**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**Form 10-Q**

**(Mark**One)

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

**Forthe quarterly period ended September 30, 2006**

**OR**

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

**Forthe transition periodfrom              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 telephonenumber, including area code)

** **

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

**Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934, as amended (the “Exchange Act”) during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.**

**Yes  **x    No  o

**Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):**
| **Large accelerated  filer  **o | ** ** | **Accelerated  filer  **o | ** ** | **Non-accelerated  filer  **x |
|-------------------------------------------|------------|-------------------------------------|------------|-----------------------------------------|

 

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

**Yes  **o    No  x

As of November 10, 2006,the registrant had 30,685,110 shares of common stock outstanding

 

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**ITERIS, INC.Quarterly Report on Form 10-QFor the Three Months and Six Months Ended September 30, 2006**

**Table of Contents**
| **PART I.**  | ** ** | **FINANCIAL INFORMATION**                                                                                                           | ** ** | ** ** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|              |       |                                                                                                                                |       |       |
| **ITEM 1.**       | ** ** | **FINANCIAL STATEMENTS**                                                                                                            | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS AT  SEPTEMBER 30, 2006 AND MARCH 31, 2006**                             | ** ** | ** ** |
| ** **        | ** ** | ** **                                                                                                                          | ** ** | ** ** |
| ** **        | ** ** | **UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF  OPERATIONS FOR THE THREE AND SIX MONTHS ENDED SEPTEMBER 30, 2006 AND  2005** | ** ** | ** ** |
|              |       |                                                                                                                                |       |       |
| ** **        | ** ** | **UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH  FLOWS FOR THE SIX MONTHS ENDED SEPTEMBER 30, 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**                                                                                                                        | ** ** | ** ** |

 

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

2

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**PART I. FINANCIALINFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

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

** **
| ** **                                                                                                                                                                   | ** ** | **September 30,  2006** | ** ** | **March 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **(unaudited)**              | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                                                                   | ** ** | ** **                   | ** ** | ** **               | ** ** |
| Current  assets:                                                                                                                                                             |       |                         |       |                     |       |
| Cash  and cash equivalents                                                                                                                                                   | ** ** | **$**                        | **19**     |                     | $          | 131 |   |
| Trade  accounts receivable, net of allowance for doubtful accounts of $555 and $429  at September 30, 2006 and March 31, 2006, respectively                             | ** ** | **12,462**                   |       | 11,426                   |       |
| Costs  and estimated earnings in excess of billings on uncompleted contracts                                                                                                 | ** ** | **3,033**                    |       | 2,693                    |       |
| Inventories,  net of reserve for inventory obsolescence of $721 and $592 at September 30,  2006 and March 31, 2006, respectively                                        | ** ** | **4,792**                    |       | 2,814                    |       |
| Deferred  income taxes                                                                                                                                                       | ** ** | **761**                      |       | 790                      |       |
| Prepaid  expenses and other current assets                                                                                                                                   | ** ** | **504**                      |       | 368                      |       |
| Total  current assets                                                                                                                                                        | ** ** | **21,571**                   |       | 18,222                   |       |
| Property  and equipment, net                                                                                                                                                 | ** ** | **1,745**                    |       | 1,783                    |       |
| Deferred  income taxes                                                                                                                                                       | ** ** | **1,475**                    |       | 818                      |       |
| Intangible  assets, net of accumulated amortization of $334 and $261 at September 30,  2006 and March 31, 2006, respectively                                            | ** ** | **478**                      |       | 551                      |       |
| Goodwill                                                                                                                                                                     | ** ** | **27,774**                   |       | 27,774                   |       |
| Other  assets                                                                                                                                                                | ** ** | **438**                      |       | 485                      |       |
| Total assets                                                                                                                                                                 | ** ** | **$**                        | **53,481** |                     | $          | 49,633 |   |
| ** **                                                                                                                                                                   | ** ** | ** **                   | ** ** | ** **               | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                               | ** ** | ** **                   | ** ** | ** **               | ** ** |
| Current liabilities:                                                                                                                                                         |       |                         |       |                     |       |
| Trade  accounts payable                                                                                                                                                      | ** ** | **$**                        | **6,161**  |                     | $          | 3,620 |   |
| Accrued  payroll and related expenses                                                                                                                                        | ** ** | **2,924**                    |       | 3,481                    |       |
| Accrued  liabilities                                                                                                                                                         | ** ** | **2,749**                    |       | 2,304                    |       |
| Billings  in excess of costs and estimated earnings on uncompleted contracts                                                                                                 | ** ** | **845**                      |       | 893                      |       |
| Revolving  line of credit                                                                                                                                                    | ** ** | **577**                      |       | 2,662                    |       |
| Current  portion of long-term debt                                                                                                                                           | ** ** | **2,261**                    |       | 1,969                    |       |
| Total  current liabilities                                                                                                                                                   | ** ** | **15,517**                   |       | 14,929                   |       |
| Non-current accrued  liabilities                                                                                                                                             | ** ** | **216**                      |       | 12                       |       |
| Deferred compensation  plan liability                                                                                                                                        | ** ** | **788**                      |       | 820                      |       |
| Deferred gain on sale of  building                                                                                                                                           | ** ** | **307**                      |       | 449                      |       |
| Long-term debt                                                                                                                                                               | ** ** | **1,213**                    |       | 2,171                    |       |
| Convertible debentures,  net                                                                                                                                                 | ** ** | **9,307**                    |       | 9,203                    |       |
| Total  liabilities                                                                                                                                                           | ** ** | **27,348**                   |       | 27,584                   |       |
| Commitments and  contingencies                                                                                                                                               |       |                         |       |                     |       |
| Redeemable common stock,  1,219 shares issued and outstanding at September 30, 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 September 30, 2006 and March 31, 2006                                       |       | —                       |       | —                   |       |
| Common  stock, $0.10 par value, 50,000 shares authorized, 29,363 and 27,432 shares  issued and outstanding at September 30, 2006 and March 31, 2006,  respectively | ** ** | **2.936**                    |       | 2,743                    |       |
| Additional  paid-in capital                                                                                                                                                  | ** ** | **129,538**                  |       | 126,664                  |       |
| Common  stock held in trust, 311 shares at September 30, 2006 and March 31, 2006                                                                                        | ** ** | **(374**                     | **)**      | (374                     | )          |
| Notes  receivable from employees                                                                                                                                             | ** ** | **(45**                      | **)**      | (49                      | )          |
| Accumulated  deficit                                                                                                                                                         | ** ** | **(109,345**                 | **)**      | (110,356                 | )          |
| Accumulated  other comprehensive income                                                                                                                                      | ** ** | **9**                        |       | 7                        |       |
| Total stockholders’  equity                                                                                                                                             | ** ** | **22,719**                   |       | 18,635                   |       |
| Total liabilities and stockholders’ equity                                                                                                                              | ** ** | **$**                        | **53,481** |                     | $          | 49,633 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

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

 
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                             | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales and  contract revenues:                          |       |                                                 |       |                                               |       |   |   |   |   |
| Net sales                                                  | ** ** | **$**                                                | **9,323**  |                                               | $          | 7,975 | ** ** | **$** | **17,923** |   | $ | 15,500 |   |
| Contract revenues                                          | ** ** | **5,143**                                            |       | 4,740                                              | ** ** | **10,359** |   | 9,294 |   |
| Total net sales and contract revenues                      | ** ** | **14,466**                                           |       | 12,715                                             | ** ** | **28,282** |   | 24,794 |   |
|                                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Costs and  expenses:                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Cost of net sales(a)                                       | ** ** | **5,296**                                            |       | 4,236                                              | ** ** | **10,054** |   | 7,991 |   |
| Cost of contract revenues(a)                               | ** ** | **3,213**                                            |       | 3,037                                              | ** ** | **6,552** |   | 6,006 |   |
| Gross profit                                               | ** ** | **5,957**                                            |       | 5,442                                              | ** ** | **11,676** |   | 10,797 |   |
| Operating  expenses:                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Selling, general and administrative(a)                     | ** ** | **3,985**                                            |       | 4,086                                              | ** ** | **7,986** |   | 7,914 |   |
| Research and development(a)                                | ** ** | **771**                                              |       | 1,370                                              | ** ** | **1,774** |   | 3,116 |   |
| Deferred compensation plan                                 | ** ** | **34**                                               |       | 16                                                 | ** ** | **(32** | **)** | 78 |   |
| Amortization of intangible assets                          | ** ** | **37**                                               |       | 36                                                 | ** ** | **73** |   | 73 |   |
| Total operating expenses                                   | ** ** | **4,827**                                            |       | 5,508                                              | ** ** | **9,801** |   | 11,181 |   |
| Operating income  (loss)                                   | ** ** | **1,130**                                            |       | (66                                                | )          | **1,875** |   | (384 | ) |
| Non-operating  income (expense):                           |       |                                                 |       |                                               |       |   |   |   |   |
| Other income (expense), net                                | ** ** | **45**                                               |       | 86                                                 | ** ** | **(645** | **)** | 38 |   |
| Interest expense, net                                      | ** ** | **(424**                                             | **)**      | (358                                               | )          | **(810** | **)** | (710 | ) |
| Income (loss)  before income taxes                         | ** ** | **751**                                              |       | (338                                               | )          | **420** |   | (1,056 | ) |
| Income tax  benefit (provision)                            | ** ** | **(19**                                              | **)**      | 183                                                | ** ** | **591** |   | 175 |   |
| Net income  (loss)                                         | ** ** | **$**                                                | **732**    |                                               | $          | (155 | ) | **$** | **1,011** |   | $ | (881 | ) |
|                                                       |       |                                                 |       |                                               |       |   |   |   |   |
| Earnings (loss)  per share:                                |       |                                                 |       |                                               |       |   |   |   |   |
| Basic                                                      | ** ** | **$**                                                | **0.03**   |                                               | $          | (0.01 | ) | **$** | **0.04** |   | $ | (0.03 | ) |
| Diluted                                                    | ** ** | **$**                                                | **0.02**   |                                               | $          | (0.01 | ) | **$** | **0.03** |   | $ | (0.03 | ) |
| Weighted average  shares outstanding:                      |       |                                                 |       |                                               |       |   |   |   |   |
| Basic                                                      | ** ** | **28,882**                                           |       | 28,106                                             | ** ** | **28,637** |   | 28,084 |   |
| Diluted                                                    | ** ** | **33,020**                                           |       | 28,106                                             | ** ** | **32,694** |   | 28,084 |   |
| (a) Includes  stock-based compensation expense as follows: |       |                                                 |       |                                               |       |   |   |   |   |
| Cost of net sales                                          |       | $                                                    | 4          |                                               | $          | 9 |   | $ | 9 |   | $ | 18 |   |
| Cost of contract revenues                                  |       | $                                                    | 19         |                                               | $          | 67 |   | $ | 48 |   | $ | 137 |   |
| Selling, general and administrative expense                |       | $                                                    | 5          |                                               | $          | 136 |   | $ | 59 |   | $ | 275 |   |
| Research and  development expense                          |       | $                                                    | 46         |                                               | $          | 46 |   | $ | 58 |   | $ | 93 |   |

 

See accompanying notes to unaudited condensed consolidated financialstatements.

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**ITERIS, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**
| ** **                                                                                | ** ** | **Six Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2006**                                           | ** ** | **2005** | ** ** |
| **Cash  flows from operating activities**                                                 |       |                                               |       |   |   |
| Net income (loss)                                                                         | ** ** | **$**                                              | **1,011**  |   | $ | (881 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                               |       |   |   |
| Change in deferred tax assets                                                             | ** ** | **(628**                                           | **)**      | (189 | ) |
| Depreciation and amortization of property and  equipment                                  | ** ** | **278**                                            |       | 335 |   |
| Stock-based compensation expense                                                          | ** ** | **174**                                            |       | 523 |   |
| Issuance of warrants for services                                                         | ** ** | **21**                                             |       | — |   |
| Amortization of deferred gain on sale—leaseback  transaction                         | ** ** | **(142**                                           | **)**      | (142 | ) |
| Amortization of debt discount                                                             | ** ** | **104**                                            |       | 104 |   |
| Amortization of intangible assets                                                         | ** ** | **73**                                             |       | 73 |   |
| Amortization of deferred financing costs                                                  | ** ** | **69**                                             |       | 69 |   |
| Changes in operating assets and liabilities:                                              |       |                                               |       |   |   |
| Accounts receivable                                                                       | ** ** | **(1,036**                                         | **)**      | (17 | ) |
| Net costs and estimated earnings in excess of  billings                                   | ** ** | **(388**                                           | **)**      | (435 | ) |
| Inventories                                                                               | ** ** | **(1,978**                                         | **)**      | 1,341 |   |
| Prepaid expenses and other assets                                                         | ** ** | **(158**                                           | **)**      | (177 | ) |
| Accounts payable and accrued liabilities                                                  | ** ** | **2,735**                                          |       | (563 | ) |
| Net cash  provided by operating activities                                                | ** ** | **135**                                            |       | 41 |   |
|                                                                                      |       |                                               |       |   |   |
| **Cash  flows from investing activities**                                                 |       |                                               |       |   |   |
| Purchases of property and equipment                                                       | ** ** | **(240**                                           | **)**      | (386 | ) |
|                                                                                      |       |                                               |       |   |   |
| **Cash  flows from financing activities**                                                 |       |                                               |       |   |   |
| Proceeds (payments) from borrowings on line of  credit, net                               | ** ** | **(2,085**                                         | **)**      | 766 |   |
| Payments on long-term debt                                                                | ** ** | **(666**                                           | **)**      | (657 | ) |
| Change in checks drawn in excess of available bank  balances                              | ** ** | **81**                                             |       | — |   |
| Proceeds from stock option and warrant exercises                                          | ** ** | **2,663**                                          |       | 190 |   |
| Net cash (used  in) provided by financing activities                                      | ** ** | **(7**                                             | **)**      | 299 |   |
| Decrease in cash                                                                          | ** ** | **(112**                                           | **)**      | (46 | ) |
| Cash at  beginning of period                                                              | ** ** | **131**                                            |       | 46 |   |
| Cash at end of  period                                                                    | ** ** | **$**                                              | **19**     |   | $ | — |   |
|                                                                                      |       |                                               |       |   |   |
| **Supplemental  cash flow information:**                                                  | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Cash paid during the period:                                                              |       |                                               |       |   |   |
| Interest                                                                                  | ** ** | **$**                                              | **637**    |   | $ | 528 |   |
| Income taxes                                                                              |       | —                                             |       | 44 |   |
| ** **                                                                                | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| **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 |   |

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

5

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

**September 30, 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 Companycompleted a merger with its majority-owned subsidiary, Iteris, Inc. (the“Iteris Subsidiary”), 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 theopinion of management, the accompanying unaudited condensed consolidatedfinancial statements contain all adjustments, consisting of normal recurringadjustments, necessary to present fairly the consolidated financial position ofthe Company as of September 30, 2006, the consolidated results of operationsfor the three and six months ended September 30, 2006 and 2005, and theconsolidated cash flows for the six months ended September 30, 2006 and 2005.Certain information and footnote disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States (“U.S. GAAP”) have been condensed or omitted pursuant tothe rules and regulations of the SEC. The results of operations for thethree and six months ended September 30, 2006, are not necessarily indicativeof those to be expected for the entire year. The accompanying unaudited condensedconsolidated financial statements should be read in conjunction with theCompany’s Annual Report on Form 10-K for the year ended March 31,2006, which was filed 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.

6

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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’s products.  Technology access fee revenues, contractengineering revenues and royalty revenues are included in net sales in theaccompanying 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 locatedthroughout North America and Europe.  TheCompany generally 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 $3.0 million and $3.2 million at September30, 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 $114,000 and $194,000 for the three and sixmonths ended September 30, 2006, respectively, resulting in no impact onearnings per share for the three months ended September 30, 2006, and a $0.01per share impact on earnings per share for the six months ended September 30,2006.

7

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**Goodwill and Long-Lived Assets**

In accordance withStatement of Financial Accounting Standards (“SFAS”) No. 142, *Goodwill and Intangible Assets*, goodwill is tested forimpairment at the reporting unit level (operating segment or one level below anoperating segment)  on an annual basis inthe Company’s fourth fiscal quarter or more frequently if indicators ofimpairment exist, of which none have been identified.  The performance of the test involves atwo-step process.  The first step of theimpairment test involves comparing the fair value of the Company’s reportingunits with each respective 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 impairment loss.  The second step of the goodwill impairmenttest involves comparing the implied fair value of the reporting unit’s goodwillwith 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.Should the activity result in a permanent improvement to one of the Company’sleased facilities, the cost is capitalized as a leasehold improvement andamortized over its useful life or the remainder of the lease period, whicheveris shorter.  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.

8

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**Other Comprehensive Income**

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

**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 ofCash Flows*.  Generally, theapproach in SFAS 123R is similar to the approach described in SFAS 123.  However, SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values (i.e., proforma disclosure is no longer an alternative to financial statementrecognition).  As further discussed inNote 6, the Company adopted SFAS 123R effective April 1, 2006 using themodified prospective method.

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,presentation and disclosure of uncertain tax positions taken or expected to betaken in income tax returns.  The Companyis currently 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 and expectsto adopt SFAS 157 in the first quarter of its 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. 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, 2008.

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 the IncomeStatement (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 if significant.  EITF 06-3 is effective for the first interimreporting 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:
| ** **              | ** ** | **September 30,  2006** | ** ** | **March 31,  2006** | ** ** |
|-------------------------|------------|------------------------------|------------|--------------------------|------------|
| ** **              | ** ** | **(In thousands)**      | ** ** |
| Materials and  supplies | ** ** | **$**                        | **3,750**  |                     | $          | 2,258 |   |
| Work in process         | ** ** | **200**                      |       | 217                      |       |
| Finished goods          | ** ** | **842**                      |       | 339                      |       |
| ** **              | ** ** | **$**                        | **4,792**  |                     | $          | 2,814 |   |

 

9

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**Goodwilland Intangible Assets**

The following table setsforth the Company’s intangible assets that are subject to amortization:
| ** **            | ** ** | **September 30, 2006** | ** ** | **March 31, 2006**  | ** ** |
|-----------------------|------------|----------------------------------|------------|-------------------------------|------------|
| ** **            | ** ** | **Gross  Carrying  Amount**      | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **            | ** ** | **(In thousands)**          | ** ** |
| Developed  technology | ** ** | **$**                            | **495**    | ** **                    | **$**      | **(230** | **)** | $ | 495 |   | $ | (179 | ) |
| Patents               | ** ** | **317**                          | ** ** | **(104**                      | **)**      | 317 |   | (82 | ) |
| Total                 | ** ** | **$**                            | **812**    | ** **                    | **$**      | **(334** | **)** | $ | 812 |   | $ | (261 | ) |

 

Amortizationexpense for intangible assets subject to amortization was $37,000 and $73,000for the three and six months ended September 30, 2006, respectively, and$36,000 and $73,000 for the three and six months ended September 30, 2005,respectively.  Future estimated amortizationexpense for the remainder of the current fiscal year, the next four fiscalyears and thereafter is as follows:

| Fiscal Year Ending March 31: | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|------------|------------|
| **(In thousands)**                          | ** ** | ** ** | ** ** |
| Remainder of  2007                               |       | $          | 73         |   |
| 2008                                             |       | 147        |       |
| 2009                                             |       | 147        |       |
| 2010                                             |       | 59         |       |
| 2011                                             |       | 46         |       |
| Thereafter                                       |       | 6          |       |
|                                             |       | $          | 478        |   |

 

At September 30, 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  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                             | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(In thousands)**                              | ** ** |
| Balance at  beginning of period    | ** ** | **$**                                                | **590**    |                                               | $          | 342 | ** ** | **$** | **519** |   | $ | 326 |   |
| Additions charged to cost of sales | ** ** | **155**                                              |       | 190                                                | ** ** | **290** |   | 265 |   |
| Warranty claims                    | ** ** | **(66**                                              | **)**      | (91                                                | )          | **(130** | **)** | (150 | ) |
| Balance at end of  period          | ** ** | **$**                                                | **679**    |                                               | $          | 441 | ** ** | **$** | **679** |   | $ | 441 |   |

 

10

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**Earnings (Loss) Per Share**

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

|                                                              | ** ** | **Three Months Ended  September 30,**                  | ** ** | **Six Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2006**                                                              | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                   |       |                                                                  |       |                                               |       |   |   |   |   |
| Net income (loss)                                            | ** ** | **$**                                                                 | **732**    |                                               | $          | (155 | ) | **$** | **1,011** |   | $ | (881 | ) |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Denominator:                                                 |       |                                                                  |       |                                               |       |   |   |   |   |
| Weighted average common shares used in basic  computation    | ** ** | **28,882**                                                            |       | 28,106                                             | ** ** | **28,637** |   | 28,084 |   |
| Dilutive stock options                                       | ** ** | **3,550**                                                             |       | —                                             | ** ** | **3,484** |   | — |   |
| Dilutive warrants                                            | ** ** | **588**                                                               |       | —                                             | ** ** | **573** |   | — |   |
| Weighted average common shares used in dilutive  computation | ** ** | **33,020**                                                            |       | 28,106                                             | ** ** | **32,694** |   | 28,084 |   |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Earnings (loss)  per share:                                  |       |                                                                  |       |                                               |       |   |   |   |   |
| Basic                                                        | ** ** | **$**                                                                 | **0.03**   |                                               | $          | (0.01 | ) | **$** | **0.04** |   | $ | (0.03 | ) |
| Diluted                                                      | ** ** | **$**                                                                 | **0.02**   |                                               | $          | (0.01 | ) | **$** | **0.03** |   | $ | (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  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                             | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **              | ** ** | **(In thousands)**                              | ** ** |
| Stock options           | ** ** | **568**                                              |       | 4,299                                              | ** ** | **547** |   | 4,093 |   |
| Warrants                | ** ** | **1,200**                                            |       | 983                                                | ** ** | **1,290** |   | 872 |   |
| 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 primary 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.  

Subsequentto September 30, 2006, the Company replaced its current facility and enteredinto a new two year credit facility with a different bank.  The new facility provides for combined lineof credit and bank term note borrowings of up to $8.0 million.  Under the new credit facility, the Companymay borrow against its eligible accounts receivable and eligible inventory, asdefined in the credit agreement.  Line ofcredit interest on borrowed amounts is payable monthly at the current statedprime rate plus 1.25%.  Additionally, theCompany is obligated to pay an unused line fee of 0.25% per annum applied tothe amount by which the maximum credit amount exceeds the average dailyprincipal balance during the preceding month. The new credit facility requires$2,000 in monthly collateral management fees and includes an early terminationfee equal to 2% of the total facility during the first year of the agreementand 1% of the total facility in the second year of the agreement.  Additionally, the Company paid a commitmentfee of $40,000 in October 2006 and is obligated to pay an additional $40,000 onthe one year anniversary of the facility. The new credit facility is secured bysubstantially all of the assets of the Company. 

OnSeptember 30, 2006, the available credit under the prior line of creditagreement was $4.4 million, of which $3.8 million was unused.

11

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**Long-Term Debt**

TheCompany’s long-term debt consists of the following:
| ** **                   | ** ** | **September 30,  2006** | ** ** | **March 31,  2006** | ** ** |
|------------------------------|------------|------------------------------|------------|--------------------------|------------|
| ** **                   | ** ** | **(In thousands)**      | ** ** |
|                         |       |                         |       |                     |       |
| Convertible debentures,  net | ** ** | **$**                        | **9,307**  |                     | $          | 9,203 |   |
| Bank term note               | ** ** | **2,084**                    |       | 2,708                    |       |
| Promissory note  to landlord | ** ** | **1,292**                    |       | 1,292                    |       |
| Other                        | ** ** | **98**                       |       | 140                      |       |
|                         | ** ** | **12,781**                   |       | 13,343                   |       |
| Less current  portion        | ** ** | **(2,261**                   | **)**      | (1,969                   | )          |
|                         | ** ** | **$**                        | **10,520** |                     | $          | 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 September 30, 2006, $250,000 ofconvertible debentures had been converted into 69,252 shares of common stock leaving $9.9 million of the originallyissued convertible debentures outstanding at September 30, 2006.

*Bank TermNote.*  In October 2004,the Company entered into a $5.0 million term note payable with a bank.  The note is due on May 27, 2008, andprovides for monthly principal payments of approximately $104,000.  Interest accrues at the current stated primerate plus 0.25% (8.50% at September 30, 2006). Subsequent to September 30, 2006the term note was assumed by the Company’s new bank as part of the Company’snew $8.0 million credit facility. The new term note is also due on May 27, 2008and provides 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 September 30, 2006).  Beginning on October 1, 2006, theCompany is required to make four equal quarterly payments of principal andaccrued interest.  All outstandingaccrued interest and principal becomes payable in full on July 1, 2007.The first principal payment of approximately $323,000 was made on October 5,2006.

Scheduledaggregate maturities of long-term debt principal as of September 30, 2006 wereas follows:
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| Remainder of  2007                                   | ** ** | **$**      | **1,292**  | ** ** |
| 2008                                                 | ** ** | **1,939**  | ** ** |
| 2009                                                 | ** ** | **243**    | ** ** |
| 2010                                                 | ** ** | **9,850**  | ** ** |
|                                                 | ** ** | **$**      | **13,324** | ** ** |
| Less:  unamortized debt discount                     | ** ** | **(543**   | **)**      |
|                                                 | ** ** | **$**      | **12,781** | ** ** |

** **

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**4.  CommonStock Warrants**

On September 27, 2006,the Company issued warrants to purchase an aggregate 246,250 shares of commonstock at an exercise price of $3.25 with a five year life to an existingshareholder 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 September 30, 2006, no liquidateddamages were payable under the provisions of the registration rights agreementassociated with these warrants.  

**5.  Commitmentsand 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 Company issued88,912 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 six months endedSeptember 30, 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.

13

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**Operating Lease Commitments**

The Company has lease commitments for facilities invarious locations throughout the United States. Future commitments under thesenon-cancelable operating leases at September 30, 2006 were as follows:

| Fiscal Year Ending March 31, | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|------------|------------|
| **(In thousands)**                          | ** ** | ** ** | ** ** |
| Remainder of  2007                               | ** ** | **$**      | **761**    | ** ** |
| 2008                                             | ** ** | **983**    | ** ** |
| 2009                                             | ** ** | **146**    | ** ** |
| 2010                                             | ** ** | **85**     | ** ** |
| 2011                                             | ** ** | **43**     | ** ** |
| Total                                            | ** ** | **$**      | **2,018**  | ** ** |

 

**Inventory Purchase Commitments**

At September 30, 2006, the Company had firm commitments topurchase inventory in the amount of $1.5 million during the third and fourthquarters of its fiscal year ending March 31, 2007.

**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,based on grant-date fair values estimated in accordance with the originalprovisions of SFAS 123.  Accordingly,prior period amounts presented herein have not been restated to reflect theadoption of SFAS 123R.

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 Companycontinues to use both the BSM option-pricing formula and straight-lineamortization of compensation expense over the requisite service period of stockoption grants.  The Company willreconsider use of this model if additional information becomes available in thefuture that indicates another model would be more appropriate, or if grantsissued in future periods have characteristics that cannot be reasonablyestimated using this model.  SFAS 123 didnot require the estimation of forfeitures in the calculation of stockcompensation expense; however, SFAS 123R does require such estimation and uponadoption of SFAS 123R, the Company changed its methodology to include anestimate of forfeitures. The adoption of SFAS 123R had no effect on cash flowsfrom operating activities because no tax benefits are realized from stockoption exercises. The adoption of SFAS 123R also had no effect on cash flowsfrom financing activities.

Thefollowing table illustrates the impact of adopting SFAS 123R:
| ** **                            | ** ** | **Three Months  Ended  September 30, 2006**                           | ** ** | **Six Months  Ended  September 30, 2006** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Income before  income taxes           | ** ** | **$**                                                                 | **(39**    | **)**                                          | $          | (94 | ) |
| Net income                            | ** ** | **$**                                                                 | **(39**    | **)**                                          | $          | (94 | ) |
| Basic and  diluted earnings per share | ** ** | **$**                                                                 | **0.00**   |                                           | $          | 0.00 |   |

 

14

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Thefollowing table illustrates the effect on net loss and net loss per share forthe three and six months ended September 30, 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:
| ** **                                                                                               | ** ** | **Three Months Ended  September 30, 2005**        | ** ** | **Six Months Ended  September 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                               | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net loss — as  reported                                                                             |       | $                                                                     | (155       | )                                                            | $          | (881 | ) |
| Add: Stock-based  compensation expense included in net loss — as reported                           |       | 258                                                                   |       | 523                                                          |       |
| Deduct: Total  stock-based compensation expense determined under fair value based method for  all awards |       | (364                                                                  | )          | (735                                                         | )          |
| Net loss — pro  forma                                                                               |       | $                                                                     | (261       | )                                                            | $          | (1,093 | ) |
|                                                                                                     |       |                                                                  |       |                                                         |       |
| Basic and  diluted loss per share — as reported                                                     |       | $                                                                     | (0.01      | )                                                            | $          | (0.03 | ) |
| Basic and  diluted loss per share — pro forma                                                       |       | $                                                                     | (0.01      | )                                                            | $          | (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 September 30, 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 September 30, 2006, options to purchase5.4 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 both the Plan and the 1998 Plan (collectively, the“Plans”) provide for accelerated vesting of unvested options in the event of achange in control under certain circumstances. These change-in-control provisions meet the criteria of a performancecondition under SFAS 123R.

Asummary of activity in the Plans for the six months ended September 30, 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                                                                  |       | (191                                                                  | )          | $                                      | 1.16       |                                                        | N/A        |                                |       |   |
| Forfeited                                                                  |       | (18                                                                   | )          | $                                      | 2.64       |                                                        | N/A        |                                |       |   |
| Expired                                                                    |       | (24                                                                   | )          | $                                      | 2.50       |                                                        | N/A        |                                |       |   |
| Options  outstanding at September 30, 2006                                 |       | 6,913                                                                 |       | $                                      | 1.44       |                                                        | 3.62       |                                | $          | 8,890 |   |
| Vested and  expected to vest at September 30, 2006                         |       | 6,839                                                                 |       | $                                      | 1.43       |                                                        | 3.56       |                                | $          | 8,874 |   |
| Options  exercisable at September 30, 2006                                 |       | 6,462                                                                 |       | $                                      | 1.38       |                                                        | 3.26       |                                | $          | 8,716 |   |
| Options  exercisable at September 30, 2006 pursuant to a change-in-control |       | 6,913                                                                 |       | $                                      | 1.44       |                                                        | 3.62       |                                | $          | 8,890 |   |

 

15

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AtSeptember 30, 2006, there were 106,000 shares of common stock available forgrant under the Plan.

Forthe six month periods ended September 30, 2006 and 2005, the Company received $224,000and $153,000, respectively, in cash from the exercise of stock options.  Total stock-based compensation expense forthe three and six months ended September 30, 2006 was $74,000 and $174,000,respectively.  No income tax benefit wasrealized from activity in the Plans during the six months ended September 30,2006 and 2005.

AtSeptember 30, 2006, there was $780,000 of total unrecognized compensationexpense related to unvested stock options. This expense is expected to be recognized over a weighted-average periodof approximately 2.9 years.

The fair value of each stock-based award is estimatedon the grant date using the BSM option-pricing formula. Expected volatility isbased on the historical volatility of the Company’s stock price. The expectedlife of options granted subsequent to the adoption of SFAS 123R is derivedbased on the historical life of the Company’s options.  The risk-free interest rate for periodswithin the expected life of the option is based on the U.S. Treasury interestrates in effect at the time of grant. The grant date fair value of optionsgranted was estimated using the following weighted-average assumptions:

|                                      | ** ** | **Three Months  Ended September 30,** | ** ** | **Six Months  Ended September 30,** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **   2006   **         | ** ** | **   2005   **       | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
|                                 |       |                                                 |       |                                               |       |   |   |   |   |
| Dividend yield                       | ** ** | **0.0**                                              |       | 0.0                                                | ** ** | **0.0** |   | 0.0 |   |
| Expected life —  years          | ** ** | **7.0**                                              |       | 7.0                                                | ** ** | **7.0** |   | 7.0 |   |
| Risk-free interest  rate             | ** ** | **4.7**                                              | **%**      | 5.5                                                | %          | **4.8** | **%** | 5.5 | % |
| Expected  volatility of common stock | ** ** | **0.89**                                             |       | 0.50                                               | ** ** | **0.89** |   | 0.50 |   |

 

A summary of thegrant date fair value and intrinsic value information is as follows:

|                                                       | ** ** | **Three Months  Ended September 30,**                  | ** ** | **Six Months  Ended September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                            | ** ** | **   2006   **                          | ** ** | **   2005   **       | ** ** | **   2006   ** | ** ** | **   2005   ** | ** ** |
| ** **                                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Weighted average  grant date fair value per share     | ** ** | **$**                                                                 | **2.01**   |                                               | $          | 1.82 | ** ** | **$** | **1.86** |   | $ | 1.82 |   |
| Intrinsic value  of options exercised                 | ** ** | **$**                                                                 | **63**     |                                               | $          | 89 | ** ** | **$** | **225** |   | $ | 179 |   |
| Total fair value  of options vested during the period | ** ** | **$**                                                                 | **134**    |                                               | $          | 879 | ** ** | **$** | **517** |   | $ | 1,352 |   |

 

**7.  BusinessSegment Information**

TheCompany currently operates in three reportable segments: Roadway Sensors,Automotive Sensors and Transportation Systems. The Roadway Sensors segment includes the Company’s Vantage vehicledetection systems for traffic intersection control, incident detection andcertain highway traffic data collection applications.  The Automotive Sensors segment includesAutoVue and is comprised of all activities related to lane departure warningsystems for vehicle safety.  TheTransportation Systems segment includes transportation engineering andconsulting services and the development of transportation management andtraveler information systems for the ITS industry. The accounting policies ofthe reportable segments are the same as those described in the summary ofsignificant accounting policies except that certain expenses, such as interest,amortization of certain intangibles and certain corporate expenses are notallocated to the segments. In addition, certain assets, including cash and cashequivalents, deferred taxes and certain long-lived and intangible assets, arenot allocated to the segments.  Thereportable segments are each managed separately because they manufacture anddistribute distinct products or provide services with different processes.  All segment revenues are derived fromexternal customers.

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The following table sets forth selected unauditedfinancial information for the Company’s reportable segments for the three andsix months ended September 30, 2006 and 2005:

|                                                    | ** ** | **Roadway  Sensors**    | ** ** | **Automotive  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| **Three  Months Ended September 30, 2006**         |       |                    |       |                    |       |                        |       |      |       |
| Product revenue  from external customers           |       | $                       | 6,961      |                    | $          | 1,658                       |       | $         | —     |   | $ | 8,619 |   |
| Service and  other revenue from external customers | ** ** | **—**              |       | 704                     |       | 5,143                       |       | 5,847     |       |
| Depreciation and  amortization                     |       | 20                      |       | 34                      |       | 34                          |       | 88        |       |
| Segment income  (loss)                             |       | 1,601                   |       | (527                    | )          | 707                         |       | 1,781     |       |
|                                               |       |                    |       |                    |       |                        |       |      |       |
| **Three  Months Ended September 30, 2005**         |       |                    |       |                    |       |                        |       |      |       |
| Product revenue  from external customers           |       | $                       | 5,798      |                    | $          | 1,472                       | ** ** | **$**     | **—** |   | $ | 7,270 |   |
| Service and  other revenue from external customers | ** ** | **—**              |       | 705                     |       | 4,740                       |       | 5,445     |       |
| Depreciation and  amortization                     |       | 33                      |       | 48                      |       | 68                          |       | 149       |       |
| Segment income  (loss)                             |       | 878                     |       | (608                    | )          | 600                         |       | 870       |       |
|                                               |       |                    |       |                    |       |                        |       |      |       |
| **Six  Months Ended September 30, 2006**           |       |                    |       |                    |       |                        |       |      |       |
| Product revenue  from external customers           |       | $                       | 13,477     |                    | $          | 2,996                       |       | $         | —     |   | $ | 16,473 |   |
| Service and  other revenue from external customers | ** ** | **—**              |       | 1,450                   |       | 10,359                      |       | 11,809    |       |
| Depreciation and  amortization                     |       | 39                      |       | 68                      |       | 62                          |       | 169       |       |
| Segment income  (loss)                             |       | 3,102                   |       | (1,161                  | )          | 1,365                       |       | 3,306     |       |
|                                               |       |                    |       |                    |       |                        |       |      |       |
| **Six  Months Ended September 30, 2005**           |       |                    |       |                    |       |                        |       |      |       |
| Product revenue  from external customers           |       | $                       | 11,145     |                    | $          | 3,199                       | ** ** | **$**     | **—** |   | $ | 14,344 |   |
| Service and  other revenue from external customers | ** ** | **—**              |       | 1,156                   |       | 9,294                       |       | 10,450    |       |
| Depreciation and  amortization                     |       | 63                      |       | 82                      |       | 151                         |       | 296       |       |
| Segment income  (loss)                             |       | 1,663                   |       | (1,308                  | )          | 1,096                       |       | 1,451     |       |
|                                               |       |                    |       |                    |       |                        |       |      |       |

 

The following tablereconciles segment income to consolidated income (loss) before income taxes:
| ** **                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|---------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                             | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(In thousands)**                              | ** ** |
| Total income for  reportable segments | ** ** | **$**                                                | **1,781**  |                                               | $          | 870 | ** ** | **$** | **3,306** |   | $ | 1,451 |   |
| Unallocated  amounts:                 |       |                                                 |       |                                               |       |   |   |   |   |
| Corporate expenses                    | ** ** | **(651**                                             | **)**      | (936                                               | )          | **(1,431** | **)** | (1,835 | ) |
| Other income (expense), net           | ** ** | **45**                                               |       | 86                                                 | ** ** | **(645** | **)** | 38 |   |
| Interest expense, net                 | ** ** | **(424**                                             | **)**      | (358                                               | )          | **(810** | **)** | (710 | ) |
| Income (loss)  before income taxes    | ** ** | **$**                                                | **751**    |                                               | $          | (338 | ) | **$** | **420** |   | $ | (1,056 | ) |

** **

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**ITEM2.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OFOPERATIONS**

*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 intendedto identify forward-looking statements. These forward-looking statementsinclude but are not limited to statements regarding our anticipated sales,revenue, expenses, profits, capital needs, competition, development plans,backlog and manufacturing capabilities, the applications for and acceptance ofour products and services, the status of our facilities and productdevelopment, and the impact of pending litigation. These statements are notguarantees of future performance and are subject to certain risks anduncertainties which could cause actual results to differ materially from thoseprojected. You should not place undue reliance on these forward-lookingstatements that speak only as of the date hereof. We undertake no obligation torepublish revised forward-looking statements to reflect events or circumstancesafter the date hereof or to reflect the occurrence of unanticipated events. Weencourage you to carefully review and consider the various disclosures made byus which describe certain factors which could affect our business, including in*“*Risk Factors” set forth in Part II, Item 1A of thisreport, before deciding to invest in our company or to maintain or increaseyour investment. We undertake no obligation to revise or update publicly anyforward-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 25,000 production AutoVueunits have been sold for truck platforms in the North American and Europeanmarkets.  Our AutoVue LDW systems arecurrently offered as an option on certain trucks, including Mercedes, MAN,Iveco, DAF, Scania, Freightliner and International.  In North America our LDW systems are soldprimarily to truck fleets, and to date, 36 U.S. heavy truck fleets haveselected our LDW systems, representing an estimated 19,000 vehicles.  In September 2003, we entered into anagreement with Valeo Schalter and Sensuren GmbH (“Valeo”), pursuant to which wegranted Valeo the exclusive right to sell and manufacture our AutoVue LDWsystems to the worldwide passenger car market in exchange for royalty paymentsfor each AutoVue LDW unit sold.  To date,royalty payments from Valeo have not been significant.  Pursuant to this agreement, we also providespecific contract engineering services, technical marketing and sales supportto Valeo to enable the launch of our LDW technology on three Infinitiplatforms, the FX, M and Q, where the device is offered as part of thetechnology option package.  Valeo iscurrently in discussions to provide our LDW system to other passenger car OEMs;however, we cannot assure you that such discussions will be successful.  We plan to continue to provide technicalmarketing and sales support to Valeo in our efforts to win new OEM customersfor the passenger car market as well as contract engineering services relatedto the possible launch of new Infiniti platforms that include our LDWsystem.  We believe that AutoVue is abroad sensor platform that, through additional software development, may beexpanded 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 communicationsequipment to enable public agencies to monitor, control and direct 

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traffic flow,assist in the quick dispatch of emergency crews and distribute real-timeinformation about traffic conditions. Our services include planning and other engineering for theimplementation of transportation infrastructure and related communicationssystems, analysis and study related to goods movement and commercial vehicleoperations, and parking systems designs. These services and systems are sold to local, state and nationaltransportation agencies in the United States. Our transportation management systems business is largely dependent upongovernmental funding and budgetary issues. The Federal Highway Bill was passed in August 2005, which provides for asignificant increase in transportation funding over the next six years.  Our Transportation management systemsbusiness is expanding partly due to the passage of the Federal Highway Billcombined with expansion of transportation funds at state and local agenciesthroughout the country.

We currently operate in three reportable segments:Roadway Sensors, Automotive Sensors and Transportation Systems. The RoadwaySensors segment includes our Vantage vehicle detection systems for trafficintersection control, incident detection and certain highway traffic datacollection applications.  The AutomotiveSensors segment is comprised of all activities related to our AutoVue LDWsystems for vehicle safety. The Transportation Systems segment includes transportationengineering and consulting services and the development of transportationmanagement and traveler information systems for the ITS industry.

**CriticalAccounting Policies and Estimates**

Management’s Discussion and Analysis of FinancialCondition and Results of Operations is based on our unaudited condensedconsolidated financial statements included herein, which have been prepared inaccordance with U.S generally accepted accounting principles. The preparationof these financial statements requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities andrelated disclosures of contingent assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. On an ongoing basis, we evaluate these estimates andassumptions, including those related to the collectibility of accountsreceivable, the valuation of inventories, the recoverability of long-livedassets and goodwill, accounting for stock-based compensation related to SFAS123R, and other contingencies. We base these estimates on historical experienceand on various other factors that we believe to be reasonable under thecircumstances, the results of which form the basis for making judgments aboutthe carrying values of assets and liabilities that are not readily apparentfrom other sources. These estimates and assumptions by their nature involverisks and uncertainties, and may prove to be inaccurate. In the event that anyof our estimates or assumptions are inaccurate in any material respect, itcould have a material adverse effect on our reported amounts of assets andliabilities at the date of the financial statements and the reported amounts ofrevenues 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 estimatedprofitability, including those arising from contract penalty provisions andfinal contract settlements, may result in revisions to recognized costs andrevenues and are recognized in the period in which the revisions aredetermined.  Profit incentives areincluded in revenue when 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 fee revenues,contract engineering revenues and royalty revenues are included in net sales.

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

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

*Warranty.*  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 a componentof cost of sales at the time revenue for that product is recognized.  The accrued warranty provision is includedwithin accrued expenses on the accompanying condensed consolidated balancesheets.  Should our actual experience ofwarranty returns be higher than anticipated, additional warranty reserves maybe required, which may adversely affect our operating results.

*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. Thisestimation process can result in significant changes to our expected effectivetax rate. When this occurs, we adjust the income tax provision during thequarter 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 requiresall stock-based payments, including grants of employee stock options, to berecognized in the 

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statement ofoperations as an expense, based on their grant date fair values with such fairvalues amortized over the requisite service period.  We elected to utilize the modifiedprospective 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 modified prospective method,compensation expense will be recognized for all stock-based compensation awardsgranted prior to but not yet vested as of April 1, 2006, based on grant-datefair values estimated in accordance with the original provisions of SFAS123.  

In implementing SFAS123R, 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 ofoperations data as a percentage of total net sales and contract revenues forthe periods indicated. The following table should be read in conjunction withManagement’s Discussion and Analysis of Financial Condition and Results ofOperations.
| ** **                            | ** ** | **Three Months  Ended  September 30,** | ** ** | **Six Months  Ended  September 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                         | ** ** | **2005**                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales and  contract revenues:     |       |                                             |       |                                           |       |   |   |   |   |
| Net sales                             | ** ** | **64.4**                                         | **%**      | 62.7                                           | %          | **63.4** | **%** | 62.5 | % |
| Contract revenues                     | ** ** | **35.6**                                         |       | 37.3                                           | ** ** | **36.6** |   | 37.5 |   |
| Total net sales and contract revenues | ** ** | **100.0**                                        | **%**      | 100.0                                          | %          | **100.0** | **%** | 100.0 | % |
| Costs and  expenses:                  |       |                                             |       |                                           |       |   |   |   |   |
| Cost of net sales                     | ** ** | **36.6**                                         |       | 33.3                                           | ** ** | **35.5** |   | 32.2 |   |
| Cost of contract revenues             | ** ** | **22.2**                                         |       | 23.9                                           | ** ** | **23.2** |   | 24.3 |   |
| Gross profit                          | ** ** | **41.2**                                         |       | 42.8                                           | ** ** | **41.3** |   | 43.5 |   |
| Operating  expenses:                  |       |                                             |       |                                           |       |   |   |   |   |
| Selling, general and administrative   | ** ** | **27.5**                                         |       | 32.1                                           | ** ** | **28.2** |   | 31.9 |   |
| Research and development              | ** ** | **5.3**                                          |       | 10.8                                           | ** ** | **6.3** |   | 12.6 |   |
| Deferred compensation plan            | ** ** | **0.3**                                          |       | 0.1                                            | ** ** | **(0.1** | **)** | 0.3 |   |
| Amortization of intangible assets     | ** ** | **0.3**                                          |       | 0.3                                            | ** ** | **0.3** |   | 0.3 |   |
| Total operating expenses              | ** ** | **33.4**                                         |       | 43.3                                           | ** ** | **34.7** |   | 45.1 |   |
| Operating income  (loss)              | ** ** | **7.8**                                          |       | (0.5                                           | )          | **6.6** |   | (1.6 | ) |
| Non-operating  income (expense):      |       |                                             |       |                                           |       |   |   |   |   |
| Other income (expense), net           | ** ** | **0.3**                                          |       | 0.7                                            | ** ** | **(2.3** | **)** | 0.2 |   |
| Interest expense, net                 | ** ** | **(2.9**                                         | **)**      | (2.8                                           | )          | **(2.8** | **)** | (2.9 | ) |
| Income (loss)  before income taxes    | ** ** | **5.2**                                          |       | (2.6                                           | )          | **1.5** |   | (4.3 | ) |
| Income tax  benefit (provision)       | ** ** | **(0.1**                                         | **)**      | 1.4                                            | ** ** | **2.1** |   | 0.7 |   |
| Net income  (loss)                    | ** ** | **5.1**                                          | **%**      | (1.2                                           | )%         | **3.6** | **%** | (3.6 | )% |

 

**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 9.6% and 10.1%of total net sales and contract revenues in the three and six months endedSeptember 30, 2006.

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Total net sales and contract revenues increased 13.8%to $14.5 million and 14.1% to $28.3 million for the three and six months endedSeptember 30, 2006, respectively, compared to $12.7 million and $24.8 millionin the corresponding periods in the prior fiscal year.  This increase was driven by increased netsales in both the Roadway Sensors and Automotive Sensors businesses as well asincreased contract revenues in the Transportation Systems business, asdiscussed below.

Net sales increased 16.9% to $9.3 million and 15.6% to$17.9 million for the three and six months ended September 30, 2006,respectively, compared to $8.0 million and $15.5 million in the correspondingperiods of the prior fiscal year.  This increase was driven by a 20.1% anda 20.9% increase in Roadway Sensors net sales in the three and six months endedSeptember 30, 2006, respectively, over the corresponding periods in the prioryear as we continue to experience positive reaction to recently introducedVantage product offerings such as eAccess and color cameras, as well as highergovernmental spending which we believe is related to the passage of the FederalHighway Bill in August 2005.  In additionto the increase in Roadway Sensors net sales, Automotive Sensors net salesincreased 8.5% and 2.1% in the three and six months ended September 30, 2006,respectively, over the corresponding periods in the prior year primarily as a resultof an increase in sales of our LDW systems in the North American aftermarketand an increase in revenues generated through engineering activities in thepassenger car market. Despite an increase of 14.7% in sales of our LDW systemsto the heavy truck market for the three months ended September 30, 2006compared to the same period in the prior year, sales of our LDW systems to thismarket have decreased by 4.7% for the six months ended September 30, 2006compared to the same period in the prior year. The higher level of sales in theprior fiscal year occurred largely as a result of our largest AutomotiveSensors customer purchasing approximately $1.0 million of spare LDW systems inthe prior year in anticipation of the changeover to the next generation LDWsystem.  $400,000 of these LDW systemswere purchased in the first quarter of the prior fiscal year and resulted inunusually high volumes for this customer in that period.  Such purchases of spare systems did not occurin the three and six months ended September 30, 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 somewhat offset by a 166% increase insales of aftermarket LDW systems in North America for the six months endedSeptember 30, 2006.  Two of the largestEuropean truck manufacturers also recently announced the launch of our LDW systemas an option on heavy duty truck models, which may positively impact our LDWsales in the current fiscal year.  Whilewe have enjoyed recent success in signing new customers in the truck market, wehave experienced a decline in sales from our largest Automotive Sensorshardware customer, which we have not been able to overcome through sales to newcustomers in North America or Europe.  Wecannot assure you that this trend will not continue.

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 8.5% to $5.1 million and11.5% to $10.4 million for the three and six months ended September 30, 2006,respectively, as compared to $4.7 million and $9.3 million in the correspondingperiods of the prior fiscal year.  Thisincrease was largely due to increased funding at the federal, state and locallevels throughout the country.  Inresponse to this growth in funding, we have increased our TransportationSystems staff by 12% in the six months ended September 30, 2006.  We expect to continue to increase ourTransportation Systems staff over the next couple quarters, although not at thesame rate as in the six months ended September 30, 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 $9.8million contract from the Federal Highway Administration (“FHWA”), which coversa period of two years beginning April 2007 and contains renewal optionsextending through 2012.  Although thiscontract is not expected to substantially affect the trend in contract revenuesin our Transportation Systems business and although we cannot assure you thatthe full face amount of the contract will be spent or that any of the optionswill be exercised, this contract does help solidify our future FHWA business.

*Gross Profit*. Total gross profit increased 9.5% to $6.0 million and 8.1% to $11.7 million forthe three and six months ended September 30, 2006, respectively, as compared to$5.4 million and $10.8 million in the corresponding periods of the prior fiscalyear.  Total gross profit as a percent ofnet sales and contract revenues decreased to 41.2% and 41.3% for the three andsix months ended September 30, 2006, respectively, as compared to 42.8% and43.5% in the corresponding periods of the prior fiscal year.

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Gross profit as apercent of net sales was 43.2% and 43.9% for the three and six months ended September30, 2006, respectively, compared to 46.9% and 48.4% in the corresponding periodsof the prior fiscal year.  This decrease was primarily due to volume discountsgiven to our largest Automotive Sensors hardware customer, increased productsupport activities in our Roadway Sensors business, an increased level of lowermargin engineering 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 declined over the lastsix quarters from a high of 50.2% in the first quarter of our prior fiscal yearto 43.2% reported for the current quarter ended September 30, 2006 mainly as aresult of the above.  

Gross profit as apercent of contract revenues increased to 37.5% and 36.8% for the three and sixmonths ended September 30, 2006, respectively, compared to 35.9% and 35.4% inthe corresponding periods of the prior fiscal year.  The increase in grossprofit as a percent of contract revenues in the current periods was primarilydue to a continued focus on higher margin contracts and a favorable contractmix.

*Selling,General and Administrative Expense*.  Selling, generaland administrative expense decreased 2.5% and increased 0.9% to $4.0 millionand $8.0 million (or 27.5% and 28.2% of total net sales and contract revenues)in the three and six months ended September 30, 2006, respectively, compared to$4.1 million and $7.9 million (or 32.1% and 31.9% of total net sales andcontract revenues) in the corresponding periods of the prior fiscal year.  Although selling, general and administrativeexpense was relatively flat year-over-year in absolute dollar terms, the threeand six months ended September 30, 2006, included legal expenses ofapproximately $90,000 and $230,000, respectively, associated with thesettlement of litigation described in Note 5 to the accompanying condensedconsolidated financial statements.  Nofurther significant legal costs are expected to be incurred related to thismatter.  In the coming quarters and nextfiscal year, we anticipate increased selling, general and administrativeexpense related to our efforts to comply with the internal control attestationrequirements of the Sarbanes-Oxley Act, with which we must begin to comply inour fiscal year ending March 31, 2008.  

*Researchand Development Expense*.  Research and developmentexpense decreased 43.7%  and 43.1% to $771,000and $1.8 million (or 5.3% and 6.3% of total net sales and contract revenues) inthe three and six months ended September 30, 2006, respectively, compared to$1.4 million and $3.1 million (or 10.8% and 12.6% of total net sales andcontract revenues) 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 supportactivities are included in cost of net sales rather than research anddevelopment expense.  

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

*DeferredCompensation Plan Expense.*  During the three and sixmonth periods ended September 30, 2006, we recorded a non-cash benefit of$34,000 and expense of $32,000, 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 expense of $16,000 and $78,000 recorded in the three and six monthperiods ended September 30, 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.

*Other Income (Expense), Net.*  Otherincome (expense), net includes the following: 

|                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                             | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                   | ** ** | **(In thousands)**                              | ** ** |
| Settlement of  lawsuit       | ** ** | **$**                                                | **53**     |                                               | $          | — | ** ** | **$** | **(635** | **)** | $ | — |   |
| Other                        | ** ** | **(8**                                               | **)**      | 86                                                 | ** ** | **(10** | **)** | 38 |   |
| Other income  (expense), net | ** ** | **$**                                                | **45**     |                                               | $          | 86 | ** ** | **$** | **(645** | **)** | $ | 38 |   |

 

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

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

|                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                             | ** ** | **2005**                                           | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                              | ** ** | **(in thousands)**                              | ** ** |
| Interest expense                        | ** ** | **$**                                                | **(338**   | **)**                                              | $          | (272 | ) | **$** | **(637** | **)** | $ | (537 | ) |
| Amortization of  debt discount          | ** ** | **(52**                                              | **)**      | (52                                                | )          | **(104** | **)** | (104 | ) |
| Amortization of  deferred finance costs | ** ** | **(34**                                              | **)**      | (34                                                | )          | **(69** | **)** | (69 | ) |
| Interest expense, net                   | ** ** | **$**                                                | **(424**   | **)**                                              | $          | (358 | ) | **$** | **(810** | **)** | $ | (710 | ) |

Interest expenseincreased 18.4% and 14.1% for the three and six months ended September 30, 2006,respectively, compared to the corresponding periods in the prior fiscal yearprimarily as a result of a higher level of borrowings on our line of credit inthe current year.

*Income Taxes*.  During thethree and six months ended September 30, 2006, we recognized income tax expenseof $19,000 and an income tax benefit of $591,000, respectively, as compared toan income tax benefit of $183,000 and $175,000 in the three and six monthsended September 30, 2005, respectively.  Thetax benefit recorded in the six months ended September 30, 2006 was based on anestimated annual effective tax rate of 1.9% applied to the pre-tax income forthe six months ended September 30, 2006, as well as a $599,000 reduction in thevaluation allowance recorded against our deferred tax assets as a result ofchanges 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 $2.2 million at September 30, 2006. In the future, we may continue to record similar adjustments to ourdeferred tax asset valuation allowance as our estimates are updated.  We anticipate this will cause our future overalleffective tax rate in any given period to fluctuate from prior effective taxrates, estimated annual effective tax rates and statutory tax rates.

**Liquidityand Capital Resources**

*CashFlows*

We have historicallyfinanced our operations with a combination of cash flows from operations,borrowings under credit facilities and the sale of equity securities. Wecurrently rely on cash flows from operations and borrowings on a line of creditfacility to fund our operations.  AtSeptember 30, 2006, we had $6.1 million in working capital, which includedborrowings of $577,000 on our revolving line of credit and $19,000 in cash andcash equivalents. This compares to working capital of $3.3 million atMarch 31, 2006, which included borrowings of $2.7 million on our revolvingline of credit and $131,000 in cash and cash equivalents. Our operations provided$135,000 of cash during the six months ended September 30, 2006, primarily as aresult of $1.0 million in net income and an increase in accounts payable due tothe timing of payments offset by an increase in inventory levels of $2.0 millionin the current fiscal year to support sales growth.  During the six months ended September 30, 2005,our operations provided $41,000 in cash, primarily as a result of planneddecreases in inventory levels.

Our investing activitiesfor the six months ended September 30, 2006 and 2005, consisted entirely ofpurchases of property and equipment, which aggregated $240,000 and $386,000,respectively.

Cash used in financingactivities was $7,000 in the six months ended September 30, 2006, which was largelythe result of net payments on our line of credit and long-term debt of $2.8million offset by cash inflows of $2.7 million from the exercise of outstandingstock options and warrants to purchase our common stock. As discussed in Note 4to the accompanying condensed consolidated financial statements, approximately$2.0 million of the $2.7 million was raised through the exercise of 1,250,000outstanding warrants.  During the sixmonths ended September 30, 2005, financing activities provided $299,000 of cash,which was comprised of net borrowings on our line of credit and long-term debt of$109,000 and cash inflows of $190,000 from the exercise of outstanding stockoptions and warrants to purchase our common stock.

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*Borrowings*

The following table summarizes our borrowings andlong-term debt:

|                              | ** ** | **At September  30, 2006** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **(In thousands)**              | ** ** |
| Convertible  debentures, net |       | $                                    | 9,307      |   |
| Bank term note               |       | 2,084                                |       |
| Promissory note  to landlord |       | 1,292                                |       |
| Other                        |       | 98                                   |       |
|                         |       | $                                    | 12,781     |   |

 

We renewed ourcredit agreement with our bank in August 2005, which provided for borrowings ofup to $5.0 million.  This creditagreement was scheduled to expire on July 31, 2006, but was extended until October31, 2006.  At September 30, 2006, we had$4.4 million available under the revolving line of credit, of which $3.8million was unused.  

Subsequent toSeptember 30, 2006, we replaced our current facility and entered into a new twoyear 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, we may borrow against our eligible accounts receivableand eligible inventory, as defined in the credit agreement.  Interest on borrowed amounts is payablemonthly at the current stated prime rate plus 1.25%.  Additionally, we are obligated to pay anunused line fee of 0.25% per annum applied to the amount by which the maximumcredit amount exceeds the average daily principal balance during the precedingmonth. The new credit facility requires $2,000 in monthly collateral managementfees and includes an early termination fee equal to 2% of the total facility duringthe first year of the agreement and 1% of the total facility in the second yearof the agreement. Additionally, we paid a commitment fee of $40,000 in October2006 and are 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.  

We believe that the cashgenerated from our operations, together with our new line of credit, will besufficient to fund our operations for at least the next twelve months. However,should a shortfall occur, we may need to raise additional funds through otherdebt financings or the sale of equity securities.

**ContractualObligations**

Our contractualobligations are as follows at September 30, 2006:
| ** **              | ** ** | **Payments Due by Period** | ** ** |
|-------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Total** | ** ** |
| ** **              | ** ** | **(In thousands)**                   | ** ** |
| Line of credit          |       | $                                         | 577        |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 577 |   |
| Notes payable           |       | 1,292                                     |       | 1,939 |   | 243 |   | — |   | — |   | 3,474 |   |
| Convertible  debentures |       | —                                    |       | — |   | — |   | 9,850 |   | — |   | 9,850 |   |
| Operating leases        |       | 761                                       |       | 983 |   | 146 |   | 85 |   | 43 |   | 2,018 |   |
| Total                   |       | $                                         | 2,630      |   | $ | 2,922 |   | $ | 389 |   | $ | 9,935 |   | $ | 43 |   | $ | 15,919 |   |

At September 30, 2006, we had firm commitments to purchaseinventory in the amount of $1.5 million during the third and fourth quarters ofour fiscal year ending March 31, 2007.

**Off Balance Sheet Arrangements**

In May 2004, we issued subordinated convertibledebentures in an aggregate original principal amount of $10.1 million.These debentures are due in full on May 19, 2009 and are convertible intoshares of our common stock at an initial conversion price of $3.61 per share.At September 30, 2006, $9.9 million of these convertible debentures remainedoutstanding. Because these debentures are conventionally convertible, we havenot separately accounted for the conversion feature and, accordingly, noseparate amounts are presented in our condensed consolidated financialstatements in connection with this conversion feature.

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At September 30, 2006, outstanding warrants topurchase an aggregate of 62,500 shares of our common stock at an exerciseprice of $1.95 per share and outstanding warrants to purchase an aggregate of246,250 shares of our common stock at an exercise price of $3.25 were callableby us if the closing sales price of our common stock for 20 consecutive days isequal to or greater than two times the exercise price of the warrants.Outstanding warrants to purchase an aggregate of 75,000 shares of ourcommon stock at an exercise price of $5.00 per share were callable by us if theprice of our common stock for 20 consecutive days is equal to or greaterthan one and a half times the exercise price of the warrants.

In connection with warrants to purchase 246,250 sharesof our common stock at $3.25 per share, we are a party to certain registrationrights agreements 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.

**RecentAccounting Pronouncements**

InJuly 2006, the FASB issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”).  FIN 48 clarifies the accounting and reportingfor income taxes recognized in accordance with SFAS No. 109, *Accounting for Income Taxes*. This Interpretation prescribes a comprehensive model for the financialstatement recognition, measurement, presentation and disclosure of uncertaintax positions taken or expected to be taken in income tax returns.  We are currently evaluating the impact of FIN48 and expect to adopt this Interpretation in the first quarter of our fiscalyear ending March 31, 2008.

InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurements* (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value, and expands disclosure about fair valuemeasurements. SFAS 157 does not require any new fair value measurements; ratherit specifies valuation methods to be applied when fair value measurements arerequired under existing or future accounting pronouncements. SFAS 157 iseffective for fiscal years beginning after November 15, 2007, and interimperiods within those fiscal years. Early application of the statement isencouraged. Generally, this statement will be applied prospectively.  We are currently evaluating the impact of SFAS157 and expect to adopt SFAS 157 in the first quarter of our fiscal year endingMarch 31, 2009. 

InSeptember 2006, the SEC staff issued Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements* (“SAB 108”).  SAB 108 provides interpretive guidance on theconsideration of the effects of prior year misstatements in quantifying currentyear misstatements for the purpose of a materiality assessment.  We are currently evaluating the impact of SAB108 and expect to adopt SAB 108 in the first quarter of our fiscal year endingMarch 31, 2008.  

InJune 2006, the FASB ratified Emerging Issues Task Force Issue No. 06-3, *How Taxes Collected from Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement (That Is, Gross versusNet Presentation)* (“EITF 06-3”). The task force reached a conclusion that either method is acceptable;however, if taxes are reported on a gross basis (included as sales) a companyshould disclose those amounts if significant. EITF 06-3 is effective for the first interim reporting period beginningafter December 15, 2006.  We arecurrently evaluating the impact of EITF 06-03 and expect to adopt EITF 06-3 inthe fourth quarter of our current fiscal year. 

**Seasonality**

Wehave historically experienced seasonality, particularly with respect to ourRoadway Sensors net sales in the third and fourth fiscal quarters due to areduction in road construction or repairs during the winter months due toinclement weather conditions.

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

Our exposure tointerest rate risk is limited to our line of credit, bank term note and apromissory 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 September 30, 2006).  Wedo not 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**

**Evaluation of Disclosure Controls andProcedures**

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures, as such term isdefined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based 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 reported withinthe time periods specified in the Securities and Exchange Commission’s rulesand 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 most recent completed fiscal quartercovered by this report, there has been no change in our internal controls overfinancial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Securities Exchange Act of 1934) that has materially affected, or isreasonably likely to materially affect, our internal controls over financialreporting.

Effective April 1, 2006, we implemented a newenterprise resource planning system that thus far has not resulted in anymaterial changes in our internal controls over financial reporting.

**PART II. OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

The informationset forth under Note 5 of Notes to Unaudited Condensed Consolidated FinancialStatements, included in Part I, Item I of this report, is incorporatedherein by reference.

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**ITEM 1A. RISK FACTORS**

*Ourbusiness is subject to a number of risks, some of which are discussedbelow.  Other risks are presentedelsewhere in this report and in our other filings with the SEC.  You should consider the following riskscarefully in addition to the other information contained in this report and ourother filings with the SEC, including our subsequent reports on Forms 10-Q and8-K, before deciding to buy, sell or hold our common stock. The risks anduncertainties described below are not the only ones facing our company.  Additional risks and uncertainties notpresently known to us or that we currently deem immaterial may also affect ourbusiness operations.  If any of theserisks actually occurs, our business, financial condition or results ofoperations could be seriously harmed.  Inthat event, the market price for our common stock could decline and you maylose all or part of your investment.*

**We Have Historically ExperiencedSubstantial Losses And May Continue To Experience Losses For TheForeseeable Future.**Although we had net income of $80,000from continuing operations in the year ended March 31, 2006, weexperienced net losses from continuing operations of $11.3 million and $1.9million in the years ended March 31, 2005 and 2004, respectively. While wehave divested other business units, we cannot assure you that our efforts todownsize our operations or reduce our operating expenses will improve our financialperformance, or that we will be able to achieve profitability on a quarterly orannual basis in the future. Most of our expenses are fixed in advance. As such,we generally are unable to reduce our expenses significantly in the short-termto compensate for any unexpected delay or decrease in anticipated revenues. Asa result, 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.

**WeMay Need To Raise Additional Capital In The Future, Which May Not BeAvailable On Terms Acceptable To Us, Or At All.**We havegenerated significant net losses and operating losses in recent periods, andhave experienced volatility in our cash flows from operations ranging frompositive cash flows from operations of $590,000 in the year endedMarch 31, 2005 to negative cash flows from operations of $718,000 in theyear ended March 31, 2004.  Additionally,we failed to meet certain debt covenants under our prior credit agreement intwo of our last six fiscal quarters, but replaced that credit facility inOctober 2006 as further described in Note 3 to the accompanying condensedconsolidated financial statements.  

At September 30,2006, we had $19,000 of cash and cash equivalents and relied on our line ofcredit to fund our operations. We may need to raise additional capital in thenear future to fund our operations or to repay indebtedness. Such additionalcapital may be raised through bank borrowings, or other debt or equityfinancings. We cannot assure you that any additional capital will be availableon a timely basis, on acceptable terms, or at all, and such additionalfinancing may result in further dilution to our stockholders.

Ourcapital requirements will depend on many factors, including, but not limitedto:

·                                       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;

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·                                       potentialacquisitions of businesses and product lines;

·                                       ourrelationships with customers and suppliers;

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

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

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

If ourcapital requirements are materially different from those currently planned, wemay need additional capital sooner than anticipated. If additional funds areraised through the issuance of equity or convertible debt securities, thepercentage ownership of our stockholders will be reduced and such securitiesmay have rights, preferences and privileges senior to our common stock.Additional financing may not be available on favorable terms, on a timelybasis, or at all. If adequate funds are not available or are not available onacceptable terms, we may be unable to continue our operations as planned,develop or enhance our products, expand our sales and marketing programs, takeadvantage of future opportunities or respond to competitive pressures.

**If Our Internal Controls OverFinancial Reporting Do Not Comply With The Requirements Of The Sarbanes-OxleyAct, Our Business And Stock Price Could Be Adversely Affected.**Alongwith our independent registered public accounting firm, we will be evaluatingthe effectiveness of our internal controls over financial reporting to complywith Section 404 of the Sarbanes-Oxley Act of 2002. Section 404currently requires us to evaluate the effectiveness of our internal controlsover financial reporting at the end of each fiscal year beginning in our fiscalyear ending March 31, 2008 at the earliest, and to include a managementreport assessing the effectiveness of our internal controls over financialreporting in all annual reports beginning with our Annual Report on Form 10-Kfor the fiscal year ending March 31, 2008 at the earliest.Section 404 also requires our independent accountant to attest to, andreport on, management’s assessment of our internal controls over financialreporting. We may not be able to complete our Section 404 compliance on atimely basis and even if we timely complete our compliance requirements, ourindependent auditors may still conclude that our internal controls overfinancial reporting are not effective.

Ourmanagement, including our CEO and CFO, does not expect that our internalcontrols over financial reporting will prevent all error and all fraud. Acontrol system, no matter how well designed and operated, can provide onlyreasonable, not absolute, assurance that the control system’s objectives will bemet. Further, the design of a control system must reflect the fact that thereare resource constraints, and the benefits of controls must be consideredrelative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within the company have been, orwill be detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty and that breakdowns can occurbecause of simple error or mistake. Controls can also be circumvented by theindividual acts of some persons, by collusion of two or more people, or bymanagement override of the controls. The design of any system of controls isbased in part on certain assumptions about the likelihood of future events, andwe cannot assure you that any design will succeed in achieving its stated goalsunder all potential future conditions. Over time, our controls may becomeinadequate because of changes in conditions or deterioration in the degree ofcompliance with policies or procedures. Because of the inherent limitations ina cost-effective control system, misstatements due to error or fraud may occurand not be detected.

As ofMarch 31, 2005, we became aware of a material weakness in our internalcontrols related to the accounting for the consolidation of our deferredcompensation savings plan and certain contract administration. We cannot assureyou that we or our independent registered public accounting firm will notidentify additional material weaknesses in our internal controls. A materialweakness is a control deficiency, or combination of control deficiencies, thatresults in more than a remote likelihood that a material misstatement of theannual or interim financial statements will not be prevented or detected. Basedon our evaluation, our management concluded that, as of March 31, 2004,our internal control over financial reporting was not effective due to theexistence of one material weakness. We may experience additional materialweaknesses in the future. If our internal controls over financial reporting arenot considered adequate, we may experience a loss of public confidence, whichcould have an adverse effect on our business and our stock price.

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**WeMay Experience Production Gaps Which Could Materially And Adversely ImpactOur Sales And Financial Results And The Ultimate Acceptance Of Our Products. **It is possible that wecould experience unforeseen quality control issues or part shortages as we increaseproduction to meet current demand of our products.  We have historically used single suppliers forcertain of our components in our AutoVue and Vantage products. Should any suchdelay or disruption occur, our future sales will likely be materially andadversely affected.  

Additionally,we rely heavily on select contract manufacturers to produce many of ourproducts.  Although we believe ourcontract manufacturers have sufficient capacity to meet our productionschedules for the foreseeable future and we believe we could find alternativecontract manufacturing sources if necessary, we could experience a productiongap if for any reason our contract manufacturers were unable to meet ourproduction requirements.  

**We DependUpon Valeo To Market Our AutoVue Technologies For The OEM Passenger Car Market.**We have granted Valeo the exclusive right to sell andmanufacture our AutoVue LDW system to the worldwide passenger car market inexchange for royalty payments for each AutoVue unit sold. As such, the futuresuccess and broad market acceptance of our AutoVue technologies in thepassenger car market will depend upon Valeo’s ability to manufacture, marketand sell our technologies, and to convince more OEM passenger car manufacturersto adopt our technologies. If Valeo does not devote considerable resources andaggressively pursue opportunities, our expansion into the passenger car marketcould be adversely affected.

**WeMay Be Unable To Attract And Retain Key Personnel, Which Could SeriouslyHarm Our Business.**Due to the specialized nature of ourbusiness, we are highly dependent on the continued service of our executiveofficers and other key management, engineering and technical personnel. Theloss of any of our executive officers or key members of management couldadversely affect our business, financial condition or results of operations.Our success will also depend in large part upon our ability to continue toattract, retain and motivate qualified engineering and other highly skilledtechnical personnel. In particular, the future success of our TransportationSystems business will depend on our ability to hire additional qualifiedengineers and planners. Competition for qualified employees, particularlydevelopment engineers, is intense. We may not be able to continue to attractand retain sufficient numbers of such highly skilled employees. Our inabilityto attract and retain additional key employees or the loss of one or more ofour current key employees could adversely affect our business, financialcondition and results of operations.

**If We AreUnable To Develop And Introduce New Products And Product EnhancementsSuccessfully And In A Cost-Effective And Timely Manner, Or Are Unable ToAchieve Market Acceptance Of Our New Products, Our Operating Results Would BeAdversely Affected.**We believe our revenue growth and futureoperating results will depend on our ability to complete development of newproducts and enhancements, introduce these products in a timely, cost-effectivemanner, achieve broad market acceptance of these products and enhancements, andreduce our product costs. We cannot guarantee the success of these products andwe may not be able to introduce any new products or any enhancements to ourexisting products on a timely basis, or at all. In addition, the introductionof any new products could adversely affect the sales of certain of our existingproducts.

Webelieve that we must continue to make substantial investments to supportongoing research and development in order to remain competitive. We need tocontinue to develop and introduce new products that incorporate the latesttechnological advancements in outdoor image processing hardware, software andcamera 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.

Marketacceptance of our new products depends upon many factors, including our abilityto accurately predict market requirements and evolving industry standards, ourability to resolve technical challenges in a timely and cost-effective manner,qualify any new products with OEMs and achieve manufacturing efficiencies, theperceived advantages of our new products over traditional products and themarketing capabilities of our independent distributors and strategic partners,including Valeo’s ability to expand sales of AutoVue in the passenger carmarket. The success of our AutoVue system will also depend in part on thesuccess of the automotive vehicles that incorporate our technology, as well asthe success of optional equipment that OEMs bundle with our technologies.

Certainof the components used in our Vantage and AutoVue products may need to bere-engineered in the next 18 months as the industry is moving towards astandard of using lead-free components. We cannot assure you as to the timingof the adoption of this new standard or our ability to successfully redesignour products to incorporate compliant components and gain market acceptance ofsuch redesigned products. In addition, if the standard is adopted earlier thananticipated we may experience a shortage of Vantage and AutoVue products as aresult of potential scarcity of lead-free components.

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Ourbusiness and results of operations could also be seriously harmed by anysignificant delays in our new product development. Certain of our new productscould contain undetected design faults and software errors or “bugs” when firstreleased by us, despite our testing. We may not discover these faults or errorsuntil after a product has been installed and used by our customers. Any faultsor errors in our existing products or in any new products may cause delays inproduct introduction and shipments, require design modifications or harmcustomer relationships, any of which could adversely affect our business andcompetitive position.

**TheMarkets In Which We Operate Are Highly Competitive And Have Many MoreEstablished Competitors, Which Could Adversely Affect Our Sales Or The MarketAcceptance Of Our Products.**We compete with numerous othercompanies in our target markets including, but not limited to, large,multinational corporations, which include tier one automotive suppliers, andmany smaller regional engineering firms. We expect such competition to increasedue to technological advancements, industry consolidations and reduced barriersto entry. Increased competition is likely to result in price reductions,reduced gross margins and loss of market share, any of which could seriouslyharm our business, financial condition and results of operations. We have experiencedmore competition in our Vantage business in fiscal 2007 as the Department of Transportationin one of our largest sales territories has recently moved to a multisourcecontracting environment from one in which Iteris was the sole supplier. Inaddition, one of the other developers of LDW systems was recently acquired by alarger company. While this developer has not been a material competitor todate, we may experience more competition from this provider as a result of itsgreater access to resources from its acquirer, and additional competitors mayenter this market in the future.

Manyof our competitors have far greater name recognition and greater financial,technological, marketing and customer service resources than we do. This mayallow them to respond more quickly to new or emerging technologies and changesin customer requirements. It may also allow them to devote greater resources tothe development, promotion, sale and support of their products than we can.Recent consolidations of end users, distributors and manufacturers in ourtarget markets have exacerbated this problem. As a result of the foregoingfactors, we may not be able to compete effectively in our target markets andcompetitive pressures could adversely affect our business, financial conditionand results of operations.

**An Economic Slowdown Or The Significant Military OperationsIn The Middle East Or Elsewhere May Impact Government Funding Or ConsumerSpending, 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. 

Concernsabout the recent international conflicts and terrorist and military actions, aswell as concerns about inflation, decreased consumer confidence, and reducedcorporate profits and capital spending have also resulted in a downturn inworldwide economic conditions, particularly in the United States. Theseunfavorable economic conditions may have a negative impact on customer orders(and also may result in decreased sales of automobiles and trucks thatincorporate our LDW systems).  Suchconcerns may result in cancellations and rescheduling of backlog.  In addition, the recent decline in the U.S.real estate market, particularly in new home construction, could adverselyimpact new road construction resulting in a decline in Roadway Sensor andAutomotive Sensor net sales and Transportation Systems contract revenues.  Any of the foregoing political, social andeconomic conditions make it extremely difficult for our customers, oursuppliers and us to accurately forecast and plan future business activities andcould result in a decline in our net sales and contract revenues. If suchconditions continue or worsen, our business, financial condition and results ofoperations could be materially and adversely affected.

**New Environmental Regulations May Result In A Decline In OurAutoVue Sales and Royalties. **Recentenvironmental regulations in Europe are expected to be in place during Fall2006 which will require more stringent emissions compliance in new trucksmanufactured, that could cause a decline in new truck sales in Europe in thenear future.  Similar regulations havebeen announced in North America that may impact diesel engines built afterJanuary 2007, which could similarly impact North American OEM truck sales ingeneral.  As a result, we may experiencea decline in our LDW sales to truck OEMs related to these stricter regulations.

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**We DependOn Government Contracts And Subcontracts, And Because Many Of Our GovernmentContracts Are Fixed Price Contracts, Higher Than Anticipated Costs Will ReduceOur Profit And Could Adversely Impact Our Operating Results.**Asignificant portion of our sales are derived from contracts with governmentalagencies, either as a general contractor, subcontractor or supplier. Governmentcontracts represented approximately 38.3%, 37.4% and 48.2% of our total netsales and contract revenues for the years ended March 31, 2006, 2005 and2004, respectively. We anticipate that revenue from government contracts willcontinue to increase in the near future. Government business is, in general,subject to special risks and challenges, including:

·                                          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

Inaddition, a large number of our government contracts are fixed price contracts.As a result, we may not be able to recover any cost overruns we may incur.These fixed price contracts require us to estimate the total project cost basedon preliminary projections of the project’s requirements. The financialviability of any given project depends in large part on our ability to estimatethese costs accurately and complete the project on a timely basis. In the eventour costs on these projects exceed the fixed contractual amount, we will berequired to bear the excess costs. Such additional costs would adversely affectour financial condition and results of operations. Moreover, certain of ourgovernment contracts are subject to termination or renegotiation at theconvenience of the government, which could result in a large decline in our netsales and contract revenues in any given quarter. Our inability to address anyof the foregoing concerns or the loss or renegotiation of any materialgovernment contract could seriously harm our business, financial condition andresults of operations.

**OurQuarterly Operating Results Fluctuate As A Result Of Many Factors. Therefore,We May Fail To Meet Or Exceed The Expectations Of Securities Analysts AndInvestors, Which Could Cause Our Stock Price To Decline.**Ourquarterly revenues and operating results have fluctuated and are likely tocontinue to vary from quarter to quarter due to a number of factors, many ofwhich are not within our control. Factors that could affect our revenuesinclude, among others, the following:

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

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

·                                          delaysin government contracts from time to time, including from delays in theallocation of funds to state and local agencies from the U.S. governmenttransportation bill;

·                                          ourability to raise additional capital;

·                                          ourability to control costs;

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·                                          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 toall of the factors listed above as well as other unforeseen factors, our futureoperating results could be below the expectations of securities analysts orinvestors. If that happens, the trading price of our common stock coulddecline. As a result of these quarterly variations, you should not rely onquarter-to-quarter comparisons of our operating results as an indication of ourfuture performance.

**WeMay Engage In Acquisitions Of Companies Or Technologies ThatMay Require Us To Undertake Significant Capital Infusions And Could ResultIn Disruptions Of Our Business And Diversion Of Resources And ManagementAttention.**We have historically acquired, and may in thefuture acquire, complementary businesses, products and technologies.Acquisitions may require significant capital infusions and, in general,acquisitions also involve a number of special risks, including:

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

·                                          thefailure to retain or integrate key acquired personnel;

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·                                          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.

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

**We HaveExperienced 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.

Toaccommodate this growth, we launched a new ERP system in April 2006.Accordingly, we may experience problems commonly experienced by other companiesin connection with such implementations, including but not limited to,potential bugs in the system, component or supply delays, training requirementsand other integration challenges and delays. Any difficulties we mightexperience in connection with our new ERP system could have a material adverseeffect on our financial reporting system and internal controls.

**If We DoNot Keep Pace With Rapid Technological Changes And Evolving Industry Standards,We Will Not Be Able To Remain Competitive And There Will Be No Demand For OurProducts.**Our markets are in general characterized by thefollowing 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.

Our futuresuccess will depend upon our ability to anticipate and adapt to changes intechnology and industry standards, and to effectively develop, introduce,market and gain broad acceptance of new products and product enhancementsincorporating the latest technological advancements. In particular, our LDWsystem is incorporated into automobiles and trucks that face significanttechnological changes in each model year and among different vehicle models.Accordingly, we must adapt our technology from time to time to function withsuch changes.

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

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 cease marketingor using certain products or technologies. We may not be able to obtain anylicenses on terms acceptable to us, or at all. We also may have to indemnifycertain customers or strategic partners if it is determined that we haveinfringed upon or misappropriated another party’s intellectual property. Any ofthese results could adversely affect our business, financial condition andresults 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.

**TheTrading Price Of Our Common Stock Is Highly Volatile.**Thetrading price of our common stock has been subject to wide fluctuations in thepast. Since January 2000, our Class A common stock (now known as ourcommon stock) has traded at prices as low as $0.45 per share and as high as $29.44per share. The market price of our common stock could continue to fluctuate inthe future in response to various factors, including, but not limited to:

·                                          quarterlyvariations in operating results;

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

·                                          ourability to raise additional capital;

·                                          shortagesannounced by suppliers;

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

·                                          transitionsto new products or product enhancements;

·                                          acquisitionsof businesses, products or technologies;

·                                          theimpact of any litigation;

·                                          changesin investor perceptions;

·                                          governmentfunding, political agendas and other budgetary issues;

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

·                                          internationalconflicts, political unrest and acts of terrorism.

Inaddition, options to purchase an aggregate of 1.5 million shares of our commonstock at a weighted average price of $0.53 per share terminate on or prior toSeptember 30, 2007.  Our commonstock has traditionally been thinly traded. The exercise of these options andthe sale of a large number of shares of our common stock could cause our stockprice to decline.

Thestock market in general has recently experienced volatility, which hasparticularly affected the market prices of equity securities of many technologycompanies. This volatility has often been unrelated to the operatingperformance of these companies. These broad market fluctuations may adverselyaffect the market price of our common stock. In the past,

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companies thathave experienced volatility in the market price of their securities have beenthe subject of securities class action litigation. If we were to become thesubject of a class action lawsuit, it could result in substantial losses anddivert management’s attention and resources from other matters.

**OurInternational Business Operations May Be Threatened By Many Factors ThatAre Outside Of Our Control.**We currently market our AutoVueand Vantage products internationally and we anticipate that our internationaloperations will expand in the near future. International business operationsare subject to various inherent risks including, 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 ofour international sales are denominated in U.S. dollars. As a result, anincrease in the relative value of the dollar could make our products moreexpensive and potentially less price competitive in international markets. Wedo not engage in any transactions as a hedge against risks of loss due toforeign currency fluctuations.

Any ofthe factors mentioned above may adversely affect our future international salesand, consequently, affect our business, financial condition and operatingresults. Furthermore, as we increase our international sales, our totalrevenues may also be affected to a greater extent by seasonal fluctuationsresulting from lower sales that typically occur during the summer months inEurope and other parts of the world.

**We CouldExperience Negative Financial Impacts Arising From Developments InContingencies Created Under Our Previous Structure Or By Former Subsidiaries.**Althoughwe divested ourselves of all business units, with the exception of our Iterisbusiness, from time to time we could experience unforeseen developments incontingencies related to our former subsidiaries. For example, we recentlyentered into a settlement agreement in connection with a lawsuit broughtagainst Mariner Networks, Inc., one of our former subsidiaries, by one ofMariner’s suppliers, pursuant to which we issued 88,912 shares of our commonstock to this 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 beginning in November2006.  Although we are not aware of anyother 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 financialresults and cash flows.

**Some OfOur Directors, Officers And Their Affiliates Can Control The Outcome Of MattersThat Require The Approval Of Our Stockholders, And Accordingly We Will Not BeAble To Engage In Certain Transactions Without Their Approval.**Asof September 30, 2006, our officers and directors owned approximately 14% ofthe outstanding shares of our common stock (and approximately 22% of our commonstock when including options, warrants and other convertible securities held bythem which are currently exercisable or

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convertible orwill become exercisable or convertible within 60 days after September 30,2006). As a result of their stock ownership, our management will be able tosignificantly influence the election of our directors and the outcome ofcorporate actions requiring stockholder approval, such as mergers andacquisitions, regardless of how our other stockholders may vote. Thisconcentration of voting control may have a significant effect in delaying,deferring or preventing a change in our management or change in control and mayadversely affect the voting or other rights of other holders of common stock.

**CertainAnti-Takeover Provisions May Affect The Price Of Our Common Stock AndDiscourage 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 AND USE OF PROCEEDS**

None.

**ITEM 3. DEFAULTS UPON SENIOR SECURITIES**

None.

**ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

In connection with our Annual Meeting of Stockholdersheld on September 14, 2006, the following proxies were tabulatedrepresenting 19,902,272 shares of our common stock or 69% of the outstandingshares:

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

| Director Nominee     | ** ** | **Total Votes for  Each Director** | ** ** | **Total Votes Withheld from  Each Director** | ** ** |
|---------------------------|------------|----------------------------------------------|------------|-------------------------------------------------------------|------------|
| Richard J. Char           |       | 19,861,084                                   |       | 41,188                                                      |       |
| Kevin C. Daly,  Ph.D.     |       | 19,801,654                                   |       | 100,618                                                     |       |
| Gary Hernandez            |       | 19,859,634                                   |       | 42,638                                                      |       |
| Jack Johnson              |       | 19,849,209                                   |       | 53,063                                                      |       |
| Dr. Hartmut  Marwitz |       | 19,819,851                                   |       | 82,421                                                      |       |
| Gregory A. Miner          |       | 19,845,437                                   |       | 56,835                                                      |       |
| Abbas Mohaddes            |       | 19,819,851                                   |       | 82,421                                                      |       |
| John W.  Seazholtz        |       | 19,860,634                                   |       | 41,638                                                      |       |
| Joel Slutzky              |       | 19,843,937                                   |       | 58,335                                                      |       |
| Thomas L. Thomas          |       | 19,858,334                                   |       | 43,938                                                      |       |
| Paul E. Wright            |       | 19,860,634                                   |       | 41,638                                                      |       |

 

**Proposal II: The ratification ofMcGladrey & Pullen, LLP as the Company’s independent auditors for thefiscal year ending March 31, 2007.**

|             | ** ** | **Shares of**         | ** ** |
|-------------|------------|-----------------------|------------|
|             | ** ** | **Common Stock** | ** ** |
| **For**     |       | 19,839,957            |       |
| **Against** |       | 50,436                |       |
| **Abstain** |       | 11,879                |       |

 

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**ITEM5.  OTHER INFORMATION**

None.

**ITEM 6. EXHIBITS**

Thefollowing exhibits are filed herewith or are incorporated by reference to thelocation indicated.
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                          | ** ** | **Where Located**                                                                                                                                                              |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Amended and Restated Certificate of Incorporation of  the registrant                                                                                                                                                                                     | * *   | *Exhibit 3.1 to the registrant’s current  report on Form 8-K as filed with the SEC on October 28, 2004*                                                    |
| * *        | * *   | * *                                                                                                                                                                                                                                                 | * *   | * *                                                                                                                                                                       |
| 3.2             |       | Bylaws of registrant, as amended                                                                                                                                                                                                                         | * *   | *Exhibit 4.2 to the registrant’s Registration  Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on  July 6, 1993*                     |
| * *        | * *   | * *                                                                                                                                                                                                                                                 | * *   | * *                                                                                                                                                                       |
| 3.3             |       | Certificates of Amendment to Bylaws of the  registrant dated April 24, 1998 and August 10, 2001                                                                                                                                                | * *   | *Exhibit 3.4 to the registrant’s Annual  Report on Form 10-K/A for the year ended March 31, 2003 as filed  with the SEC on July 29, 2003*             |
| * *        | * *   | * *                                                                                                                                                                                                                                                 | * *   | * *                                                                                                                                                                       |
| 3.4             |       | Certificate of Amendment to Bylaws of registrant dated  September 9, 2004                                                                                                                                                                           | * *   | *Exhibit 3.1 to the registrant’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2004 as  filed with the SEC on November 15, 2004* |
| * *        | * *   | * *                                                                                                                                                                                                                                                 | * *   | * *                                                                                                                                                                       |
| 4.1             |       | Specimen of Common Stock Certificate                                                                                                                                                                                                                     | * *   | *Exhibit 4.1 to the registrant’s Amendment  No. 1 to the Registration Statement on Form 8-A as filed with the  SEC on December 8, 2004*               |
| * *        | * *   | * *                                                                                                                                                                                                                                                 | * *   | * *                                                                                                                                                                       |
| 4.2             |       | Amended and Restated Rights Agreement, dated as of  May 10, 2004, by and between the registrant and U.S. Stock Transfer  Corporation, including exhibits thereto                                                                                    | * *   | *Exhibit 99.1 to the registrant’s  Registration Statement on Form 8-A/A as filed with the SEC on  June 18, 2004*                                           |
|            |       |                                                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                       |
| 10.1            |       | Warrant Exercise Agreement dated September 27, 2006  by and among the registrant and Special Situations Fund III QP, L.P., Special  Situations Fund III, L.P., Special Situations Cayman Fund, L.P. and Special  Situations Private Equity Fund, L.P.    | * *   | *Filed herewith*                                                                                                                                                               |
|            |       |                                                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                       |
| 10.2            |       | Registration Rights Agreement dated September 28,  2006 by and among the registrant and Special Situations Fund III QP, L.P.,  Special Situations Fund III, L.P., Special Situations Cayman Fund, L.P. and  Special Situations Private Equity Fund, L.P. | * *   | *Filed herewith*                                                                                                                                                               |
|            |       |                                                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                       |
| 10.3†      |       | National Intelligent Transportation Systems (ITS)  Architecture Evolution and Support Award/Contract effective as of October 1,  2006 by and between the registrant and the Federal Highway Administration                                               | * *   | *Filed herewith*                                                                                                                                                               |

 

38

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| 10.4     |     | Loan and Security Agreement effective as of October  16, 2006 by and between the registrant and Silicon Valley Bank                           | * * | *Filed herewith* |
|----------|----------|-----------------------------------------------------------------------------------------------------------------------------------------------|----------|------------------|
|     |     |                                                                                                                                          | * * | * *         |
| 10.5     |     | Intellectual Property Security Agreement dated  October 9, 2006 by and between the registrant and Silicon Valley Bank                         | * * | *Filed herewith* |
|     |     |                                                                                                                                          | * * | * *         |
| 31.1     |     | Certification of the Principal Executive Officer, as  required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                 | * * | *Filed herewith* |
| * * | * * | * *                                                                                                                                      | * * | * *         |
| 31.2     |     | Certification of the Principal Financial and  Accounting Officer, as required pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 | * * | *Filed herewith* |
| * * | * * | * *                                                                                                                                      | * * | * *         |
| 32.1     |     | Certification of the Chief 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* |

 

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†              Confidential treatment has been requested for certainconfidential portions of this exhibit pursuant to Rule 24b-2 under theSecurities Exchange Act of 1934.  Inaccordance with Rule 24b-2, these confidential portions have been omitted fromthe exhibit and filed separately with the Securities and Exchange Commission.

39

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**SIGNATURES**

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.
| Dated: November 14, 2006 | 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) |

 

40

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