**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

** **

----

 

**Form 10-Q**

 
| **(Mark****One)** |
|-------------------|

 

| **x**  | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**   |
|--------|----------------------------------------------------------------------------------------------------------|
|   |                                                                                                     |
|   | **For the  quarterly period ended December 31, 2007**                                               |
|   |                                                                                                     |
|   | **OR**                                                                                                   |
|   |                                                                                                     |
| **o**  | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**For the transition periodfrom          to**

** **

**Commission file number:  001-08762**

** **

**ITERIS, INC.**

(Exactname of registrant as specified in its charter)

 

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

 

**(949)**270-9400

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

** **

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

 

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

** **

**Yes **x  No o

** **

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

** **

**Large acceleratedfiler  **o                Accelerated filer  o           Non-acceleratedfiler  x

** **

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

** **

**Yes **o No x

** **

As of January 31,2008, the registrant had 33,304,527 shares of common stock outstanding.

** **

** **

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**ITERIS, INC.**

**Quarterly Reporton Form 10-QFor the Three and Nine Months Ended December 31, 2007**

** **

**Table of Contents**

** **
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                                      | ** ** | **3**      |
|-------------------|--------------------------------------------------------------------------------------------------------------------------------|------------|------------|
|              |                                                                                                                           |       |       |   |
| **ITEM 1.**       | **FINANCIAL STATEMENTS**                                                                                                       | ** ** | **3**      |
|              |                                                                                                                           |       |       |   |
| ** **        | **CONDENSED CONSOLIDATED  BALANCE SHEETS AT DECEMBER 31, 2007 AND MARCH 31, 2007**                                        | **3**      |
| ** **        | ** **                                                                                                                     | ** ** | ** ** | ** ** |
| ** **        | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED  DECEMBER 31, 2007 AND 2006** | **4**      |
|              |                                                                                                                           |       |       |   |
| ** **        | **UNAUDITED CONDENSED  CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE MONTHS ENDED DECEMBER 31,  2007 AND 2006**           | **5**      |
|              |                                                                                                                           |       |       |   |
| ** **        | **NOTES TO UNAUDITED CONDENSED  CONSOLIDATED FINANCIAL STATEMENTS**                                                            | **6**      |
|              |                                                                                                                           |       |       |   |
| **ITEM 2.**       | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS**                                | **17**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 3.**       | **QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**                                                                | ** ** | **25**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 4.**       | **CONTROLS AND PROCEDURES**                                                                                                    | **25**     |
|              |                                                                                                                           |       |       |   |
| **PART II.** | **OTHER INFORMATION**                                                                                                          | **27**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 1.**       | **LEGAL PROCEEDINGS**                                                                                                          | **27**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 1A.**      | **RISK FACTORS**                                                                                                               | **27**     |
| ** **        | ** **                                                                                                                     | ** ** | ** ** | ** ** |
| **ITEM 2.**       | **UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS**                                                               | **36**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 3.**       | **DEFAULTS UPON  SENIOR SECURITIES**                                                                                           | **36**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 4.**       | **SUBMISSION OF  MATTERS TO A VOTE OF SECURITY HOLDERS**                                                                       | **36**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 5.**       | **OTHER INFORMATION**                                                                                                          | **36**     |
|              |                                                                                                                           |       |       |   |
| **ITEM 6.**       | **EXHIBITS**                                                                                                                   | **36**     |

 

Unless otherwise indicated in this report, the“Company,” “we,” “us” and “our” collectively refer to Iteris, Inc. and itsformer subsidiary, Meyer, Mohaddes Associates, Inc., which was dissolvedeffective April 2006.

 

AutoVue®, Iteris®,Vantage® andeAccessTM are among the trademarks of Iteris, Inc. Any other trademarks ortrade names mentioned herein are the property of their respective owners.

 

2

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**PART I. FINANCIALINFORMATION**

**ITEM 1.  FINANCIAL STATEMENTS**

**ITERIS,INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

** **
| ** **                                                                                                                                                                                         | ** ** | **December 31,  2007** | ** ** | **March 31,  2007** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                                         | ** ** | **(unaudited)**             | ** ** | ** **               | ** ** |
| **ASSETS**                                                                                                                                                                                         |       |                        |       |                     |       |
| Current assets:                                                                                                                                                                                    |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                                                                                                          | ** ** | **$**                       | **679**    |                     | $          | 35 |   |
| Trade accounts receivable, net of allowance for doubtful accounts of  $812 and $664 at December 31, 2007 and March 31, 2007, respectively                                                | ** ** | **12,607**                  |       | 11,493                   |       |
| Costs and estimated earnings in excess of billings on uncompleted  contracts                                                                                                                       | ** ** | **5,149**                   |       | 3,689                    |       |
| Inventories, net of reserve for inventory obsolescence of $910 and  $844 at December 31, 2007 and March 31, 2007, respectively                                                           | ** ** | **4,400**                   |       | 6,379                    |       |
| Deferred income taxes                                                                                                                                                                              | ** ** | **611**                     |       | 494                      |       |
| Prepaid expenses and other current assets                                                                                                                                                          | ** ** | **413**                     |       | 385                      |       |
| Total current assets                                                                                                                                                                               | ** ** | **23,859**                  |       | 22,475                   |       |
| Property and equipment, net                                                                                                                                                                        | ** ** | **3,496**                   |       | 1,712                    |       |
| Deferred income taxes                                                                                                                                                                              | ** ** | **2,645**                   |       | 2,533                    |       |
| Intangible assets, net                                                                                                                                                                             | ** ** | **294**                     |       | 404                      |       |
| Goodwill                                                                                                                                                                                           | ** ** | **27,774**                  |       | 27,774                   |       |
| Other assets                                                                                                                                                                                       | ** ** | **386**                     |       | 352                      |       |
| Total assets                                                                                                                                                                                       | ** ** | **$**                       | **58,454** |                     | $          | 55,250 |   |
|                                                                                                                                                                                               |       |                        |       |                     |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                                     | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Current liabilities:                                                                                                                                                                               |       |                        |       |                     |       |
| Trade accounts payable                                                                                                                                                                             | ** ** | **$**                       | **3,206**  |                     | $          | 3,542 |   |
| Accrued payroll and related expenses                                                                                                                                                               | ** ** | **3,822**                   |       | 3,527                    |       |
| Accrued liabilities                                                                                                                                                                                | ** ** | **2,168**                   |       | 1,618                    |       |
| Billings in excess of costs and estimated earnings on uncompleted  contracts                                                                                                                       | ** ** | **1,199**                   |       | 847                      |       |
| Revolving line of credit                                                                                                                                                                           | ** ** | **199**                     |       | 4,015                    |       |
| Current portion of long-term debt                                                                                                                                                                  | ** ** | **570**                     |       | 1,947                    |       |
| Total current liabilities                                                                                                                                                                          | ** ** | **11,164**                  |       | 15,496                   |       |
| Deferred rent                                                                                                                                                                                      | ** ** | **1,963**                   |       | —                   |       |
| Deferred compensation plan liability                                                                                                                                                               | ** ** | **669**                     |       | 730                      |       |
| Other non-current liabilities                                                                                                                                                                      | ** ** | **97**                      |       | 163                      |       |
| Long-term debt                                                                                                                                                                                     | ** ** | **9,565**                   |       | 9,760                    |       |
| Total liabilities                                                                                                                                                                                  | ** ** | **23,458**                  |       | 26,149                   |       |
| Commitments and contingencies                                                                                                                                                                      |       |                        |       |                     |       |
| Redeemable common stock, none issued and outstanding at  December 31, 2007 and 1,219 shares issued and outstanding at  March 31, 2007                                                    | ** ** | **—**                  |       | 3,414                    |       |
| Stockholders’ equity:                                                                                                                                                                         |       |                        |       |                     |       |
| Preferred stock, $1.00 par value, 2,000 shares authorized, none  issued and outstanding at December 31, 2007 and March 31, 2007                                                          |       | —                      |       | —                   |       |
| Common stock, $0.10 par value, 70,000 and 50,000 shares authorized,  33,264 and 30,601 shares issued or issuable and outstanding, at December 31,  2007 and March 31, 2007, respectively | ** ** | **3,326**                   |       | 3,060                    |       |
| Additional paid-in capital                                                                                                                                                                         | ** ** | **135,278**                 |       | 130,425                  |       |
| Common stock held in trust, 167 and 311 shares at December 31,  2007 and March 31, 2007, respectively                                                                                    | ** ** | **(202**                    | **)**      | (374                     | )          |
| Notes receivable from employees                                                                                                                                                                    |       | —                      |       | (5                       | )          |
| Accumulated deficit                                                                                                                                                                                | ** ** | **(103,442**                | **)**      | (107,438                 | )          |
| Accumulated other comprehensive income                                                                                                                                                             | ** ** | **36**                      |       | 19                       |       |
| Total stockholders’ equity                                                                                                                                                                    | ** ** | **34,996**                  |       | 25,687                   |       |
| Total liabilities and stockholders’ equity                                                                                                                                                    | ** ** | **$**                       | **58,454** |                     | $          | 55,250 |   |

 

Seeaccompanying notes to unaudited condensed consolidated financial statements.

 

3

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**ITERIS, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
| ** **                                | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net sales and contract revenues:          |       |                                                |       |                                               |       |   |   |   |   |
| Net sales                                 | ** ** | **$**                                               | **9,176**  |                                               | $          | 8,575 | ** ** | **$** | **30,215** |   | $ | 26,498 |   |
| Contract revenues                         | ** ** | **6,187**                                           |       | 5,913                                              | ** ** | **17,881** |   | 16,272 |   |
| Total net sales and contract revenues     | ** ** | **15,363**                                          |       | 14,488                                             | ** ** | **48,096** |   | 42,770 |   |
|                                      |       |                                                |       |                                               |       |   |   |   |   |
| Costs of net sales and contract revenues: |       |                                                |       |                                               |       |   |   |   |   |
| Cost of net sales(a)                      | ** ** | **4,631**                                           |       | 4,746                                              | ** ** | **15,302** |   | 14,800 |   |
| Cost of contract revenues(a)              | ** ** | **4,232**                                           |       | 4,066                                              | ** ** | **11,938** |   | 10,618 |   |
| Gross profit                              | ** ** | **6,500**                                           |       | 5,676                                              | ** ** | **20,856** |   | 17,352 |   |
| Operating expenses:                       |       |                                                |       |                                               |       |   |   |   |   |
| Selling, general and administrative(a)    | ** ** | **4,041**                                           |       | 3,879                                              | ** ** | **12,820** |   | 11,865 |   |
| Research and development(a)               | ** ** | **1,002**                                           |       | 1,038                                              | ** ** | **2,623** |   | 2,812 |   |
| Deferred compensation plan                | ** ** | **290**                                             |       | (29                                                | )          | **299** |   | (61 | ) |
| Amortization of intangible assets         | ** ** | **37**                                              |       | 37                                                 | ** ** | **110** |   | 110 |   |
| Total operating expenses                  | ** ** | **5,370**                                           |       | 4,925                                              | ** ** | **15,852** |   | 14,726 |   |
| Operating income                          | ** ** | **1,130**                                           |       | 751                                                | ** ** | **5,004** |   | 2,626 |   |
| Non-operating income (expense):           |       |                                                |       |                                               |       |   |   |   |   |
| Other income (expense), net               | ** ** | **(3**                                              | **)**      | (5                                                 | )          | **41** |   | (650 | ) |
| Interest expense, net                     | ** ** | **(314**                                            | )          | (390                                               | )          | **(1,046** | **)** | (1,200 | ) |
| Income before income taxes                | ** ** | **813**                                             |       | 356                                                | ** ** | **3,999** |   | 776 |   |
| Income tax benefit (provision)            | ** ** | **141**                                             |       | (46                                                | )          | **221** |   | 545 |   |
| Net income                                | ** ** | **$**                                               | **954**    |                                               | $          | 310 | ** ** | **$** | **4,220** |   | $ | 1,321 |   |
|                                      |       |                                                |       |                                               |       |   |   |   |   |
| Earnings per share:                       |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                     | ** ** | **$**                                               | **0.03**   |                                               | $          | 0.01 | ** ** | **$** | **0.13** |   | $ | 0.05 |   |
| Diluted                                   | ** ** | **$**                                               | **0.03**   |                                               | $          | 0.01 | ** ** | **$** | **0.12** |   | $ | 0.04 |   |
| Weighted average shares outstanding:      |       |                                                |       |                                               |       |   |   |   |   |
| Basic                                     | ** ** | **32,914**                                          |       | 30,438                                             | ** ** | **32,568** |   | 29,238 |   |
| Diluted                                   | ** ** | **35,256**                                          |       | 33,813                                             | ** ** | **34,674** |   | 33,067 |   |
|                                      | ** ** | ** **                                          |       |                                               | ** ** | ** ** |   |   |   |

----

| (a) Includes stock-based compensation expense as follows: |       |   |   |   |       |    |       |   |    |
|----------------------------------------------------------------|------------|--------|--------|--------|------------|---------|------------|--------|---------|
| Cost of net sales                                              | ** ** | **$**  | **1**  |   | $          | 3       | ** ** | **$**  | **3**   |   | $ | 12 |   |
| Cost of contract revenues                                      | ** ** | **3**  |   | 8      | ** ** | **9**   |       | 56     |    |
| Selling, general and administrative expense                    | ** ** | **77** |   | 46     | ** ** | **190** |       | 147    |    |
| Research and development expense                               | ** ** | **1**  |   | 2      | ** ** | **5**   |       | 18     |    |
| Total                                                          | ** ** | **$**  | **82** |   | $          | 59      | ** ** | **$**  | **207** |   | $ | 233 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

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**ITERIS, INC.**

**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

** **
| ** **                                                                                   | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2007**                                           | ** ** | **2006** | ** ** |
| **Cash flows from operating activities**                                 |       |                                               |       |   |   |
| Net income                                                                                   | ** ** | **$**                                              | **4,220**  |   | $ | 1,321 |   |
| Adjustments to reconcile net income to net cash provided by (used in)  operating activities: |       |                                               |       |   |   |
| Depreciation and amortization of property and equipment                                      | ** ** | **443**                                            |       | 405 |   |
| Change in deferred tax assets                                                                | ** ** | **(229**                                           | **)**      | (512 | ) |
| Stock-based compensation expense                                                             | ** ** | **207**                                            |       | 233 |   |
| Amortization of deferred gain on sale—leaseback transaction                             | ** ** | **(165**                                           | **)**      | (213 | ) |
| Amortization of debt discount                                                                | ** ** | **155**                                            |       | 155 |   |
| Amortization of intangible assets                                                            | ** ** | **110**                                            |       | 110 |   |
| Amortization of deferred financing costs                                                     | ** ** | **104**                                            |       | 103 |   |
| Issuance of warrants for services                                                            | ** ** | **—**                                         |       | 22 |   |
| Changes in operating assets and liabilities:                                                 |       |                                               |       |   |   |
| Accounts receivable                                                                          | ** ** | **(1,114**                                         | **)**      | (443 | ) |
| Net costs and estimated earnings in excess of billings                                       | ** ** | **(1,108**                                         | **)**      | (798 | ) |
| Inventories                                                                                  | ** ** | **1,979**                                          |       | (3,616 | ) |
| Prepaid expenses and other assets                                                            | ** ** | **(166**                                           | **)**      | (399 | ) |
| Accounts payable and accrued liabilities                                                     | ** ** | **928**                                            |       | 1,350 |   |
| Net cash provided by (used in) operating activities                                          | ** ** | **5,364**                                          |       | (2,282 | ) |
|                                                                                         |       |                                               |       |   |   |
| **Cash flows from investing activities**                                                     |       |                                               |       |   |   |
| Purchases of property and equipment                                                          | ** ** | **(455**                                           | **)**      | (311 | ) |
|                                                                                         |       |                                               |       |   |   |
| **Cash flows from financing activities**                                                     |       |                                               |       |   |   |
| Net payments on line of credit                                                               | ** ** | **(3,816**                                         | **)**      | 1,490 |   |
| Payments on long-term debt                                                                   | ** ** | **(1,727**                                         | **)**      | (1,195 | ) |
| Proceeds from stock option and warrant exercises                                             | ** ** | **1,325**                                          |       | 2,945 |   |
| Change in checks drawn in excess of available bank balances                                  | ** ** | **(47**                                            | **)**      | (651 | ) |
| Proceeds from notes receivable from employees                                                | ** ** | **—**                                         |       | 40 |   |
| Net cash provided by (used in) financing activities                                          | ** ** | **(4,265**                                         | **)**      | 2,629 |   |
| Increase in cash                                                                             | ** ** | **644**                                            |       | 36 |   |
| Cash at beginning of period                                                                  | ** ** | **35**                                             |       | 131 |   |
| Cash at end of period                                                                        | ** ** | **$**                                              | **679**    |   | $ | 167 |   |
|                                                                                         |       |                                               |       |   |   |
| **Supplemental cash flow information:**                                                      | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Cash paid during the period:                                                                 |       |                                               |       |   |   |
| Interest                                                                                     | ** ** | **$**                                              | **825**    |   | $ | 937 |   |
| Income taxes                                                                                 | ** ** | **48**                                             |       | 26 |   |
| ** **                                                                                   | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| **Supplemental schedule of non-cash investing  and financing activities:**              | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Conversion of redeemable common stock to common stock                                        | ** ** | **$**                                              | **3,414**  |   | $ | — |   |
| Lease incentives in connection with new headquarters lease                                   | ** ** | **1,772**                                          |       | — |   |
| Fair value of common stock issued in settlement of liabilities                               | ** ** | **350**                                            |       | 213 |   |
| Write-off of notes receivable from employees                                                 | ** ** | **(5**                                             | **)**      | — |   |

 

See accompanying notes tounaudited condensed consolidated financial statements.

 

5

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**ITERIS, INC.**

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2007**

** **

**1. Description of Business and Summary of Significant AccountingPolicies**

 

**Description of Business**

 

Iteris, Inc. is a leader in the trafficmanagement market and focuses on the development and application of advancedtechnologies that reduce traffic congestion, minimize the environmental impactof traffic congestion and improve the safety of surface transportation systems.By combining outdoor image processing, traffic engineering and informationtechnology, the Company offers a broad range of Intelligent TransportationSystems and driver safety solutions to customers worldwide. The Company wasoriginally incorporated in Delaware in 1987. On October 22, 2004, theCompany completed a merger with its majority-owned subsidiary, Iteris, Inc.(the “Iteris Subsidiary”), and officially changed its corporate name fromIteris Holdings, Inc. to Iteris, Inc.

 

**Basis of Presentation**

 

The unaudited condensed consolidated financialstatements of the Company have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Securities and Exchange Commission (“SEC”)Form 10-Q and Article 10 of SEC Regulation S-X. In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements contain all adjustments, consisting of normal recurring adjustments,necessary to present fairly the consolidated financial position of the Companyas of December 31, 2007, the consolidated results of operations for thethree and nine months ended December 31, 2007 and 2006, and theconsolidated cash flows for the nine months ended December 31, 2007 and 2006.Certain information and footnote disclosures normally included in financialstatements prepared in accordance with accounting principles generally acceptedin the United States (“U.S. GAAP”) have been condensed or omitted pursuant tothe rules and regulations of the SEC. The results of operations for thethree and nine months ended December 31, 2007 are not necessarilyindicative of those to be expected for the entire year. The accompanyingunaudited condensed consolidated financial statements should be read inconjunction with the Company’s Annual Report on Form 10-K for the yearended March 31, 2007, which was filed with the SEC on June 21, 2007.

 

# **Use ofEstimates**

#  

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

 

**Reclassifications**

** **

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

 

# **RevenueRecognition**

#  

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

 

Contract revenues arederived primarily from long-term contracts with governmental agencies. Contractrevenues include costs incurred plus a portion of estimated fees or profitsdetermined on the percentage of completion method of accounting based on therelationship of costs incurred to date to total estimated costs. Anyanticipated losses on contracts are charged to earnings when identified.Changes in job performance and estimated profitability, including those arisingfrom 

 

6

----

 

contract penaltyprovisions and final contract settlements, may result in revisions to costs andrevenues and are recognized in the period in which the revisions are determined.Profit incentives are included in revenue when their realization is reasonablyassured.

 

In addition to productand contract revenue, the Company derives revenue from technology access fees,the provision of specific non-recurring contract engineering services androyalties. Technology access fee revenues are recognized evenly over the periodin which they are earned. Non-recurring contract engineering revenues arerecognized in the period in which the related services are performed. Royaltyrevenues are recorded in the period in which the royalty is earned, based onunit sales of the Company’s products. Technology access fee revenues,non-recurring contract engineering revenues and royalty revenues are includedin net sales in the accompanying condensed consolidated statements ofoperations.

 

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

 

**Concentration of Credit Risk**

 

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

 

**Fair Values of Financial Instruments**

 

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

 

# **Inventories**

#  

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

 

**Property and Equipment**

 

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

 

**Goodwill and Long-Lived Assets**

 

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

 

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

 

7

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**Income Taxes**

 

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

 

## **Stock-Based Compensation**

##  

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

 

**Research and Development Expenditures**

 

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

 

**Shipping and Handling Costs**

 

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

 

**Sales Taxes**

 

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

 

**Warranty**

 

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

 

**Repair and Maintenance Costs**

 

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

 

**Other Comprehensive Income**

 

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

 

**Recent Accounting Pronouncements**

 

In July 2006, theFinancial Accounting Standards Board (the “FASB”) issued FASB Interpretation No. 48,*Accounting for Uncertainty in Income Taxes*(“FIN 48”). FIN 48 applies to all tax positions accounted for under SFAS 109,and defines the confidence level that a tax position must meet in order to berecognized in the financial statements. The interpretation requires that thetax effects of a position be recognized only if it is “more-likely-than-not” tobe sustained by 

 

8

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the taxing authority as of the reporting date. If atax position is not considered “more-likely-than-not” to be sustained, then nobenefits of the position are to be recognized. FIN 48 requires additionaldisclosures and is effective as of the beginning of the first fiscal yearbeginning after December 15, 2006. As further discussed in Note 4, theCompany adopted FIN 48 effective April 1, 2007.

 

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

 

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

 

**2. Supplemental Financial Information**

 

**Inventories**

 

The following tablepresents details of the Company’s inventories:

 
| ** **             | ** ** | **December 31,  2007** | ** ** | **March 31,  2007** | ** ** |
|------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **             | ** ** | **(In thousands)**     | ** ** |
| Materials and supplies | ** ** | **$**                       | **3,419**  |                     | $          | 4,705 |   |
| Work in process        | ** ** | **268**                     |       | 366                      |       |
| Finished goods         | ** ** | **713**                     |       | 1,308                    |       |
| ** **             |       | **$**                       | **4,400**  |                     | $          | 6,379 |   |

 

**IntangibleAssets**

 
| ** **           | ** ** | **December 31, 2007** | ** ** | **March 31, 2007**  | ** ** |
|----------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **           | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **           | ** ** | **(In thousands)**         | ** ** |
| Developed technology | ** ** | **$**                           | **495**    | ** **                    | **$**      | **(356** | **)** | $ | 495 |   | $ | (280 | ) |
| Patents              | ** ** | **317**                         | ** ** | **(162**                      | **)**      | 317 |   | (128 | ) |
| Total                | ** ** | **$**                           | **812**    | ** **                    | **$**      | **(518** | **)** | $ | 812 |   | $ | (408 | ) |

 

Amortizationexpense for intangible assets subject to amortization was $37,000 and $110,000for the three and nine months ended December 31, 2007, respectively, and$37,000 and $110,000 for the three and nine months ended December 31,2006, respectively. Future estimated amortization expense for the remainder ofthe current fiscal year and the next four fiscal years is as follows:

 

9

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| **Fiscal Year Ending March 31:** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| 2008                                                 |       | $          | 37         |   |
| 2009                                                 |       | 147        |       |
| 2010                                                 |       | 58         |       |
| 2011                                                 |       | 46         |       |
| 2012                                                 |       | 6          |       |
|                                                 |       | $          | 294        |   |

 

**Warranty Reserve Activity**

 

The following table presents activity in accrued warrantyobligations:

 
| ** **                         | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                         | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                         | ** ** | **(In thousands)**                             | ** ** |
| Balance at beginning of period     | ** ** | **$**                                               | **489**    |                                               | $          | 679 | ** ** | **$** | **520** |   | $ | 519 |   |
| Additions charged to cost of sales | ** ** | **109**                                             |       | 160                                                | ** ** | **253** |   | 450 |   |
| Warranty claims                    | ** ** | **(74**                                             | **)**      | (265                                               | )          | **(249** | **)** | (395 | ) |
| Balance at end of period           | ** ** | **$**                                               | **524**    |                                               | $          | 574 | ** ** | **$** | **524** |   | $ | 574 |   |

 

**Earnings Per Share**

 

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

 
| ** **                                                   | ** ** | **Three Months Ended  December 31,**                   | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                                              | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                   |       |                                                                  |       |                                               |       |   |   |   |   |
| Net income                                                   | ** ** | **$**                                                                 | **954**    |                                               | $          | 310 | ** ** | **$** | **4,220** |   | $ | 1,321 |   |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Denominator:                                                 |       |                                                                  |       |                                               |       |   |   |   |   |
| Weighted average common  shares used in basic computation    | ** ** | **32,914**                                                            |       | 30,438                                             | ** ** | **32,568** |   | 29,238 |   |
| Dilutive stock options                                       | ** ** | **2,329**                                                             |       | 3,342                                              | ** ** | **2,086** |   | 3,436 |   |
| Dilutive warrants                                            | ** ** | **13**                                                                |       | 33                                                 | ** ** | **20** |   | 393 |   |
| Weighted average common  shares used in dilutive computation | ** ** | **35,256**                                                            |       | 33,813                                             | ** ** | **34,674** |   | 33,067 |   |
|                                                         |       |                                                                  |       |                                               |       |   |   |   |   |
| Earnings per share:                                          |       |                                                                  |       |                                               |       |   |   |   |   |
| Basic                                                        | ** ** | **$**                                                                 | **0.03**   |                                               | $          | 0.01 | ** ** | **$** | **0.13** |   | $ | 0.05 |   |
| Diluted                                                      | ** ** | **$**                                                                 | **0.03**   |                                               | $          | 0.01 | ** ** | **$** | **0.12** |   | $ | 0.04 |   |

 

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

 
| ** **             | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **             | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **             | ** ** | **(In thousands)**                             | ** ** |
| Stock options          | ** ** | **355**                                             |       | 567                                                | ** ** | **552** |   | 553 |   |
| Warrants               | ** ** | **1,150**                                           |       | 1,190                                              | ** ** | **1,177** |   | 1,257 |   |
| Convertible debentures | ** ** | **2,729**                                           |       | 2,729                                              | ** ** | **2,729** |   | 2,729 |   |

 

10

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

 

**RevolvingLine of Credit**

 

In October 2006, theCompany entered into a two-year credit facility with a bank. At December 31,2007, the facility provided for line of credit borrowings of up to $10.0million. Under the credit facility, the Company may borrow against its eligibleaccounts receivable and eligible inventory, as defined in the credit agreement.Interest on borrowed amounts under the line of credit is payable monthly at thecurrent stated prime rate plus 1.00% (8.25% at December 31, 2007).Additionally, the Company is obligated to pay an unused line fee of 0.25% perannum applied to the amount by which the maximum credit amount exceeds theaverage daily principal balance during the preceding month. The credit facilityrequires $2,000 in monthly collateral management fees and includes an earlytermination fee equal to 2% of the total facility during the first year of theagreement and 1% of the total facility in the second year of the agreement. Thecredit facility is secured by substantially all of the assets of the Company.

 

On December 31,2007, the available credit under the Company’s credit facility was $9.3million, of which $9.1 million was unused.

 

**Long-TermDebt**

 

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

 
| ** **                  | ** ** | **December 31,  2007** | ** ** | **March 31,  2007** | ** ** |
|-----------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                  | ** ** | **(In thousands)**     | ** ** |
| Convertible debentures, net | ** ** | **$**                       | **9,565**  |                     | $          | 9,410 |   |
| Bank term note              | ** ** | **524**                     |       | 1,573                    |       |
| Promissory note to landlord | ** ** | **—**                  |       | 646                      |       |
| Other                       | ** ** | **46**                      |       | 78                       |       |
| ** **                  |       | **10,135**                  |       | 11,707                   |       |
| Less current portion        | ** ** | **(570**                    | **)**      | (1,947                   | )          |
| ** **                  |       | **$**                       | **9,565**  |                     | $          | 9,760 |   |

 

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

 

The debentures are due infull on May 19, 2009, provide for 6.0% annual interest, payable quarterly,and are convertible into the Company’s common stock at an initial conversionprice of $3.61 per share, subject to certain adjustments, including adjustmentsfor dilutive issuances. From May 19, 2008, until the maturity date, theCompany may redeem the debentures at 110% of the principal amount. As of December 31,2007, $250,000 of convertible debentures had been converted into 69,252 sharesof common stock leaving $9.9 million of the originally issued convertibledebentures outstanding at December 31, 2007.

 

*Bank Term Note.*InOctober 2004, the Company entered into a $5.0 million term note payablewith a bank. The note was due on May 27, 2008, and provided for monthlyprincipal payments of approximately $104,000. In October 2006, the termnote was assumed by the Company’s new bank as part of the Company’s new creditfacility. The new term note is also due on May 27, 2008 and provides formonthly principal payments of approximately $104,000. Interest accrues underthe new term note at an annual rate of 8.75%.

 

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

 

*Promissory Note to Landlord.*TheCompany had an unsecured promissory note payable to the landlord of itsprevious headquarters. Under the terms of the note agreement, interest waspayable quarterly and accrued at a rate of prime plus 2.0%. In October 2006,January 2007, April 2007 and July 2007, the Company made fourrequired equal quarterly principal payments of $323,000. As of December 31,2007, all interest and principal under this note was paid in full.

 

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Scheduled aggregatematurities of long-term debt principal as of December 31, 2007 were asfollows:

 
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| 2008                                                 | ** ** | **$**      | **221**    | ** ** |
| 2009                                                 | ** ** | **349**    | ** ** |
| 2010                                                 | ** ** | **9,850**  | ** ** |
| ** **                                           | ** ** | **10,420** | ** ** |
| Less: unamortized debt discount                      | ** ** | **(285**   | **)**      |
| ** **                                           | ** ** | **$**      | **10,135** | ** ** |

 

**4. Income Taxes**

 

On April 1, 2007,the Company adopted FIN 48. In connection with the adoption of FIN 48, theCompany recognized an adjustment of approximately $224,000 to the beginningbalance of retained earnings on its condensed consolidated balance sheet. TheCompany’s continuing practice is to recognize interest and/or penalties relatedto income tax matters in income tax expense. As of December 31, 2007, theCompany had recorded approximately $22,000 of accrued interest and penaltiesrelated to uncertain tax positions.

 

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

 

**5. Commitments and Contingencies**

 

**Litigation and Other Contingencies**

 

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

 

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

 

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

 

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

 

12

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**Operating Lease Commitments**

 

In May 2007, the Company entered into anagreement to lease 52,000 square feet of space in Santa Ana, California for aterm of 88 months. In September 2007, the Company relocated itsheadquarters and principal operations into this space. The monthly lease rateis $102,000 during the first year of the lease and increases each yearthereafter, up to a maximum of $120,000 during the last year of the lease. Thelease may be extended for a period of five years, at the option of the Company,at a lease rate to be based on the market lease rate for comparable propertydetermined as of the commencement date of the extension period. Additionally,the lease agreement provides for $1.8 million in incentives in the form oftenant improvement allowances, which the Company recorded as deferred rent inits condensed consolidated balance sheet at December 31, 2007. This amountwill reduce future rent expense over the term of the lease. An equal amount wascapitalized as property and equipment in the condensed consolidated balancesheet at December 31, 2007, and will be depreciated over the estimateduseful life of the related leasehold improvements.

 

The Company has lease commitments for facilities invarious locations throughout the United States. Future commitments under thesenon-cancelable operating leases at December 31, 2007 were as follows:

 
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| Remainder of 2008                                    | ** ** | **$**      | **343**    | ** ** |
| 2009                                                 | ** ** | **1,488**  | ** ** |
| 2010                                                 | ** ** | **1,391**  | ** ** |
| 2011                                                 | ** ** | **1,348**  | ** ** |
| 2012                                                 | ** ** | **1,332**  | ** ** |
| Thereafter                                           | ** ** | **3,823**  | ** ** |
| Total                                                | ** ** | **$**      | **9,725**  | ** ** |

 

The Company previouslysubleased office space to MAXxess Systems, Inc. (“MAXxess”), a formersubsidiary of the Company that was sold by the Company in September 2003and is currently owned by an investor group that includes two of the Company’sdirectors, one of which is the Chief Executive Officer of MAXxess. At December 31,2007, MAXxess owed the Company an aggregate of $274,000 related to thissublease, which terminated in September 2007, and certain relatedancillary services that were provided by the Company to MAXxess. The Companypreviously had reserved for amounts aggregating $183,000 of this balance due toMAXxess’ inability to pay these obligations. During the nine months ended December 31,2007, the Company reserved for all incremental amounts charged to MAXxess,which aggregated $91,000.

 

**Inventory Purchase Commitments**

 

At December 31, 2007, the Company had firm commitments to purchaseinventory in the amount of $4.1 million during the next three fiscal quarters.

 

**6. Common Stock Warrants**

 

On September 27, 2006, the Company issuedwarrants to purchase an aggregate 246,250 shares of common stock at an exerciseprice of $3.25 with a five year life to an existing stockholder in exchange forthe early exercise of warrants to purchase an aggregate of 1,250,000 shares ofcommon stock at an exercise price of $1.61 per share. The new warrants areimmediately exercisable and are callable by the Company if the market price ofthe Company’s common stock trades for 20 consecutive days at a price greaterthan or equal to two times the exercise price of the warrants. The fair valueof the new warrants was $320,000 calculated using the Black-Scholes-Merton (“BSM”)option-pricing formula. The warrants were considered a cost of raising capitaland were recorded in equity.

 

In connection with the issuance of the new warrants,the Company is party to a registration rights agreement that containsprovisions under which the Company could be subjected to liquidated damagesshould it fail to maintain effective registration statements for the underlyingshares of common stock. These warrants have been accounted for within equity inthe condensed consolidated balance sheet in accordance with EITF 00-19 *Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock*, and, accordingly, noliabilities have been recorded in connection therewith. As of December 31,2007, no liquidated damages were payable under the provisions of theregistration rights agreement associated with these warrants.

 

13

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**7. Redeemable Common Stock**

 

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

 

**8. Stock-Based Compensation**

 

On September 21,2007, the Company’s stockholders approved the 2007 Omnibus Incentive Plan (the “2007Plan”), which provides that options to purchase shares of the Company’sunissued common stock may be granted to employees, officers, consultants anddirectors to the Company at exercise prices which are equal to or greater thanthe fair market value of the Company’s common stock on the date of grant.Options expire no more than ten years after the date of grant and generallyvest at the rate of 25% on each of the first four anniversaries of the grantdate. The 2007 Plan also allows for the issuance of stock appreciation rights,restricted stock, restricted stock units and other stock-based awards based onthe value of the Company’s common stock. New shares are issued to satisfy stockoption exercises and share issuances under the 2007 Plan. As of December 31,2007, options to purchase an aggregate of 230,000 shares of common stock wereoutstanding under the 2007 Plan.

 

The Company’s 1997 StockIncentive Plan (the “1997 Plan”) terminated in September 2007; however,all stock options outstanding under the 1997 Plan will remain outstandingpursuant to the terms of such stock options. As of December 31, 2007,options to purchase 1.5 million shares of the Company’s common stock wereoutstanding under the 1997 Plan.

 

In connection with themerger of the Company and the Iteris Subsidiary (Note 1), the Company assumedthe 1998 Stock Incentive Plan of the Iteris Subsidiary (the “1998 Plan”) andall outstanding options granted thereunder. As of December 31, 2007,options to purchase 2.9 million shares of the Company’s common stock wereoutstanding under the 1998 Plan. No further options may be granted under the1998 Plan.

 

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

 

14

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A summary of activity inthe Plans for the nine months ended December 31, 2007 is as follows:

 
| ** **                                                                     | ** ** | **Options**                                                                                                   | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Life (In Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                     | ** ** | **(In thousands, except per share amounts and number of years)** | ** ** |
| Options outstanding at March 31, 2007                                     |       | 5,818                                                                                                         |       | $                                      | 1.60       |                                                        | 3.4        |                                | $          | 6,115 |   |
| Granted                                                                        |       | 230                                                                                                           |       | $                                      | 2.32       |                                                        | N/A        |                                |       |   |
| Exercised                                                                      |       | (1,358                                                                                                        | )          | $                                      | 0.88       |                                                        | N/A        |                                |       |   |
| Forfeited                                                                      |       | (26                                                                                                           | )          | $                                      | 3.04       |                                                        | N/A        |                                |       |   |
| Expired                                                                        |       | (57                                                                                                           | )          | $                                      | 3.16       |                                                        | N/A        |                                |       |   |
| Options outstanding at December 31, 2007                                  |       | 4,607                                                                                                         |       | $                                      | 1.82       |                                                        | 3.8        |                                | $          | 3,649 |   |
| Vested and expected to vest at December 31, 2007                          |       | 4,504                                                                                                         |       | $                                      | 1.81       |                                                        | 3.6        |                                | $          | 3,649 |   |
| Options exercisable at December 31, 2007                                  |       | 4,063                                                                                                         |       | $                                      | 1.73       |                                                        | 3.1        |                                | $          | 3,647 |   |
| Options exercisable at December 31, 2007 pursuant to a  change-in-control |       | 4,607                                                                                                         |       | $                                      | 1.82       |                                                        | 3.8        |                                | $          | 3,649 |   |

 

At December 31,2007, there were 620,000 shares of common stock available for grant under the2007 Plan.

 

For the nine monthperiods ended December 31, 2007 and 2006, the Company received $1.2million and $505,000, respectively, in cash from the exercise of stock options.Total stock-based compensation expense was $82,000 and $207,000 for the threeand nine months ended December 31, 2007, respectively, and $59,000 and$233,000 for the three and nine months ended December 31, 2006,respectively. No income tax benefit was realized from activity in the Plansduring the nine months ended December 31, 2007 and 2006.

 

At December 31,2007, there was $1.0 million of total unrecognized compensation expense relatedto unvested stock options. This expense is expected to be recognized over aweighted-average period of approximately 3.4 years.

 

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

 
| ** **                           | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                            | ** ** | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                 |       |                                                |       |                                               |       |   |   |   |   |
| Dividend yield                       | ** ** | **0.0**                                             |       | N/A                                                | ** ** | **0.0** |   | 0.0 |   |
| Expected life — years           | ** ** | **7.0**                                             |       | N/A                                                | ** ** | **7.0** |   | 7.0 |   |
| Risk-free interest rate              | ** ** | **4.2**                                             | **%**      | N/A                                                | ** ** | **4.3** | % | 4.8 | % |
| Expected volatility of  common stock | ** ** | **0.85**                                            |       | N/A                                                | ** ** | **0.85** |   | 0.89 |   |

 

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

 
| ** **                                            | ** ** | **Three Months  Ended December 31,**                        | ** ** | **Nine Months  Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                            | ** ** | **2007**                                                              | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                            | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Weighted average grant  date fair value per share     | ** ** | **$**                                                                 | **1.82**   |                                          | N/A        | ** ** | **$** | **1.81** |   | $ | 1.86 |   |
| Intrinsic value of options  exercised                 | ** ** | **$**                                                                 | **650**    |                                          | $          | 541 | ** ** | **$** | **2,297** |   | $ | 766 |   |
| Total fair value of  options vested during the period | ** ** | **$**                                                                 | **33**     |                                          | $          | 104 | ** ** | **$** | **210** |   | $ | 621 |   |

 

**9. Business Segment Information**

 

The Company currentlyoperates in three reportable segments: Roadway Sensors, Vehicle Sensors andTransportation Systems. The Roadway Sensors segment includes the Company’sVantage vehicle detection systems for 

 

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traffic intersection control, incident detection and certainhighway traffic data collection applications. The Vehicle Sensors segmentincludes AutoVue and is comprised of all activities related to lane departurewarning systems for vehicle safety. The Transportation Systems segment includestransportation engineering and consulting services and the development oftransportation management and traveler information systems for the ITSindustry. The accounting policies of the reportable segments are the same asthose described in the summary of significant accounting policies. Prior to April 1,2007, certain expenses, such as interest, amortization of certain intangiblesand certain corporate expenses were not allocated to the segments. Beginning onApril 1, 2007, the Company increased the portion of its corporate expensesthat it allocates to its segments such that substantially all corporateexpenses are allocated. Interest, amortization of certain intangibles andcertain corporate expenses are still not allocated to the segments. Inaddition, certain assets, including cash and cash equivalents, deferred incometaxes and certain long-lived and intangible assets, are not allocated to thesegments. The reportable segments are each managed separately because theymanufacture and distribute distinct products or provide services with differentprocesses. All segment revenues are derived from external customers.

 

The following table setsforth selected unaudited financial information for the Company’s reportablesegments for the three and nine months ended December 31, 2007 and 2006:

 
| ** **                                    | ** ** | **Roadway  Sensors**    | ** ** | **Vehicle  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|----------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                    | ** ** | **(In thousands)** | ** ** |
| **Three Months Ended December 31, 2007** |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 6,432      |                 | $          | 2,281                       |       | $         | —     |   | $ | 8,713 |   |
| Service and other revenue                     |       | —                  |       | 463                  |       | 6,187                       |       | 6,650     |       |
| Stock-based compensation expense              |       | 3                       |       | 10                   |       | 6                           |       | 19        |       |
| Depreciation and amortization                 |       | 26                      |       | 32                   |       | 39                          |       | 97        |       |
| Segment income                                |       | 929                     |       | 167                  |       | 449                         |       | 1,545     |       |
|                                          |       |                    |       |                 |       |                        |       |      |       |
| **Three Months Ended December 31, 2006** |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 6,499      |                 | $          | 1,460                       | ** ** | $         | —     |   | $ | 7,959 |   |
| Service and other revenue                     |       | —                  |       | 616                  |       | 5,913                       |       | 6,529     |       |
| Stock-based compensation expense              |       | 5                       |       | 14                   |       | 12                          |       | 31        |       |
| Depreciation and amortization                 |       | 21                      |       | 35                   |       | 32                          |       | 88        |       |
| Segment income (loss)                         |       | 1,384                   |       | (892                 | )          | 652                         |       | 1,144     |       |
|                                          |       |                    |       |                 |       |                        |       |      |       |
| **Nine Months Ended December 31, 2007**  |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 21,273     |                 | $          | 7,630                       |       | $         | —     |   | 28,903 |   |
| Service and other revenue                     |       | —                  |       | 1,312                |       | 17,881                      |       | 19,193    |       |
| Stock-based compensation expense              |       | 13                      |       | 34                   |       | 19                          |       | 66        |       |
| Depreciation and amortization                 |       | 79                      |       | 98                   |       | 105                         |       | 282       |       |
| Segment income                                |       | 3,725                   |       | 439                  |       | 1,426                       |       | 5,590     |       |
|                                          |       |                    |       |                 |       |                        |       |      |       |
| **Nine Months Ended December 31, 2006**  |       |                    |       |                 |       |                        |       |      |       |
| Product revenue                               |       | $                       | 19,976     |                 | $          | 4,282                       | ** ** | $         | —     |   | $ | 24,258 |   |
| Service and other revenue                     |       | —                  |       | 2,240                |       | 16,272                      |       | 18,512    |       |
| Stock-based compensation expense              |       | 33                      |       | 41                   |       | 71                          |       | 145       |       |
| Depreciation and amortization                 |       | 60                      |       | 103                  |       | 94                          |       | 257       |       |
| Segment income (loss)                         |       | 4,458                   |       | (2,080               | )          | 1,958                       |       | 4,336     |       |

 

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

 
| ** **                                               | ** ** | **Three Months Ended  December 31,** | ** **      | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------------|-----------------|----------------------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                            | ** **      | **2006**                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                               | ** ** | **(In thousands)**                             | ** **      |
| Total income for reportable segments | ** ** | **$**                                               | ** 1,545** |                                               | $          |  1,144 |   | **$** | ** 5,590** |   | $ |  4,336 |   |
| Unallocated amounts:                                     |       |                                                |            |                                               |       |   |   |   |   |
| Corporate expenses                                       | ** ** | **(415**                                            | )               | (393                                               | )          | **(586** | **)** | (1,710 | ) |
| Other income (expense),  net                             | ** ** | **(3**                                              | )               | (5                                                 | )          | **41** |   | (650 | ) |
| Interest expense, net                                    | ** ** | **(314**                                            | )               | (390                                               | )          | **(1,046** | **)** | (1,200 | ) |
| Income before income taxes                               | ** ** | **$**                                               | **813**         |                                               | $          | 356 | ** ** | **$** | **3,999** |   | $ | 776 |   |

 

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

** **

*This report, including the following discussion and analysis, containsforward-looking statements (within the meaning of the Private SecuritiesLitigation Reform Act of 1995) that are based on our current expectations,estimates and projections about our business and our industry, and reflectmanagement’s beliefs and certain assumptions made by us based upon informationavailable to us as of the date of this report. When used in this report and theinformation incorporated herein by reference, the words “expect(s),” “feel(s),”“believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s)” andsimilar expressions or variations of these words are intended to identifyforward-looking statements. These forward-looking statements include but arenot limited to statements regarding our anticipated sales, revenue, expenses,profits, capital needs, competition, development plans, backlog andmanufacturing capabilities, the applications for and acceptance of our productsand services, and the status of our facilities and product development. Thesestatements are not guarantees of future performance and are subject to certainrisks and uncertainties that could cause our actual results to differmaterially from those projected. You should not place undue reliance on theseforward-looking statements that speak only as of the date hereof. We undertakeno obligation to republish revised forward-looking statements to reflect eventsor circumstances after the date hereof or to reflect the occurrence ofunanticipated events. We encourage you to carefully review and consider thevarious disclosures made by us which describe certain factors which couldaffect our business, including in* “*Risk Factors”set forth in Part II, Item 1A of this report, before deciding to invest inour company or to maintain or increase your investment. We undertake noobligation to revise or update publicly any forward-looking statement for anyreason.*

 

**Overview**

 

We are a leader in the traffic management market that focuses on thedevelopment and application of advanced technologies that reduce trafficcongestion, minimize the environmental impact of traffic congestion and improvethe safety of surface transportation systems. By combining outdoor imageprocessing, traffic engineering and information technology, we offer a broadrange of Intelligent Transportation Systems and driver safety solutions tocustomers worldwide.

 

Wecurrently operate in three reportable segments: Roadway Sensors, VehicleSensors and Transportation Systems. The Roadway Sensors segment includes ourVantage vehicle detection systems for traffic intersection control,incident detection and certain highway traffic data collection applications.The Vehicle Sensors segment is comprised of all activities related to ourAutoVue Lane Departure Warning (“LDW”) systems for vehicle safety. TheTransportation Systems segment includes transportation engineering andconsulting services and the development of transportation management andtraveler information systems for the ITS industry.

 

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

 

Our AutoVue LDW systems consist of a small windshield mounted sensorthat uses proprietary software to detect and warn drivers of unintended lanedepartures. In excess of 90,000 production AutoVue units have been sold for carand truck platforms in the North American and European markets. Our AutoVue LDWsystems are currently qualified as an option on certain heavy trucks, includingMercedes-Benz, MAN, Iveco, DAF, Scania, Freightliner and FUSO, as well asNeoplan and MAN luxury bus and coach lines. In North America, our LDW systemsare sold primarily to truck fleets, and to date, 56 U.S. heavy truck fleetshave selected our LDW systems, representing an estimated 30,000 vehicles. In September 2003,we entered into an agreement with Valeo Schalter and Sensuren GmbH (“Valeo”),pursuant to which we granted Valeo the exclusive right to sell and manufactureour AutoVue LDW systems to the worldwide passenger car market in exchange forroyalty payments for each AutoVue LDW unit sold. To date, royalty payments fromValeo have not been significant. Pursuant to this agreement, we also providespecific contract engineering services, technical marketing and sales supportto Valeo to enable the incorporation of our LDW technology on four Infinitiplatforms, the FX, M, Q and EX, where the device is offered as part of variousoption packages. Valeo is currently in discussions to provide our LDW system toother passenger car OEMs; however, we cannot assure you that such discussionswill be successful. We plan to continue to provide technical marketing andsales support to Valeo in our efforts to win new OEM customers for thepassenger car market as well as contract engineering services related to thepossible launch of new Infiniti platforms that include our LDW system. Webelieve that AutoVue is a broad sensor platform that, through additionalsoftware development, may be expanded to incorporate additional safety andconvenience features.

 

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Ourtransportation management systems business includes transportation engineeringand consulting services focused on the planning, design, development andimplementation of software-based systems that integrate sensors, videosurveillance, computers and advanced communications equipment to enable publicagencies to monitor, control and direct traffic flow, assist in the quickdispatch of emergency crews and distribute real-time information about trafficconditions. Our services include planning, design and implementation of surfacetransportation infrastructure systems. We perform analysis and study goods movement,commercial vehicle operations, travel demand forecasting and systemsengineering, and identify mitigation measures to reduce traffic congestion.These services and systems are primarily sold to local, state and nationaltransportation agencies in the United States. Our transportation managementsystems business is largely dependent upon governmental funding and budgetaryissues. The Federal Highway Bill that was passed in August 2005 providedfor a significant increase in transportation funding over the following sixyears. We believe the recent expansion of our transportation management systemsbusiness was due in part to the passage of the Federal Highway Bill, combinedwith increased transportation funds available at state and local agencies throughoutthe country. 

 

**CriticalAccounting Policies and Estimates**

 

Management’sDiscussion and Analysis of Financial Condition and Results of Operations isbased on our unaudited condensed consolidated financial statements includedherein, which have been prepared in accordance with U.S generally acceptedaccounting principles. The preparation of these financial statements requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and related disclosures of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. On an ongoing basis, weevaluate these estimates and assumptions, including those related to the collectibilityof accounts receivable, the valuation of inventories, the recoverability oflong-lived assets and goodwill, the realizability of deferred tax assets,accounting for stock-based compensation, the valuation of equity instruments,warranty reserves and other contingencies. We base these estimates on ourhistorical experience and on various other factors that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. These estimates and assumptions bytheir nature involve risks and uncertainties, and may prove to be inaccurate.In the event that any of our estimates or assumptions are inaccurate in anymaterial respect, it could have a material adverse effect on our reportedassets and liabilities at the date of the financial statements and our reportedrevenues and expenses during the reporting period.

 

Thefollowing critical accounting policies affect our more significant judgmentsand estimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

 

*RevenueRecognition*. We record product revenues and related costs ofsales upon transfer of title, which is generally upon shipment or, if required,upon acceptance by the customer, provided that we believe collectibility of thenet sales amount is reasonably assured. Accordingly, at the date revenue isrecognized, the significant uncertainties concerning the sale have beenresolved.

 

Contractrevenues are derived primarily from long-term contracts with governmentalagencies. 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 on contracts are charged to earnings whenidentified. Changes in job performance and estimated profitability, includingthose arising from contract penalty provisions and final contract settlements,may result in revisions to recognized costs and revenues and are recognized inthe period in which the revisions are determined. Profit incentives areincluded in revenue when their realization is reasonably assured.

 

Inaddition to product and contract revenues, we derive revenue from technologyaccess fees, the provision of specific non-recurring contract engineeringservices to our strategic partner, Valeo, related to our AutoVue LDW systems,and royalties earned on unit sales of our AutoVue LDW systems by Valeo to thepassenger car market. Technology access fee revenues are recognized evenly overthe period in which they are earned. Non-recurring contract engineeringrevenues are recognized in the period in which the related services areperformed. Royalty revenues are recorded based on unit sales of our products byValeo and are recognized in the period in which such sales occur. Technologyaccess fee revenues, non-recurring contract engineering revenues and royalty revenuesare included in net sales.

 

Revenuesfrom follow-on service and support, for which we generally charge separately,are recorded in the period in which the services are performed.

 

*AccountsReceivable*. We estimate the collectibility of customer receivableson an ongoing basis by periodically reviewing invoices outstanding greater thana certain period of time. We record reserves for receivables deemed to be atrisk for collection as well as a general reserve based on our historicalcollections experience. A considerable amount of judgment 

 

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is required in assessing theultimate realization of trade receivables, including the currentcredit-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 reserves for potentially excess and obsoleteinventory. In assessing the ultimate realization of inventories, we makejudgments as to future demand requirements and compare that with the current orcommitted inventory levels. Reserves are established for inventory levels thatexceed anticipated future demand. It is possible that reserves over and abovethose already established may be required in the future if market conditionsfor our products deteriorate.

 

*Goodwill*. Goodwill istested for impairment annually in our fourth fiscal quarter at the reportingunit level unless a change in circumstances indicates that more frequentimpairment analysis is required. Impairment, if any, is measured based on theestimated fair value of the reporting units with the recorded goodwill. Fairvalue is determined by using the income approach methodology of valuation whichutilizes discounted cash flows. Significant management judgment is required in theforecasts of future operating results that are used in the discounted cash flowmethod of valuation. In estimating future cash flows, we generally use thefinancial assumptions in our current budget and our current strategic plan,subject to modification as considered necessary, including sales and expensegrowth rates and the discount rates we estimate to represent our cost of funds.It is possible, however, that the plans and estimates used may be incorrect. Ifour actual results, or the plans and estimates used in future impairmentanalyses, are lower than the original estimates used to assess therecoverability of goodwill, we could incur impairment charges.

 

*Warranty.*We generally provide a one to three year warranty from the originalinvoice date on all products, materials and workmanship. Defective products areeither repaired or replaced, at our option, upon meeting certain criteria. Weaccrue a provision for the estimated costs that may be incurred for productwarranties relating to a product as a component of cost of sales at the timerevenue for that product is recognized. The accrued warranty provision isincluded within accrued expenses on the accompanying condensed consolidatedbalance sheets. Should our actual experience of warranty returns be higher thananticipated, additional warranty reserves may be required, which may adverselyaffect our operating results.

 

*Income Taxes.*We recorded a valuationallowance to reduce our deferred tax assets to amounts that we believe are morelikely than not to be realized. Realization of deferred tax assets (such as netoperating loss carryforwards) is dependent on future taxable earnings and istherefore uncertain. On a quarterly basis, we assess the likelihood that ourdeferred tax asset balance will be recovered from future taxable income. To theextent we believe that recovery is not likely, we establish a valuationallowance against our deferred tax asset, increasing our income tax expense inthe period such determination is made.

 

Onan interim basis, we estimate what our anticipated annual effective tax ratewill be and record a quarterly income tax provision in accordance with thisanticipated rate. As the fiscal year progresses, we refine our estimates basedupon actual events and earnings during the year. This estimation process canresult in significant changes to our expected effective tax rate. When thisoccurs, we adjust the income tax provision during the quarter in which thechange in estimate occurs so that the year-to-date provision reflects theexpected annual rate. The changes described in the preceding sentence andadjustments to our valuation allowance may create fluctuations in our overalleffective tax rate from quarter to quarter.

 

Effective April 1,2007, we adopted FIN 48, which applies to all tax positions accounted for underSFAS 109 and defines the confidence level that a tax position must meet inorder to be recognized in the financial statements. FIN 48 requires that thetax effects of a position be recognized only if it is “more-likely-than-not” tobe sustained by the taxing authority as of the reporting date. If a taxposition is not considered “more-likely-than-not” to be sustained, then nobenefits of the position are to be recognized.

 

*Stock-Based Compensation*.Effective April 1, 2006, we adopted SFAS 123R, which requires allstock-based payments, including grants of employee stock options, to berecognized in the statement of operations as an expense, based on their grantdate fair values with such fair values amortized over the requisite serviceperiod. We elected to utilize the modified prospective method for thetransition to SFAS 123R. Under the modified prospective method, SFAS 123Rapplies to all awards granted or modified after the date of adoption. Inaddition, under the modified prospective method, compensation expense isrecognized for all stock-based compensation awards granted prior to but not yetvested as of April 1, 2006, based on grant-date fair values estimated inaccordance with the original provisions of SFAS 123.

 

We use the BSM option-pricing formula to estimate thefair value of stock-based awards granted subsequent to April 1, 2006. Ourassumptions under the BSM formula include the following:  expected volatilities are based on the 

 

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historical volatility of our stock price, the expectedlife of options is derived based on the historical life of our options, and therisk-free interest rate for periods within the expected life of the option isbased on the U.S. Treasury interest rates in effect at the time of grant.Additionally, our calculation of stock compensation expense under SFAS 123Rincludes an estimate of forfeitures based on our historical forfeiture rate.Future stock-based compensation expense in any particular quarter or year couldbe affected by changes in our assumptions or changes in market conditions.

 

**Results ofOperations**

 

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

 
| ** **                                 | ** ** | **Three Months  Ended December 31,** | ** ** | **Nine Months  Ended December 31,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                 | ** ** | **2007**                                       | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net sales and contract  revenues:          |       |                                           |       |                                          |       |   |   |   |   |
| Net sales                                  | ** ** | **59.7**                                       | **%**      | 59.2                                          | %          | **62.8** | **%** | 62.0 | % |
| Contract revenues                          | ** ** | **40.3**                                       |       | 40.8                                          | ** ** | **37.2** |   | 38.0 |   |
| Total net sales and  contract revenues     | ** ** | **100.0**                                      | **%**      | 100.0                                         | %          | **100.0** | **%** | 100.0 | % |
| Costs of net sales and  contract revenues: |       |                                           |       |                                          |       |   |   |   |   |
| Cost of net sales                          | ** ** | **30.1**                                       |       | 32.8                                          | ** ** | **31.8** |   | 34.6 |   |
| Cost of contract revenues                  | ** ** | **27.5**                                       |       | 28.1                                          | ** ** | **24.8** |   | 24.8 |   |
| Gross profit                               | ** ** | **42.3**                                       |       | 39.2                                          | ** ** | **43.4** |   | 40.6 |   |
| Operating expenses:                        |       |                                           |       |                                          |       |   |   |   |   |
| Selling, general and  administrative       | ** ** | **26.3**                                       |       | 26.8                                          | ** ** | **26.7** |   | 27.7 |   |
| Research and development                   | ** ** | **6.5**                                        |       | 7.2                                           | ** ** | **5.5** |   | 6.6 |   |
| Deferred compensation plan                 | ** ** | **1.9**                                        |       | (0.2                                          | )          | **0.6** |   | (0.1 | ) |
| Amortization of intangible  assets         | ** ** | **0.2**                                        |       | 0.3                                           | ** ** | **0.2** |   | 0.3 |   |
| Total operating expenses                   | ** ** | **35.0**                                       |       | 34.0                                          | ** ** | **33.0** |   | 34.4 |   |
| Operating income                           | ** ** | **7.4**                                        |       | 5.2                                           | ** ** | **10.4** |   | 6.1 |   |
| Non-operating income  (expense):           |       |                                           |       |                                          |       |   |   |   |   |
| Other income (expense),  net               | ** ** | **(0.0**                                       | **)**      | (0.0                                          | )          | **0.1** |   | (1.5 | ) |
| Interest expense, net                      | ** ** | **(2.0**                                       | **)**      | (2.7                                          | )          | **(2.2** | **)** | (2.8 | ) |
| Income before income taxes                 | ** ** | **5.3**                                        |       | 2.5                                           | ** ** | **8.3** |   | 1.8 |   |
| Income tax benefit  (provision)            | ** ** | **0.9**                                        |       | (0.3                                          | )          | **0.5** |   | 1.3 |   |
| Net income                                 | ** ** | **6.2**                                        | **%**      | 2.1                                           | %          | **8.8** | **%** | 3.1 | % |

 

**Analysis ofQuarterly Results of Operations**

 

*Net Sales and Contract Revenues*.  Netsales are comprised of Roadway Sensors sales, which are derived from sales ofour Vantage video detection systems, and Vehicle Sensor sales, which arederived from sales of AutoVue LDW systems, technology access fees, contractengineering revenue and royalty revenue generated from AutoVue relatedactivities.  Contract revenues consist entirely of Transportation Systemsrevenues, which are generated from systems integration and ITS consultingservices with federal, state, county and municipal agencies. We currently havea relatively diverse customer base with our largest customer constituting 7.5%and 7.0% of total net sales and contract revenues in the three and nine monthsended December 31, 2007, respectively.

 

Totalnet sales and contract revenues increased 6.0% to $15.4 million and 12.5% to$48.1 million for the three and nine months ended December 31, 2007,respectively, compared to $14.5 million and $42.8 million in the correspondingperiods of the prior fiscal year. The increase was primarily driven byincreased net sales in the Vehicle Sensors segment, as well as increasedcontract revenues in the Transportation Systems segment, as discussed below.

 

Netsales increased 7.0% to $9.2 million and 14.0% to $30.2 million for the threeand nine months ended December 31, 2007, respectively, compared to $8.6million and $26.5 million in the corresponding periods of the prior fiscalyear.

 

Roadway Sensors net sales decreased 1.0% to $6.4 million and increased6.5% to $21.3 million for the three and nine months ended December 31,2007, respectively, versus $6.5 million and $20.0 million in the correspondingperiods of the prior fiscal year. The decrease in Roadway Sensors net sales forthe three months ended December 31, 2007 was largely due to lower salesvolumes in Texas as a result of local budgetary issues, a trend that we expectto continue for at least the next few fiscal quarters.  The decreased sales volumes in Texas were

 

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largely offset by increased net sales in other regions.  The increase in Roadway Sensors net sales forthe nine months ended December 31, 2007 primarily reflects the continuedadoption of video vehicle detection technology, such as the technology offered byour Vantage line of products, both domestically and internationally.  We continue to believe that the currentincreased rate of adoption has to some extent been due to increased governmentspending on traffic initiatives, which we believe has been at least partiallymade possible by the passage of the Federal Highway Bill in August 2005,as well as expanded sales and marketing efforts, particularly in North America.Although we are not aware of any imminent changes in government spendingpatterns, it is conceivable that, as a result of softening macroeconomicconditions in the U.S., government funding for certain traffic initiatives androadway improvement projects could be delayed or diverted to focus on otherbudgetary needs.  Should this occur, itis possible that future domestic Roadway Sensors net sales would be adverselyaffected.

 

Vehicle Sensors net sales increased 32.2% to$2.7 million and 37.1% to $8.9 million for the three and nine months ended December 31,2007, respectively, versus $2.1 million and $6.5 million in the correspondingperiods of the prior fiscal year. This increase was primarily a result ofincreased unit sales of our LDW systems to European and Asian OEMs. Salesof LDW systems to the heavy truck market increased by $821,000, or 56.2%, and$3.3 million, or 78.2%, for the three and nine month periods ended December 31,2007, respectively, when compared to the corresponding periods in the priorfiscal year. Also included in Automotive Sensors net sales are revenues fromcontract engineering services, technology access fees and royalty revenues inthe passenger car market that are derived from our strategic relationship withValeo, which aggregated $463,000 and $1.3 million for the three and nine monthsended December 31, 2007, respectively, compared to $616,000 and $2.2million in the corresponding periods of the prior fiscal year.

 

We expect sales of LDW units to the heavytruck market to continue to increase, when compared to the prior year period,for at least the remainder of fiscal 2008 due to increased sales of LDW unitsin Europe and Asia; however we expect to experience a decline in sales to theNorth American heavy truck market in our next two fiscal quarters as a resultof an overall decline in new truck sales in the U.S. due to new engineemissions standards that went into effect at the beginning of the calendar yearas well as due to the general slowdown in the U.S. housing market and overalleconomy. Additionally, we expect revenues from our strategic partnership withValeo to decrease slightly as compared to the prior year largely because wewill not receive any technology access fee revenues in fiscal 2008. Technologyaccess fee revenues totaled $125,000 and $375,000 for the three and nine monthsended December 31, 2006, respectively. Royalty revenues from Valeo forsales of our LDW systems for the passenger car market have remained relativelyinsignificant in the current fiscal year. Our LDW systems are now offered as anoption on four Infiniti models. While Valeo is currently in discussions tooffer our LDW systems on other passenger car platforms, we cannot assure youthat Valeo will be successful in these efforts.

 

Contract revenues increased 4.6% to $6.2 million and 9.9% to $17.9million for the three and nine months ended December 31, 2007,respectively, compared to $5.9 million and $16.3 million in the correspondingperiods of the prior fiscal year. This increase was largely due to increasedfunding at the federal, state and local levels throughout the country, as well asnew contract awards. In response to this growth in funding, we have increasedour Transportation Systems staff by 15% in the nine months ended December 31,2007, and we expect to continue to increase our Transportation Systems staffover the remainder of fiscal 2008. We believe the ability of our TransportationSystems business to grow and successfully win and service new contracts will behighly dependent upon our continued success in recruiting and retainingqualified personnel. All of our contract revenues are derived from workperformed in North America under a broad range of fixed price and cost plusfixed fee contracts.

 

*Gross Profit*. Total gross profit increased 14.5% to $6.5 million and 20.2% to $20.9 millionfor the three and nine months ended December 31, 2007, respectively, ascompared to $5.7 million and $17.4 million in the corresponding periods of theprior fiscal year. Total gross profit as a percent of net sales and contractrevenues increased to 42.3% and 43.4% for the three and nine months ended December 31,2007, respectively, as compared to 39.2% and 40.6% in the corresponding periodsof the prior fiscal year.

 

Gross profit as a percent of net sales was 49.5% and 49.4% for thethree and nine months ended December 31, 2007, respectively, compared to44.7% and 44.1% in the corresponding periods of the prior fiscal year. Thisincrease in gross profit was a result of increased gross profits in both theRoadway Sensors and Vehicle Sensors segments, largely as a result of afavorable sales mix in terms of both geography and product mix.  Additionally, gross margins were positivelyimpacted by improved production efficiencies. Vehicle Sensors gross marginshave also improved as the customer base for our LDW systems has expanded.  Through diversification of our heavy truckcustomer base we have been able to mitigate the gross margin impact of lowercontractual pricing to our largest European customer. Gross profit as a percentof net sales generally fluctuates in any specific quarter based on customermix. Gross profit as a percent of net sales has fluctuated over the last elevenquarters from a high of 50.2% in the first quarter of fiscal 2006 to a low of39.2% reported in the third quarter of fiscal 2007.

 

 

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Gross profit as a percent of contract revenues was 31.6% and 33.2% forthe three and nine months ended December 31, 2007, respectively, comparedto 31.2% and 34.7% in the corresponding periods of the prior fiscal year. Werecognize contract revenues and related gross profit using percentage ofcompletion contract accounting and the underlying mix of contract activityaffects the related gross profit recognized in any given period. Gross profitduring our third fiscal quarter generally tends to decrease as a percentage ofcontract revenues due to the larger number of company holidays during thisperiod which reduces the number of billable days our engineers work in thethird quarter.  The decrease in grossprofit as a percent of contract revenues for the nine months ended December 31,2007 reflects a contract mix weighted more toward lower margin contracts in theperiod. Lower margin contracts generally have a higher proportion ofsub-consulting revenues associated with them.

 

*Selling, General and Administrative Expense*. Selling, general and administrative expense increased 4.2% to $4.0 million (or26.3% of total net sales and contract revenues) and 8.0% to $12.8 million (or26.7% of total net sales and contract revenues) in the three and nine monthsended December 31, 2007, respectively, compared to $3.9 million (or 26.8%of total net sales and contract revenues) and $11.9 million (or 27.7% of totalnet sales and contract revenues) in the corresponding periods of the priorfiscal year. The increase for the three and nine month periods ended December 31,2007 compared to the prior year periods was largely attributable to highercommissions and selling expenses driven by sales growth in our Roadway Sensorssegment. In the coming quarters, we expect to continue to experience increasedselling expenses as we pursue further sales growth. Additionally, we anticipatewe will incur increased general and administrative expenses related to ourefforts to comply with the internal control attestation requirements of theSarbanes-Oxley Act, with which we must begin to comply in fiscal 2008.

 

*Research and Development Expense*. Research and development expense was relatively flat at $1.0 million (or 6.5%of total net sales and contract revenues) and $2.6 million (or 5.5% of totalnet sales and contract revenues) for the three and nine months ended December 31,2007, respectively, compared to $1.0 million (or 7.2% of total net sales andcontract revenues) and $2.8 million (or 6.6% of total net sales and contract revenues)in the corresponding periods of the prior fiscal year. Although year-over-yearour research and development expense was relatively flat, we have increasedresearch and development spending in Roadway Sensors. This increased spendingwas offset by reduced research and development activities in Vehicle Sensors asmany of our significant truck OEM customers now have production LDW unitsrequiring minimal further development and the majority of our passenger carresearch and development efforts are funded by our strategic partner, Valeo. Webelieve research and development activities are crucial to our ability tocontinue to be a leader in our markets, and we expect our expenditures in thisarea to be in line with historical amounts for the remainder of fiscal 2008.

 

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

 

*Deferred Compensation Plan Expense.*Duringthe three and nine months ended December 31, 2007, we recorded non-cashexpense of $290,000 and $299,000, respectively, related to the change in valueof shares of our common stock held in trust by our deferred compensationsavings plan. This compares to a non-cash benefit of $29,000 and $61,000recorded in the three and nine month periods ended December 31, 2006,respectively. In May 2007, our former Chief Executive Officer, whodeparted in March 2007, elected to receive a distribution of approximatelyfifty percent of his deferred compensation plan balance, representing 143,333shares of our common stock and $10,000 in cash, all of which was paid out in June 2007,and his remaining deferred compensation plan balance of 143,333 shares of ourcommon stock and $5,000 in cash on the one year anniversary of this election.As a result of this election, at December 31, 2007, the trust held 167,177shares of our common stock and $5,000 of cash. We expect to continue toexperience non-cash expense or benefit in future periods as the value of theassets held in our deferred compensation savings plan fluctuates.

 

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

 
| ** **                  | ** ** | **Three Months Ended   December 31,** | ** ** | **Nine Months Ended   December 31,** | ** ** |
|-----------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                                  | ** ** | **2006**                                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                  | ** ** | ** **                                                | ** ** | **(In thousands)**                                  | ** ** | ** ** | ** ** |
| Settlement of lawsuit       | ** ** | **$**                                                     | **—** |                                                     | $          | — | ** ** | **$** | **—** |   | $ | (635 | ) |
| Other                       | ** ** | **(3**                                                    | **)**      | (5                                                       | )          | **41** |   | (15 | ) |
| Other income (expense), net | ** ** | **$**                                                     | **(3**     | **)**                                                    | $          | (5 | ) | **$** | **41** |   | $ | (650 | ) |

 

 

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Other income (expense), net for the nine months ended December 31,2006 primarily reflects $635,000 of expense 

recorded inconnection with the settlement of litigation described in Note 5 to theaccompanying condensed consolidated financial statements.

 

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

 
| ** **                             | ** ** | **Three Months Ended   December 31,** | ** ** | **Nine Months Ended   December 31,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                             | ** ** | **2007**                                                  | ** ** | **2006**                                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                             | ** ** | ** **                                                | ** ** | **(in thousands)**                                  | ** ** | ** ** | ** ** |
| Interest expense                       | ** ** | **$**                                                     | **(228**   | **)**                                                    | $          | (305 | ) | **$** | **(787** | **)** | $ | (942 | ) |
| Amortization of debt discount          | ** ** | **(51**                                                   | **)**      | (51                                                      | )          | **(155** | **)** | (155 | ) |
| Amortization of deferred finance costs | ** ** | **(35**                                                   | **)**      | (34                                                      | )          | **(104** | **)** | (103 | ) |
| Interest expense, net                  | ** ** | **$**                                                     | **(314**   | **)**                                                    | $          | (390 | ) | **$** | **(1,046** | **)** | $ | (1,200 | ) |

 

Interest expense decreased for the three and nine months ended December 31,2007 compared to the corresponding periods in the prior fiscal year as a resultof an overall lower level of borrowings.

 

*Income Taxes*. During the three and nine months ended December 31, 2007, we recognized anincome tax benefit of $141,000 and $221,000, respectively, as compared toincome tax expense of $46,000 and an income tax benefit of $545,000 in thethree and nine months ended December 31, 2006, respectively. The incometax benefit recorded in the three and nine months ended December 31, 2007was primarily based on anticipated taxes to be paid in the current year, aswell as a slight decrease in the valuation allowance recorded against ourdeferred tax assets as a result of changes in estimates of the futurerealizability of these assets. Total deferred tax assets on our consolidatedbalance sheet increased from $3.0 million at March 31, 2007 to $3.3million at December 31, 2007. The income tax benefit recorded during thenine months ended December 31, 2006 was also the result of a decrease inthe valuation allowance recorded against our deferred tax assets. In thefuture, we may continue to record similar adjustments to our deferred tax assetvaluation allowance as our estimates are updated. We anticipate this will causeour future overall effective tax rate in any given period to fluctuate fromprior effective tax rates, estimated annual effective tax rates and statutorytax rates.

 

As discussed in Notes 1 and 4 of the accompanying condensedconsolidated financial statements, we adopted FIN 48 on April 1, 2007. Inconnection with our adoption of FIN 48, we recognized an adjustment ofapproximately $224,000 to the beginning balance of retained earnings on ourconsolidated balance sheet. Additionally, there was no significant change inour income tax expense for the three and nine months ended December 31,2007 as a result of our implementation of FIN 48.

 

**Liquidityand Capital Resources**

 

*Cash Flows*

 

We have historically financed our operations with a combination of cashflows from operations, borrowings under credit facilities and the sale ofequity securities. We currently rely on cash flows from operations and borrowingson a line of credit facility to fund our operations. At December 31, 2007,we had $12.7 million in working capital, which included borrowings of $199,000on our revolving line of credit and $679,000 in cash and cash equivalents. Thiscompares to working capital of $7.0 million at March 31, 2007, whichincluded borrowings of $4.0 million on our revolving line of credit and $35,000in cash and cash equivalents.

 

Our operating activities provided $5.4 million in cash during the ninemonths ended December 31, 2007, primarily as a result of net incomegenerated during the period and net cash inflows related to operating assetsand liabilities. Inventories decreased by $2.0 million from March 31,2007, to a level more in line with what we expect inventory levels to be overthe next six to twelve months. Accounts receivable and net unbilled accountsreceivable each increased by $1.1 million since March 31, 2007, largely asa result of increased sales as well as the timing of invoicing in ourTransportation Systems segment. Over the next several fiscal quarters, weexpect net unbilled accounts receivable to decrease by ten to twenty percent,which we expect will result in increased cash inflows from operations. Duringthe nine months ended December 31, 2006, our operations used $2.3 millionof cash, primarily as a result of investments in inventory and an increasedlevel of accounts receivable and net costs and estimated earnings in excess ofbillings due to sales growth.  This waspartially offset by a $1.4 million increase in accounts payable and accruedliabilities and $1.3 million in net income.

 

Our investing activities for the nine months ended December 31,2007 and 2006 consisted entirely of purchases of property and equipment, whichaggregated $455,000 and $311,000, respectively. In September 2007, wemoved our corporate headquarters. As further discussed in Note 5 of theaccompanying condensed consolidated financial statements, in 

 

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connectionwith this move, we spent $1.8 million on tenant improvements, all of which wasfinanced by our landlord in the form of tenant improvement allowances under thelease. We do not expect significant additional investments in leaseholdimprovements to our facilities as substantially all major planned leaseholdimprovements were completed prior to December 31, 2007.

 

Cash used in financing activities was $4.3 million in the nine monthsended December 31, 2007, which was the result of $5.6 million in netpayments against borrowings, partially offset by $1.3 million in proceeds fromthe exercise of outstanding stock options and warrants to purchase our commonstock. During the nine months ended December 31, 2006, financingactivities provided $2.6 million of cash, which was primarily the result of$2.9 million in proceeds from the exercise of outstanding stock options andwarrants to purchase our common stock, partially offset by $356,000 in netpayments against borrowings.  As discussedin Note 6 to the accompanying condensed consolidated financial statements,approximately $2.0 million of the $2.9 million in cash inflows from theexercise of outstanding stock options and warrants during the nine months endedDecember 31, 2006 was raised through the exercise of outstanding warrantsto purchase 1,250,000 shares of common stock.

 

*Borrowings*

 

The following table summarizes our borrowings andlong-term debt:

 
| ** **                  | ** ** | **At December   31, 2007** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|
| ** **                  | ** ** | **(In thousands)**                   | ** ** |
| Convertible debentures, net |       | $                                         | 9,565      |   |
| Line of credit              |       | 199                                       |       |
| Bank term note              |       | 524                                       |       |
| Other                       |       | 46                                        |       |
|                        |       | $                                         | 10,334     |   |

 

In October 2006, weentered into a two-year credit facility with a bank which includes our line ofcredit and bank term note.  The creditfacility provides for line of credit borrowings of up to $10.0 million against oureligible accounts receivable and inventory, as defined in the creditagreement.  The term note provides formonthly principal payments of approximately $104,000 and matures in May 2008.The interest rate on the line of credit is the current stated prime rate plus1.00%, and the interest rate on the bank term note is fixed at an annual rateof 8.75%. We are obligated to pay an unused line fee of 0.25% per annum appliedto the amount by which the maximum credit amount exceeds the average dailyprincipal balance during the preceding month. The credit facility also requires$2,000 in monthly collateral management fees and includes an early terminationfee equal to 1% of the total facility. The credit facility is secured bysubstantially all of the assets of the Company. At December 31, 2007, wehad $9.3 million available under our credit facility, of which $9.1 million wasunused.

 

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

 

**Contractual Obligations**

 

Our contractual obligations were as follows at December 31, 2007:

 
| ** **              | ** ** | **Payments Due by Fiscal Year** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|
| ** **              | ** ** | **2008**                                            | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **              | ** ** | **(In thousands)**                             | ** ** |
| Line of credit          |       | $                                                   | 199        |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 199 |   |
| Notes payable           |       | 221                                                 |       | 349 |   | — |   | — |   | — |   | — |   | 570 |   |
| Convertible  debentures |       | —                                              |       | — |   | 9,850 |   | — |   | — |   | — |   | 9,850 |   |
| Operating leases        |       | 343                                                 |       | 1,488 |   | 1,391 |   | 1,348 |   | 1,332 |   | 3,823 |   | 9,725 |   |
| Total                   |       | $                                                   | 763        |   | $ | 1,837 |   | $ | 11,241 |   | $ | 1,348 |   | $ | 1,332 |   | $ | 3,823 |   | $ | 20,344 |   |

 

At December 31, 2007, we had firm commitments to purchaseinventory in the amount of $4.1 million during our next three fiscal quarters.

 

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**Off Balance Sheet Arrangements**

 

In May 2004, we issued subordinated convertible debentures in anaggregate original principal amount of $10.1 million. These debentures aredue in full on May 19, 2009 and are convertible into shares of our commonstock at an initial conversion price of $3.61 per share. At December 31,2007, $9.9 million of these convertible debentures remained outstanding.Because these debentures are conventionally convertible, we have not separatelyaccounted for the conversion feature and, accordingly, no separate amounts arepresented in our condensed consolidated financial statements in connection withthis conversion feature.

 

At December 31, 2007, outstanding warrants to purchase anaggregate of 246,250 shares of our common stock at an exercise price of $3.25were callable by us if the closing sales price of our common stock for 20consecutive days is equal to or greater than two times the exercise price ofthe warrants. Outstanding warrants to purchase an aggregate of75,000 shares of our common stock at an exercise price of $5.00 per sharewere callable by us if the price of our common stock for 20 consecutivedays is equal to or greater than one and a half times the exercise price of thewarrants.

 

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

 

**Recent Accounting Pronouncements**

 

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

 

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

 

**Seasonality**

 

We have historically experienced, and expectto continue to experience, 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 in manymarkets as a result of inclement weather conditions.

 

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

 

Our exposure to interest rate risk is limitedto our line of credit. Our line of credit bears interest based on theprevailing prime rate (7.25% at December 31, 2007). We do not believe thata 10% increase in the interest rate on our line of credit (from 8.25% to 9.08%)would have a material impact on our financial position, operating results orcash flows. In addition, we believe that the carrying value of our outstandingdebt approximates fair value.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the 

 

 

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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 that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures areeffective to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms and are effective in ensuring thatinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, our managementrecognized that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives. Our management necessarily applied its judgment inevaluating the cost-benefit relationship of such controls and procedures.

 

**Changesin Internal Controls**

 

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

 

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**PART II. OTHER INFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

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

 

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

 

*Our business is subject to a number of risks, some of whichare discussed below. Other risks are presented elsewhere in this report and inthe information incorporated by reference into this report. You should considerthe following risks carefully in addition to the other information contained inthis report and our other filings with the SEC, including our annual report on Form 10-Kand subsequent reports on Forms 10-Q and 8-K, before deciding to buy, sell orhold our common stock. The risks and uncertainties described below are not theonly ones facing our company. Additional risks and uncertainties not presentlyknown to us or that we currently deem immaterial may also affect our businessoperations. If any of these risks actually occurs, our business, financialcondition or results of operations could be seriously harmed. In that event,the market price for our common stock could decline and you may lose all orpart of your investment.*

 

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

 

At December 31,2007, we had $679,000 of cash and cash equivalents and relied on our line ofcredit to fund our operations. We may need to raise additional capital in thenear future to fund our operations or to repay indebtedness. Such additionalcapital may be raised through bank borrowings, or other debt or equityfinancings. We cannot assure you that any additional capital will be availableon a timely basis, on acceptable terms, or at all, and such additionalfinancing may result in further dilution to our stockholders.

 

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

 

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

 

·                                       ourability to control costs;

 

·                                       thesupply of key components for our products;

 

·                                       ourability to generate net income;

 

·                                       increasedresearch and development expenses;

 

·                                       increasedsales and marketing expenses;

 

·                                       technologicaladvancements and our competitors’ response to our products;

 

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

 

·                                       potentialacquisitions of businesses and product lines;

 

·                                       ourrelationships with customers and suppliers;

 

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

 

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

 

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

 

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

 

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

 

**If Our Internal Controls Over Financial Reporting Do Not Comply WithThe Requirements Of The Sarbanes-Oxley Act, Our Business And Stock Price CouldBe Adversely Affected.**Along with our independentregistered public accounting firm, we will be evaluating the effectiveness ofour internal controls over financial reporting to comply with Section 404of the Sarbanes-Oxley Act of 2002. Section 404 currently requires us toevaluate the effectiveness of our internal controls over financial reporting atthe end of each fiscal year beginning in our fiscal year ending March 31,2008 and to include a management report assessing the effectiveness of ourinternal controls over financial reporting in all annual reports beginning withour Annual Report on Form 10-K for the fiscal year ending March 31,2008. Section 404 also requires our independent accountant to attest to,and report on, management’s assessment of our internal controls over financialreporting beginning in our fiscal year ending March 31, 2009. We may notbe able to complete our Section 404 compliance on a timely basis, and evenif we timely complete our compliance requirements, our independent auditors maystill conclude that our internal controls over financial reporting are noteffective.

 

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

 

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

 

 

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

 

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

 

**We Depend Upon Valeo To Market Our AutoVueTechnologies For The OEM Passenger Car Market.**We havegranted Valeo the exclusive right to sell and manufacture our AutoVue LDWsystem to the worldwide passenger car market in exchange for royalty paymentsfor each AutoVue unit sold. As such, the future success and broad marketacceptance of our AutoVue technologies in the passenger car market will dependupon Valeo’s ability to manufacture, market and sell our technologies, and toconvince more OEM passenger car manufacturers to adopt our technologies. IfValeo does not devote considerable resources and aggressively pursueopportunities, our expansion into the passenger car market could be adverselyaffected.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

**The SignificantMilitary Operations In The Middle East Or Elsewhere May Impact GovernmentFunding Or Consumer Spending, Causing A Decline In Our Revenues.**Inthe near term, the funding of U.S. military operations in the Middle East orelsewhere may cause disruptions in funding of government contracts. Sincemilitary operations of such magnitude are not routinely included in U.S.defense budgets, supplemental legislative funding actions are often required tofinance such operations. Even when such legislation is enacted, it may not beadequate for ongoing operations, causing other government resources to betemporarily or permanently diverted. Since a significant portion of our salesare derived from contracts with government agencies, such diversion of fundscould produce interruptions in funding or delays in receipt of our contracts,causing disruptions and adversely effecting our revenue and operations.

 

**An Economic Slowdown Could Lead To Reduced OrDelayed Government Funding For Transportation Infrastructure And InitiativesAnd Decreased Availability Of Financial Capital For Our Customers, Causing ADecline In Our Revenues. **Concernsabout inflation, decreased consumer confidence, and reduced corporate profitsand capital spending have resulted in a downturn in worldwide economicconditions, particularly in the United States. These unfavorable economicconditions may have a negative impact on customer orders (and also may resultin decreased sales of automobiles and trucks that incorporate our LDW systems).Such concerns may result in cancellations and rescheduling of backlog. Inaddition, the recent decline in

 

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the U.S. real estate market, particularly in new home construction,could adversely impact new road construction resulting in a decline in RoadwaySensor and Vehicle Sensor net sales and Transportation Systems contractrevenues. Any of the foregoing economic conditions make it extremely difficultfor our customers, our suppliers and us to accurately forecast and plan futurebusiness activities and could result in a decline in our net sales and contractrevenues. If such conditions continue or worsen, our business, financialcondition and results of operations could be materially and adversely affected.

 

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

 

·                                          longpurchase cycles or approval processes;

 

·                                          competitivebidding and qualification requirements;

 

·                                          theimpact of international conflicts;

 

·                                          performancebond requirements;

 

·                                          changesin government policies and political agendas;

 

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

 

·                                          othergovernment budgetary constraints and cut-backs; and

 

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

 

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

 

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

 

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

 

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

 

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

 

·                                          declinesin new home construction and related road construction;

 

 

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·                                          ourability to control costs;

 

·                                          ourability to raise additional capital;

 

·                                          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;

 

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

 

·                                          marketacceptance of the products incorporating our technologies and products;

 

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

 

·                                          theintroduction of new products by competitors;

 

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

 

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

 

·                                          theeffects of technological changes in our target markets;

 

·                                          theamount of our backlog at any given time;

 

·                                          thenature of our government contracts;

 

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

 

·                                          risksand uncertainties associated with our international business;

 

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

 

·                                          generaleconomic and political conditions.

 

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

 

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

 

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

 

·                                          thefailure to retain or integrate key acquired personnel;

 

 

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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.

 

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

 

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

 

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

 

·                                          rapidtechnological advances;

 

·                                          downwardprice pressure in the marketplace as technologies mature;

 

·                                          changesin customer requirements;

 

·                                          frequentnew product introductions and enhancements; and

 

·                                          evolvingindustry standards and changes in the regulatory environment.

 

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

 

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

 

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

 

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

 

·                                          quarterlyvariations in operating results;

 

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

 

·                                          ourability to raise additional capital;

 

·                                          shortagesannounced by suppliers;

 

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

 

·                                          transitionsto new products or product enhancements;

 

·                                          acquisitionsof businesses, products or technologies;

 

·                                          theimpact of any litigation;

 

·                                          changesin investor perceptions;

 

·                                          governmentfunding, political agendas and other budgetary issues;

 

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

 

·                                          internationalconflicts, political unrest and acts of terrorism.

 

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

 

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

 

·                                          currencyfluctuations and restrictions;

 

·                                          political,social and economic instability;

 

 

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·                                          longeraccounts receivable payment cycles;

 

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

 

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

 

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

 

·                                          difficultiesin managing and staffing international operations;

 

·                                          potentiallyadverse tax consequences; and

 

·                                          reducedprotection for intellectual property rights in some countries.

 

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

 

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

 

**We Could Experience Negative FinancialImpacts Arising From Developments In Contingencies Created Under Our PreviousStructure Or By Former Subsidiaries.**Although wedivested ourselves of all business units prior to October 2004, with theexception of our Iteris business, from time to time we could experienceunforeseen developments in contingencies related to our former subsidiaries.For example, in July 2006 we entered into a settlement agreement inconnection with a lawsuit brought against Mariner Networks, Inc., one ofour former subsidiaries, by one of Mariner’s suppliers, pursuant to which weissued 88,912 shares of our common stock to this supplier (valued at $213,000as of the date of issuance), paid this supplier $125,000 on October 20,2006 and are required to pay an additional $350,000 in 36 equal monthlyinstallments of $9,700 beginning in November 2006. Although we are notaware of any other material contingencies, it is possible that other matterscould be brought against us in connection with activities related to formersubsidiaries and that such matters could materially and adversely affect ourfinancial results and cash flows.

 

**Some Of Our Directors, Officers And TheirAffiliates Can Control The Outcome Of Matters That Require The Approval Of OurStockholders, And Accordingly We Will Not Be Able To Engage In CertainTransactions Without Their Approval.**As of December 31,2007, our officers and directors beneficially owned approximately 11% of theoutstanding shares of our common stock (and approximately 16% of our commonstock when including options, warrants and other convertible securities held bythem which are currently exercisable or convertible or will become exercisableor convertible within 60 days after December 31, 2007). As a resultof their stock ownership, our management will be able to influence the electionof our directors and the outcome of corporate actions requiring stockholderapproval, such as mergers and acquisitions, regardless of how our otherstockholders may vote. This concentration of voting control may have asignificant effect in delaying, deferring or preventing a change in ourmanagement or change in control and may adversely affect the voting or otherrights of other holders of common stock.

 

**Certain Anti-Takeover Provisions May AffectThe Price Of Our Common Stock And Discourage A Third Party From Acquiring Us.**Certainprovisions of our certificate of incorporation and our stockholder rights plancould make it difficult for a third party to acquire us, even though anacquisition might be beneficial to our stockholders. Such provisions couldlimit the price that investors might be willing to pay in the future for sharesof our common stock. Under the terms of our certificate of incorporation, ourBoard of Directors is authorized to issue, without stockholder approval, up to2,000,000 shares of preferred stock with voting, conversion and other rightsand preferences superior to those of our common stock. Our future issuance ofpreferred stock could be used to discourage an unsolicited acquisitionproposal. In addition, in March 1998, we adopted a stockholder rights planand declared a dividend of preferred stock purchase rights to our stockholders.We amended this plan in May 2004. In the event a third party acquires morethan 15% of the outstanding voting control of our company or 15% of ouroutstanding common stock, the holders of these rights will be able to purchase 

 

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the junior participating preferred stock at a substantial discount offof the then current market price. The exercise of these rights and purchase ofa significant 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**

 

None.

 

**ITEM 5. OTHER INFORMATION**

 

None.

 

**ITEM 6. EXHIBITS**

 

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

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                       | ** ** | **Where Located**                                                                                                                                                         |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Amended and  Restated Certificate of Incorporation of the registrant                                                                                                  | * *   | *Exhibit 3.1  to the registrant’s Current Report on Form 8-K as filed with the SEC on  October 28, 2004*                                                   |
| * *            | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.2                 |       | Certificate  of Amendment to Amended and Restated Certificate of Incorporation filed  September 26, 2007                                                         | * *   | *Exhibit 3.2  to the registrant’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2007 as filed with the SEC on November 13, 2007* |
| * *            | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.3                 |       | Bylaws of  registrant, as amended                                                                                                                                     | * *   | *Exhibit 4.2  to the registrant’s Registration Statement on Form S-1 (Reg.  No. 033-67932) as filed with the SEC on July 6, 1993*                     |
| * *            | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.4                 |       | Certificates  of Amendment to Bylaws of the registrant dated April 24, 1998 and  August 10, 2001                                                            | * *   | *Exhibit 3.4  to the registrant’s Annual Report on Form 10-K/A for the year ended  March 31, 2003 as filed with the SEC on July 29, 2003*             |
| * *            | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.5                 |       | Certificate  of Amendment to Bylaws of registrant dated September 9, 2004                                                                                        | * *   | *Exhibit 3.1  to the registrant’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2004 as filed with the SEC on November 15, 2004* |
|                |       |                                                                                                                                                                  |       |                                                                                                                                                                           |
| 3.6                 |       | Certificate  of Amendment to Bylaws of registrant dated December 7, 2007                                                                                         | * *   | *Exhibit 3.1  to the registrant’s Current Report on Form 8-K as filed with the SEC on  December 13, 2007*                                                  |
|                |       |                                                                                                                                                                  |       |                                                                                                                                                                           |
| 4.1                 |       | Specimen of  Common Stock Certificate                                                                                                                                 | * *   | *Exhibit 4.1  to the registrant’s Amendment No. 1 to the Registration Statement on  Form 8-A as filed with the SEC on December 8, 2004*               |
| * *            | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 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*                                           |

 

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| 10.1     |     | Amendment to  Loan and Security Agreement, dated October 17, 2007, by and between  Silicon Valley Bank and the registrant                | * * | *Exhibit 10.1  to the registrant’s Current Report on Form 8-K as filed with the SEC on  October 23, 2007* |
|----------|----------|-----------------------------------------------------------------------------------------------------------------------------------------------|----------|-------------------------------------------------------------------------------------------------------------------------------|
|     |     |                                                                                                                                          |     |                                                                                                                          |
| 31.1     |     | Certification  of the Principal Executive Officer, as required pursuant to Section 302  of the Sarbanes-Oxley Act of 2002                | * * | *Filed  herewith*                                                                                                             |
| * * | * * | * *                                                                                                                                      | * * | * *                                                                                                                      |
| 31.2     |     | Certification  of the Principal Financial and Accounting Officer, as required pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 | * * | *Filed  herewith*                                                                                                             |
| * * | * * | * *                                                                                                                                      | * * | * *                                                                                                                      |
| 32.1     |     | Certification  of the Chief Executive Officer, as required pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                    | * * | *Filed  herewith*                                                                                                             |
| * * | * * | * *                                                                                                                                      | * * | * *                                                                                                                      |
| 32.2     |     | Certification  of the Chief Financial Officer, as required pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                    | * * | *Filed  herewith*                                                                                                             |

 

37

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**SIGNATURES**

 

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

 
| Dated:  February 1, 2008 |   | ITERIS, INC. |                                          |
|-------------------------------|--------|--------------|-----------------------------------------------|
|                          |   | (Registrant) |                                          |
|                          |   |         |                                          |
|                          |   | By           | /S/ ABBAS  MOHADDES                           |   |
|                          |   |         | Abbas  Mohaddes                               |
|                          |   |         | Chief  Executive Officer                      |
|                          |   |         | (Principal  Executive Officer)                |
|                          |   |         |                                          |
|                          |   |         |                                          |
|                          |   | By           | /S/ JAMES S.  MIELE                           |   |
|                          |   |         | James S.  Miele                               |
|                          |   |         | Chief  Financial Officer                      |
|                          |   |         | (Principal  Financial and Accounting Officer) |
|                               |        |              |                                               |  |  |  |

 

 

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