1.25% (9.00% at September 30, 2007); however, in October 2007,the interest rate became fixed at 8.75%.

 

Both the bank term noteand the line of credit are held by one bank under the same credit agreement andare secured by substantially all of the assets of the Company.

 

11

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*Promissory Note to Landlord.*TheCompany had an unsecured promissory note payable to the landlord of itsprevious headquarters. Under the terms of the note agreement, interest waspayable quarterly and accrued at a rate of prime plus 2.0%. In October 2006,January 2007, April 2007 and July 2007, the Company made fourrequired equal quarterly principal payments of $323,000. As of September 30,2007, all interest and principal under this note was paid in full.

 

Scheduled aggregatematurities of long-term debt principal as of September 30, 2007 were asfollows:

 
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| 2008                                                 | ** ** | **$**      | **651**    | ** ** |
| 2009                                                 | ** ** | **349**    | ** ** |
| 2010                                                 | ** ** | **9,850**  | ** ** |
| ** **                                           | ** ** | **10,850** | ** ** |
| Less:  unamortized debt discount                     | ** ** | **(336**   | **)**      |
| ** **                                           | ** ** | **$**      | **10,514** | ** ** |

 

**4. Income Taxes**

 

On April 1, 2007,the Company adopted FIN 48. In connection with the adoption of FIN 48, theCompany recognized an adjustment of approximately $224,000 to the beginningbalance of retained earnings on its condensed consolidated balance sheet. TheCompany’s continuing practice is to recognize interest and/or penalties relatedto income tax matters in income tax expense. As of September 30, 2007, theCompany had recorded approximately $45,000 of accrued interest and penaltiesrelated to uncertain tax positions.

 

At April 1, 2007,the Company’s fiscal 2004 through fiscal 2007 tax years remained open toexamination by the Federal taxing authorities. The Company’s fiscal 2003through fiscal 2007 tax years remained open to examination by the state taxingauthorities. However, the Company has consolidated and acquired net operatinglosses (“NOLs”) beginning in fiscal 1995 which would cause the statute oflimitations to remain open for the year in which the NOL was incurred.

 

**5. Commitments and Contingencies**

 

**Litigation and Other Contingencies**

 

On June 29, 2004, asupplier to Mariner Networks, Inc., a former subsidiary of the Companythat was discontinued in the fiscal year ended March 31, 2002, filed acomplaint in Orange County Superior Court against the Company alleging variousbreaches of written contract claims arising out of alleged purchase orders. Theplaintiff in this lawsuit sought monetary damages aggregating approximately$850,000 plus attorney fees and related costs. On July 20, 2006, theCompany entered into a settlement agreement in connection with this matter. Thedispute was settled in full for $688,000 payable as follows:  (i) the Company issued 88,912 shares ofthe Company’s common stock on August 18, 2006 valued at $213,000 based onthe closing sales price of the Company’s common stock on the date of issuance; (ii) theCompany made a cash payment of $125,000 on October 20, 2006; and (iii) theCompany is obligated to pay $350,000 in cash in equal monthly installments of$9,700 over three years beginning in November 2006. In connection withthis settlement, the Company recorded a charge of $635,000, representing thefair value of the settlement, to other expense in the accompanying condensedconsolidated statement of operations for the six months ended September 30,2006.

 

In August 2007, the Company received acomplaint filed by American Signal Company against the Company and six otherdefendants in the United States District Court, Middle District of Louisiana,which alleges negligence and other charges in connection with a contract towhich the Company was a third party engineering service provider. The Companyis reviewing the complaint but does not believe that this matter willultimately have a material adverse effect on its consolidated results ofoperations, financial position or cash flows.

 

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 suchlegal proceedings, the adverse outcome of which, in management’s opinion,individually or in the aggregate, would have a material adverse effect on itsconsolidated results of operations, financial position or cash flows.

 

12

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

 

**Operating Lease Commitments**

 

In May 2007, the Company entered into anagreement to lease 52,000 square feet of space in Santa Ana, California for aterm of 88 months. In September 2007, the Company relocated itsheadquarters and principal operations into this space. The monthly lease rateis $102,000 during the first year of the lease and increases each yearthereafter, up to a maximum of $120,000 during the last year of the lease. Thelease may be extended for a period of five years, at the option of the Company,at a lease rate to be based on the market lease rate for comparable propertydetermined as of the commencement date of the extension period. Additionally,the lease agreement provides for $1.8 million in incentives in the form oftenant improvement allowances, which the Company recorded as deferred rent inits condensed consolidated balance sheet at September 30, 2007. Thisamount will reduce future rent expense over the term of the lease. An equalamount was capitalized as property and equipment in the condensed consolidatedbalance sheet at September 30, 2007, and will be depreciated over theestimated useful life of the related leasehold improvements.

 

The Company has lease commitments forfacilities in various locations throughout the United States. Futurecommitments under these non-cancelable operating leases at September 30,2007 were as follows:

 
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| Remainder of  2008                                   | ** ** | **$**      | **465**    | ** ** |
| 2009                                                 | ** ** | **1,483**  | ** ** |
| 2010                                                 | ** ** | **1,391**  | ** ** |
| 2011                                                 | ** ** | **1,348**  | ** ** |
| 2012                                                 | ** ** | **1,332**  | ** ** |
| Thereafter                                           | ** ** | **3,823**  | ** ** |
| Total                                                | ** ** | **$**      | **9,842**  | ** ** |

 

The Company previouslysubleased office space to MAXxess Systems, Inc. (“MAXxess”), a formersubsidiary of the Company that was sold by the Company in September 2003and is currently owned by an investor group that includes two of the Company’sdirectors, one of which is the Chief Executive Officer of MAXxess. At September 30,2007, MAXxess owed the Company an aggregate of $274,000 related to thissublease and certain related ancillary services that were provided by theCompany to MAXxess. The Company previously had reserved for amounts aggregating$183,000 of this balance due to MAXxess’ inability to pay these obligations. Duringthe three and six months ended September 30, 2007, the Company reservedfor all incremental amounts charged to MAXxess, which aggregated $45,000 and$91,000, respectively. The Company intends to pursue full payment of any andall amounts due from MAXxess under this sublease, which terminated in September 2007.

 

**Inventory Purchase Commitments**

 

At September 30, 2007, the Company had firm commitments topurchase inventory in the amount of $2.8 million during the next two fiscalquarters.

 

**6. Common Stock Warrants**

 

On September 27, 2006, the Companyissued warrants to purchase an aggregate 246,250 shares of common stock at anexercise price of $3.25 with a five year life to an existing stockholder inexchange for the early exercise of warrants to purchase an aggregate of1,250,000 shares of common stock at an exercise price of $1.61 per share. Thenew warrants are immediately exercisable and are callable by the Company if themarket price of the Company’s common stock trades for 20 consecutive days at aprice greater than or equal to two times the exercise price of the warrants. Thefair value of the new warrants was $320,000 calculated using theBlack-Scholes-Merton (“BSM”) option-pricing formula. The warrants wereconsidered a cost of raising capital and were recorded in equity.

 

13

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In connection with the issuance of the newwarrants, the Company is party to a registration rights agreement that containsprovisions under which the Company could be subjected to liquidated damagesshould it fail to maintain effective registration statements for the underlyingshares of common stock. These warrants have been accounted for within equity inthe condensed consolidated balance sheet in accordance with EITF 00-19 *Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock*, and, accordingly, noliabilities have been recorded in connection therewith. As of September 30,2007, no liquidated damages were payable under the provisions of theregistration rights agreement associated with these warrants.

 

**7. Redeemable Common Stock**

 

In connection with the merger of the IterisSubsidiary into the Company (Note 1), on May 28, 2004, the Companyacquired 547,893 shares of common stock of the Iteris Subsidiary in exchangefor the issuance of 1,219,445 shares of the Company’s common stock which wasvalued at $3.4 million at the date of issuance. Beginning on May 28, 2007,the holder of these shares had the right to require the Company to repurchaseup to 100% of the shares at a purchase price of $1.438 per share. All suchrights to require the repurchase of these shares expired on September 28,2007. Because these rights were outside of the control of the Company, theCompany previously had classified the $3.4 million value of the 1,219,445shares as redeemable common stock on its condensed consolidated balance sheet. Uponthe expiration of these rights, the Company reclassified $122,000 to commonstock and $3.3 million to additional paid-in capital on its condensedconsolidated balance sheet at September 30, 2007.

 

**8. Stock-Based Compensation**

 

On September 21,2007, the Company’s shareholders approved the 2007 Omnibus Incentive Plan (the “2007Plan”), which provides that options to purchase shares of the Company’sunissued common stock may be granted to employees, officers, consultants anddirectors to the Company at exercise prices which are equal to or greater thanthe fair market value of the Company’s common stock on the date of grant. Optionsexpire no more than ten years after the date of grant and generally vest at therate of 25% on each of the first four anniversaries of the grant date. The 2007Plan also allows for the issuance of stock appreciation rights, restrictedstock, restricted stock units and other stock-based awards based on the valueof the Company’s common stock. New shares are issued to satisfy stock optionexercises and share issuances under the 2007 Plan. As of September 30,2007, options to purchase an aggregate of 30,000 shares of common stock wereoutstanding under the 2007 Plan.

 

The Company’s 1997 StockIncentive Plan (the “1997 Plan”) expired in September 2007; however, allstock options outstanding under the 1997 Plan will remain outstanding pursuantto the terms of such stock options. As of September 30, 2007, options topurchase 1.5 million shares of the Company’s common stock were outstandingunder the 1997 Plan.

 

In connection with themerger of the Company and the Iteris Subsidiary (Note 1), the Company assumedthe 1998 Stock Incentive Plan of the Iteris Subsidiary (the “1998 Plan”) andall outstanding options granted thereunder. As of September 30, 2007,options to purchase 3.2 million shares of the Company’s common stock wereoutstanding under the 1998 Plan. No further options may be granted under the1998 Plan.

 

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

 

14

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A summary of activity inthe Plans for the six months ended September 30, 2007 is as follows:

 
| ** **                                                                      | ** ** | **Options**                                                           | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Life (In Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Options  outstanding at March 31, 2007                                     |       | 5,818                                                                 |       | $                                      | 1.60       |                                                        | 3.4        |                                | $          | 6,115 |   |
| Granted                                                                         |       | 30                                                                    |       | $                                      | 2.21       |                                                        | N/A        |                                |       |   |
| Exercised                                                                       |       | (1,049                                                                | )          | $                                      | 0.78       |                                                        | N/A        |                                |       |   |
| Forfeited                                                                       |       | (23                                                                   | )          | $                                      | 3.02       |                                                        | N/A        |                                |       |   |
| Expired                                                                         |       | (34                                                                   | )          | $                                      | 3.24       |                                                        | N/A        |                                |       |   |
| Options  outstanding at September 30, 2007                                 |       | 4,742                                                                 |       | $                                      | 1.77       |                                                        | 3.6        |                                | $          | 4,542 |   |
| Vested and  expected to vest at September 30, 2007                         |       | 4,679                                                                 |       | $                                      | 1.76       |                                                        | 3.5        |                                | $          | 4,538 |   |
| Options  exercisable at September 30, 2007                                 |       | 4,379                                                                 |       | $                                      | 1.70       |                                                        | 3.1        |                                | $          | 4,523 |   |
| Options  exercisable at September 30, 2007 pursuant to a change-in-control |       | 4,742                                                                 |       | $                                      | 1.77       |                                                        | 3.6        |                                | $          | 4,542 |   |

 

At September 30,2007, there were 820,000 shares of common stock available for grant under the2007 Plan.

 

For the six month periodsended September 30, 2007 and 2006, the Company received $818,000 and$224,000, respectively, in cash from the exercise of stock options. Totalstock-based compensation expense was $59,000 and $125,000 for the three and sixmonths ended September 30, 2007, respectively, and $74,000 and $174,000for the three and six months ended September 30, 2006, respectively. Noincome tax benefit was realized from activity in the Plans during the sixmonths ended September 30, 2007 and 2006.

 

At September 30,2007, there was $686,000 of total unrecognized compensation expense related tounvested stock options. This expense is expected to be recognized over aweighted-average period of approximately 3.1 years.

 

The fair value of eachstock-based award is estimated on the grant date using the Black-Scholes-Merton(“BSM”) option-pricing formula. Expected volatility is based on the historicalvolatility of the Company’s stock price. The expected life of options grantedsubsequent to the adoption of SFAS 123R is derived based on the historical lifeof the Company’s options. The risk-free interest rate for periods within theexpected life of the option is based on the U.S. Treasury interest rates ineffect at the time of grant. The grant date fair value of options granted wasestimated using the following weighted-average assumptions:

 
| ** **                          | ** ** | **Three Months  Ended September 30,** | ** ** | **Six Months  Ended September 30,** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                          | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                |       |                                            |       |                                          |       |   |   |   |   |
| Dividend yield                      | ** ** | **0.0**                                         |       | 0.0                                           | ** ** | **0.0** |   | 0.0 |   |
| Expected life — years          | ** ** | **7.0**                                         |       | 7.0                                           | ** ** | **7.0** |   | 7.0 |   |
| Risk-free interest rate             | ** ** | **4.3**                                         | **%**      | 4.7                                           | %          | **4.3** | **%** | 4.8 | % |
| Expected volatility of common stock | ** ** | **0.86**                                        |       | 0.89                                          | ** ** | **0.86** |   | 0.89 |   |

 

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

 
| ** **                                            | ** ** | **Three Months  Ended September 30,**                       | ** ** | **Six Months  Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                            | ** ** | **2007**                                                              | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Weighted average grant date fair value per  share     | ** ** | **$**                                                                 | **1.72**   | ** **                                    | **$**      | **2.01** | ** ** | **$** | **1.72** | ** ** | **$** | **1.86** | ** ** |
| Intrinsic value of options exercised                  | ** ** | **$**                                                                 | **230**    | ** **                                    | **$**      | **63** | ** ** | **$** | **1,647** | ** ** | **$** | **225** | ** ** |
| Total fair value of options vested during  the period | ** ** | **$**                                                                 | **130**    | ** **                                    | **$**      | **134** | ** ** | **$** | **176** | ** ** | **$** | **517** | ** ** |

 

15

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**9. Business Segment Information**

 

The Company currentlyoperates in three reportable segments: Roadway Sensors, Vehicle Sensors andTransportation Systems. The Roadway Sensors segment includes the Company’sVantage vehicle detection systems for traffic intersection control,incident detection and certain highway traffic data collection applications. TheVehicle Sensors segment includes AutoVue and is comprised of all activitiesrelated to lane departure warning systems for vehicle safety. TheTransportation Systems segment includes transportation engineering andconsulting 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 of significantaccounting policies. Prior to April 1, 2007, certain expenses, such asinterest, amortization of certain intangibles and certain corporate expenseswere not allocated to the segments. Beginning on April 1, 2007, theCompany increased the portion of its corporate expenses that it allocates toits segments such that substantially all corporate expenses are allocated.Interest, amortization of certain intangibles and certain corporate expensesare still not allocated to the segments. In addition, certain assets, includingcash and cash equivalents, deferred income taxes and certain long-lived andintangible assets, are not allocated to the segments. The reportable segmentsare each managed separately because they manufacture and distribute distinctproducts or provide services with different processes. All segment revenues arederived from external customers.

 

The following table setsforth selected unaudited financial information for the Company’s reportablesegments for the three and six months ended September 30, 2007 and 2006:

 
| ** **                                      | ** ** | **Roadway  Sensors**    | ** ** | **Vehicle  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                      | ** ** | **(In thousands)** | ** ** |
| **Three  Months Ended September 30, 2007** |       |                    |       |                 |       |                        |       |      |       |
| Product  revenue                                |       | $                       | 7,617      |                 | $          | 2,765                       | ** ** | $         | **—** |   | $ | 10,382 |   |
| Service and  other revenue                      |       | —                  |       | 413                  |       | 6,181                       |       | 6,594     |       |
| Stock-based  compensation                       |       | 4                       |       | 11                   |       | 6                           |       | 21        |       |
| Depreciation  and amortization                  |       | 27                      |       | 30                   |       | 35                          |       | 92        |       |
| Segment  income                                 |       | 1,691                   |       | 222                  |       | 433                         |       | 2,346     |       |
|                                            |       |                    |       |                 |       |                        |       |      |       |
| **Three  Months Ended September 30, 2006** |       |                    |       |                 |       |                        |       |      |       |
| Product  revenue                                |       | $                       | 6,961      |                 | $          | 1,658                       | ** ** | $         | **—** |   | $ | 8,619 |   |
| Service and  other revenue                      |       | —                  |       | 704                  |       | 5,143                       |       | 5,847     |       |
| Stock-based  compensation                       |       | 9                       |       | 14                   |       | 23                          |       | 46        |       |
| Depreciation  and amortization                  |       | 20                      |       | 34                   |       | 34                          |       | 88        |       |
| Segment  income (loss)                          |       | 1,592                   |       | (541                 | )          | 684                         |       | 1,735     |       |
|                                            |       |                    |       |                 |       |                        |       |      |       |
| **Six Months  Ended September 30, 2007**   |       |                    |       |                 |       |                        |       |      |       |
| Product  revenue                                |       | $                       | 14,841     |                 | $          | 5,349                       | ** ** | $         | **—** |   | $ | 20,190 |   |
| Service and  other revenue                      |       | —                  |       | 849                  |       | 11,694                      |       | 12,543    |       |
| Stock-based  compensation                       |       | 10                      |       | 24                   |       | 13                          |       | 47        |       |
| Depreciation  and amortization                  |       | 53                      |       | 66                   |       | 66                          |       | 185       |       |
| Segment  income                                 |       | 2,796                   |       | 272                  |       | 977                         |       | 4,045     |       |
|                                            |       |                    |       |                 |       |                        |       |      |       |
| **Six  Months Ended September 30, 2006**   |       |                    |       |                 |       |                        |       |      |       |
| Product  revenue                                |       | $                       | 13,477     |                 | $          | 2,996                       | ** ** | $         | **—** |   | $ | 16,473 |   |
| Service and  other revenue                      |       | —                  |       | 1,450                |       | 10,359                      |       | 11,809    |       |
| Stock-based  compensation                       |       | 28                      |       | 27                   |       | 59                          |       | 114       |       |
| Depreciation  and amortization                  |       | 39                      |       | 68                   |       | 62                          |       | 169       |       |
| Segment  income (loss)                          |       | 3,074                   |       | (1,188               | )          | 1,306                       |       | 3,192     |       |

 

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

 
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                           | ** ** | **(In thousands)**                              | ** ** |
| Total income for reportable segments | ** ** | **$**                                                | **2,346**  |                                               | $          | 1,735 | ** ** | **$** | **4,045** |   | $ | 3,192 |   |
| Unallocated amounts:                 |       |                                                 |       |                                               |       |   |   |   |   |
| Corporate expenses                   | ** ** | **(46**                                              | **)**      | (605                                               | )          | **(171** | **)** | (1,317 | ) |
| Other income (expense), net          | ** ** | **25**                                               | ** ** | 45                                                 |       | **44** | ** ** | (645 | ) |
| Interest expense, net                | ** ** | **(369**                                             | **)**      | (424                                               | )          | **(732** | **)** | (810 | ) |
| Income before income taxes           | ** ** | **$**                                                | **1,956**  | ** **                                         | $          | 751 |   | **$** | **3,186** | ** ** | $ | 420 |   |

 

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**ITEM 2.**                        MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

** **

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

 

**Overview**

 

We are a leader in the traffic management market that focuses on thedevelopment and application of advanced technologies that reduce trafficcongestion, minimize the environmental impact of traffic congestion and improvethe safety of surface transportation systems. By combining outdoor image processing,traffic engineering and information technology, we offer a broad range ofIntelligent Transportation Systems and driver safety solutions to customersworldwide.

 

We currently operate in three reportable segments: Roadway Sensors,Vehicle Sensors and Transportation Systems. The Roadway Sensors segmentincludes our Vantage vehicle detection systems for traffic intersection control,incident detection and certain highway traffic data collection applications. TheVehicle Sensors segment is comprised of all activities related to our AutoVue LaneDeparture Warning (“LDW”) systems for vehicle safety. The TransportationSystems segment includes transportation engineering and consulting services andthe development of transportation management and traveler information systemsfor the ITS industry.

 

Our Vantage product is a video vehicle detection system that detectsthe presence of vehicles on roadways. Vantage systems are used at signalizedintersections to enable a traffic controller to more efficiently allocate greensignal time and are also used for incident detection and highway traffic datacollection applications. We sell and distribute our Vantage products primarilyto commercial customers and municipal agencies.

 

Our AutoVue LDW systems consist of a small windshield mounted sensorthat uses proprietary software to detect and warn drivers of unintended lanedepartures. Approximately 90,000 production AutoVue units have been sold forcar and truck platforms in the North American and European markets. Our AutoVueLDW systems are currently qualified as an option on certain heavy trucks,including Mercedes-Benz, MAN, Iveco, DAF, Scania, Freightliner and FUSO, aswell as Neoplan and MAN luxury bus and coach lines. In North America our LDWsystems are sold primarily to truck fleets, and to date, 51 U.S. heavy truckfleets have selected our LDW systems, representing an estimated 28,000 vehicles.In September 2003, we entered into an agreement with Valeo Schalter andSensuren GmbH (“Valeo”), pursuant to which we granted Valeo the exclusive rightto sell and manufacture our AutoVue LDW systems to the worldwide passenger carmarket in exchange for royalty payments for each AutoVue LDW unit sold. Todate, royalty payments from Valeo have not been significant. Pursuant to thisagreement, we also provide specific contract engineering services, technicalmarketing and sales support to Valeo to enable the incorporation of our LDWtechnology on four Infiniti platforms, the FX, M, Q and EX, where the device isoffered as part of various option packages. Valeo is currently in discussionsto provide our LDW system to other passenger car OEMs; however, we cannotassure you that such discussions will be successful. We plan to continue toprovide technical marketing and sales support to Valeo in our efforts to winnew OEM customers for the passenger car market as well as contract engineeringservices related to the possible launch of new Infiniti platforms that includeour LDW system. We believe that AutoVue is a broad sensor platform that,through additional software development, may be expanded to incorporateadditional safety and convenience features.

 

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Our transportation management systems business includes transportationengineering and consulting services focused on the planning, design,development and implementation of software-based systems that integratesensors, video surveillance, computers and advanced communications equipment toenable public agencies to monitor, control and direct traffic flow, assist inthe quick dispatch of emergency crews and distribute real-time informationabout traffic conditions. Our services include planning, design andimplementation of surface transportation infrastructure systems. We performanalysis and study goods movement, commercial vehicle operations, travel demandforecasting and systems engineering, and identify mitigation measures to reducetraffic congestion. These services and systems are primarily sold to local,state and national transportation agencies in the United States. Ourtransportation management systems business is largely dependent upongovernmental funding and budgetary issues. The Federal Highway Bill that waspassed in August 2005 provided for a significant increase intransportation funding over the following six years. We believe the recentexpansion of our transportation management systems business was due in part tothe passage of the Federal Highway Bill, combined with increased transportationfunds available at state and local agencies throughout the country.

 

**CriticalAccounting Policies and Estimates**

 

Management’s Discussion and Analysis of Financial Condition and Resultsof Operations is based on our unaudited condensed consolidated financialstatements included herein, which have been prepared in accordance with U.Sgenerally accepted accounting principles. The preparation of these financialstatements requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and related disclosures ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period. Onan ongoing basis, we evaluate these estimates and assumptions, including thoserelated to the collectibility of accounts receivable, the valuation ofinventories, the recoverability of long-lived assets and goodwill, therealizability of deferred tax assets, accounting for stock-based compensation,the valuation of equity instruments, warranty reserves and other contingencies.We base these estimates on our 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 or assumptionsare inaccurate in any material respect, it could have a material adverse effecton our reported assets and liabilities at the date of the financial statementsand our reported revenues and expenses during the reporting period.

 

The following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our unaudited condensedconsolidated financial statements.

 

*Revenue Recognition*. We record productrevenues and related costs of sales upon transfer of title, which is generallyupon shipment or, if required, upon acceptance by the customer, provided thatwe believe collectibility of the net sales amount is reasonably assured. Accordingly,at the date revenue is recognized, the significant uncertainties concerning thesale have been resolved.

 

Contract revenues are derived primarily from long-term contracts withgovernmental agencies. Contract revenues include costs incurred plus a portionof estimated fees or profits determined using the percentage of completionmethod of accounting based on the relationship of costs incurred to totalestimated costs. Any anticipated losses on contracts are charged to earningswhen identified. Changes in job performance and estimated profitability,including those arising from contract penalty provisions and final contractsettlements, may result in revisions to recognized costs and revenues and arerecognized in the period in which the revisions are determined. Profitincentives are included in revenue when their realization is reasonablyassured.

 

In addition to product and contract revenues, we derive revenue fromtechnology access fees, the provision of specific non-recurring contractengineering services to our strategic partner, Valeo, related to our AutoVueLDW systems, and royalties earned on unit sales of our AutoVue LDW systems byValeo to the passenger car market. Technology access fee revenues arerecognized evenly over the period in which they are earned. Non-recurringcontract engineering revenues are recognized in the period in which the relatedservices are performed. Royalty revenues are recorded based on unit sales ofour products by Valeo and are recognized in the period in which such salesoccur. Technology access fee revenues, contract engineering revenues androyalty revenues are included in net sales.

 

Revenues from follow-on service and support, for which we generallycharge separately, are recorded in the period in which the services areperformed.

 

18

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*Accounts Receivable*. We estimate thecollectibility of customer receivables on an ongoing basis by periodicallyreviewing invoices outstanding greater than a certain period of time. We recordreserves for receivables deemed to be at risk for collection as well as ageneral reserve based on our historical collections experience. A considerableamount of judgment is required in assessing the ultimate realization of tradereceivables, including the current credit-worthiness of each customer. If thefinancial condition of our customers deteriorates, resulting in an impairmentof their ability to make required payments, additional allowances may berequired that could adversely affect our operating results.

 

*Inventory*. Inventories consist offinished goods, work-in-process and raw materials and are stated at the lowerof cost or market. We provide reserves for potentially excess and obsoleteinventory. In assessing the ultimate realization of inventories, we makejudgments as to future demand requirements and compare that with the current orcommitted inventory levels. Reserves are established for inventory levels thatexceed anticipated future demand. It is possible that reserves over and abovethose already established may be required in the future if market conditionsfor our products deteriorate.

 

*Goodwill*. Goodwill is tested for impairmentannually in our fourth fiscal quarter at the reporting unit level unless achange in circumstances indicates that more frequent impairment analysis isrequired. Impairment, if any, is measured based on the estimated fair value ofthe reporting units with the recorded goodwill. Fair value is determined byusing the income approach methodology of valuation which utilizes discountedcash flows. Significant management judgment is required in the forecasts offuture operating results that are used in the discounted cash flow method ofvaluation. In estimating future cash flows, we generally use the financialassumptions in our current budget and our current strategic plan, subject to modificationas considered necessary, including sales and expense growth rates and thediscount rates we estimate to represent our cost of funds. It is possible,however, that the plans and estimates used may be incorrect. If our actualresults, or the plans and estimates used in future impairment analyses, arelower than the original estimates used to assess the recoverability ofgoodwill, we could incur impairment charges.

 

*Warranty.*We generally provide a one to threeyear warranty from the original invoice date on all products, materials andworkmanship. Defective products are either 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 is recognized. Theaccrued warranty provision is included within accrued expenses on theaccompanying condensed consolidated balance sheets. Should our actualexperience of warranty returns be higher than anticipated, additional warrantyreserves may be required, which may adversely affect our operating results.

 

*Income Taxes.*Werecorded a valuation allowance to reduce our deferred tax assets to amountsthat we believe are more likely than not to be realized. Realization ofdeferred tax assets (such as net operating loss carryforwards) is dependent onfuture taxable earnings and is therefore uncertain. On a quarterly basis, weassess the likelihood that our deferred tax asset balance will be recoveredfrom future taxable income. To the extent we believe that recovery is notlikely, we establish a valuation allowance against our deferred tax asset,increasing our income tax expense in the period such determination is 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 andadjustments to our valuation allowance may create fluctuations in our overalleffective tax rate from quarter to quarter.

 

Effective April 1,2007, we adopted FIN 48, which applies to all tax positions accounted for underSFAS No. 109, *Accounting for IncomeTaxes*, and defines the confidence level that a tax position mustmeet in order to be recognized in the financial statements. FIN 48 requiresthat the tax effects of a position be recognized only if it is “more-likely-than-not”to be sustained by the taxing authority as of the reporting date. If a taxposition is not considered “more-likely-than-not” to be sustained, then nobenefits of the position are to be recognized.

 

*Stock-Based Compensation*. EffectiveApril 1, 2006, we adopted SFAS 123R, which requires all stock-basedpayments, including grants of employee stock options, to be recognized in thestatement of operations as an expense, based on their grant date fair valueswith such fair values amortized over the requisite service period. We electedto utilize the modified prospective method for the transition to SFAS 123R.Under the modified prospective method, SFAS 123R applies to all awards grantedor modified after the date of adoption. In addition, under the modifiedprospective method, compensation expense is recognized for all stock-basedcompensation awards granted prior to but not yet vested as of April 1,2006, based on grant-date fair values estimated in accordance with the originalprovisions of SFAS No. 123, *Accounting for Stock-BasedCompensation*.

 

19

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We use the BSM option-pricing formula to estimate thefair value of stock-based awards granted subsequent to April 1, 2006. Ourassumptions under the BSM formula include the following:  expected volatilities are based on thehistorical volatility of our stock price, the expected life of options isderived based on the historical life of our options, and the risk-free interestrate for periods within the expected life of the option is based on the U.S.Treasury interest rates in effect at the time of grant. Additionally, ourcalculation of stock compensation expense under SFAS 123R includes an estimateof forfeitures based on our historical forfeiture rate. Future stock-basedcompensation expense in any particular quarter or year could be affected bychanges in our assumptions or changes in market conditions.

 

**Resultsof Operations**

 

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

 
| ** **                                | ** ** | **Three Months  Ended September 30,** | ** ** | **Six Months  Ended September 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net sales and contract revenues:          |       |                                            |       |                                          |       |   |   |   |   |
| Net sales                                 | ** ** | **63.6**                                        | **%**      | 64.4                                          | %          | **64.3** | **%** | 63.4 | % |
| Contract revenues                         | ** ** | **36.4**                                        | ** ** | 35.6                                          |       | **35.7** | ** ** | 36.6 |   |
| Total net sales and contract revenues     | ** ** | **100.0**                                       | **%**      | 100.0                                         | %          | **100.0** | **%** | 100.0 | % |
| Costs of net sales and contract revenues: |       |                                            | ** ** |                                          |       |   | ** ** |   |   |
| Cost of net sales                         | ** ** | **32.4**                                        | ** ** | 36.6                                          |       | **32.6** | ** ** | 35.5 |   |
| Cost of contract revenues                 | ** ** | **24.8**                                        | ** ** | 22.2                                          |       | **23.5** | ** ** | 23.2 |   |
| Gross profit                              | ** ** | **42.8**                                        | ** ** | 41.2                                          |       | **43.9** | ** ** | 41.3 |   |
| Operating expenses:                       |       |                                            | ** ** |                                          |       |   | ** ** |   |   |
| Selling, general and administrative       | ** ** | **25.5**                                        | ** ** | 27.5                                          |       | **26.8** | ** ** | 28.2 |   |
| Research and development                  | ** ** | **3.7**                                         | ** ** | 5.3                                           |       | **5.0** | ** ** | 6.3 |   |
| Deferred compensation plan                | ** ** | **(0.1**                                        | **)**      | 0.3                                           |       | **0.0** | ** ** | (0.1 | ) |
| Amortization of intangible assets         | ** ** | **0.2**                                         | ** ** | 0.3                                           |       | **0.2** | ** ** | 0.3 |   |
| Total operating expenses                  | ** ** | **29.2**                                        | ** ** | 33.4                                          |       | **32.0** | ** ** | 34.7 |   |
| Operating income                          | ** ** | **13.5**                                        | ** ** | 7.8                                           |       | **11.8** | ** ** | 6.6 |   |
| Non-operating income (expense):           |       |                                            | ** ** |                                          |       |   | ** ** |   |   |
| Other income (expense), net               | ** ** | **0.1**                                         | ** ** | 0.3                                           |       | **0.1** | ** ** | (2.3 | ) |
| Interest expense, net                     | ** ** | **(2.2**                                        | **)**      | (2.9                                          | )          | **(2.2** | **)** | (2.8 | ) |
| Income before income taxes                | ** ** | **11.5**                                        | ** ** | 5.2                                           |       | **9.7** | ** ** | 1.5 |   |
| Income tax benefit (provision)            | ** ** | **1.3**                                         | ** ** | (0.1                                          | )          | **0.2** | ** ** | 2.1 |   |
| Net income                                | ** ** | **12.8**                                        | **%**      | 5.1                                           | %          | **10.0** | **%** | 3.6 | % |

 

**Analysisof Quarterly Results of Operations**

 

*Net Sales and Contract Revenues*. Net sales are comprised of Roadway Sensors sales, which are derived from salesof our Vantage video detection systems, and Vehicle Sensor sales, which arederived from sales of AutoVue LDW systems, technology access fees, contractengineering revenue and royalty revenue generated from AutoVue relatedactivities.  Contract revenues consist entirely of Transportation Systemsrevenues, which are generated from systems integration and ITS consultingservices with federal, state, county and municipal agencies. We currently havea relatively diverse customer base with our largest customer constituting 6.4%and 6.8% of total net sales and contract revenues in the three and six monthsended September 30, 2007, respectively.

 

Total net sales and contract revenues increased 17.4% to $17.0 millionand 15.7% to $32.7 million for the three and six months ended September 30,2007, respectively, compared to $14.5 million and $28.3 million in thecorresponding periods of the prior fiscal year. This increase was driven byincreased net sales in both the Roadway Sensors and Vehicle Sensors segments,as well as increased contract revenues in the Transportation Systems segment,as discussed below.

 

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Net sales increased 15.8% to $10.8 million and 17.4% to $21.0 millionfor the three and six months ended September 30, 2007, respectively,compared to $9.3 million and $10.4 million in the corresponding periods of theprior fiscal year.

 

Roadway Sensors net sales increased 9.4% to$7.6 million and 10.1% to $14.8 million for the three and six months ended September 30,2007, respectively, versus $7.0 million and $13.5 million in the correspondingperiods of the prior fiscal year. This increase primarily reflects thecontinued adoption of video vehicle detection technology such as the technologyoffered by our Vantage line of products both domestically and internationally. Additionally,we continue to believe that the current increased rate of adoption has to someextent been due to increased government spending on traffic initiatives, whichwe believe has been at least partially made possible by the passage of theFederal Highway Bill in August 2005, as well as expanded sales andmarketing efforts, particularly in North America. Our Roadway Sensors segmentrelies heavily on our network of dealers to market and sell our Vantageproducts into the marketplace. Historically sales of our products through agiven dealer can fluctuate significantly from period to period. In fiscal 2008,we have experienced a decline in sales at our largest customer. We anticipatethat this decline in net sales to our largest customer could continue andcannot assure you that we will be able to offset this decline in net sales withincreased net sales to other customers or in other regions.

 

Beginning on approximately October 26,2007, southern California experienced severe wildfires. As a result of thedamage caused, it is conceivable that funding for certain roadway improvementprojects could be delayed or deferred to focus on disaster relief and othercritical infrastructure requirements, which could adversely impact RoadwaySensors net sales in the next couple quarters.

 

Vehicle Sensors net sales increased 34.6% to$3.2 million and 39.4% to $6.2 million for the three and six months ended September 30,2007, respectively, versus $2.4 million and $4.4 million in the correspondingperiods of the prior fiscal year. This increase was primarily a result ofincreased unit sales of our LDW systems to European and Asian OEMs. Salesof LDW systems to the heavy truck market increased by $1.1 million, or 66.8%,and $2.4 million, or 78.5%, for the three and six month periods ended September 30,2007, respectively, when compared to the corresponding periods in the priorfiscal year. Also included in Automotive Sensors net sales are revenues fromcontract engineering services, technology access fees and royalty revenues inthe passenger car market that are derived from our strategic relationship withValeo, which aggregated $413,000 and $849,000 for the three and six monthsended September 30, 2007, respectively, compared to $704,000 and $1.5million in the corresponding periods of the prior fiscal year.

 

We expect sales of LDW units to the heavytruck market to continue to increase, when compared to the prior year period,for at least the remainder of fiscal 2008 due to increased sales of LDW unitsin Europe and Asia; however we expect to experience a decline in sales to theNorth American heavy truck market in our next two fiscal quarters as a resultof an overall decline in new truck sales in the U.S. due to new engineemissions standards that went into effect at the beginning of the calendar yearas well as due to the general slowdown in the U.S. housing market. Additionally,we expect revenues from our strategic partnership with Valeo to decreaseslightly as compared to the prior year largely because we will not receive anytechnology access fee revenues in fiscal 2008. Technology access fee revenuestotaled $125,000 and $250,000 for the three and six months ended September 30,2006, respectively. Royalty revenues from Valeo for sales of our LDW systemsfor the passenger car market have remained relatively insignificant in thecurrent fiscal year. Our LDW systems are now offered as an option on fourInfiniti models. While Valeo is currently in discussions to offer our LDWsystems on other passenger car platforms, we cannot assure you that Valeo willbe successful in these efforts.

 

Contract revenues increased 20.2% to $6.2 million and 12.9% to $11.7million for the three and six months ended September 30, 2007,respectively, compared to $5.1 million and $10.4 million in the corresponding periodsof the prior fiscal year. This increase was largely due to increased funding atthe federal, state and local levels throughout the country, as well as newcontract awards. In response to this growth in funding, we have increased ourTransportation Systems staff by 5% in the six months ended September 30,2007, and we expect to continue to increase our Transportation Systems staffover the remainder of fiscal 2008. We believe the ability of our TransportationSystems business to grow and successfully win and service new contracts will behighly dependent upon our continued success in recruiting and retainingqualified personnel. All of our contract revenues are derived from workperformed in North America under a broad range of fixed price and cost plusfixed fee contracts.

 

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*Gross Profit*. Total gross profit increased 21.9% to $7.3 million and 23.0% to $14.4 millionfor the three and six months ended September 30, 2007, respectively, ascompared to $6.0 million and $11.7 million in the corresponding periods of theprior fiscal year. Total gross profit as a percent of net sales and contractrevenues increased to 42.8% and 43.9% for the three and six months ended September 30,2007, respectively, as compared to 41.2% and 41.3% in the corresponding periodsof the prior fiscal year.

 

Gross profit as a percent of net sales was 49.1% and 49.3% for thethree and six months ended September 30, 2007, respectively, compared to43.2% and 43.9% in the corresponding periods of the prior fiscal year. Thisincrease in gross profit was a result of increased gross profits in both theRoadway Sensors and Vehicle Sensors segments largely as a result of improvedproduction efficiencies. Roadway Sensors gross margins were also positivelyimpacted by sales mix in terms of both geography and product mix. VehicleSensors gross margins have also improved as the customer base has expanded,which has mitigated the gross margin impact of lower contractual pricing to ourlargest European customer. Gross profit as a percent of net sales generallyfluctuates in any specific quarter based on customer mix. Gross profit as apercent of net sales has fluctuated over the last ten quarters from a high of50.2% in the first quarter of fiscal 2006 to a low of 43.2% reported in thesecond quarter of fiscal 2007, mainly as a result of customer mix.

 

Gross profit as a percent of contract revenues was 31.8% and 34.1% forthe three and six months ended September 30, 2007, respectively, comparedto 37.5% and 36.8% in the corresponding periods of the prior fiscal year. Werecognize contract revenues and related gross profit using percentage ofcompletion contract accounting and the underlying mix of contract activityaffects the related gross profit recognized in any given period. The decreasein gross profit as a percent of contract revenues for the three and six monthsended September 30, 2007 reflects a contract mix weighted more towardlower margin contracts in the period. Lower margin contracts generally have ahigher proportion of sub-consulting revenues associated with them.

 

*Selling, General and Administrative Expense*. Selling, general and administrative expense increased 8.4% to $4.3 million (or25.5% of total net sales and contract revenues) and 9.9% to $8.8 million (or26.8% of total net sales and contract revenues) in the three and six monthsended September 30, 2007, respectively, compared to $4.0 million (or 27.5%of total net sales and contract revenues) and $8.0 million (or 28.2% of total netsales and contract revenues) in the corresponding periods of the prior fiscalyear. The increase for the three and six month periods ended September 30,2007 compared to the prior year periods, was largely attributable to highercommissions and selling expenses driven by sales growth in our Roadway Sensorssegment. In the coming quarters, we expect to continue to experience increasedselling expenses as we pursue further sales growth. Additionally, we anticipateincreased general and administrative expenses related to our efforts to complywith the internal control attestation requirements of the Sarbanes-Oxley Act,with which we must begin to comply in fiscal 2008.

 

*Research and Development Expense*. Research and development expense was relatively flat at $627,000 (or 3.7% oftotal net sales and contract revenues) and $1.6 million (or 5.0% of total netsales and contract revenues) for the three and six months ended September 30,2007, respectively, compared to $771,000 (or 5.3% of total net sales and contractrevenues) and $1.8 million (or 6.3% of total net sales and contract revenues)in the corresponding periods of the prior fiscal year. Although year-over-yearour research and development expense was relatively flat, we have increasedresearch and development spending in Roadway Sensors. This increased spendingwas largely offset by reduced research and development activities in VehicleSensors as many of our significant truck OEM customers now have production LDWunits requiring minimal further development and the majority of our passengercar research and development efforts are funded by our strategic partner, Valeo.We believe research and development activities are crucial to our ability tocontinue to be a leader in our markets and we expect our expenditures in thisarea to be more in line with historical amounts for the remainder of fiscal2008.

 

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

 

*Deferred Compensation Plan Expense.*Duringthe three and six months ended September 30, 2007, we recorded a non-cashbenefit of $22,000 and expense of $9,000, respectively, related to the changein value of shares of our common stock held in trust by our deferredcompensation savings plan. This compares to a non-cash expense of $34,000 andbenefit of $32,000 recorded in the three and six month periods ended September 30,2006, respectively. In May 2007, our former Chief Executive Officer, whodeparted in March 2007, elected to receive a distribution of approximatelyfifty percent of his deferred compensation plan balance, representing 143,333shares of our common stock and $10,000 in cash, all of which was paid out in June 2007,and his remaining deferred compensation plan balance of 143,333 shares of ourcommon stock and $5,000 in cash on the one year anniversary of this election. Asa result of this election, at September 30, 2007, the trust held 167,177shares of our common stock and $5,000 of cash. We expect to continue toexperience non-cash expense or benefit in future periods as the value of theassets held in our deferred compensation savings plan fluctuates.

 

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*Other Income (Expense), Net.*Other income (expense), net includes thefollowing: 

 
| ** **                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                   | ** ** | **(In thousands)**                              | ** ** |
| Settlement  of lawsuit       | ** ** | **$**                                                | **—** |                                               | $          | 53 | ** ** | **$** | **—** |   | $ | (635 | ) |
| Other                        | ** ** | **25**                                               |       | (8                                                 | )          | **44** |   | (10 | ) |
| Other income  (expense), net | ** ** | **$**                                                | **25**     |                                               | $          | 45 | ** ** | **$** | **44** |   | $ | (645 | ) |

 

Other income (expense), net for the six months ended September 30,2006 primarily reflects $635,000 of expense recorded in connection with thesettlement of litigation described in Note 5 to the accompanying condensedconsolidated financial statements.

 

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

 
| ** **                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                             | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **(in thousands)**                              | ** ** |
| Interest  expense                       | ** ** | **$**                                                | **(283**   | **)**                                              | $          | (338 | ) | **$** | **(559** | **)** | $ | (637 | ) |
| Amortization  of debt discount          | ** ** | **(52**                                              | **)**      | (52                                                | )          | **(104** | **)** | (104 | ) |
| Amortization  of deferred finance costs | ** ** | **(34**                                              | **)**      | (34                                                | )          | **(69** | **)** | (69 | ) |
| Interest  expense, net                  | ** ** | **$**                                                | **(369**   | **)**                                              | $          | (424 | ) | **$** | **(732** | **)** | $ | (810 | ) |

 

Interest expense decreased for the three and six months ended September 30,2007 compared to the corresponding period in the prior fiscal year as a resultof an overall lower level of borrowings due to the paydown of long-term debt.

 

*Income Taxes*. During the three and six months ended September 30, 2007, we recognized anincome tax benefit of $214,000 and $80,000, respectively, as compared to incometax expense of $19,000 and an income tax benefit of $591,000 in the threemonths and six months ended September 30, 2006, respectively. The incometax benefit recorded in the three and six months ended September 30, 2007was primarily based on anticipated taxes to be paid in the current year, aswell as a slight decrease in the valuation allowance recorded against ourdeferred tax assets as a result of changes in estimates of the futurerealizability of these assets. Total deferred tax assets on our consolidatedbalance sheet increased from $3.0 million at March 31, 2007 to $3.2million at September 30, 2007. The income tax benefit recorded during thesix months ended September 30, 2006 was also the result of a decrease inthe valuation allowance recorded against our deferred tax assets. In thefuture, we may continue to record similar adjustments to our deferred tax assetvaluation allowance as our estimates are updated. We anticipate this will causeour future overall effective tax rate in any given period to fluctuate fromprior effective tax rates, estimated annual effective tax rates and statutorytax rates.

 

As discussed in Notes 1 and 4 of the accompanying condensedconsolidated financial statements, we adopted FIN 48 on April 1, 2007. Inconnection with our adoption of FIN 48, we recognized an adjustment ofapproximately $224,000 to the beginning balance of retained earnings on ourconsolidated balance sheet. Additionally, there was no significant change in ourincome tax expense for the three and six months ended September 30, 2007as a result of our implementation of FIN 48.

 

**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. At September 30,2007, we had $10.8 million in working capital, which included borrowings of$2.5 million on our revolving line of credit and $55,000 in cash and cashequivalents. This compares to working capital of $7.0 million at March 31,2007, which included borrowings of $4.0 million on our revolving line of creditand $35,000 in cash and cash equivalents.

 

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Our operating activities provided $2.0 million in cash during the sixmonths ended September 30, 2007, primarily as a result of net incomegenerated during the period offset partially by net cash outflows related tooperating assets and liabilities. Inventories decreased by approximately $1.5million from March 31, 2007, to a level more in line with what we expectinventory levels to be over the next six to twelve months. Accounts receivableand net unbilled accounts receivable increased by $1.7 million and $1.4million, respectively, since March 31, 2007, largely as a result ofincreased sales as well as the timing of invoicing in our TransportationSystems segment. Over the next several fiscal quarters, we expect net unbilledaccounts receivable to decrease by ten to twenty percent, which we expect willresult in increased cash inflows from operations. During the six months ended September 30,2006, our operations provided $135,000 of cash, primarily as a result of $1.0million in net income and an increase in accounts payable due to the timing ofpayments, offset in part by an increase in inventory levels of $2.0 million tosupport sales growth and the introduction of new products in our RoadwaySensors and Vehicle Sensors segments.

 

Our investing activities for the six months ended September 30,2007 and 2006, consisted entirely of purchases of property and equipment, whichaggregated $293,000 and $240,000, respectively. In September 2007, wemoved our corporate headquarters. As further discussed in Note 5 of theaccompanying condensed consolidated financial statements, in connection withthis move we spent $1.8 million on tenant improvements, all of which wasfinanced by our landlord in the form of tenant improvement allowances under thelease. We do not expect significant additional investments in leaseholdimprovements to our facilities as substantially all major planned leaseholdimprovements were completed prior to our headquarters move.

 

Cash used in financing activities was $1.7 million in the six monthsended September 30, 2007, which was the result of $2.6 million in netpayments against borrowings, partially offset by $940,000 in proceeds from theexercise of outstanding stock options and warrants to purchase our common stock.During the six months ended September 30, 2006, financing activities used$7,000 of cash, which was the result of net borrowings of $2.7 million offsetby $2.7 million in proceeds from the exercise of outstanding stock options andwarrants to purchase our common stock. As discussed in Note 6 to theaccompanying condensed consolidated financial statements, approximately $2.0million of the $2.7 million in cash inflows from the exercise of outstandingstock options and warrants during the six months ended September 30, 2006was raised through the exercise of outstanding warrants to purchase 1,250,000shares of common stock.

 

*Borrowings*

 

The following table summarizes our borrowings andlong-term debt:

 
| ** **                   | ** ** | **At September  30, 2007** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **(In thousands)**              | ** ** |
| Convertible  debentures, net |       | $                                    | 9,514      |   |
| Line of  credit              |       | 2,521                                |       |
| Bank term  note              |       | 944                                  |       |
| Other                        |       | 56                                   |       |
|                         |       | $                                    | 13,035     |   |

 

In October 2006, weentered into a two-year credit facility with a bank which includes our line ofcredit and bank term note. This credit facility was amended in October 2007to allow for potentially increased levels of borrowings, based on availablecollateral. The amended facility provides for line of credit borrowings of upto $10.0 million against our eligible accounts receivable and inventory, asdefined in the credit agreement. Additionally, the amended credit agreementcarried over the then outstanding term note balance of $944,000 with no changesto required monthly principal payments or the maturity date. Interest onborrowed amounts is payable monthly. The interest rate on the line of credit isthe current stated prime rate plus 1.00%, and the interest rate on the bankterm note is fixed at an annual rate of 8.75%. We are obligated to pay anunused line fee of 0.25% per annum applied to the amount by which the maximumcredit amount exceeds the average daily principal balance during the precedingmonth. The amended credit facility also requires $2,000 in monthly collateralmanagement fees and includes an early termination fee equal to 1% of the totalfacility. Additionally, we paid a commitment fee of $50,000 in October 2007.The credit facility is secured by substantially all of the assets of theCompany. At September 30, 2007, we had $8.0 million available under ourcredit facility, of which $4.5 million was unused.

 

We believe that the cashgenerated from our operations, together with funds available under our creditagreement, will be sufficient to fund our operations for at least the nexttwelve months. However, should a shortfall occur, we may need to raiseadditional funds through other debt financings or the sale of equitysecurities.

 

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**Contractual Obligations**

 

Our contractual obligations were as follows at September 30, 2007:

 
| ** **              | ** ** | **Payments Due by Period** | ** ** |
|-------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **              | ** ** | **(In thousands)**                   | ** ** |
| Line of  credit         |       | $                                         | 2,521      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 2,521 |   |
| Notes  payable          |       | 651                                       |       | 349 |   | — |   | — |   | — |   | — |   | 1,000 |   |
| Convertible  debentures |       | —                                    |       | — |   | 9,850 |   | — |   | — |   | — |   | 9,850 |   |
| Operating  leases       |       | 465                                       |       | 1,483 |   | 1,391 |   | 1,348 |   | 1,332 |   | 3,823 |   | 9,842 |   |
| Total                   |       | $                                         | 3,637      |   | $ | 1,832 |   | $ | 11,241 |   | $ | 1,348 |   | $ | 1,332 |   | $ | 3,823 |   | $ | 23,213 |   |

 

At September 30, 2007, we had firm commitments to purchaseinventory in the amount of $2.8 million during our next two fiscal quarters.

 

**Off Balance Sheet Arrangements**

 

In May 2004, we issued subordinated convertible debentures in anaggregate original principal amount of $10.1 million. These debentures aredue in full on May 19, 2009 and are convertible into shares of our commonstock at an initial conversion price of $3.61 per share. At September 30,2007, $9.9 million of these convertible debentures remained outstanding.Because these debentures are conventionally convertible, we have not separatelyaccounted for the conversion feature and, accordingly, no separate amounts arepresented in our condensed consolidated financial statements in connection withthis conversion feature.

 

At September 30, 2007, outstanding warrants to purchase anaggregate of 62,500 shares of our common stock at an exercise price of$1.95 per share and outstanding warrants to purchase an aggregate of 246,250shares of our common stock at an exercise price of $3.25 were callable by us ifthe closing sales price of our common stock for 20 consecutive days is equal toor greater than two times the exercise price of the warrants. Outstandingwarrants to purchase an aggregate of 75,000 shares of our common stock atan exercise price of $5.00 per share were callable by us if the price of our commonstock for 20 consecutive days is equal to or greater than one and a halftimes the exercise price of the warrants.

 

In connection with warrants to purchase 246,250 shares of our commonstock at $3.25 per share, we are a party to certain registration rights agreementsthat contain provisions under which we could be subjected to liquidated damagesshould we fail to maintain effective registration statements for the underlyingshares of common stock. These warrants have been accounted for within equity inour condensed consolidated balance sheets in accordance with EITF 00-19, *Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock*, and, accordingly, noliabilities have been recorded in connection therewith. As of the date of thisfiling, no liquidated damages are payable under the provisions of theregistration rights agreements associated with these warrants.

 

**Recent Accounting Pronouncements**

 

In September 2006, the FASB issued SFAS157, which defines fair value, establishes a framework for measuring fairvalue, and expands disclosure about fair value measurements. SFAS 157 does notrequire any new fair value measurements; rather it specifies valuation methodsto be applied when fair value measurements are required under existing orfuture accounting pronouncements. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007, and interim periods within those fiscalyears. Early application of the statement is encouraged. Generally, thisstatement will be applied prospectively. We are currently evaluating the impactof SFAS 157 and expect to adopt SFAS 157 in the first quarter of our fiscalyear ending March 31, 2009.

 

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities — Including an Amendment of FASB Statement No. 115*(“SFAS 159”). SFAS 159 permits entities to choose to measure many financialinstruments and certain other items at fair value. Unrealized gains and losseson items for which the fair value option has been elected will be recognized inearnings at each subsequent reporting date. SFAS 159 is effective for financialstatements issued for fiscal years beginning after November 15, 2007. Weare evaluating the impact that the adoption of SFAS 159 will have on ourresults of operations and financial condition and expect to adopt SFAS 159 inour fiscal year ending March 31, 2009.

 

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**Seasonality**

 

We have historically experienced seasonality,particularly with respect to our Roadway Sensors net sales in the third andfourth fiscal quarters due to a reduction in road construction or repairsduring the winter months in many markets as a result of inclement weatherconditions.

 

**ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Our exposure to interest rate risk is limitedto our line of credit and bank term note. Our line of credit and, prior to October 2007,the bank term note bear interest based on the prevailing prime rate (7.75% at September 30,2007). We do not believe that a 10% increase in the interest rate on our lineof credit (from 9.00% to 9.90%) would have a material impact on our financialposition, operating results or cash flows. In addition, we believe that thecarrying value of our outstanding debt approximates fair value.

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures, as such term isdefined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based uponthat evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures are effective to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms and are effective in ensuring that information required to be disclosed byus in the reports that we file or submit under the Exchange Act is accumulatedand communicated to our management, including our Chief Executive Officer andChief Financial Officer, as appropriate, to allow timely decisions regardingrequired disclosure. In designing and evaluating the disclosure controls andprocedures, our management recognized that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives. Our management necessarily appliedits judgment in evaluating the cost-benefit relationship of such controls andprocedures.

 

**Changesin Internal Controls**

 

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

 

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**PART II. OTHER INFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

The information set forth under Note 5 of Notes to Unaudited CondensedConsolidated Financial Statements, included in Part I, Item I of thisreport, is incorporated herein by reference.

 

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

 

*Our business is subject to a number of risks, some of whichare discussed below. Other risks are presented elsewhere in this report and inthe information incorporated by reference into this report. You should considerthe following risks carefully in addition to the other information contained inthis report and our other filings with the SEC, including our subsequentreports on Forms 10-Q and 8-K, before deciding to buy, sell or hold our commonstock. The risks and uncertainties described below are not the only ones facingour company. Additional risks and uncertainties not presently known to us orthat we currently deem immaterial may also affect our business operations. Ifany of these risks actually occurs, our business, financial condition orresults of operations could be seriously harmed. In that event, the marketprice for our common stock could decline and you may lose all or part of yourinvestment.*

 

**We May Need To Raise Additional CapitalIn The Future, Which May Not Be Available On Terms Acceptable To Us, Or AtAll.**We have historically generated significant netlosses and operating losses and have experienced volatility in our cash flowsfrom operations ranging from positive cash flows from operations of $590,000 inthe year ended March 31, 2005 to negative cash flows from operations of$2.0 million in the year ended March 31, 2007. Additionally, we failed tomeet certain debt covenants under our prior credit agreement during two fiscalquarters, prior to the replacement of that credit facility in October 2006.Furthermore, we have $9.9 million in subordinated convertible debentures thatare due in full in May 2009. Should the holders of the convertibledebentures not elect to convert the principal into shares of our common stock,we may need to raise additional capital to refinance this debt.

 

At September 30,2007, we had $55,000 of cash and cash equivalents and relied on our line ofcredit to fund our operations. We may need to raise additional capital in thenear future to fund our operations or to repay indebtedness. Such additionalcapital may be raised through bank borrowings, or other debt or equityfinancings. We cannot assure you that any additional capital will be availableon a timely basis, on acceptable terms, or at all, and such additionalfinancing may result in further dilution to our stockholders.

 

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

 

•                                       marketacceptance of our products and product enhancements, and the overall level ofsales of our products;

 

•                                       ourability to control costs;

 

•                                       thesupply of key components for our products;

 

•                                       ourability to generate net income;

 

•                                       increasedresearch and development expenses;

 

•                                       increasedsales and marketing expenses;

 

•                                       technologicaladvancements and our competitors’ response to our products;

 

•                                       capitalimprovements to new and existing facilities and enhancements to ourinfrastructure and systems;

 

•                                       potentialacquisitions of businesses and product lines;

 

•                                       ourrelationships with customers and suppliers;

 

•                                       governmentbudgets, political agendas and other funding issues, including potential delaysin government contract awards;

 

•                                       ourability to successfully negotiate credit arrangements with our bank; and

 

•                                       generaleconomic conditions, including the effects of the current economic slowdown andinternational conflicts.

 

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

 

**We Have Historically Experienced Substantial Losses And May ExperienceLosses In The Future.**Although we have achieved netincome in recent periods, we experienced a net loss of $11.3 million in theyear ended March 31, 2005. We cannot assure you that we will be able tosustain or improve our financial performance, or that we will be able tocontinue to achieve profitability on a quarterly or annual basis in the future.Most of our expenses are fixed in advance. As such, we generally are unable toreduce our expenses significantly in the short-term to compensate for anyunexpected delay or decrease in anticipated revenues. As a result, we maycontinue to experience operating losses and net losses, which would make itdifficult to fund our operations and achieve our business plan, and could causethe market price of our common stock to decline.

 

**If Our Internal Controls Over Financial Reporting Do Not Comply WithThe Requirements Of The Sarbanes-Oxley Act, Our Business And Stock Price CouldBe Adversely Affected.**Along with our independentregistered public accounting firm, we will be evaluating the effectiveness ofour internal controls over financial reporting to comply with Section 404of 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 fiscal year ending March 31,2008 and to include a management report assessing the effectiveness of ourinternal controls over financial reporting in all annual reports beginning withour Annual Report on Form 10-K for the fiscal year ending March 31,2008. Section 404 also requires our independent accountant to attest to,and report on, management’s assessment of our internal controls over financialreporting beginning in our fiscal year ending March 31, 2009. We may notbe able to complete our Section 404 compliance on a timely basis, and evenif we timely complete our compliance requirements, our independent auditors maystill conclude that our internal controls over financial reporting are noteffective.

 

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

 

As of March 31, 2005, we became aware ofa material weakness in our internal controls related to the accounting for theconsolidation of our deferred compensation savings plan and certain contractadministration. We cannot assure you that we or our independent registeredpublic accounting firm will not identify additional material weaknesses in ourinternal controls. A material weakness is a control deficiency, or combinationof control deficiencies, that results in more than a remote likelihood that amaterial misstatement of the annual or interim financial statements will not beprevented or detected. Based on our evaluation, our management concluded that,as of March 31, 2004, our internal control over financial reporting wasnot effective due to the existence of one material weakness. We may experienceadditional material weaknesses in the future. If our internal controls overfinancial reporting are not considered adequate, we may experience a loss ofpublic confidence, which could have an adverse effect on our business and ourstock price.

 

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**New EnvironmentalRegulations May Result In A Decline In Our AutoVue Sales and Royalties.**Recentenvironmental regulations in Europe became effective in 2006, which requiredmore stringent emissions compliance in new trucks manufactured in Europe after2006. These regulations caused the cost of certain trucks to increasesignificantly and could cause a decline in new truck sales in Europe in thenear future. Similar regulations have been announced in North America that willimpact diesel engines built after January 2007. North America heavy trucksales through the first three quarters of 2007 have declined significantly ascompared to the prior year, which we believe was primarily a result of large2006 prebuys of heavy trucks made in anticipation of the new North Americaemission standards. We may experience a decline in our LDW sales to truck OEMsrelated to these stricter regulations.

 

**We May Experience Production Gaps WhichCould Materially And Adversely Impact Our Sales And Financial Results And TheUltimate Acceptance Of Our Products.**It is possiblethat we could experience unforeseen quality control issues or part shortages aswe increase production to meet current demand for our products. We havehistorically used single suppliers for certain of our components in our AutoVueand Vantage products. Should any such delay or disruption occur, our futuresales will likely be materially and adversely affected. Additionally, we relyheavily on select contract manufacturers to produce many of our products. Althoughwe believe our contract manufacturers have sufficient capacity to meet ourproduction schedules for the foreseeable future and we believe we could findalternative contract manufacturing sources if necessary, we could experience aproduction gap if for any reason our contract manufacturers were unable to meetour production requirements.

 

**We Depend Upon Valeo To Market Our AutoVueTechnologies For The OEM Passenger Car Market.**We havegranted Valeo the exclusive right to sell and manufacture our AutoVue LDWsystem to the worldwide passenger car market in exchange for royalty paymentsfor 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.

 

**We May Be Unable To Attract And RetainKey Personnel, Which Could Seriously Harm Our Business.**Dueto the specialized nature of our business, we are highly dependent on thecontinued service of our executive officers and other key management,engineering and technical personnel. The loss of Abbas Mohaddes, our ChiefExecutive Officer, or any of the other executive officers or key members ofmanagement could adversely affect our business, financial condition or resultsof operations. Our success will also depend in large part upon our ability tocontinue to attract, retain and motivate qualified engineering and other highlyskilled technical personnel. In particular, the future success of ourTransportation Systems segment will depend on our ability to hire additionalqualified engineers and planners. Competition for qualified employees,particularly development engineers, is intense. We may not be able to continueto attract and retain sufficient numbers of such highly skilled employees. Ourinability to attract and retain additional key employees or the loss of one ormore of our current key employees could adversely affect our business, financialcondition and results of operations.

 

**If We Are Unable To Develop And Introduce NewProducts And Product Enhancements Successfully And In A Cost-Effective AndTimely Manner, Or Are Unable To Achieve Market Acceptance Of Our New Products,Our Operating Results Would Be Adversely Affected.**Webelieve our revenue growth and future operating results will depend on ourability to complete development of new products and enhancements, introducethese products in a timely, cost-effective manner, achieve broad marketacceptance of these products and enhancements, and reduce our product costs. Wecannot guarantee the success of these products and we may not be able tointroduce any new products or any enhancements to our existing products on atimely basis, or at all. In addition, the introduction of any new productscould adversely affect the sales of certain of our existing products.

 

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

 

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Market acceptance of our new products dependsupon many factors, including our ability to accurately predict marketrequirements and evolving industry standards, our ability to resolve technicalchallenges in a timely and cost-effective manner, qualify any new products withOEMs and achieve manufacturing efficiencies, the perceived advantages of ournew products over traditional products and the marketing capabilities of ourindependent distributors and strategic partners, including Valeo’s ability toexpand sales of AutoVue in the passenger car market. The success of our AutoVuesystem will also depend in part on the success of the automotive vehicles thatincorporate our technology, as well as the success of optional equipment thatOEMs bundle with our technologies.

 

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

 

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

 

**The Markets In Which We Operate Are HighlyCompetitive And Have Many More Established Competitors, Which Could AdverselyAffect Our Sales Or The Market Acceptance Of Our Products.**Wecompete with numerous other companies in our target markets including, but notlimited to, large, multinational corporations, which include tier oneautomotive suppliers, and many smaller regional engineering firms. We expectsuch competition to increase due to technological advancements, industry consolidationsand reduced barriers to entry. Increased competition is likely to result inprice reductions, reduced gross margins and loss of market share, any of whichcould seriously harm our business, financial condition and results ofoperations. In fiscal 2007, we began to experience more competition in ourRoadway Sensors segment as the Department of Transportation in one of ourlargest sales territories moved to a multi-source contracting environment fromone in which we were the sole supplier. In addition, one of the otherdevelopers of LDW systems was acquired by a larger company during fiscal 2007.While this developer has not been a material competitor to date, we mayexperience more competition from this provider as a result of its greateraccess to resources from its acquirer, and additional competitors may enterthis market in the future. Furthermore, awareness of LDW technology isincreasing and other market players are attempting to develop competingtechnologies, which may contain improvements or added features beyond thoseoffered by our LDW systems. Should such efforts be successful, this could erodeour ability to successfully market and sell our LDW systems.

 

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

 

**An Economic SlowdownOr The Significant Military Operations In The Middle East Or Elsewhere May ImpactGovernment Funding Or Consumer Spending, Causing A Decline In Our Revenues.**Inthe near term, the funding of U.S. military operations in the Middle East orelsewhere may cause disruptions in funding of government contracts. Sincemilitary operations of such magnitude are not routinely included in U.S.defense budgets, supplemental legislative funding actions are often required tofinance such operations. Even when such legislation is enacted, it may not beadequate for ongoing operations, causing other government resources to be temporarilyor permanently diverted. Since a significant portion of our sales are derivedfrom contracts with government agencies, such diversion of funds could produceinterruptions in funding or delays in receipt of our contracts, causingdisruptions and adversely effecting our revenue and operations.

 

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Concerns about the recent internationalconflicts and terrorist and military actions, as well as concerns aboutinflation, decreased consumer confidence, and reduced corporate profits andcapital spending have also resulted in a downturn in worldwide economicconditions, particularly in the United States. These unfavorable economicconditions may have a negative impact on customer orders (and also may result indecreased sales of automobiles and trucks that incorporate our LDW systems). Suchconcerns may result in cancellations and rescheduling of backlog. In addition,the recent decline in the U.S. real estate market, particularly in new homeconstruction, could adversely impact new road construction resulting in adecline in Roadway Sensor and Vehicle Sensor net sales and TransportationSystems contract revenues. Any of the foregoing political, social and economicconditions make it extremely difficult for our customers, our suppliers and usto accurately forecast and plan future business activities and could result ina decline in our net sales and contract revenues. If such conditions continueor worsen, our business, financial condition and results of operations could bematerially and adversely affected.

 

**We Depend On Government Contracts AndSubcontracts, And Because Many Of Our Government Contracts Are Fixed PriceContracts, Higher Than Anticipated Costs Will Reduce Our Profit And CouldAdversely Impact Our Operating Results.**A significantportion of our sales are derived from contracts with governmental agencies,either as a general contractor, subcontractor or supplier. Government contractsrepresented approximately 37.8%, 38.3% and 37.4% of our total net sales andcontract revenues for the years ended March 31, 2007, 2006 and 2005,respectively. We anticipate that revenue from government contracts willcontinue to remain a significant portion of our net sales and contractrevenues. Government business is, in general, subject to special risks andchallenges, including:

 

•                                          longpurchase cycles or approval processes;

 

•                                          competitivebidding and qualification requirements;

 

•                                          theimpact of international conflicts;

 

•                                          performancebond requirements;

 

•                                          changesin government policies and political agendas;

 

•                                          delaysin funding, including the delays in the allocation of funds to state and localagencies from the U.S. Federal Highway Bill;

 

•                                          othergovernment budgetary constraints and cut-backs; and

 

•                                          milestonerequirements and liquidated damage provisions for failure to meet contractmilestones.

 

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

 

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**Our Quarterly Operating Results Fluctuate AsA Result Of Many Factors. Therefore, We May Fail To Meet Or Exceed TheExpectations Of Securities Analysts And Investors, Which Could Cause Our StockPrice To Decline.**Our quarterly revenues and operatingresults have fluctuated and are likely to continue to vary from quarter toquarter due to a number of factors, many of which are not within our control.Factors that could affect our revenues include, among others, the following:

 

•                                          changesin our pricing policies and the pricing policies of our suppliers andcompetitors, pricing concessions on volume sales, as well as increased pricecompetition in general;

 

•                                          thelong lead times associated with government contracts or required by vehiclemanufacturers;

 

•                                          delaysin government contracts from time to time, including from delays in theallocation of funds to state and local agencies from the U.S. Federal HighwayBill;

 

•                                          ourability to raise additional capital;

 

•                                          ourability to control costs;

 

•                                          themix of our products and services sold in a quarter, which mix has varied and isexpected to continue to vary from time to time;

 

•                                          seasonalitydue to winter weather conditions;

 

•                                          internationalconflicts and acts of terrorism;

 

•                                          declinesin new home construction and related road construction;

 

•                                          ourability to develop, introduce, patent, market and gain market acceptance of newproducts, applications and product enhancements in a timely manner, or at all;

 

•                                          marketacceptance of the products incorporating our technologies and products;

 

•                                          thesize, timing, rescheduling or cancellation of significant customer orders;

 

•                                          theintroduction of new products by competitors;

 

•                                          theavailability and cost of components used in the manufacture of our products;

 

•                                          oursuccess in expanding and implementing our sales and marketing programs;

 

•                                          theeffects of technological changes in our target markets;

 

•                                          theamount of our backlog at any given time;

 

•                                          thenature of our government contracts;

 

•                                          deferralsof customer orders in anticipation of new products, applications or productenhancements;

 

•                                          risksand uncertainties associated with our international business;

 

•                                          currencyfluctuations and our ability to get currency out of certain foreign countries;and

 

•                                          generaleconomic and political conditions.

 

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

 

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**We May Engage In Acquisitions OfCompanies Or Technologies That May Require Us To Undertake SignificantCapital Infusions And Could Result In Disruptions Of Our Business And DiversionOf Resources And Management Attention.**We havehistorically acquired, and may in the future acquire, complementary businesses,products and technologies. Acquisitions may require significant capitalinfusions and, in general, acquisitions also involve a number of special risks,including:

 

•                                          potentialdisruption of our ongoing business and the diversion of our resources andmanagement’s attention;

 

•                                          thefailure to retain or integrate key acquired personnel;

 

•                                          thechallenge of assimilating diverse business cultures, and the difficulties inintegrating the operations, technologies and information system of the acquiredcompanies;

 

•                                          increasedcosts to improve managerial, operational, financial and administrative systemsand to eliminate duplicative services;

 

•                                          theincurrence of unforeseen obligations or liabilities;

 

•                                          potentialimpairment of relationships with employees or customers as a result of changesin management; and

 

•                                          increasedinterest expense and amortization of acquired intangible assets.

 

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

 

**We HaveExperienced Growth In Recent Periods. If We Fail To Manage Our GrowthEffectively, We May Be Unable To Execute Our Business Plan And May ExperienceFuture Weaknesses In Our Internal Controls.**We have expandedour overall business. In order to achieve our business objectives, we will needto continue to expand our business and add additional qualified personnel. Suchexpansion has placed and is expected to continue to place, a significant strainon our managerial, administrative, operational, financial and other resources.If we are unable to successfully manage our growth, our business, financialcondition and results of operations will be adversely affected.

 

To accommodate this growth, we launched a newERP system in April 2006. Accordingly, we may experience problems commonlyexperienced by other companies in connection with such implementations,including but not limited to, potential bugs in the system, component or supplydelays, training requirements and other integration challenges and delays. Anydifficulties we might experience in connection with our new ERP system couldhave a material adverse effect on our financial reporting system and internalcontrols.

 

**If We Do Not Keep Pace With RapidTechnological Changes And Evolving Industry Standards, We Will Not Be Able ToRemain Competitive And There Will Be No Demand For Our Products.**Ourmarkets are in general characterized by the following factors:

 

•                                          rapidtechnological advances;

 

•                                          downwardprice pressure in the marketplace as technologies mature;

 

•                                          changesin customer requirements;

 

•                                          frequentnew product introductions and enhancements; and

 

•                                          evolvingindustry standards and changes in the regulatory environment.

 

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

 

**We May Not Be Able To Adequately ProtectOr Enforce Our Intellectual Property Rights, Which Could Harm Our CompetitivePosition.**If we are not able to adequately protect orenforce the proprietary aspects of our technology, competitors could be able toaccess our proprietary technology and our business, financial condition andresults of operations will likely be seriously harmed. We currently attempt toprotect our technology through a combination of patent, copyright, trademark andtrade secret laws, employee and third party nondisclosure agreements andsimilar means. Despite our efforts, other parties may attempt to disclose,obtain or use our technologies or systems. Our competitors may also be able toindependently develop products that are substantially equivalent or superior toour products or design around our patents. In addition, the laws of someforeign countries do not protect our proprietary rights as fully as do the lawsof the United States. As a result, we may not be able to protect ourproprietary rights adequately in the United States or abroad.

 

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

 

**The Trading Price Of Our Common Stock IsHighly Volatile.**The trading price of our common stockhas been subject to wide fluctuations in the past. Since January 2000, ourClass A common stock (now known as our common stock) has traded at pricesas low as $0.45 per share and as high as $29.44 per share. The market price ofour common stock could continue to fluctuate in the future in response tovarious factors, including, but not limited to:

 

•                                          quarterlyvariations in operating results;

 

•                                          ourability to control costs, improve cash flow and sustain profitability;

 

•                                          ourability to raise additional capital;

 

•                                          shortagesannounced by suppliers;

 

•                                          announcementsof technological innovations or new products or applications by ourcompetitors, customers or us;

 

•                                          transitionsto new products or product enhancements;

 

•                                          acquisitionsof businesses, products or technologies;

 

•                                          theimpact of any litigation;

 

•                                          changesin investor perceptions;

 

•                                          governmentfunding, political agendas and other budgetary issues;

 

•                                          changesin earnings estimates or investment recommendations by securities analysts; and

 

•                                          internationalconflicts, political unrest and acts of terrorism.

 

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

 

**Our International Business Operations May BeThreatened By Many Factors 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:

 

•                                          currencyfluctuations and restrictions;

 

•                                          political,social and economic instability;

 

•                                          longeraccounts receivable payment cycles;

 

•                                          importand export license requirements and restrictions of the United States and eachother country in which we operate;

 

•                                          unexpectedchanges in regulatory requirements, tariffs and other trade barriers orrestrictions;

 

•                                          theburdens of compliance with a wide variety of foreign laws and more restrictivelabor laws and obligations;

 

•                                          difficultiesin managing and staffing international operations;

 

•                                          potentiallyadverse tax consequences; and

 

•                                          reducedprotection for intellectual property rights in some countries.

 

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

 

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

 

**We Could Experience Negative FinancialImpacts Arising From Developments In Contingencies Created Under Our PreviousStructure Or By Former Subsidiaries.**Although we divestedourselves of all business units prior to October 2004, with the exceptionof our Iteris business, from time to time we could experience unforeseendevelopments in contingencies related to our former subsidiaries. For example,in July 2006 we entered into a settlement agreement in connection with alawsuit brought against Mariner Networks, Inc., one of our formersubsidiaries, by one of Mariner’s suppliers, pursuant to which we issued 88,912shares of our common stock to this supplier (valued at $213,000 as of the dateof issuance), paid this supplier $125,000 on October 20, 2006 and arerequired to pay an additional $350,000 in 36 equal monthly installments of$9,700 beginning in November 2006. Although we are not aware of any othermaterial contingencies, it is possible that other matters could be broughtagainst us in connection with activities related to former subsidiaries andthat such matters could materially and adversely affect our financial resultsand cash flows.

 

**Some Of Our Directors, Officers And TheirAffiliates Can Control The Outcome Of Matters That Require The Approval Of OurStockholders, And Accordingly We Will Not Be Able To Engage In CertainTransactions Without Their Approval.**As of September 30,2007, our officers and directors beneficially owned approximately 11% of theoutstanding shares of our common stock (and approximately 17% of our commonstock when including options, warrants and other convertible securities held bythem which are currently exercisable or convertible or will become exercisableor convertible within 60 days after September 30, 2007). As a resultof their stock ownership, our management will be able to influence the electionof our directors and the outcome of corporate actions requiring stockholderapproval, such as mergers and acquisitions, regardless of how our otherstockholders may vote. This concentration of voting control may have asignificant effect in delaying, deferring or preventing a change in ourmanagement or change in control and may adversely affect the voting or otherrights of other holders of common stock.

 

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**Certain Anti-Takeover Provisions May AffectThe Price Of Our Common Stock And Discourage A Third Party From Acquiring Us.**Certainprovisions of our certificate of incorporation and our stockholder rights plancould make it difficult for a third party to acquire us, even though anacquisition might be beneficial to our stockholders. Such provisions couldlimit the price that investors might be willing to pay in the future for sharesof our common stock. Under the terms of our certificate of incorporation, ourBoard of Directors is authorized to issue, without stockholder approval, up to2,000,000 shares of preferred stock with voting, conversion and other rightsand preferences superior to those of our common stock. Our future issuance ofpreferred stock could be used to discourage an unsolicited acquisitionproposal. In addition, in March 1998, we adopted a stockholder rights planand declared a dividend of preferred stock purchase rights to our stockholders.We amended this plan in May 2004. In the event a third party acquires morethan 15% of the outstanding voting control of our company or 15% of ouroutstanding common stock, the holders of these rights will be able to purchasethe junior participating preferred stock at a substantial discount off of thethen current market price. The exercise of these rights and purchase of asignificant amount of stock at below market prices could cause substantialdilution to a particular acquirer and discourage the acquirer from pursuing ourcompany. The mere existence of a stockholder rights plan often delays or makesa merger, tender offer or proxy contest more difficult.

 

**ITEM 2.  UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

 

None.

 

**ITEM 3.  DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

 

In connection with our Annual Meeting ofStockholders held on September 21, 2007, the following proxies weretabulated, representing 22,395,254 shares of our common stock, or 68.61% of theoutstanding shares:

 

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

 

| **Director Nominee** | ** ** | **Total Votes for  Each Director** | ** ** | **Total Votes Withheld from  Each Director** | ** ** |
|---------------------------|------------|---------------------------------------------------|------------|------------------------------------------------------------------|------------|
| Richard J.  Char          |       | 22,331,896                                        |       | 63,358                                                           |       |
| Kevin C.  Daly, Ph.D.     |       | 22,234,211                                        |       | 161,043                                                          |       |
| Gregory A.  Miner         |       | 22,143,118                                        |       | 252,136                                                          |       |
| Abbas  Mohaddes           |       | 22,242,123                                        |       | 153,131                                                          |       |
| John W.  Seazholtz        |       | 22,233,034                                        |       | 162,220                                                          |       |
| Joel Slutzky              |       | 22,190,002                                        |       | 205,252                                                          |       |
| Thomas L.  Thomas         |       | 22,158,982                                        |       | 236,272                                                          |       |

 

**Proposal II: To approve the Amendment of ourCertificate of Incorporation to increase the number of authorized shares of ourcommon stock by 20,000,000, from 50,000,000 shares to 70,000,000 shares.**

 

| ** **    | ** ** | **Shares of**    | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **Common Stock** | ** ** |
| **For**       |       | 20,503,957            |       |
| **Against**   |       | 1,870,299             |       |
| **Abstain**   |       | 21,685                |       |
| **Non-votes** | ** ** | **—**            | ** ** |

 

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**Proposal III: To approve the Iteris, Inc.2007 Omnibus Incentive Plan and the issuance of up to 850,000 shares of commonstock thereunder.**

 

| ** **    | ** ** | **Shares of**    | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **Common Stock** | ** ** |
| **For**       |       | 14,594,393            |       |
| **Against**   |       | 691,622               |       |
| **Abstain**   |       | 156,778               |       |
| **Non-votes** |       | 6,952,461             |       |

 

**Proposal IV: Ratification of McGladrey &Pullen, LLP as the independent auditors of Iteris for the fiscal year ending March 31,2008:**

 

| ** **    | ** ** | **Shares of**    | ** ** |
|---------------|------------|-----------------------|------------|
| ** **    | ** ** | **Common Stock** | ** ** |
| **For**       |       | 22,352,645            |       |
| **Against**   |       | 14,790                |       |
| **Abstain**   |       | 27,819                |       |
| **Non-votes** | ** ** | **—**            | ** ** |

 

**ITEM 5.  OTHER INFORMATION**

 

None.

 

**ITEM 6.  EXHIBITS**

 

The following exhibits are filed herewith or are incorporated byreference to the location indicated.

 
| Exhibit  Number | ** ** | **Description**                                                                                                                                                       | ** ** | **Where Located**                                                                                                                                                         |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Amended and Restated  Certificate of Incorporation of the registrant                                                                                                  | * *   | *Exhibit 3.1 to the  registrant’s current report on Form 8-K as filed with the SEC on October 28,  2004*                                                   |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.2             |       | Certificate of  Amendment to Amended and Restated Certificate of Incorporation filed September 26,  2007                                                         | * *   | *Filed herewith*                                                                                                                                                               |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.3             |       | Bylaws of registrant,  as amended                                                                                                                                     | * *   | *Exhibit 4.2 to the  registrant’s Registration Statement on Form S-1 (Reg. No. 033-67932)  as filed with the SEC on July 6, 1993*                     |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.4             |       | Certificates of  Amendment to Bylaws of the registrant dated April 24, 1998 and August 10,  2001                                                            | * *   | *Exhibit 3.4 to the  registrant’s Annual Report on Form 10-K/A for the year ended March 31,  2003 as filed with the SEC on July 29, 2003*             |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.5             |       | Certificate of  Amendment to Bylaws of registrant dated September 9, 2004                                                                                        | * *   | *Exhibit 3.1 to the  registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30,  2004 as filed with the SEC on November 15, 2004* |
|            |       |                                                                                                                                                                  | * *   | * *                                                                                                                                                                       |
| 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*                                           |
|            |       |                                                                                                                                                                  |       |                                                                                                                                                                           |
| 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*                                                                                                                                                               |
|                 |            |                                                                                                                                                                       |            |                                                                                                                                                                                |  |  |

 

37

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**SIGNATURES**

 

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

 
| Dated: November 12,  2007 |   | ITERIS, INC. |
|--------------------------------|--------|--------------|
|                           |   | (Registrant) |
|                           |   |         |
|                           |   | By           | /s/ ABBAS MOHADDES |   |
|                           |   |         | Abbas Mohaddes |
|                           |   |         | Chief Executive Officer |
|                           |   |         | (Principal Executive  Officer) |
|                           |   |         |   |   |
|                           |   |         |   |   |
|                           |   | By           | /s/ JAMES S. MIELE |   |
|                           |   |         | James S. Miele |
|                           |   |         | Chief Financial Officer |
|                           |   |         | (Principal Financial  and Accounting Officer) |
|                                |        |              |  |  |  |

 

38

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