**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

----

 

**Form 10-Q**

**(Mark** One)

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended December 31, 2006**

**OR**

**o**                                 TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from          to**

**Commissionfile 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.) |
|                                     |   |                 |
| **1515  South Manchester Avenue**        |   | ** **           |
| **Anaheim,  California**                 |   | **92802**            |
| (Address of  principal executive office) |   | (Zip Code)           |

 

**(714)** 774-5000(Registrant’s telephone number, including areacode)

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

**Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”) during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.**

**Yes **x No o

**Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):**
| **Large accelerated  filer  **o | ** ** | **Accelerated  filer  **o | ** ** | **Non-accelerated  filer  **x |
|-------------------------------------------|------------|-------------------------------------|------------|-----------------------------------------|

 

**Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).**

**Yes **o No x

As of February 8, 2007, the registrant had 31,251,473shares of common stock outstanding

 

 

----

**ITERIS, INC.Quarterly Report on Form 10-QFor the Three and Nine Months Ended December 31, 2006**

**Table of Contents**
| **PART I.**  | ** ** | **FINANCIAL INFORMATION**                                                                                                           | ** ** | ** ** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|              |       |                                                                                                                                |       |       |
| **ITEM 1.**       | ** ** | **FINANCIAL STATEMENTS**                                                                                                            | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **UNAUDITED  CONDENSED CONSOLIDATED BALANCE SHEETS AT DECEMBER 31, 2006 AND MARCH 31,  2006**                                  | ** ** | ** ** |
| ** **        | ** ** | ** **                                                                                                                          | ** ** | ** ** |
| ** **        | ** ** | **UNAUDITED  CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND NINE MONTHS  ENDED DECEMBER 31, 2006 AND 2005** | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **UNAUDITED  CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED  DECEMBER 31, 2006 AND 2005**           | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **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**                                                                                                                        | ** ** | ** ** |

 

                Unlessotherwise indicated in this report, the “Company,” “we,” “us” and “our”collectively refer to Iteris, Inc., formerly known as IterisHoldings, Inc. and Odetics, Inc., and its former subsidiary, Meyer,Mohaddes Associates, Inc., which was dissolved effective April 2006.

AutoVue®, Iteris®, Vantage® and eAccessTM are among the trademarks ofIteris, Inc. Any other trademarks or trade names mentioned herein are theproperty of their respective owners.

 

----

**PART I.FINANCIAL INFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS**

**ITERIS,INC.CONDENSED CONSOLIDATED BALANCE SHEETS(In thousands, except per share amounts)**

** **
| ** **                                                                                                                                                                  | ** ** | **December 31,  2006** | ** ** | **March 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **(unaudited)**             | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                                                                  |       |                        |       |                     |       |
| Current assets:                                                                                                                                                             |       |                        |       |                     |       |
| Cash and cash  equivalents                                                                                                                                                  | ** ** | **$**                       | **167**    |                     | $          | 131 |   |
| Trade accounts  receivable, net of allowance for doubtful accounts of $612 and $429 at  December 31, 2006 and March 31, 2006, respectively                             | ** ** | **11,869**                  |       | 11,426                   |       |
| Costs and  estimated earnings in excess of billings on uncompleted contracts                                                                                                | ** ** | **3,419**                   |       | 2,693                    |       |
| Inventories, net  of reserve for inventory obsolescence of $794 and $592 at December 31, 2006  and March 31, 2006, respectively                                        | ** ** | **6,430**                   |       | 2,814                    |       |
| Deferred income  taxes                                                                                                                                                      | ** ** | **854**                     |       | 790                      |       |
| Prepaid expenses  and other current assets                                                                                                                                  | ** ** | **757**                     |       | 368                      |       |
| Total current  assets                                                                                                                                                       | ** ** | **23,496**                  |       | 18,222                   |       |
| Property and  equipment, net                                                                                                                                                | ** ** | **1,689**                   |       | 1,783                    |       |
| Deferred income  taxes                                                                                                                                                      | ** ** | **1,266**                   |       | 818                      |       |
| Intangible  assets, net of accumulated amortization of $371 and $261 at December 31, 2006  and March 31, 2006, respectively                                            | ** ** | **441**                     |       | 551                      |       |
| Goodwill                                                                                                                                                                    | ** ** | **27,774**                  |       | 27,774                   |       |
| Other assets                                                                                                                                                                | ** ** | **392**                     |       | 485                      |       |
| Total assets                                                                                                                                                                | ** ** | **$**                       | **55,058** |                     | $          | 49,633 |   |
|                                                                                                                                                                        | ** ** | ** **                  |       |                     |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                              | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Current liabilities:                                                                                                                                                        |       |                        |       |                     |       |
| Trade accounts  payable                                                                                                                                                     | ** ** | **$**                       | **4,453**  |                     | $          | 3,620 |   |
| Accrued payroll  and related expenses                                                                                                                                       | ** ** | **3,558**                   |       | 3,481                    |       |
| Accrued  liabilities                                                                                                                                                        | ** ** | **1,763**                   |       | 2,304                    |       |
| Billings in  excess of costs and estimated earnings on uncompleted contracts                                                                                                | ** ** | **821**                     |       | 893                      |       |
| Revolving line  of credit                                                                                                                                                   | ** ** | **4,152**                   |       | 2,662                    |       |
| Current portion  of long-term debt                                                                                                                                          | ** ** | **2,270**                   |       | 1,969                    |       |
| Total current  liabilities                                                                                                                                                  | ** ** | **17,017**                  |       | 14,929                   |       |
| Non-current accrued  liabilities                                                                                                                                            | ** ** | **184**                     |       | 12                       |       |
| Deferred compensation  plan liability                                                                                                                                       | ** ** | **760**                     |       | 820                      |       |
| Deferred gain on sale  of building                                                                                                                                          | ** ** | **236**                     |       | 449                      |       |
| Long-term debt                                                                                                                                                              | ** ** | **675**                     |       | 2,171                    |       |
| Convertible debentures,  net                                                                                                                                                | ** ** | **9,358**                   |       | 9,203                    |       |
| Total  liabilities                                                                                                                                                          | ** ** | **28,230**                  |       | 27,584                   |       |
| Commitments and  contingencies                                                                                                                                              |       |                        |       |                     |       |
| Redeemable  common stock, 1,219 shares issued and outstanding at December 31, 2006 and  March 31, 2006                                                                 | ** ** | **3,414**                   |       | 3,414                    |       |
| Stockholders’ equity:                                                                                                                                                  |       |                        |       |                     |       |
| Preferred stock,  $1.00 par value, 2,000 shares authorized, none issued and outstanding at  December 31, 2006 and March 31, 2006                                       |       | —                      |       | —                   |       |
| Common stock,  $0.10 par value, 50,000 shares authorized, 29,775 and 27,432 shares issued  and outstanding at December 31, 2006 and March 31, 2006,  respectively | ** ** | **2,977**                   |       | 2,743                    |       |
| Additional  paid-in capital                                                                                                                                                 | ** ** | **129,839**                 |       | 126,664                  |       |
| Common stock  held in trust, 311 shares at December 31, 2006 and March 31, 2006                                                                                        | ** ** | **(374**                    | **)**      | (374                     | )          |
| Notes receivable  from employees                                                                                                                                            | ** ** | **(5**                      | **)**      | (49                      | )          |
| Accumulated  deficit                                                                                                                                                        | ** ** | **(109,035**                | **)**      | (110,356                 | )          |
| Accumulated  other comprehensive income                                                                                                                                     | ** ** | **12**                      |       | 7                        |       |
| Total stockholders’  equity                                                                                                                                            | ** ** | **23,414**                  |       | 18,635                   |       |
| Total liabilities and stockholders’ equity                                                                                                                             | ** ** | **$**                       | **55,058** |                     | $          | 49,633 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

2

----

 

**ITERIS,INC.UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share amounts)**

 

 
| ** **                                           | ** ** | **Three Months ended  December 31,** | ** ** | **Nine Months Ended  December 31** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales and contract revenues: | ** ** | ** **                                          |       |                                              |       |   |   |   |   |
| Net sales                                            | ** ** | **$**                                               | **8,575**  |                                              | $          | 7,276 | ** ** | **$** | **26,498** |   | $ | 22,776 |   |
| Contract revenues                                    | ** ** | **5,913**                                           |       | 4,907                                             | ** ** | **16,272** |   | 14,201 |   |
| Total net sales and contract revenues                | ** ** | **14,488**                                          |       | 12,183                                            | ** ** | **42,770** |   | 36,977 |   |
|                                                 | ** ** | ** **                                          |       |                                              | ** ** | ** ** |   |   |   |
| Costs and  expenses:                                 | ** ** | ** **                                          |       |                                              | ** ** | ** ** |   |   |   |
| Cost of net sales (a)                                | ** ** | **4,746**                                           |       | 3,898                                             | ** ** | **14,800** |   | 11,889 |   |
| Cost of contract revenues (a)                        | ** ** | **4,066**                                           |       | 3,304                                             | ** ** | **10,618** |   | 9,310 |   |
| Gross profit                                         | ** ** | **5,676**                                           |       | 4,981                                             | ** ** | **17,352** |   | 15,778 |   |
| Operating  expenses:                                 | ** ** | ** **                                          |       |                                              | ** ** | ** ** |   |   |   |
| Selling, general and administrative (a)              | ** ** | **3,879**                                           |       | 3,599                                             | ** ** | **11,865** |   | 11,513 |   |
| Research and development (a)                         | ** ** | **1,038**                                           |       | 1,172                                             | ** ** | **2,812** |   | 4,288 |   |
| Deferred compensation plan                           | ** ** | **(29**                                             | **)**      | (90                                               | )          | **(61** | **)** | (12 | ) |
| Amortization of intangible assets                    | ** ** | **37**                                              |       | 37                                                | ** ** | **110** |   | 110 |   |
| Total operating expenses                             | ** ** | **4,925**                                           |       | 4,718                                             | ** ** | **14,726** |   | 15,899 |   |
| Operating income  (loss)                             | ** ** | **751**                                             |       | 263                                               | ** ** | **2,626** |   | (121 | ) |
| Non-operating  income (expense):                     | ** ** | ** **                                          |       |                                              | ** ** | ** ** |   |   |   |
| Other income (expense), net                          | ** ** | **(5**                                              | **)**      | (6                                                | )          | **(650** | **)** | 32 |   |
| Interest expense, net                                | ** ** | **(390**                                            | **)**      | (377                                              | )          | **(1,200** | **)** | (1,087 | ) |
| Income (loss)  before income taxes                   | ** ** | **356**                                             |       | (120                                              | )          | **776** |   | (1,176 | ) |
| Income tax  benefit (provision)                      | ** ** | **(46**                                             | **)**      | 256                                               | ** ** | **545** |   | 431 |   |
| Net income (loss)                                    | ** ** | **$**                                               | **310**    |                                              | $          | 136 | ** ** | **$** | **1,321** |   | $ | (745 | ) |
|                                                 | ** ** | ** **                                          |       |                                              | ** ** | ** ** |   |   |   |
| Earnings (loss)  per share:                          | ** ** | ** **                                          |       |                                              | ** ** | ** ** |   |   |   |
| Basic                                                | ** ** | **$**                                               | **0.01**   |                                              | $          | 0.00 | ** ** | **$** | **0.05** |   | $ | (0.03 | ) |
| Diluted                                              | ** ** | **$**                                               | **0.01**   |                                              | $          | 0.00 | ** ** | **$** | **0.04** |   | $ | (0.03 | ) |
| Weighted average  shares outstanding:                | ** ** | ** **                                          |       |                                              | ** ** | ** ** |   |   |   |
| Basic                                                | ** ** | **30,438**                                          |       | 28,246                                            | ** ** | **29,238** |   | 28,138 |   |
| Diluted                                              | ** ** | **33,813**                                          |       | 32,700                                            | ** ** | **33,067** |   | 28,138 |   |

----

(a)             Includes stock-based compensation expense as follows
| Cost of net sales                            |   | $ | 3  |   | $ | 5  |   | $ | 12  |   | $ | 23  |   |
|----------------------------------------------|--------|---|----|--------|---|----|--------|---|-----|--------|---|-----|--------|
| Cost of contract  revenues                   |   | $ | 8  |   | $ | 35 |   | $ | 56  |   | $ | 172 |   |
| Selling, general and  administrative expense |   | $ | 46 |   | $ | 44 |   | $ | 147 |   | $ | 319 |   |
| Research and development expense             |   | $ | 2  |   | $ | 19 |   | $ | 18  |   | $ | 112 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

3

----

 

**ITERIS,INC.UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**
| ** **                                                                                           | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| **Cash flows from operating activities**                                         | ** ** | ** **                                         |       |   |   |
| Net income  (loss)                                                                                   | ** ** | **$**                                              | **1,321**  |   | $ | (745 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided (used in) by operating  activities: |       |                                               |       |   |   |
| Change in  deferred tax assets                                                                       | ** ** | **(512**                                           | **)**      | (472 | ) |
| Depreciation and  amortization of property and equipment                                             | ** ** | **405**                                            |       | 506 |   |
| Stock-based  compensation expense                                                                    | ** ** | **233**                                            |       | 626 |   |
| Amortization of  deferred gain on sale—leaseback transaction                                    | ** ** | **(213**                                           | **)**      | (213 | ) |
| Amortization of  debt discount                                                                       | ** ** | **155**                                            |       | 155 |   |
| Amortization of  intangible assets                                                                   | ** ** | **110**                                            |       | 110 |   |
| Amortization of  deferred financing costs                                                            | ** ** | **103**                                            |       | 103 |   |
| Issuance of  warrants for services                                                                   | ** ** | **22**                                             |       | — |   |
| Changes in  operating assets and liabilities:                                                        |       |                                               |       |   |   |
| Accounts  receivable                                                                                 | ** ** | **(443**                                           | **)**      | 26 |   |
| Net costs and  estimated earnings in excess of billings                                              | ** ** | **(798**                                           | **)**      | (474 | ) |
| Inventories                                                                                          | ** ** | **(3,616**                                         | **)**      | 1,692 |   |
| Prepaid expenses  and other assets                                                                   | ** ** | **(399**                                           | **)**      | (98 | ) |
| Accounts payable  and accrued liabilities                                                            | ** ** | **1,350**                                          |       | (275 | ) |
| Net cash provided by  (used in) operating activities                                                 | ** ** | **(2,282**                                         | **)**      | 941 |   |
|                                                                                                 |       |                                               |       |   |   |
| **Cash flows from investing  activities**                                                            |       |                                               |       |   |   |
| Purchases of  property and equipment                                                                 | ** ** | **(311**                                           | **)**      | (716 | ) |
|                                                                                                 |       |                                               |       |   |   |
| **Cash flows from financing  activities**                                                            |       |                                               |       |   |   |
| Net borrowings  on line of credit                                                                    | ** ** | **1,490**                                          |       | 444 |   |
| Payments on  long-term debt                                                                          | ** ** | **(1,195**                                         | **)**      | (980 | ) |
| Change in checks  drawn in excess of available bank balances                                         | ** ** | **(651**                                           | **)**      | — |   |
| Proceeds from  stock option and warrant exercises                                                    | ** ** | **2,945**                                          |       | 265 |   |
| Proceeds from  notes receivable from employees                                                       | ** ** | **40**                                             |       | — |   |
| Net cash provided by  (used in) financing activities                                                 | ** ** | **2,629**                                          |       | (271 | ) |
| Increase (decrease) in  cash                                                                         | ** ** | **36**                                             |       | (46 | ) |
| Cash at beginning of  period                                                                         | ** ** | **131**                                            |       | 46 |   |
| Cash at end of period                                                                                | ** ** | **$**                                              | **167**    |   | $ | — |   |
|                                                                                                 |       |                                               |       |   |   |
| **Supplemental cash flow  information:**                                                             | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Cash paid during  the period:                                                                        |       |                                               |       |   |   |
| Interest                                                                                             | ** ** | **$**                                              | **937**    |   | $ | 795 |   |
| Income taxes                                                                                         | ** ** | **26**                                             |       | (2 | ) |
| ** **                                                                                           | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| **Supplemental schedule of  non-cash investing and financing activities:**                      | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Fair value of common  stock issued in settlement of liabilities                                      | ** ** | **$**                                              | **213**    |   | $ | — |   |
| Fair value of warrants  issued in settlement of liabilities                                          | ** ** | **—**                                         |       | 28 |   |
| Retirement of treasury stock                                                                         | ** ** | **—**                                         |       | 1 |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

4

----

**ITERIS, INC.NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31, 2006**

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

**Description of Business**

Iteris, Inc.,formerly known as Iteris Holdings, Inc. and Odetics, Inc. (“Iteris” or the“Company”), is a leading provider of outdoor machine vision systems and sensorsthat optimize the flow of traffic and enhance driver safety. Using proprietarysoftware and Intelligent Transportation Systems (“ITS”) industry expertise, theCompany provides video sensor systems, transportation management and travelerinformation systems and other engineering consulting services to the ITSindustry. The ITS industry is comprised of companies applying a variety oftechnologies to enable the safe and efficient movement of people and goods. TheCompany uses its outdoor image recognition software expertise to developproprietary algorithms for video sensor systems that improve vehicle safety andthe flow of traffic. Using its knowledge of the ITS industry, the Companydesigns and implements transportation management systems that help publicagencies reduce traffic congestion and provide greater access to travelerinformation.  The Company was originallyincorporated in Delaware in 1987 as Odetics, Inc. and inSeptember 2003 changed its name to Iteris Holdings, Inc. to reflectits focus on the ITS industry and its capital structure at that time.  On October 22, 2004, the Company completeda merger with its majority-owned subsidiary, Iteris, Inc. (the “IterisSubsidiary”), and officially changed its corporate name from IterisHoldings, Inc. to Iteris, Inc.

**Basis ofPresentation**

The unaudited condensed consolidated financialstatements of the Company have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Securities and Exchange Commission (“SEC”)Form 10-Q and Article 10 of SEC Regulation S-X. In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements contain all adjustments, consisting of normal recurring adjustments,necessary to present fairly the consolidated financial position of the Companyas of December 31, 2006, the consolidated results of operations for the threeand nine months ended December 31, 2006 and 2005, and the consolidated cashflows for the nine months ended December 31, 2006 and 2005. Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United States (“U.S.GAAP”) have been condensed or omitted pursuant to the rules andregulations of the SEC. The results of operations for the three and nine monthsended December 31, 2006, are not necessarily indicative of those to be expectedfor the entire year. The accompanying unaudited condensed consolidatedfinancial statements should be read in conjunction with the Company’s AnnualReport on Form 10-K for the year ended March 31, 2006, which wasfiled with the SEC on June 29, 2006.

# **Use ofEstimates**

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

# **RevenueRecognition**

Productrevenues and related costs of sales are recognized upon the transfer of title,which generally occurs upon shipment or, if required, upon acceptance by thecustomer, provided that the Company believes collectibility of the net salesamount is probable.  Accordingly, at thedate revenue is recognized, the significant uncertainties concerning the salehave been resolved.

5

----

Contractrevenues are derived primarily from long-term contracts with governmentalagencies.  Contract revenues includecosts incurred plus a portion of estimated fees or profits determined on thepercentage of completion method of accounting based on the relationship ofcosts incurred to date to total estimated costs.  Any anticipated losses on contracts arecharged to earnings when identified. Changes in job performance and estimated profitability, including thosearising from contract penalty provisions and final contract settlements, mayresult in revisions to costs and revenues and are recognized in the period inwhich the revisions are determined. Profit incentives are included in revenue when their realization isreasonably assured.

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

Revenuesfrom follow-on service and support, for which the Company charges separately,are recorded in the period in which the services are performed.

**Concentrationof Credit Risk**

Accountsreceivable are primarily derived from revenues earned from customers located throughoutNorth America and Europe.  The Companygenerally does not require collateral or other security from customers.Collectibility of receivable balances is estimated through review of invoicesoutstanding greater than a certain period of time and ongoing creditevaluations of customers’ financial condition. Reserves are maintained for potential credit losses, and such losseshave historically been within management’s expectations.

**Fair Values of Financial Instruments**

The fair values of cashand cash equivalents, receivables, inventories, accounts payable and accruedexpenses approximate carrying value because of the short period of time tomaturity. The fair values of line of credit agreements and long-term debtapproximate carrying value because the related rates of interest approximatecurrent market rates.  The fair value ofconvertible debentures approximates carrying value because the effectiveinterest rate, taking into account recorded debt discounts, approximatescurrent market rates.  The estimated fairvalue of redeemable common stock was $2.9 million and $3.2 million at December31, 2006 and March 31, 2006, respectively, based on the closing price of theCompany’s common stock on those dates.

# **Inventories**

Inventories are stated atthe lower of cost or market. Cost is determined using the first-in, first-outmethod.

**Property and Equipment**

Property and equipmentare recorded at cost and are depreciated over the estimated useful life rangingfrom three to eight years.  Leaseholdimprovements are depreciated over the term of the related lease or theestimated useful life of the improvement, whichever is shorter.  Beginning April 1, 2006, the Company begandepreciating property and equipment using the straight-line method ofdepreciation.  Prior to this date, theCompany used the double declining balance method of depreciation.  As a result of this change in estimate,depreciation expense declined by $125,000 and $319,000 for the three and ninemonths ended December 31, 2006, respectively, resulting in no impact onearnings per share for the three months ended December 31, 2006, and a $0.01per share impact on earnings per share for the nine months ended December 31,2006.

**Goodwill and Long-Lived Assets**

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 142, *Goodwill and Intangible Assets*, goodwill is tested forimpairment on an annual basis in the Company’s fourth fiscal quarter or morefrequently if indicators of impairment exist, of which none have beenidentified.  The performance of the testinvolves a two-step process.  The firststep of the impairment test involves comparing the fair value of the Company’sreporting units with each respective 

6

----

reporting unit’s carrying amount, includinggoodwill.  The Company determines thefair value of reporting units using the income approach.  If the carrying amount of a reporting unitexceeds the reporting unit’s fair value, the second step of the goodwillimpairment test is performed to determine the amount of any impairmentloss.  The second step of the goodwillimpairment test involves comparing the implied fair value of the reporting unit’sgoodwill with the carrying amount of that goodwill.

The Company evaluateslong-lived assets for impairment in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets,*which requires impairment evaluation on long-lived assets used in operationswhen indicators of impairment are present. Reviews are performed to determine whether the carrying value of assetsis impaired, based on a comparison to undiscounted expected future cashflows.  If this comparison indicates thatthere is impairment, 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 excess of the carrying amount over the fairvalue of those assets.

**Income Taxes**

The Company utilizes theliability method of accounting for income taxes as set forth in SFASNo. 109, *Accounting for Income Taxes*(“SFAS109”)*.* Under the liability method, deferred taxes are determined based on thetemporary differences between the financial statement and tax bases of assetsand liabilities using enacted tax rates. A valuation allowance is recorded when it is more likely than not thatall or a portion of the deferred tax assets will not be realized.

**Researchand Development Expenditures**

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

**Shipping and Handling Costs**

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

**Warranty**

The Company generally provides a one to three yearwarranty from the original invoice date on all products, materials andworkmanship.  Products sold to certainoriginal equipment manufacturer (“OEM”) customers sometimes carry longerwarranties. Defective products will be either repaired or replaced, generallyat the Company’s option, upon meeting certain criteria. The Company accrues aprovision for the estimated costs that may be incurred for product warrantiesrelating to a product as a component of cost of sales at the time revenue forthat product is recognized.  The accruedwarranty provision is included within accrued expenses on the accompanyingcondensed consolidated balance sheets.

**Repair and Maintenance Costs**

TheCompany incurs repair and maintenance costs in the normal course of business. Shouldthe activity result in a permanent improvement to one of the Company’s leasedfacilities, the cost is capitalized as a leasehold improvement and amortizedover its useful life or the remainder of the lease period, whichever isshorter.  Non-permanent repair andmaintenance costs are charged to expense as incurred.

**Reclassifications**

Certainamounts in the prior period financial statements have been reclassified toconform with current year presentation.

**Other Comprehensive Income**

The only component of accumulated other comprehensiveincome is foreign currency translation adjustments.

7

----

**Recent Accounting Pronouncements**

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004), *Share-Based Payment* (“SFAS 123R”), which replaces SFAS No.123, *Accounting for Stock-Based Compensation*(“SFAS 123”), supersedes Accounting Principles Board Opinion No. 25 (“APB 25”),and amends SFAS No. 95, *Statement of Cash Flows*.  Generally, the approach in SFAS 123R issimilar to the approach described in SFAS 123. However, SFAS 123R requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values (i.e., pro forma disclosure is no longeran alternative to financial statement recognition).  As further discussed in Note 6, the Companyadopted SFAS 123R effective April 1, 2006 using the modified prospectivemethod.

In July 2006, the FASB issued FASB Interpretation No.48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”).  FIN 48 clarifies theaccounting and reporting for income taxes recognized in accordance with SFAS109.  This Interpretation prescribes acomprehensive model for the financial statement recognition, measurement, presentationand disclosure of uncertain tax positions taken or expected to be taken inincome tax returns.  The Company iscurrently evaluating the impact of FIN 48 and expects to adopt thisInterpretation in the first quarter of its fiscal year ending March 31, 2008.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”), which defines fairvalue, establishes a framework for measuring fair value, and expands disclosureabout fair value measurements. SFAS 157 does not require any new fair valuemeasurements; rather it specifies valuation methods to be applied when fairvalue measurements are required under existing or future accountingpronouncements. SFAS 157 is effective for fiscal years beginning after November15, 2007, and interim periods within those fiscal years. Early application ofthe statement is encouraged. Generally, this statement will be appliedprospectively. The Company is currently evaluating the impact of SFAS 157 andexpects to adopt SFAS 157 in the first quarter of its fiscal year ending March31, 2009.

In September 2006, the SEC staff issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (“SAB 108”). SAB 108 provides interpretive guidance on the consideration of theeffects of prior year misstatements in quantifying current year misstatementsfor the purpose of a materiality assessment. The Company is currently evaluating the impact of SAB 108 and expects toadopt SAB 108 in the first quarter of its fiscal year ending March 31, 2007.

In June 2006, the FASB ratified Emerging Issues TaskForce Issue No. 06-3, *How Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in theIncome Statement (That Is, Gross versus Net Presentation)* (“EITF06-3”).  The task force reached aconclusion that either method is acceptable; however, if taxes are reported ona gross basis (included as sales) a company should disclose those amounts ifsignificant.  EITF 06-3 is effective forthe first interim reporting period beginning after December 15, 2006.  The Company is currently evaluating theimpact of EITF 06-3 and expects to adopt EITF 06-3 in the fourth quarter of thecurrent fiscal year.

**2. Supplemental Financial Information**

**Inventories**

Thefollowing table presents details of the Company’s inventories:
| ** **              | ** ** | **December 31,  2006** | ** ** | **March 31,  2006** | ** ** |
|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **              | ** ** | **(In thousands)**     | ** ** |
| Materials and  supplies | ** ** | **$**                       | **4,893**  |                     | $          | 2,258 |   |
| Work in process         | ** ** | **329**                     |       | 217                      |       |
| Finished goods          | ** ** | **1,208**                   |       | 339                      |       |
| ** **              | ** ** | **$**                       | **6,430**  |                     | $          | 2,814 |   |

 

8

----

**Goodwill and Intangible Assets**

The following table setsforth the Company’s intangible assets that are subject to amortization:
| ** **            | ** ** | **December 31, 2006** | ** ** | **March 31, 2006**  | ** ** |
|-----------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **            | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **            | ** ** | ** **                      | ** ** | **(In thousands)**       | ** ** | ** ** | ** ** |
| Developed  technology | ** ** | **$**                           | **495**    |                          | **$**      | **(255** | ) | $ | 495 |   | $ | (179 | ) |
| Patents               | ** ** | **317**                         |       | **(116**                      | )          | 317 |   | (82 | ) |
| Total                 | ** ** | **$**                           | **812**    |                          | **$**      | **(371** | ) | $ | 812 |   | $ | (261 | ) |

 

Amortizationexpense for intangible assets subject to amortization was $37,000 and $110,000for the three and nine months ended December 31, 2006, respectively, and$37,000 and $110,000 for the three and nine months ended December 31, 2005,respectively.  Future estimatedamortization expense for the remainder of the current fiscal year, the nextfour fiscal years and thereafter is as follows:

| Fiscal Year Ending March 31: | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|------------|------------|
| **(In thousands)**                          | ** ** | ** ** | ** ** |
| Remainder of  2007                               |       | $          | 37         |   |
| 2008                                             |       | 147        |       |
| 2009                                             |       | 147        |       |
| 2010                                             |       | 58         |       |
| 2011                                             |       | 46         |       |
| Thereafter                                       |       | 6          |       |
|                                             |       | $          | 441        |   |

 

At December 31, 2006, goodwill of $27.8 million wascomprised of $18.0 million associated with the October 2004 merger betweenthe Company and its Iteris Subsidiary; $9.6 million associated with theacquisitions of the Rockwell International Transportation Systems Group, MeyerMohaddes Associates, Inc. and the Viggen Systems Consulting Group; and $200,000associated with the purchase of the assets of Mil-Lektron, a complementaryproduct to the Company’s Vantage video detection business.

**Warranty Reserve Activity**

Thefollowing table presents activity in accrued warranty obligations:

|                                    | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | ** **                                          | ** ** | **(In thousands)**                            | ** ** | ** ** | ** ** |
| Balance at  beginning of period    |       | **$**                                               | **679**    |                                               | $          | 441 | ** ** | **$** | **519** |   | $ | 326 |   |
| Additions charged to cost of sales |       | **160**                                             |       | 80                                                 | ** ** | **450** |   | 345 |   |
| Warranty claims                    |       | **(265**                                            | )          | (92                                                | )          | **(395** | **)** | (242 | ) |
| Balance at end of  period          |       | **$**                                               | **574**    |                                               | $          | 429 | ** ** | **$** | **574** |   | $ | 429 |   |

 

**Earnings (Loss) Per Share**

Thefollowing table sets forth the computation of basic and diluted earnings (loss)per share:

9

----

 

|                                                              | ** ** | **Three Months Ended  December 31,**                   | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                                              | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                   |       |                                                                  |       |                                               |       |   |   |   |   |
| Net income (loss)                                            |       | **$**                                                                 | **310**    |                                               | $          | 136 |   | **$** | **1,321** |   | $ | (745 | ) |
|                                                         |       | ** **                                                            |       |                                               |       | ** ** |   |   |   |
| Denominator:                                                 |       | ** **                                                            |       |                                               |       | ** ** |   |   |   |
| Weighted average common  shares used in basic computation    |       | **30,438**                                                            |       | 28,246                                             |       | **29,238** |   | 28,138 |   |
| Dilutive stock options                                       |       | **3,342**                                                             |       | 3,725                                              |       | **3,436** |   | — |   |
| Dilutive warrants                                            |       | **33**                                                                |       | 729                                                |       | **393** |   | — |   |
| Weighted average common  shares used in dilutive computation |       | **33,813**                                                            |       | 32,700                                             |       | **33,067** |   | 28,138 |   |
|                                                         |       | ** **                                                            |       |                                               |       | ** ** |   |   |   |
| Earnings (loss) per share:                                   |       | ** **                                                            |       |                                               |       | ** ** |   |   |   |
| Basic                                                        |       | **$**                                                                 | **0.01**   |                                               | $          | 0.00 |   | **$** | **0.05** |   | $ | (0.03 | ) |
| Diluted                                                      |       | **$**                                                                 | **0.01**   |                                               | $          | 0.00 |   | **$** | **0.04** |   | $ | (0.03 | ) |

 

Thefollowing shares were excluded from the computation of diluted earnings (loss)per share as their effect would have been antidilutive:

|                         | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **              | ** ** | **(In thousands)**                             | ** ** |
| Stock options           | ** ** | **567**                                             |       | 532                                                |       | **553** |   | 480 |   |
| Warrants                | ** ** | **1,190**                                           |       | 1,380                                              |       | **1,257** |   | 1,226 |   |
| Convertible  debentures | ** ** | **2,729**                                           |       | 2,729                                              |       | **2,729** |   | 2,729 |   |

 

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

**Revolving Line of Credit**

TheCompany renewed its line of credit agreement with its former bank in August2005, which provided for borrowings of up to $5.0 million.  This line of credit agreement was scheduledto expire on July 31, 2006 but was extended until October 31, 2006.

InOctober 2006, the Company replaced its former facility and entered into a newtwo-year credit facility with a different bank. The new facility provides for combined line of credit and bank term noteborrowings of up to $8.0 million.  Underthe new credit facility, the Company may borrow against its eligible accountsreceivable and eligible inventory, as defined in the credit agreement.  Line of credit interest on borrowed amountsis payable monthly at the current stated prime rate plus 1.25%.  Additionally, the Company is obligated to payan unused line fee of 0.25% per annum applied to the amount by which themaximum credit amount exceeds the average daily principal balance during thepreceding month. The new credit facility requires $2,000 in monthly collateralmanagement fees and includes an early termination fee equal to 2% of the totalfacility during the first year of the agreement and 1% of the total facility inthe second year of the agreement. Additionally, the Company paid a commitment fee of $40,000 in October2006 and is obligated to pay an additional $40,000 on the one-year anniversaryof the facility. The new credit facility is secured by substantially all of theassets of the Company.

OnDecember 31, 2006, the available credit under the credit facility was $8.0million, of which $2.0 million was unused.

**Long-Term Debt**

TheCompany’s long-term debt consists of the following:

10

----

 
| ** **                  | ** ** | **December 31,  2006** | ** ** | **March 31,  2006** | ** ** |
|-----------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                  | ** ** | **(In thousands)**     | ** ** |
|                        |       |                        |       |                     |       |
| Convertible debentures, net | ** ** | **$**                       | **9,358**  |                     | $          | 9,203 |   |
| Bank term note              | ** ** | **1,888**                   |       | 2,708                    |       |
| Promissory note to landlord | ** ** | **969**                     |       | 1,292                    |       |
| Other                       | ** ** | **88**                      |       | 140                      |       |
|                        | ** ** | **12,303**                  |       | 13,343                   |       |
| Less current portion        | ** ** | **(2,270**                  | )          | (1,969                   | )          |
|                        | ** ** | **$**                       | **10,033** |                     | $          | 11,374 |   |

 

*ConvertibleDebentures, Net.*  InMay 2004, the Company sold and issued subordinated convertible debentures inthe aggregate original principal amount of $10.1 million.  In connection with the issuance of thedebentures, the Company issued warrants to purchase an aggregate of 639,847shares of its common stock, the value of which was recorded as a debt discountagainst the face amount of the debentures on the date of issuance and is beingamortized to interest expense over the term of the convertible debentures.

Thedebentures are due in full on May 19, 2009, provide for 6.0% annualinterest, payable quarterly, and are convertible into the Company’s commonstock at an initial conversion price of $3.61 per share, subject to certainadjustments, including adjustments for dilutive issuances.  From May 19, 2007 until May 18,2008, the debentures may be redeemed by the Company, at its option, at 120% ofthe principal amount; and from May 19, 2008, until the maturity date, theCompany may redeem the debentures at 110% of the principal amount.  As of December 31, 2006, $250,000 ofconvertible debentures had been converted into 69,252 shares of common stockleaving $9.9 million of the originally issued convertible debenturesoutstanding at December 31, 2006.

*Bank TermNote.*  In October 2004,the Company entered into a $5.0 million term note payable with a bank.  The note was due on May 27, 2008, andprovided for monthly principal payments of approximately $104,000.  Interest accrued at the current stated primerate plus 0.25%.  In October 2006, theterm note was assumed by the Company’s new bank as part of the Company’s new$8.0 million credit facility. The new term note is also due on May 27, 2008 andprovides for monthly principal payments of approximately $104,000.  Interest accrues under the new term note atthe current stated prime rate plus 1.25%. Amounts due under the term note reduce the Company’s ability to borrowagainst its eligible assets on its line of credit.

Boththe new bank term note and the new line of credit are held by one bank underthe same credit agreement and are secured by substantially all of the assets ofthe Company.

*PromissoryNote to Landlord.*  TheCompany has a $1.3 million unsecured promissory note payable to the landlord ofits Anaheim headquarters.  Under theterms of the note agreement, interest is payable quarterly and accrues at arate of prime plus 2.0% (10.25% at December 31, 2006).  In October 2006, the Company made the firstof four required equal quarterly principal payments of $323,000.  All outstanding accrued interest andprincipal becomes payable in full on July 1, 2007.

Scheduledaggregate maturities of long-term debt principal as of December 31, 2006 wereas follows:
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| Remainder of 2007                                    | ** ** | **$**      | **648**    | ** ** |
| 2008                                                 | ** ** | **1,948**  | ** ** |
| 2009                                                 | ** ** | **349**    | ** ** |
| 2010                                                 | ** ** | **9,850**  | ** ** |
|                                                 | ** ** | **$**      | **12,795** | ** ** |
| Less: unamortized debt discount                      | ** ** | **(492**   | **)**      |
|                                                 | ** ** | **$**      | **12,303** | ** ** |

 

**4.  CommonStock Warrants**

On September 27, 2006,the Company issued warrants to purchase an aggregate 246,250 shares of commonstock at

11

----

an exercise price of $3.25 with a five-year life to anexisting shareholder in exchange for the early exercise of 1,250,000 outstandingwarrants with an exercise price of $1.61. The new warrants are immediately exercisable and are callable by theCompany if the market price of the Company’s common stock trades for 20consecutive days at a price greater than or equal to two times the exerciseprice of the warrants.  The fair value ofthe new warrants was $320,000 calculated using the Black-Scholes-Merton (“BSM”)option-pricing formula.  The warrantswere considered a cost of raising capital and were recorded in equity.

In connection with theissuance of the new warrants, the Company is party to a registration rightsagreement that contains provisions under which the Company could be subjectedto liquidated damages should it fail to maintain effective registrationstatements for the underlying shares of common stock.  These warrants have been accounted for withinequity in the condensed consolidated balance sheet in accordance with EITF00-19 *Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock*, and,accordingly, no liabilities have been recorded in connection therewith.  As of December 31, 2006, no liquidateddamages were payable under the provisions of the registration rights agreementassociated with these warrants.

**5. Commitments and Contingencies**

**Litigation and Other Contingencies**

OnJune 29, 2004, a supplier to Mariner Networks, Inc., a formersubsidiary of the Company that was discontinued in the fiscal year endedMarch 31, 2002, filed a complaint in Orange County Superior Court againstthe Company alleging various breaches of written contract claims arising out ofalleged purchase orders. The plaintiff in this lawsuit sought monetary damagesaggregating approximately $850,000 plus attorney fees and related costs.  On July 20, 2006, the Company entered into asettlement agreement in connection with this matter.  The dispute was settled in full for $688,000payable as follows:  (i) the Companyissued 88,912 shares of the Company’s common stock on August 18, 2006 valued at$213,000 based on the closing sales price of the Company’s common stock on thedate of issuance; (ii) the Company made a cash payment of $125,000 on October20, 2006; and (iii) the Company is obligated to pay $350,000 in cash in equalmonthly installments of $9,700 over the next three years beginning in November2006.  In connection with thissettlement, the Company has recorded a charge of $636,000, representing thefair value of the settlement, within other expense in the accompanyingcondensed consolidated statement of operations for the nine months endedDecember 31, 2006.

From time to time, theCompany has been involved in litigation relating to claims arising out of itsoperations in the normal course of business. The Company currently is not a party to any legal proceedings, theadverse outcome of which, in management’s opinion, individually or in theaggregate, would have a material adverse effect on its consolidated results ofoperations, financial position or cash flows.

Furthermore, from time totime, the Company has experienced unforeseen developments in contingenciesrelated to its former subsidiaries.  Forexample, the Company has been the subject of a number of routine tax audits fortime periods and jurisdictions related to the businesses of its formersubsidiaries, some of which are still in process.  Although the development and ultimate outcomeof these and other unforeseen matters cannot be predicted with any certainty,management does not believe that the Company is presently involved in anymatters related to its former subsidiaries that would have a material adverseeffect on the Company’s consolidated results of operations, financial positionor cash flows.

**Operating Lease Commitments**

The Company has lease commitments for facilities invarious locations throughout the United States. Future commitments under thesenon-cancelable operating leases at December 31, 2006 were as follows:
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| Remainder of 2007                                    | ** ** | **$**      | **380**    | ** ** |
| 2008                                                 | ** ** | **983**    | ** ** |
| 2009                                                 | ** ** | **146**    | ** ** |
| 2010                                                 | ** ** | **85**     | ** ** |
| 2011                                                 | ** ** | **43**     | ** ** |
| Total                                                | ** ** | **$**      | **1,637**  | ** ** |

 

12

----

**Inventory Purchase Commitments**

At December 31, 2006, the Company had firm commitments to purchaseinventory in the amount of $1.5 million during the next two fiscal quarters.

**6.  Stock-Based Compensation**

TheCompany adopted SFAS 123R effective April 1, 2006.  Prior to April 1, 2006, the Company followedthe disclosure-only provisions of SFAS 123, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure*,and, accordingly, accounted for its stock-based compensation plans using theintrinsic value method under APB 25 and related interpretations.

SFAS123R requires all stock-based payments, including grants of employee stockoptions, to be recognized in the statement of operations as an expense, basedon their grant date fair values with such fair values amortized over therequisite service period.  The Companyelected to utilize the modified prospective method for the transition to SFAS123R. Under the modified prospective method, SFAS 123R applies to all awardsgranted or modified after the date of adoption. In addition, under the modifiedprospective method, compensation expense will be recognized for all stock-basedcompensation awards granted prior to but not yet vested as of April 1, 2006, basedon grant-date fair values estimated in accordance with the original provisionsof SFAS 123.  Accordingly, prior periodamounts presented herein have not been restated to reflect the adoption of SFAS123R.

Thefair value concepts were not changed significantly as a result of implementingSFAS 123R; however, in adopting SFAS 123R, companies must choose amongalternative valuation models and amortization assumptions. After assessingalternative valuation models and amortization assumptions, the Company continuesto use both the BSM option-pricing formula and straight-line amortization ofcompensation expense over the requisite service period of stock optiongrants.  The Company will reconsider useof this model if additional information becomes available in the future thatindicates another model would be more appropriate, or if grants issued infuture periods have characteristics that cannot be reasonably estimated usingthis model.  SFAS 123 did not require theestimation of forfeitures in the calculation of stock compensation expense;however, SFAS 123R does require such estimation and upon adoption of SFAS 123R,the Company changed its methodology to include an estimate of forfeitures. Theadoption of SFAS 123R had no effect on cash flows from operating activitiesbecause no tax benefits are realized from stock option exercises. The adoptionof SFAS 123R also had no effect on cash flows from financing activities.

Thefollowing table illustrates the impact of adopting SFAS 123R:
| ** **                  | ** ** | **Three Months Ended  December 31, 2006**         | ** ** | **Nine Months Ended  December 31, 2006** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                  | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Income before income taxes  | ** ** | **$**                                                                 | **(59**    | **)**                                                        | $          | (153 | ) |
| Net income                  | ** ** | **$**                                                                 | **(59**    | **)**                                                        | $          | (153 | ) |
| Basic earnings per share    | ** ** | **$**                                                                 | **0.00**   |                                                         | $          | (0.01 | ) |
| Diluted earnings  per share | ** ** | **$**                                                                 | **0.00**   |                                                         | $          | 0.00 |   |

 

Thefollowing table illustrates the effect on net loss and net loss per share forthe three and nine months ended December 31, 2005 as if the Company had appliedthe fair value recognition provisions of SFAS 123 to options granted under theCompany’s stock option plans.  Forpurposes of this pro forma disclosure, the fair value of the options wasestimated using the BSM option-pricing formula and amortized on a straight-linebasis to expense over the options’ vesting period:

13

----

 
| ** **                                                                                              | ** ** | **Three Months Ended  December 31, 2005**         | ** ** | **Nine Months Ended  December 31, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net income (loss) — as reported                                                                    |       | $                                                                     | 136        |                                                         | $          | (745 | ) |
| Add: Stock-based compensation expense included in  net income (loss) — as reported                 |       | 103                                                                   |       | 626                                                          |       |
| Deduct: Total stock-based compensation expense  determined under fair value based method for all awards |       | (205                                                                  | )          | (941                                                         | )          |
| Net income (loss) — pro forma                                                                      |       | $                                                                     | 34         |                                                         | $          | (1,060 | ) |
|                                                                                                    |       |                                                                  |       |                                                         |       |
| Basic and diluted income (loss) per share — as  reported                                           |       | $                                                                     | 0.00       |                                                         | $          | (0.03 | ) |
| Basic and  diluted income (loss) per share — pro forma                                             |       | $                                                                     | 0.00       |                                                         | $          | (0.04 | ) |

 

TheCompany’s 1997 Stock Incentive Plan (the “Plan”) provides that options topurchase shares of the Company’s unissued common stock may be granted todirectors, associates and consultants to the Company at exercise prices whichare equal to or greater than the fair market value of the Company’s commonstock on the date of grant.  Optionsexpire ten years after the date of grant or 90 days after termination ofemployment and generally vest ratably at the rate of 25% on each of the firstfour anniversaries of the grant date. New shares are issued to satisfy stock option exercises under thePlan.  As of December 31, 2006, optionsto purchase 1.5 million shares of the Company’s common stock were outstandingunder the Plan.

Inconnection with the merger of the Company and the Iteris Subsidiary (Note 1),the Company assumed the 1998 Stock Incentive Plan of the Iteris Subsidiary (the“1998 Plan”) and all outstanding options granted thereunder.  As of December 31, 2006, options to purchase3.8 million shares of the Company’s common stock were outstanding under the1998 Plan.  No further options may begranted under the 1998 Plan.

Certainoptions granted under the 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 meet the criteria of a performancecondition under SFAS 123R.

As ofDecember 31, 2006, the Company had 1.3 million outstanding stock options thatwere originally granted outside of the Plans and that were assumed by the Planin connection with the merger of the Company and the Iteris Subsidiary (Note1).

Asummary of activity in the Plans for the nine months ended December 31, 2006 isas 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, 2006                                     |       | 6,977                                                                 |       | $                                      | 1.42       |                                                        | 3.97       |                                |       |   |
| Granted                                                                   |       | 169                                                                   |       | $                                      | 2.33       |                                                        | N/A        |                                |       |   |
| Exercised                                                                 |       | (548                                                                  | )          | $                                      | 0.92       |                                                        | N/A        |                                |       |   |
| Forfeited                                                                 |       | (18                                                                   | )          | $                                      | 2.64       |                                                        | N/A        |                                |       |   |
| Expired                                                                   |       | (24                                                                   | )          | $                                      | 2.50       |                                                        | N/A        |                                |       |   |
| Options outstanding at December 31, 2006                                  |       | 6,556                                                                 |       | $                                      | 1.48       |                                                        | 3.5        |                                | $          | 7,756 |   |
| Vested and expected to vest at December 31, 2006                          |       | 6,489                                                                 |       | $                                      | 1.47       |                                                        | 3.4        |                                | $          | 7,745 |   |
| Options exercisable at December 31, 2006                                  |       | 6,151                                                                 |       | $                                      | 1.41       |                                                        | 3.1        |                                | $          | 7,628 |   |
| Options  exercisable at December 31, 2006 pursuant to a change-in-control |       | 6,556                                                                 |       | $                                      | 1.48       |                                                        | 3.5        |                                | $          | 7,756 |   |

 

AtDecember 31, 2006, there were 106,000 shares of common stock available forgrant under the Plan.

Forthe nine month periods ended December 31, 2006 and 2005, the Company received$505,000 and $228,000, respectively, in cash from the exercise of stockoptions.  Total stock-based compensationexpense for the three and nine months ended December 31, 2006 was $59,000 and$233,000, respectively.  No income taxbenefit was realized from activity in the Plans during the nine months endedDecember 31, 2006 and 2005.

 

14

----

 

At December 31,2006, there was $676,000 of total unrecognized compensation expense related tounvested stock options.  This expense isexpected to be recognized over a weighted-average period of approximately 3.0years.

The fair value of each stock-based award is estimated on the grant dateusing the BSM option-pricing formula. Expected volatility is based on thehistorical volatility of the Company’s stock price. The expected life ofoptions granted subsequent to the adoption of SFAS 123R is derived based on thehistorical life of the Company’s options. The risk-free interest rate for periods within the expected life of theoption is based on the U.S. Treasury interest rates in effect at the time ofgrant. The grant date fair value of options granted was estimated using thefollowing weighted-average assumptions:
| ** **                           | ** ** | **Three Months  Ended December 31,** | ** ** | **Nine Months  Ended December 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | ** **                                          | ** ** | ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Dividend yield                       | ** ** | **N/A**                                             |       | 0.0                                                | %          | **0.0** | **%** | 0.0 | % |
| Expected life —  years          | ** ** | **N/A**                                             |       | 7.0                                                | ** ** | **7.0** |   | 7.0 |   |
| Risk-free  interest rate             | ** ** | **N/A**                                             |       | 5.5                                                | %          | **4.8** | **%** | 5.5 | % |
| Expected  volatility of common stock | ** ** | **N/A**                                             |       | 0.50                                               | ** ** | **0.89** |   | 0.50 |   |

 

 

A summary of thegrant date fair value and intrinsic value information is as follows:
| ** **                                            | ** ** | **Three Months  Ended December 31,**                   | ** ** | **Nine Months  Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Weighted average  grant date fair value per share     | ** ** | **N/A**                                                               |       | $                                                   | 1.53       | ** ** | **$** | **1.86** |   | $ | 1.79 |   |
| Intrinsic value  of options exercised                 | ** ** | **$**                                                                 | **541**    |                                                | $          | 61 | ** ** | **$** | **766** |   | $ | 240 |   |
| Total fair value  of options vested during the period | ** ** | **$**                                                                 | **104**    |                                                | $          | 146 | ** ** | **$** | **621** |   | $ | 1,498 |   |

 

**7.  BusinessSegment Information**

The Companycurrently operates in three reportable segments: Roadway Sensors, AutomotiveSensors and Transportation Systems.  TheRoadway Sensors segment includes the Company’s Vantage vehicle detectionsystems for traffic intersection control, incident detection and certainhighway traffic data collection applications. The Automotive Sensors segment includes AutoVue and is comprised of allactivities related to lane departure warning systems for vehicle safety.  The Transportation Systems segment includestransportation engineering and consulting services and the development oftransportation management and traveler information systems for the ITSindustry. The accounting policies of the reportable segments are the same asthose described in the summary of significant accounting policies except thatcertain expenses, such as interest, amortization of certain intangibles andcertain corporate expenses are not allocated to the segments. In addition,certain assets, including cash and cash equivalents, deferred taxes and certainlong-lived and intangible assets, are not allocated to the segments.  The reportable segments are each managedseparately because they manufacture and distribute distinct products or provideservices with different processes.  Allsegment revenues are derived from external customers.

The followingtable sets forth selected unaudited financial information for the Company’sreportable segments for the three and nine months ended December 31, 2006 and2005:

15

----

 
| ** **                                        | ** ** | **Roadway  Sensors**    | ** ** | **Automotive  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                        | ** ** | **(In thousands)** | ** ** |
| **Three Months Ended December 31, 2006**          |       |                    |       |                    |       |                        |       |      |       |
| Product revenue from external customers           |       | $                       | 6,499      |                    | $          | 1,460                       |       | $         | —     |   | $ | 7,959 |   |
| Service and other revenue from external customers |       | —                  |       | 616                     |       | 5,913                       |       | 6,529     |       |
| Depreciation and amortization                     |       | 21                      |       | 35                      |       | 32                          |       | 88        |       |
| Segment income (loss)                             |       | 1,389                   |       | (878                    | )          | 664                         |       | 1,175     |       |
|                                              |       |                    |       |                    |       |                        |       |      |       |
| **Three Months Ended December 31, 2005**          |       |                    |       |                    |       |                        |       |      |       |
| Product revenue from external customers           |       | $                       | 5,234      |                    | $          | 1,401                       | ** ** | **$**     | **—** |   | $ | 6,635 |   |
| Service and other revenue from external customers |       | —                  |       | 641                     |       | 4,907                       |       | 5,548     |       |
| Depreciation and amortization                     |       | 35                      |       | 52                      |       | 55                          |       | 142       |       |
| Segment income (loss)                             |       | 709                     |       | (558                    | )          | 411                         |       | 562       |       |
|                                              |       |                    |       |                    |       |                        |       |      |       |
| **Nine Months Ended December 31, 2006**           |       |                    |       |                    |       |                        |       |      |       |
| Product revenue from external customers           |       | $                       | 19,976     |                    | $          | 4,282                       |       | $         | —     |   | $ | 24,258 |   |
| Service and other revenue from external customers |       | —                  |       | 2,240                   |       | 16,272                      |       | 18,512    |       |
| Depreciation and amortization                     |       | 60                      |       | 103                     |       | 94                          |       | 257       |       |
| Segment income (loss)                             |       | 4,491                   |       | (2,039                  | )          | 2,029                       |       | 4,481     |       |
|                                              |       |                    |       |                    |       |                        |       |      |       |
| **Nine Months Ended December 31, 2005**           |       |                    |       |                    |       |                        |       |      |       |
| Product revenue from external customers           |       | $                       | 16,380     |                    | $          | 4,600                       | ** ** | **$**     | **—** |   | $ | 20,980 |   |
| Service and other revenue from external customers |       | —                  |       | 1,796                   |       | 14,201                      |       | 15,997    |       |
| Depreciation and amortization                     |       | 98                      |       | 134                     |       | 206                         |       | 438       |       |
| Segment income (loss)                             |       | 2,372                   |       | (1,866                  | )          | 1,507                       |       | 2,013     |       |
|                                              |       |                    |       |                    |       |                        |       |      |       |

 

The following tablereconciles segment income to consolidated income (loss) before income taxes:
| ** **                           | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                           | ** ** | ** **                                          | ** ** | **(In thousands)**                            | ** ** | ** ** | ** ** |
| Total income for reportable segments | ** ** | **$**                                               | **1,175**  |                                               | $          | 562 | ** ** | **$** | **4,481** |   | $ | 2,013 |   |
| Unallocated amounts:                 |       |                                                |       |                                               |       |   |   |   |   |
| Corporate expenses                   | ** ** | **(424**                                            | **)**      | (299                                               | )          | **(1,855** | **)** | (2,134 | ) |
| Other income (expense),  net         | ** ** | **(5**                                              | **)**      | (6                                                 | )          | **(650** | **)** | 32 |   |
| Interest expense, net                | ** ** | **(390**                                            | **)**      | (377                                               | )          | **(1,200** | **)** | (1,087 | ) |
| Income (loss)  before income taxes   | ** ** | **$**                                               | **356**    |                                               | $          | (120 | ) | **$** | **776** |   | $ | (1,176 | ) |

 

16

----

 

**ITEM 2.**                    MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

*This report, including the following discussion andanalysis, contains forward-looking statements (within the meaning of thePrivate Securities Litigation Reform Act of 1995) that are based on our currentexpectations, estimates and projections about our business and our industry,and reflect management’s beliefs and certain assumptions made by us based uponinformation available to us as of the date of this report. When used in thisreport and the information incorporated herein by reference, the words “expect(s),”“feel(s),” “believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s)”and similar expressions or variations of these words are intended to identifyforward-looking statements. These forward-looking statements include but arenot limited to statements regarding ouranticipated sales, revenue, expenses,profits, capital needs, competition, development plans, backlog andmanufacturing capabilities, the applications for and acceptance of our productsand services, and the status of our facilities and product development. Thesestatements are not guarantees of future performance and are subject to certainrisks and uncertainties that could cause our actual results to differmaterially from those projected. You should not place undue reliance on theseforward-looking statements that speak only as of the date hereof. We undertakeno obligation to republish revised forward-looking statements to reflect eventsor circumstances after the date hereof or to reflect the occurrence ofunanticipated events. We encourage you to carefully review and consider thevarious disclosures made by us which describe certain factors which couldaffect our business, including in* “*Risk Factors”set forth in Part II, Item 1A of this report, before deciding to invest in ourcompany or to maintain or increase your investment. We undertake no obligationto revise or update publicly any forward-looking statement for any reason.*

**Overview**

We are a leading providerof outdoor machine vision systems and sensors that optimize the flow of trafficand enhance driver safety. Using our proprietary software and ITS industryexpertise, we provide video sensor systems, transportation management andtraveler information systems and other engineering and consulting services tothe ITS industry. We use our outdoor image recognition software expertise todevelop proprietary algorithms for video sensor systems that improve vehiclesafety and the flow of traffic. Using our knowledge of the ITS industry, wedesign and implement transportation management systems that help publicagencies reduce traffic congestion and provide greater access to travelerinformation.

Our Vantage product is a video vehicle detection system that detectsthe presence of vehicles on roadways. Vantage systems are used at signalized intersections to enable a trafficcontroller to more efficiently allocate green signal time and are also used forincident detection and highway traffic data collection applications. We selland distribute our Vantage products primarily to commercial customers andmunicipal agencies.

Our AutoVue Lane Departure Warning (“LDW”) systems consist of a smallwindshield mounted sensor that uses proprietary software to detect and warndrivers of unintended lane departures. Approximately 30,000 production AutoVueunits have been sold for truck platforms in the North American and Europeanmarkets.  Our AutoVue LDW systems arecurrently qualified as an option on certain heavy trucks, includingMercedes-Benz, MAN, Iveco, DAF, Scania, Freightliner and International, as wellas Neoplan and MAN luxury bus and coach lines. In North America our LDW systems are sold primarily to truck fleets, andto date, 39 U.S. heavy truck fleets have selected our LDW systems, representingan estimated 19,000 vehicles.  InSeptember 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.  To date, royalty payments from Valeo have notbeen significant.  Pursuant to thisagreement, we also provide specific contract engineering services, technicalmarketing and sales support to Valeo to enable the incorporation of our LDW technologyon three Infiniti platforms, the FX, M and Q, where the device is offered aspart of Infiniti’s technology option package. Valeo is currently in discussions to provide our LDW system to otherpassenger car OEMs; however, we cannot assure you that such discussions will besuccessful.  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 AutoVueis a broad sensor platform that, through additional software development, maybe expanded to incorporate additional safety and convenience features.

Our transportation management systems businessincludes transportation engineering and consulting services focused on theplanning, design, development and implementation of software-based systems thatintegrate sensors, video surveillance, computers and advanced communications equipmentto enable public agencies to monitor, control and direct traffic flow, assistin the quick dispatch of emergency crews and distribute real-time informationabout traffic conditions.

17

----

Our services include planning and other engineering for the implementationof transportation infrastructure and related communications systems, analysisand study related to goods movement and commercial vehicle operations, andparking systems designs.  These servicesand systems are primarily sold to local, state and national transportationagencies in the United States.  Ourtransportation management systems business is largely dependent upongovernmental funding and budgetary issues. The Federal Highway Bill was passed in August 2005, which provided for asignificant increase in transportation funding over the next six years.  We believe the recent expansion of ourtransportation management systems business was due in part to the passage ofthe Federal Highway Bill, combined with the expansion of transportation fundsat state and local agencies throughout the country.

                We currently operate inthree reportable segments: Roadway Sensors, Automotive Sensors andTransportation Systems. The Roadway Sensors segment includes our Vantagevehicle detection systems for traffic intersection control, incidentdetection and certain highway traffic data collection applications.  The Automotive Sensors segment is comprisedof all activities related to our AutoVue LDW 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.

**CriticalAccounting Policies and Estimates**

Management’s Discussion and Analysis of Financial Conditionand Results of Operations is based on our unaudited condensed consolidatedfinancial statements included herein, which have been prepared in accordancewith U.S generally accepted accounting principles. The preparation of thesefinancial statements requires management to make estimates and assumptions thataffect the reported amounts of assets and liabilities and related disclosuresof contingent assets and liabilities at the date of the financial statementsand the reported amounts of revenues and expenses during the reporting period.On an ongoing basis, we evaluate these estimates and assumptions, includingthose related to the collectibility of accounts receivable, the valuation ofinventories, the recoverability of long-lived assets and goodwill, accountingfor stock-based compensation related to SFAS 123R, and other contingencies. Webase these estimates on our historical experience and on various other factorsthat we believe to be reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. These estimatesand assumptions by their nature involve risks and uncertainties, and may proveto be inaccurate. In the event that any of our estimates or assumptions areinaccurate in any material respect, it could have a material adverse effect onour reported assets and liabilities at the date of the financial statements andour reported revenues and expenses during the reporting period.

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

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

Contract revenues are derived primarily from long-termcontracts with governmental agencies. Contract revenues include costs incurred plus a portion of estimatedfees or profits determined using the percentage of completion method ofaccounting based on the relationship of costs incurred to total estimatedcosts.  Any anticipated losses oncontracts are charged to earnings when 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.  Profit incentives are included in revenuewhen their realization is reasonably assured.

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

18

----

 

Revenues from follow-on service and support, for whichwe generally charge separately, are recorded in the period in which theservices are performed.

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

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

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

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

*Taxes.*We recordeda valuation allowance to reduce our deferred tax assets to amounts that webelieve are more likely than not to be realized. Realization of deferred taxassets (such as net operating loss carryforwards) is dependent on futuretaxable earnings and is therefore uncertain. On a quarterly basis, we assessthe likelihood that our deferred tax asset balance will be recovered fromfuture taxable income. To the extent we believe that recovery is not likely, weestablish a valuation allowance against our deferred tax asset, increasing ourincome tax expense in the period such determination is made.

On an interim basis, we estimate what our anticipatedannual effective tax rate will be and record a quarterly income tax provisionin accordance with this anticipated rate. As the fiscal year progresses, werefine our estimates based upon actual events and earnings during the year.This estimation process can result in significant changes to our expectedeffective tax rate. When this occurs, we adjust the income tax provision duringthe quarter in which the change in estimate occurs so that the year-to-dateprovision reflects the expected annual rate. The changes described in thepreceding sentence and adjustments to our valuation allowance may createfluctuations in our overall effective tax rate from quarter to quarter.

*Stock-Based Compensation*.  We adopted SFAS No. 123R (revised 2004), *Share-Based Payment* (“SFAS 123R”), effective April 1,2006.  Prior to April 1, 2006, wefollowed the disclosure-only provisions of SFAS No. 123, *Accountingfor Stock-Based Compensation*(“SFAS 123”), as amended by SFAS No.148, *Accounting for Stock-Based Compensation —Transition and Disclosure*, and, accordingly, accounted for ourstock-based compensation plans using the intrinsic value method underAccounting Principles Board Opinion No. 25 (“APB 25”) and relatedinterpretations.

SFAS 123R requires allstock-based payments, including grants of employee stock options, to berecognized in the statement of operations as an expense, based on their grantdate fair values with such fair values amortized over the requisite serviceperiod.  We elected to utilize themodified prospective method for the transition to SFAS 123R. Under the modifiedprospective method, SFAS 123R applies to all awards granted or modified afterthe date of adoption. In addition, under the

19

----

modified prospective method, compensation expense will be recognizedfor all stock-based compensation awards granted prior to but not yet vested asof April 1, 2006, based on grant-date fair values estimated in accordance withthe original provisions of SFAS 123.

                In implementing SFAS 123R,we have used the Black-Scholes-Merton (“BSM”) option-pricing formula toestimate the fair value of stock-based awards granted subsequent to April 1,2006.  Our assumptions under the BSMformula include the following:  expectedvolatilities are based on the historical volatility of our stock price, theexpected life of options is derived based on the historical life of ouroptions, and the risk-free rate for periods within the expected life of theoption is based on the U.S. Treasury interest rates in effect at the time ofgrant.  Additionally, SFAS 123 did notrequire the estimation of forfeitures in the calculation of stock compensationexpense; however, SFAS 123R does require such estimation and upon adoption ofSFAS 123R, we changed our methodology to include an estimate offorfeitures.  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 operationsdata as a percentage of total net sales and contract revenues for the periodsindicated. The following table should be read in conjunction with Management’sDiscussion and Analysis of Financial Condition and Results of Operations.
| ** **                             | ** ** | **Three Months  Ended  December 31,** | ** ** | **Nine Months  Ended  December 31,** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                        | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales and contract revenues:       |       |                                            |       |                                           |       |   |   |   |   |
| Net sales                              | ** ** | **59.2**                                        | **%**      | 59.7                                           | %          | **62.0** | **%** | 61.6 | % |
| Contract revenues                      | ** ** | **40.8**                                        |       | 40.3                                           | ** ** | **38.0** |   | 38.4 |   |
| Total net sales and  contract revenues | ** ** | **100.0**                                       | **%**      | 100.0                                          | %          | **100.0** | **%** | 100.0 | % |
| Costs and expenses:                    |       |                                            |       |                                           |       |   |   |   |   |
| Cost of net sales                      | ** ** | **32.8**                                        |       | 32.0                                           | ** ** | **34.6** |   | 32.2 |   |
| Cost of contract  revenues             | ** ** | **28.1**                                        |       | 27.1                                           | ** ** | **24.8** |   | 25.2 |   |
| Gross profit                           | ** ** | **39.2**                                        |       | 40.9                                           | ** ** | **40.6** |   | 42.7 |   |
| Operating expenses:                    |       |                                            |       |                                           |       |   |   |   |   |
| Selling, general and  administrative   | ** ** | **26.8**                                        |       | 29.5                                           | ** ** | **27.7** |   | 31.1 |   |
| Research and  development              | ** ** | **7.2**                                         |       | 9.6                                            | ** ** | **6.6** |   | 11.6 |   |
| Deferred compensation  plan            | ** ** | **(0.2**                                        | **)**      | (0.7                                           | )          | **(0.1** | **)** | (0.0 | ) |
| Amortization of  intangible assets     | ** ** | **0.3**                                         |       | 0.3                                            | ** ** | **0.3** |   | 0.3 |   |
| Total operating  expenses              | ** ** | **34.0**                                        |       | 38.7                                           | ** ** | **34.4** |   | 43.0 |   |
| Operating income (loss)                | ** ** | **5.2**                                         |       | 2.1                                            | ** ** | **6.1** |   | (0.3 | ) |
| Non-operating income (expense):        |       |                                            |       |                                           |       |   |   |   |   |
| Other income (expense),  net           | ** ** | **(0.0**                                        | **)**      | (0.0                                           | )          | **(1.5** | **)** | 0.0 |   |
| Interest expense, net                  | ** ** | **(2.7**                                        | **)**      | (3.1                                           | )          | **(2.8** | **)** | (2.9 | ) |
| Income (loss) before income taxes      | ** ** | **2.5**                                         |       | (1.0                                           | )          | **1.8** |   | (3.2 | ) |
| Income tax benefit (provision)         | ** ** | **(0.3**                                        | **)**      | 2.1                                            | ** ** | **1.3** |   | 1.2 |   |
| Net income  (loss)                     | ** ** | **2.1**                                         | **%**      | 1.1                                            | %          | **3.1** | **%** | (2.0 | )% |

 

**Analysisof Quarterly Results of Operations**

*Net Sales and Contract Revenues*. Net sales are comprised of Roadway Sensor sales, which are derived from salesof our Vantage video detection systems; and Automotive 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 diverse customer base with our largest customer constituting 14.0% and 11.4%of total net sales and contract revenues in the three and nine months endedDecember 31, 2006, respectively.

Total net sales and contract revenues increased 18.9%to $14.5 million and 15.7% to $42.8 million for the three and

20

----

nine months ended December 31, 2006, respectively, compared to $12.2million and $37.0 million in the corresponding periods in the prior fiscalyear.  This increase was primarily drivenby increased net sales in both the Roadway Sensors and Automotive Sensorsbusinesses, as well as increased contract revenues in the TransportationSystems business, as discussed below.

                Net sales increased 17.9%to $8.6 million and 16.3% to $26.5 million for the three and nine months endedDecember 31, 2006, respectively, compared to $7.3 million and $22.8 million inthe corresponding periods of the prior fiscal year.

$1.3 million and$3.6 million of the increase in net sales in the three and nine months endedDecember 31, 2006, respectively, was due to an increase in Roadway Sensors netsales over the corresponding periods in the prior year.   This increase was primarily due to higherunit sales of Roadway Sensor systems, which reflected continued positivereaction to new Vantage product offerings such as color cameras and eAccess, aswell as higher governmental spending which we believe was related to thepassage of the Federal Highway Bill in August 2005.

Automotive Sensorsnet sales increased $34,000 and $126,000 in the three and nine months endedDecember 31, 2006, respectively, over the corresponding periods in the prioryear primarily as a result of an increase in sales of our LDW systems in theNorth American aftermarket and an increase in non-recurring contractengineering revenues generated in the passenger car market. Despite an increaseof 8.1% in sales of our LDW systems to the heavy truck market for the threemonths ended December 31, 2006 compared to the same period in the prior year,sales of our LDW systems to this market have remained flat for the nine monthsended December 31, 2006 compared to the same period in the prior year. Thelimited growth in Automotive Sensors sales in the current fiscal year hasoccurred largely as a result of our largest Automotive Sensors customerpurchasing approximately $1.0 million of spare LDW systems in the prior year inanticipation of the changeover to the next generation LDW system.  Such purchases of spare systems did not occurin the three and nine months ended December 31, 2006, and are not expected tooccur for at least the remainder of this current fiscal year.  Additionally, our largest customer benefitedfrom volume pricing discounts which became effective January 1, 2006 andnegatively impacted our net sales for Automotive Sensors.  The reduced level of sales to our largestAutomotive Sensors hardware customer was offset by a 130% increase in sales ofaftermarket LDW systems in North America for the nine months ended December 31,2006.  In January 2007, we receivedorders for initial LDW production shipments as part of a development agreementwe entered into with a large Asian heavy truck OEM.  While this OEM has indicated its intention tomake our LDW system a standard feature on one of its heavy duty truck modelswith volumes estimated at approximately 5,000 units in the coming year, wecannot assure you that we will ultimately receive any such orders.

Royalty revenues from Valeo for sales of our LDWsystems for the passenger car market remained relatively insignificant in thecurrent quarter.  Our LDW systems are nowoffered as an option on three Infiniti models. While Valeo is currently in discussions to offer our LDW systems onother passenger car platforms, we cannot assure you that Valeo will besuccessful in these efforts.

Contract revenues increased 20.5% to $5.9 million and14.6% to $16.3 million for the three and nine months ended December 31, 2006,respectively, as compared to $4.9 million and $14.2 million in thecorresponding periods of the prior fiscal year. This increase was largely due to increased funding at the federal, stateand local levels throughout the country. In response to this growth in funding, we have increased ourTransportation Systems staff by 16% in the nine months ended December 31,2006.  We expect to continue to increaseour Transportation Systems staff over the next couple quarters, although not atthe same rate as in the nine months ended December 31, 2006.  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 contractrevenues are derived from work performed in North America under a broad rangeof fixed price and cost plus fixed fee contracts.  In September 2006 we were awarded a $9.8 millioncontract from the Federal Highway Administration (“FHWA”), which covers aperiod of two years beginning April 2007 and contains renewal options extendingthrough 2012.  Although this contract isnot expected to substantially affect the trend in contract revenues in ourTransportation Systems business and although we cannot assure you that the fullface amount of the contract will be spent or that any of the options will beexercised, we believe this contract helps to solidify our future FHWA business.

*Gross Profit*. Total gross profit increased 14.0% to $5.7 million and 10.0% to $17.4 millionfor the three and nine

21

----

months ended December 31, 2006, respectively, as compared to $5.0million and $15.8 million in the corresponding periods of the prior fiscalyear.  Total gross profit as a percent ofnet sales and contract revenues decreased to 39.2% and 40.6% for the three andnine months ended December 31, 2006, respectively, as compared to 40.9% and42.7% in the corresponding periods of the prior fiscal year.

                Gross profit as a percentof net sales was 44.7% and 44.1% for the three and nine months ended December31, 2006, respectively, compared to 46.4% and 47.8% in the correspondingperiods of the prior fiscal year.  This decrease was primarily due to volumediscounts given to our largest Automotive Sensors hardware customer, and to alesser extent,  increased product supportactivities in our Roadway Sensors business, an increased level of lower marginengineering services provided to our strategic partner Valeo in the currentyear period and the mix of products sold in the current quarter. Gross profitas a percent of net sales generally fluctuates in any specific quarter based oncustomer mix. Gross profit as a percent of net sales has fluctuated over thelast seven quarters from a high of 50.2% in the first quarter of our priorfiscal year to a low of 43.2% reported in our prior fiscal quarter endedSeptember 30, 2006 mainly as a result of the above.

Gross profit as a percent of contract revenues was 31.2%and 34.7% for the three and nine months ended December 31, 2006, respectively,compared to 32.7% and 34.4% in the corresponding periods of the prior fiscalyear.  We recognize contract revenues and related gross profit usingpercentage of completion contract accounting, and the underlying mix ofcontract activity affects the related gross profit recognized in any givenperiod.  The decrease in gross profit asa percent of contract revenues in the most recent quarter reflects a contractmix weighted more toward lower margin contracts in the period.

*Selling, General and AdministrativeExpense*.  Selling, general and administrative expenseincreased 7.8% and 3.1% to $3.9 million and $11.9 million (or 26.8% and 27.7%of total net sales and contract revenues) in the three and nine months endedDecember 31, 2006, respectively, compared to $3.6 million and $11.5 million (or29.5% and 31.1% of total net sales and contract revenues) in the correspondingperiods of the prior fiscal year. Although selling, general and administrative expense was relatively flatyear-over-year in absolute dollar terms, selling, general and administrativeexpense for the nine months ended December 31, 2006, included highercommissions associated with increased Roadway Sensor net sales, as well aslegal expenses of approximately $230,000 associated with the settlement oflitigation described in Note 5 to the accompanying condensed consolidatedfinancial statements.  No furthersignificant legal costs are expected to be incurred related to this legalmatter.  In the coming quarters, weanticipate increased selling, general and administrative expense related to ourefforts to comply with the internal control attestation requirements of theSarbanes-Oxley Act, with which we must begin to comply in April 2007.

*Research and Development Expense*. Research and development expense decreased 11.4% and 34.4% to $1.0 million and$2.8 million (or 7.2% and 6.6% of total net sales and contract revenues) in thethree and nine months ended December 31, 2006, respectively, compared to $1.2million and $4.3 million (or 9.6% and 11.6% of total net sales and contractrevenues) in the corresponding periods of the prior fiscal year.  The decrease in research and developmentexpense was largely a result of higher than anticipated costs in the prior yearperiod in Automotive Sensors as we expended significant development resourcesin qualifying the next generation LDW system with our largest customer.  Additionally, in the current year, there hasbeen a slight shift in engineering resources from research and developmentactivities to product support activities as a result of new productintroductions and improvements in Roadway Sensors.  Costs associated with product support activitiesare included in cost of net sales rather than research and development expense.

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

*Deferred Compensation Plan Expense.*  Duringthe three and nine months ended December 31, 2006, we recorded a non-cashbenefit of $29,000 and $61,000, respectively, related to the change in value of310,510 shares of our common stock held in trust by our deferred compensationsavings plan.  This compares to anon-cash benefit of $90,000 and $12,000 recorded in the three and nine monthperiods ended December 31, 2005, respectively. We expect to continue to experience non-cash expense or benefit infuture periods as the value of the assets held in our deferred compensationsavings plan fluctuates.

22

----

 

*Other Income (Expense), Net.* Other income (expense), net includes the following:  
| ** **                   | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                   | ** ** | ** **                                          | ** ** | **(In thousands)**                            | ** ** | ** ** | ** ** |
| Settlement of  lawsuit       | ** ** | **$**                                               | **—** |                                               | $          | — | ** ** | **$** | **(635** | **)** | $ | — |   |
| Other                        | ** ** | **(5**                                              | **)**      | (6                                                 | )          | **(15** | **)** | 32 |   |
| Other income  (expense), net | ** ** | **$**                                               | **(5**     | **)**                                              | $          | (6 | ) | **$** | **(650** | **)** | $ | 32 |   |

 

Other income (expense), net for the nine months endedDecember 31, 2006 primarily reflects $635,000 of expense recorded in connectionwith the settlement of litigation in July 2006. See Note 5 to the accompanying condensed consolidated financialstatements for a description of the terms of the settlement and the additionalamounts still payable in connection with the settlement.

*InterestExpense, Net.*  Interest expense, net includes the following:
| ** **                              | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                            | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                              | ** ** | ** **                                          | ** ** | **(in thousands)**                            | ** ** | ** ** | ** ** |
| Interest expense                        | ** ** | **$**                                               | **(305**   | **)**                                              | $          | (292 | ) | **$** | **(942** | **)** | $ | (829 | ) |
| Amortization of  debt discount          | ** ** | **(51**                                             | **)**      | (51                                                | )          | **(155** | **)** | (155 | ) |
| Amortization of  deferred finance costs | ** ** | **(34**                                             | **)**      | (34                                                | )          | **(103** | **)** | (103 | ) |
| Interest expense, net                   | ** ** | **$**                                               | **(390**   | **)**                                              | $          | (377 | ) | **$** | **(1,200** | **)** | $ | (1,087 | ) |

Interest expenseincreased for the three and nine months ended December 31, 2006, respectively,compared to the corresponding periods in the prior fiscal year primarily as aresult of a higher level of borrowings on our line of credit in the currentyear.

*IncomeTaxes*.  During the three and nine months ended December31, 2006, we recognized income tax expense of $46,000 and an income tax benefitof $545,000, respectively, as compared to an income tax benefit of $256,000 and$431,000 in the three and nine months ended December 31, 2005,respectively.  The tax benefit recordedin the nine months ended December 31, 2006 was primarily based on a reductionin the valuation allowance recorded against our deferred tax assets as a resultof changes in estimates of the future realizability of these assets.  As a result, total deferred tax assets on ourconsolidated balance sheet increased from $1.6 million at March 31, 2006to $2.1 million at December 31, 2006.  Inthe future, we may continue to record similar adjustments to our deferred taxasset valuation allowance as our estimates are updated.  We anticipate this will cause our futureoverall effective tax rate in any given period to fluctuate from prioreffective tax rates, estimated annual effective tax rates and statutory taxrates.

**Liquidityand Capital Resources**

*Cash Flows*

We havehistorically financed our operations with a combination of cash flows fromoperations, borrowings under credit facilities and the sale of equitysecurities. We currently rely on cash flows from operations and borrowings on aline of credit facility to fund our operations. At December 31, 2006, we had $6.5 million in working capital, whichincluded borrowings of $4.2 million on our revolving line of credit and$167,000 in cash and cash equivalents. This compares to working capital of $3.3million at March 31, 2006, which included borrowings of $2.7 million onour revolving line of credit and $131,000 in cash and cash equivalents. Ouroperations used $2.3 million of cash during the nine months ended December 31,2006, primarily as a result of investments in inventory and an increased levelof accounts receivable and net costs and estimated earnings in excess ofbillings due to sales growth.  This waspartially offset by a $1.4 million increase in accounts payable and accruedliabilities and $1.3 million in net income. During the nine months ended December 31, 2005, our operations provided$941,000 in cash, primarily as a result of planned decreases in inventorylevels, partially offset by a net decrease in accounts payable and accruedexpenses and an increase in net costs and estimated earnings in excess ofbillings on uncompleted contracts.

23

----

Our investingactivities for the nine months ended December 31, 2006 and 2005, consistedentirely of purchases of property and equipment, which aggregated $311,000 and$716,000, respectively.

Cash provided byfinancing activities was $2.6 million in the nine months ended December 31,2006, which was largely the result of $2.9 million in proceeds from theexercise of stock options and warrants to purchase our common stock offset bynet borrowings of $295,000. As discussed in Note 4 to the accompanyingcondensed consolidated financial statements, approximately $2.0 million of the$2.9 million in proceeds from the exercise of stock options and warrants wasraised through the exercise of 1,250,000 outstanding warrants.  During the nine months ended December 31,2005, financing activities used $271,000 of cash, which was comprised of netpayments on our line of credit and long-term debt of $536,000 partially offsetby cash inflows of $265,000 from the exercise of outstanding stock options andwarrants to purchase our common stock.

*Borrowings*

The following tablesummarizes our borrowings and long-term debt:
| ** **                   | ** ** | **At December 31,  2006** | ** ** |
|------------------------------|------------|-----------------------------------------------|------------|
| ** **                   | ** ** | **(In thousands)**                       | ** ** |
| Convertible  debentures, net |       | $                                             | 9,358      |   |
| Bank term note               |       | 1,888                                         |       |
| Promissory note  to landlord |       | 969                                           |       |
| Other                        |       | 88                                            |       |
|                         |       | $                                             | 12,303     |   |

 

InOctober 2006, we entered into a new two-year credit facility with ourbank.  The facility provides for combinedline of credit and bank term note borrowings of up to $8.0 million.  Under the new credit facility, we may borrowagainst our eligible accounts receivable and eligible inventory, as defined inthe credit agreement.  Interest onborrowed amounts is payable monthly at the current stated prime rate plus1.25%.  Additionally, we are obligated topay an unused line fee of 0.25% per annum applied to the amount by which themaximum credit amount exceeds the average daily principal balance during thepreceding month. The new credit facility requires $2,000 in monthly collateralmanagement fees and includes an early termination fee equal to 2% of the totalfacility during the first year of the agreement and 1% of the total facility inthe second year of the agreement. Additionally, we paid a commitment fee of$40,000 in October 2006 and are obligated to pay an additional $40,000 on theone year anniversary of the facility. The new credit facility is secured bysubstantially all of the assets of the Company. At December 31, 2006, we had $8.0 million available under our creditfacility, of which $2.0 million was unused.

We believe that thecash generated from our operations, together with our new line of credit, willbe sufficient to fund our operations for at least the next twelve months.However, should a shortfall occur, we may need to raise additional fundsthrough other debt financings or the sale of equity securities.

**ContractualObligations**

Our contractualobligations are as follows at December 31, 2006:
| ** **              | ** ** | **Payments Due by Period** | ** ** |
|-------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Total** | ** ** |
| ** **              | ** ** | ** **                                | ** ** | ** ** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Line of credit          |       | $                                         | 4,152      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 4,152 |   |
| Notes payable           |       | 648                                       |       | 1,948 |   | 349 |   | — |   | — |   | 2,945 |   |
| Convertible  debentures |       | —                                    |       | — |   | — |   | 9,850 |   | — |   | 9,850 |   |
| Operating leases        |       | 380                                       |       | 983 |   | 146 |   | 85 |   | 43 |   | 1,637 |   |
| Total                   |       | $                                         | 5,180      |   | $ | 2,931 |   | $ | 495 |   | $ | 9,935 |   | $ | 43 |   | $ | 18,584 |   |

At December 31,2006, we had firm commitments to purchase inventory in the amount of $1.5million during our next two fiscal quarters.

 

24

----

**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 common stockat an initial conversion price of $3.61 per share. At December 31, 2006, $9.9million of these convertible debentures remained outstanding. Because thesedebentures are conventionally convertible, we have not separately accounted forthe conversion feature and, accordingly, no separate amounts are presented inour condensed consolidated financial statements in connection with thisconversion feature.

At December 31, 2006, outstanding warrants to purchase an aggregate of62,500 shares of our common stock at an exercise price of $1.95 per shareand outstanding warrants to purchase an aggregate of 246,250 shares of ourcommon stock at an exercise price of $3.25 were callable by us if the closingsales price of our common stock for 20 consecutive days is equal to or greaterthan two times the exercise price of the warrants. Outstanding warrants topurchase an aggregate of 75,000 shares of our common stock at an exerciseprice of $5.00 per share were callable by us if the price of our common stockfor 20 consecutive days is equal to or greater than one and a half timesthe 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 rightsagreements that contain provisions under which we could be subjected toliquidated damages should we fail to maintain effective registration statementsfor the underlying shares of common stock. These warrants have been accounted for within equity in our condensedconsolidated balance sheets in accordance with EITF 00-19, *Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock*, and, accordingly, no liabilities have beenrecorded in connection therewith.  As ofthe date of this filing, no liquidated damages are payable under the provisionsof the registration rights agreements associated with these warrants.

**Recent Accounting Pronouncements**

In July 2006, the FASB issued FASB Interpretation No.48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”).  FIN 48 clarifies theaccounting and reporting for income taxes recognized in accordance with SFASNo. 109, *Accounting for Income Taxes*.  This Interpretation prescribes acomprehensive model for the financial statement recognition, measurement,presentation and disclosure of uncertain tax positions taken or expected to betaken in income tax returns.  We arecurrently evaluating the impact of FIN 48 and expect to adopt thisInterpretation in the first quarter of our fiscal year ending March 31, 2008.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”), which defines fairvalue, establishes a framework for measuring fair value, and expands disclosureabout fair value measurements. SFAS 157 does not require any new fair valuemeasurements; rather it specifies valuation methods to be applied when fairvalue measurements are required under existing or future accountingpronouncements. SFAS 157 is effective for fiscal years beginning after November15, 2007, and interim periods within those fiscal years. Early application ofthe statement is encouraged. Generally, this statement will be appliedprospectively.  We are currentlyevaluating the impact of SFAS 157 and expect to adopt SFAS 157 in the firstquarter of our fiscal year ending March 31, 2009.

In September 2006, the SEC staff issued StaffAccounting Bulletin No. 108, *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (“SAB 108”). SAB 108 provides interpretive guidance on the consideration of theeffects of prior year misstatements in quantifying current year misstatementsfor the purpose of a materiality assessment. We are currently evaluating the impact of SAB 108 and expect to adopt SAB108 in the first quarter of our fiscal year ending March 31, 2007.

In June 2006, the FASB ratified Emerging Issues TaskForce Issue No. 06-3, *How Taxes Collected fromCustomers and Remitted to Governmental Authorities Should Be Presented in theIncome Statement (That Is, Gross versus Net Presentation)* (“EITF06-3”).  The task force reached aconclusion that either method is acceptable; however, if taxes are reported ona gross basis (included as sales) a company should disclose those amounts ifsignificant.  EITF 06-3 is effective forthe first interim reporting period beginning after December 15, 2006.  We are currently evaluating the impact ofEITF 06-03 and expect to adopt EITF 06-3 in the fourth quarter of our currentfiscal year.

25

----

**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 due to inclement weather conditions.

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

Ourexposure to interest rate risk is limited to our line of credit, bank term noteand a promissory note to our landlord. Our line of credit, bank term note andpromissory note to our landlord bear interest based on the prevailing primerate (8.25% at December 31, 2006).  We donot believe that a 10% increase in the interest rate on our line of credit,bank term note and promissory note to our landlord (from 9.50% to 10.45% on theline of credit, from 9.50% to 10.45% on the bank term note and from 10.25% to11.28% on the promissory note to our landlord) would have a material impact onour financial position, operating results or cash flows. In addition, webelieve that the carrying value of our outstanding debt approximates fairvalue.

**ITEM 4.  CONTROLS AND PROCEDURES**

**Evaluationof Disclosure Controls and Procedures**

As of the end ofthe period 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 upon thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective to ensure thatinformation 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’srules and forms and are effective in ensuring that information required to bedisclosed by us in the reports that we file or submit under the Exchange Act isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. In designing and evaluating the disclosurecontrols and procedures, our management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives. Ourmanagement necessarily applied its judgment in evaluating the cost-benefitrelationship of such controls and procedures.

**Changes in Internal Controls**

During the mostrecent completed fiscal quarter covered by this report, there has been nochange in our internal controls over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) under the Securities Exchange Actof 1934) that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

Effective April 1,2006, we implemented a new enterprise resource planning system that we believehas not resulted in any material changes in our internal controls overfinancial reporting.

26

----

**PART II. OTHER INFORMATION**

**ITEM 1.  LEGAL PROCEEDINGS**

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

**ITEM 1A.  RISK FACTORS**

*Our business is subject to a numberof risks, some of which are discussed below. Other risks are presented elsewhere in this report and in our otherfilings with the SEC.  You shouldconsider the following risks carefully in addition to the other informationcontained in this report and our other filings with the SEC, including oursubsequent reports on Forms 10-Q and 8-K, before deciding to buy, sell or holdour common stock. The risks and uncertainties described below are not the onlyones facing our company.  Additionalrisks and uncertainties not presently known to us or that we currently deemimmaterial may also affect our business operations.  If any of these risks actually occurs, ourbusiness, financial condition or results of operations could be seriouslyharmed.  In that event, the market pricefor our common stock could decline and you may lose all or part of yourinvestment.*

**We May Need To Raise Additional Capital InThe Future, Which May Not Be Available On Terms Acceptable To Us, Or AtAll.**We have generated significant net losses and operatinglosses in recent periods, 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$718,000 in the year ended March 31, 2004. Additionally, we failed to meet certain debt covenants under our priorcredit agreement in two of our last six fiscal quarters, but replaced thatcredit facility in October 2006 as further described in Note 3 to theaccompanying condensed consolidated financial statements.  Furthermore, we have $9.9 million insubordinated convertible debentures that are 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.

AtDecember 31, 2006, we had $167,000 of cash and cash equivalents and relied onour line of credit to fund our operations. We may need to raise additionalcapital in the near future to fund our operations or to repay indebtedness.Such additional capital may be raised through bank borrowings, or other debt orequity financings. We cannot assure you that any additional capital will beavailable on a timely basis, on acceptable terms, or at all, and suchadditional financing may result in further dilution to our stockholders.

Our capital requirements will depend on many factors,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;

27

----

·                                       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.

If our capital requirements are materially differentfrom those currently planned, we may need additional capital sooner thananticipated. If additional funds are raised through the issuance of equity orconvertible debt securities, the percentage ownership of our stockholders willbe reduced and such securities may have rights, preferences and privilegessenior to our common stock. Additional financing may not be available onfavorable terms, 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 HaveHistorically Experienced Substantial Losses And May Continue To ExperienceLosses For The Foreseeable Future.**Although we have achievednet income in recent periods, we have historically experienced significant netlosses from continuing operations of $11.3 million and $1.9 million in theyears ended March 31, 2005 and 2004, respectively. We cannot assure youthat we will be able to sustain or improve our financial performance, or thatwe will be able to continue to achieve profitability on a quarterly or annualbasis in the future. Most of our expenses are fixed in advance. As such, wegenerally are unable to reduce our expenses significantly in the short-term tocompensate for any unexpected delay or decrease in anticipated revenues. As aresult, we may continue to experience operating losses and net losses, whichwould make it difficult to fund our operations and achieve our business plan,and could cause the market price of our common stock to decline.

**If OurInternal Controls Over Financial Reporting Do Not Comply With The RequirementsOf The Sarbanes-Oxley Act, Our Business And Stock Price Could Be AdverselyAffected.**Along with our independent registered publicaccounting firm, we will be evaluating the effectiveness of our internalcontrols over financial reporting to comply with Section 404 of theSarbanes-Oxley Act of 2002. Section 404 currently requires us to evaluatethe effectiveness of our internal controls over financial reporting at the endof each fiscal year beginning in our fiscal year ending March 31, 2008 atthe earliest, and to include a management report assessing the effectiveness ofour internal controls over financial reporting in all annual reports beginningwith our Annual Report on Form 10-K for the fiscal year endingMarch 31, 2008 at the earliest. Section 404 also requires ourindependent accountant to attest to, and report on, management’s assessment ofour internal controls over financial reporting. We may not be able to completeour Section 404 compliance on a timely basis and even if we timelycomplete our compliance requirements, our independent auditors may stillconclude that our internal controls over financial reporting are not effective.

Our management, including our CEO and CFO, does notexpect that our internal controls over financial reporting will prevent allerror and all fraud. A control system, no matter how well designed andoperated, can provide only reasonable, not absolute, assurance that the controlsystem’s objectives will be met. Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the company 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 of amaterial 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

28

----

remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. Based on our evaluation, ourmanagement concluded that, as of March 31, 2004, our internal control overfinancial reporting was not effective due to the existence of one materialweakness. We may experience additional material weaknesses in the future. Ifour internal controls over financial reporting are not considered adequate, wemay experience a loss of public confidence, which could have an adverse effecton our business and our stock price.

**We May Experience Production Gaps Which CouldMaterially And Adversely Impact Our Sales And Financial Results And TheUltimate Acceptance Of Our Products. **Itis possible that we could experience unforeseen quality control issues or partshortages as we increase production to meet current demand of ourproducts.  We have historically usedsingle suppliers for certain of our components in our AutoVue and Vantageproducts. Should any such delay or disruption occur, our future sales willlikely be materially and adversely affected. Additionally, we rely heavily on select contract manufacturers toproduce 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 Retain KeyPersonnel, Which Could Seriously Harm Our Business.**Due tothe 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 any of our executive officersor key members of management could adversely affect our business, financialcondition or results of operations. Our success will also depend in large partupon our ability to continue to attract, retain and motivate qualifiedengineering and other highly skilled technical personnel. In particular, thefuture success of our Transportation Systems business will depend on ourability to hire additional qualified engineers and planners. Competition forqualified employees, particularly development engineers, is intense. We may notbe able to continue to attract and retain sufficient numbers of such highlyskilled employees. Our inability to attract and retain additional key employeesor the loss of one or more of our current key employees could adversely affectour business, financial condition 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.**We believeour revenue growth and future operating results will depend on our ability tocomplete development of new products and enhancements, introduce these productsin a timely, cost-effective manner, achieve broad market acceptance of theseproducts and enhancements, and reduce our product costs. We cannot guaranteethe success of these products and we may not be able to introduce any newproducts or any enhancements to our existing products on a timely basis, or at all.In addition, the introduction of any new products could adversely affect thesales of certain of our existing products.

We believe that we must continue to make substantialinvestments to support ongoing research and development in order to remain competitive.We need to continue to develop and introduce new products that incorporate thelatest technological advancements in outdoor image processing hardware,software and camera technologies in response to evolving customer requirements.  We cannot assure you that we will be able toadequately manage product transition issues. Our business and results of operations could be adversely affected if wedo not anticipate or respond adequately to technological developments orchanging customer requirements or if we cannot adequately manage inventoryissues typically related to new product transitions and introductions. Wecannot assure you that any such investments in research and development willlead to any corresponding increase in revenue.

Market acceptance of our new products depends uponmany factors, including our ability to accurately predict market requirementsand evolving industry standards, our ability to resolve technical challenges ina timely and cost-effective manner, qualify any new products with OEMs andachieve manufacturing efficiencies, the perceived advantages of our new

29

----

productsover traditional products and the marketing capabilities of our independentdistributors and strategic partners, including Valeo’s ability to expand salesof AutoVue in the passenger car market. The success of our AutoVue system willalso depend in part on the success of the automotive vehicles that incorporateour technology, as well as the success of optional equipment that OEMs bundlewith our technologies.

Certain of the components used in our Vantage andAutoVue products may need to be re-engineered in the next 18 months as theindustry is moving towards a standard of using lead-free components. We cannotassure you as to the timing of the adoption of this new standard or our abilityto successfully redesign our products to incorporate compliant components andgain market acceptance of such redesigned products. In addition, if thestandard is adopted earlier than anticipated we may experience a shortage ofVantage and AutoVue products as a result of potential scarcity of lead-freecomponents.

Our business and results of operations could also beseriously harmed by any significant delays in our new product development.Certain of our new products could contain undetected design faults and softwareerrors or “bugs” when first released by us, despite our testing. We may notdiscover these faults or errors until after a product has been installed andused by our customers. Any faults or errors in our existing products or in anynew products may cause delays in product introduction and shipments, requiredesign modifications or harm customer relationships, any of which couldadversely 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, industryconsolidations and reduced barriers to entry. Increased competition is likelyto result in price reductions, reduced gross margins and loss of market share,any of which could seriously harm our business, financial condition and resultsof operations. We have experienced more competition in our Vantage business infiscal 2007 as the Department of Transportation in one of our largest salesterritories has recently moved to a multisource contracting environment fromone in which Iteris was the sole supplier. In addition, one of the otherdevelopers of LDW systems was recently acquired by a larger company. While thisdeveloper has not been a material competitor to date, we may experience morecompetition from this provider as a result of its greater access to resourcesfrom its acquirer, and additional competitors may enter this market in thefuture.

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 Slowdown Or TheSignificant Military Operations In The Middle East Or Elsewhere May ImpactGovernment Funding Or Consumer Spending, Causing A Decline In Our Revenues.** In the near term, the funding of U.S. militaryoperations in the Middle East or elsewhere may cause disruptions in funding ofgovernment contracts.  Since militaryoperations of such magnitude are not routinely included in U.S. defensebudgets, supplemental legislative funding actions are often required to financesuch operations. Even when such legislation is enacted, it may not be adequatefor ongoing operations, causing other government sources to be temporarily orpermanently diverted.  Since asignificant portion of our sales are derived from contracts with governmentagencies, such diversion of funds could produce interruptions in funding ordelays in receipt of our contracts, causing disruptions and adversely effectingour revenue and operations.

Concerns about the recent international conflicts andterrorist and military actions, as well as concerns about inflation, decreasedconsumer confidence, and reduced corporate profits and capital spending havealso resulted in a downturn in worldwide economic conditions, particularly inthe United States. These unfavorable economic conditions may have a negativeimpact on customer orders (and also may result in decreased sales ofautomobiles and trucks that incorporate our LDW systems).  Such concerns may result in cancellations andrescheduling 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 Automotive Sensor net sales and TransportationSystems contract revenues.  Any of theforegoing political, social and economic conditions make it extremely difficultfor our customers, our suppliers and us to

30

----

accuratelyforecast and plan future business activities and could result in a decline inour net sales and contract revenues. If such conditions continue or worsen, ourbusiness, financial condition and results of operations could be materially andadversely affected.

**New Environmental Regulations MayResult In A Decline In Our AutoVue Sales and Royalties. **Recent environmentalregulations in Europe are expected to be in place during Fall 2006 which willrequire more stringent emissions compliance in new trucks manufactured, thatcould cause a decline in new truck sales in Europe in the near future.  Similar regulations have been announced inNorth America that may impact diesel engines built after January 2007, whichcould similarly impact North American OEM truck sales in general.  As a result, we may experience a decline inour LDW sales to truck OEMs related to these stricter regulations.

**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 significant portionof our sales are derived from contracts with governmental agencies, either as ageneral contractor, subcontractor or supplier. Government contracts representedapproximately 38.3%, 37.4% and 48.2% of our total net sales and contractrevenues for the years ended March 31, 2006, 2005 and 2004, respectively.We anticipate that revenue from government contracts will continue to increasein the near future. Government business is, in general, subject to specialrisks and challenges, 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. transportation 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.

**Our Quarterly Operating Results Fluctuate As AResult 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;

31

----

·                                          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. governmenttransportation bill;

·                                          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 as well asother unforeseen factors, our future operating results could be below theexpectations of securities analysts or investors. If that happens, the tradingprice of our common stock could decline. As a result of these quarterlyvariations, you should not rely on quarter-to-quarter comparisons of ouroperating results as an indication of our future performance.

**We May Engage In Acquisitions Of Companies OrTechnologies That May Require Us To Undertake Significant CapitalInfusions And Could Result In Disruptions Of Our Business And Diversion OfResources And Management Attention.**We have historicallyacquired, and may in the future acquire, complementary businesses, products

32

----

andtechnologies. Acquisitions may require significant capital infusions and, ingeneral, acquisitions also involve a number of special risks, including:

·                                          potentialdisruption of our ongoing business and the diversion of our resources and management’sattention;

·                                          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 anticipated fromany acquisition.

**WeHave Experienced Growth In Recent Periods. If We Fail To Manage Our GrowthEffectively, We May Be Unable To Execute Our Business Plan AndMay Experience Future Weaknesses In Our Internal Controls.**Wehave expanded our overall business, particularly in our Vantage and AutoVueproduct lines. In order to achieve our business objectives, we will need tocontinue 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 new ERPsystem 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 Rapid TechnologicalChanges And Evolving Industry Standards, We Will Not Be Able To RemainCompetitive 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.

33

----

Our future success will depend upon our ability toanticipate and adapt to changes in technology and industry standards, and toeffectively develop, introduce, market and gain broad acceptance of newproducts and product enhancements incorporating the latest technologicaladvancements. In particular, our LDW system is incorporated into automobilesand trucks that face significant technological changes in each model year andamong different vehicle models. Accordingly, we must adapt our technology fromtime to time to function with such changes.

**We May Not Be Able To Adequately Protect OrEnforce Our Intellectual Property Rights, Which Could Harm Our CompetitivePosition.**If we are not able to adequately protect or enforcethe proprietary aspects of our technology, competitors could be able to accessour proprietary technology and our business, financial condition and results ofoperations will likely be seriously harmed. We currently attempt to protect ourtechnology through a combination of patent, copyright, trademark and tradesecret laws, employee and third party nondisclosure agreements and similarmeans. Despite our efforts, other parties may attempt to disclose, obtain oruse 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 benecessary in the future to enforce our intellectual property rights or todetermine the validity and scope of the proprietary rights of others.Litigation may also be necessary to defend against claims of infringement orinvalidity by others. An adverse outcome in litigation or any similarproceedings could subject us to significant liabilities to third parties,require us to license disputed rights from others or require us to ceasemarketing or using certain products or technologies. We may not be able toobtain any licenses on terms acceptable to us, or at all. We also may have toindemnify certain customers or strategic partners if it is determined that wehave infringed upon or misappropriated another party’s intellectual property.Any of these results could adversely affect our business, financial conditionand results of operations. In addition, the cost of addressing any intellectualproperty litigation claim, including legal fees and expenses, and the diversionof management’s attention and resources, regardless of whether the claim isvalid, could be significant and could seriously harm our business, financialcondition and results of operations.

**The Trading Price Of Our Common Stock Is HighlyVolatile.**The trading price of our common stock has beensubject 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

34

----

·                                          internationalconflicts, political unrest and acts of terrorism.

In addition, as of December 31, 2006, options topurchase an aggregate of 1.3 million shares of our common stock at a weightedaverage price of $0.53 per share terminate on or prior to September 30,2007.  Our common stock has traditionallybeen thinly traded. The exercise of these options and the sale of a large numberof shares of our common stock could cause our stock price to decline.

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

**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 are denominated in U.S.dollars. As a result, an increase in the relative value of the dollar couldmake our products more expensive and potentially less price competitive ininternational markets. We do not engage in any transactions as a hedge againstrisks of loss due to foreign currency fluctuations.

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

**We Could Experience Negative Financial ImpactsArising From Developments In Contingencies Created Under Our Previous StructureOr By Former Subsidiaries.**Although we divested ourselves ofall business units, with the exception of our Iteris business, from time totime we could experience unforeseen developments in contingencies related toour former subsidiaries. For example, we recently entered into a settlementagreement in connection with a lawsuit brought against MarinerNetworks, Inc., one of our former subsidiaries, by one of Mariner’ssuppliers, pursuant to which we issued 88,912 shares of our common stock tothis supplier (valued at $213,000 as of the date of issuance), paid thissupplier $125,000 on October 20, 2006 and are required to pay an additional$350,000 in 36 equal monthly installments of $9,700

35

----

beginning inNovember 2006.  Although we are not awareof any other material contingencies, it is possible that other matters could bebrought against us in connection with activities related to former subsidiariesand that 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 December 31, 2006,our officers and directors owned approximately 14% of the outstanding shares ofour common stock (and approximately 22% of our common stock when includingoptions, warrants and other convertible securities held by them which arecurrently exercisable or convertible or will become exercisable or convertiblewithin 60 days after December 31, 2006). As a result of their stockownership, our management will be able to significantly 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 our managementor change in control and may adversely affect the voting or other rights ofother holders of common stock.

**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 SECURITY HOLDERS**

None.

**ITEM5.  OTHER INFORMATION**

None.

**ITEM 6. EXHIBITS**

Thefollowing exhibits are filed herewith or are incorporated by reference to thelocation indicated.

36

----

 
| Exhibit  Number | ** ** | **Description**                                                                                                                                                       | ** ** | **Where  Located**                                                                                                                                                             |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Amended and Restated Certificate of Incorporation of  the registrant                                                                                                  | * *   | *Exhibit 3.1 to the registrant’s current  report on Form 8-K as filed with the SEC on October 28, 2004*                                                    |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.2             |       | Bylaws of registrant, as amended                                                                                                                                      | * *   | *Exhibit 4.2 to the registrant’s Registration  Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on  July 6, 1993*                     |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.3             |       | Certificates of Amendment to Bylaws of the  registrant dated April 24, 1998 and August 10, 2001                                                             | * *   | *Exhibit 3.4 to the registrant’s Annual  Report on Form 10-K/A for the year ended March 31, 2003 as filed  with the SEC on July 29, 2003*             |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.4             |       | Certificate of Amendment to Bylaws of registrant  dated September 9, 2004                                                                                        | * *   | *Exhibit 3.1 to the registrant’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2004 as  filed with the SEC on November 15, 2004* |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 4.1             |       | Specimen of Common Stock Certificate                                                                                                                                  | * *   | *Exhibit 4.1 to the registrant’s Amendment  No. 1 to the Registration Statement on Form 8-A as filed with the  SEC on December 8, 2004*               |
| * *        | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 4.2             |       | Amended and Restated Rights Agreement, dated as of  May 10, 2004, by and between the registrant and U.S. Stock Transfer  Corporation, including exhibits thereto | * *   | *Exhibit 99.1 to the registrant’s  Registration Statement on Form 8-A/A as filed with the SEC on  June 18, 2004*                                           |
|            |       |                                                                                                                                                                  | * *   | * *                                                                                                                                                                       |
| 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

----

 

**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
| Dated: February 12, 2007 |   | ITERIS, INC. |   |                                         |
|--------------------------|--------|--------------|--------|----------------------------------------------|
|                     |   | (Registrant) |   |                                         |
|                     |   |         |
|                     |   | By           |   | /s/ JACK JOHNSON                             |
|                     |   |         |   | Jack Johnson                                 |
|                     |   |         |   | Chief Executive Officer                      |
|                     |   |         |   | (Principal Executive Officer)                |
|                     |   |         |   |                                         |
|                     |   |         |   |                                         |
|                     |   | By           |   | /s/ JAMES S. MIELE                           |
|                     |   |         |   | James S. Miele                               |
|                     |   |         |   | Chief Financial Officer                      |
|                     |   |         |   | (Principal Financial and Accounting Officer) |
|                          |        |              |        |                                              |  |  |

 

38

----