**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 
| **(Mark****One)**                                                                                                                                       | ** ** | ** **                                                                                               |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                              | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                                                                                                                    |       |                                                                                                     |
| **For the quarterly period ended  December 31, 2005**                                                                                              |
|                                                                                                                                                    |       |                                                                                                     |
| **OR**                                                                                                                                                  |
| ** **                                                                                                                                              | ** ** | ** **                                                                                               |
| **o**                                                                                                                                                   | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                              | ** ** | ** **                                                                                               |
| **For the transition period  from                   to** |

 

**Commission file number:  001-08762**

 

**ITERIS, INC.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                     | ** ** | **95-2588496**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **1515 South Manchester Avenue**                                 | ** ** | ** **                            |
| **Anaheim, California**                                          | ** ** | **92802**                             |
| (Address of principal  executive office)                         |       | (Zip Code)                            |

 

**(714)****774-5000**

(Registrant’stelephone number, including area code)

 

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

 

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

**Yes   ****ý****   No  ****o**

 

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

 

| **Large accelerated  filer  ****o** | ** ** | **Accelerated filer  ****o** | ** ** | **Non-accelerated filer  ****ý** |
|-----------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------|

 

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

 

**Yes  ****o****   No  ****ý**

 

As of February 6, 2006, the registrant had 28,624,803shares of common stock outstanding.

 

 

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**ITERIS, INC.**

**Quarterly Report on Form 10-Q**

**For the Three and Nine MonthsEnded December 31, 2005**

 

**Table of Contents**

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

 

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

 

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

 

2

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**PART I.FINANCIAL INFORMATION**

**ITEM1.  FINANCIAL STATEMENTS**

 

**ITERIS, INC.**

**UNAUDITED CONDENSED CONSOLIDATEDBALANCE SHEETS**

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

 
| ** **                                                                                                                                                                 | ** ** | **December 31,  2005** | ** ** | **March 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| **ASSETS**                                                                                                                                                                 |       |                        |       |                     |       |
| Current  assets:                                                                                                                                                           |       |                        |       |                     |       |
| Cash                                                                                                                                                                       | ** ** | **$**                       | **—** |                     | $          | 46 |   |
| Trade accounts receivable, net of allowance  for doubtful accounts of $429 and $239 at December 31, 2005 and  March 31, 2005, respectively                       | ** ** | **8,840**                   |       | 8,866                    |       |
| Costs and estimated earnings in excess of  billings on uncompleted contracts                                                                                               | ** ** | **2,429**                   |       | 2,086                    |       |
| Inventories, net of reserve for inventory  obsolescence of $680 and $514 at December 31, 2005 and March 31, 2005,  respectively                                       | ** ** | **2,652**                   |       | 4,344                    |       |
| Deferred income taxes                                                                                                                                                      | ** ** | **292**                     |       | 101                      |       |
| Prepaid expenses and other current assets                                                                                                                                  | ** ** | **560**                     |       | 384                      |       |
| Total current assets                                                                                                                                                       | ** ** | **14,773**                  |       | 15,827                   |       |
| Property and equipment, net                                                                                                                                                | ** ** | **1,313**                   |       | 1,103                    |       |
| Deferred income taxes                                                                                                                                                      | ** ** | **840**                     |       | 559                      |       |
| Intangible assets, net of accumulated  amortization of $224 and $114 at December 31, 2005 and March 31,  2005, respectively                                      | ** ** | **588**                     |       | 698                      |       |
| Goodwill                                                                                                                                                                   | ** ** | **27,774**                  |       | 27,774                   |       |
| Other assets                                                                                                                                                               | ** ** | **514**                     |       | 695                      |       |
| Total assets                                                                                                                                                               | ** ** | **$**                       | **45,802** |                     | $          | 46,656 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                              | ** ** | ** **                  | ** ** | ** **               | ** ** |
| Current  liabilities:                                                                                                                                                      |       |                        |       |                     |       |
| Trade accounts payable                                                                                                                                                     | ** ** | **$**                       | **2,890**  |                     | $          | 3,936 |   |
| Accrued payroll and related expenses                                                                                                                                       | ** ** | **3,601**                   |       | 3,007                    |       |
| Accrued liabilities                                                                                                                                                        | ** ** | **1,180**                   |       | 790                      |       |
| Billings in excess of costs and estimated  earnings on uncompleted contracts                                                                                               | ** ** | **813**                     |       | 944                      |       |
| Revolving line of credit                                                                                                                                                   | ** ** | **1,389**                   |       | 945                      |       |
| Current portion of long-term debt                                                                                                                                          | ** ** | **1,607**                   |       | 4,008                    |       |
| Total current liabilities                                                                                                                                                  | ** ** | **11,480**                  |       | 13,630                   |       |
| Non-current  payroll related liability                                                                                                                                     | ** ** | **101**                     |       | 330                      |       |
| Deferred  compensation plan liability                                                                                                                                      | ** ** | **760**                     |       | 772                      |       |
| Deferred  gain on sale of building                                                                                                                                         | ** ** | **520**                     |       | 733                      |       |
| Long-term  debt and capital lease obligation                                                                                                                               | ** ** | **2,740**                   |       | 1,319                    |       |
| Convertible  debentures, net                                                                                                                                               | ** ** | **9,151**                   |       | 8,996                    |       |
| Total liabilities                                                                                                                                                          | ** ** | **24,752**                  |       | 25,780                   |       |
| Commitments  and contingencies                                                                                                                                             |       |                        |       |                     |       |
| Redeemable common stock, 1,219 shares  issued and outstanding at December 31, 2005 and March 31, 2005                                                            | ** ** | **3,414**                   |       | 3,414                    |       |
| Stockholders’  equity:                                                                                                                                                |       |                        |       |                     |       |
| Preferred stock, $1.00 par value, 2,000  shares authorized, none issued and outstanding at December 31, 2005 and  March 31, 2005                                 | ** ** | **—**                  |       | —                   |       |
| Common stock, $0.10 par value, 50,000  shares authorized, 27,373 and 27,090 shares issued and outstanding at December 31,  2005 and March 31, 2005, respectively | ** ** | **2,737**                   |       | 2,709                    |       |
| Additional paid-in capital                                                                                                                                                 | ** ** | **126,693**                 |       | 126,534                  |       |
| Deferred stock-based compensation                                                                                                                                          | ** ** | **(194**                    | )          | (925                     | )          |
| Common stock held in trust, 311 shares at  December 31, 2005 and March 31, 2005                                                                                  | ** ** | **(374**                    | )          | (374                     | )          |
| Treasury stock                                                                                                                                                             | ** ** | **—**                  |       | (1                       | )          |
| Notes receivable from employees                                                                                                                                            | ** ** | **(45**                     | )          | (45                      | )          |
| Accumulated deficit                                                                                                                                                        | ** ** | **(111,181**                | )          | (110,436                 | )          |
| Total  stockholders’ equity                                                                                                                                           | ** ** | **17,636**                  |       | 17,462                   |       |
| Total  liabilities and stockholders’ equity                                                                                                                           | ** ** | **$**                       | **45,802** |                     | $          | 46,656 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

3

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**ITERIS, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
| ** **                                      | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine MonthsEnded  December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                      | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales  and contract revenues:               |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Net sales                                       | ** ** | **$**                                | **7,276**  | ** **                         | $          | 7,576 |   | **$** | **22,776** | ** ** | $ | 22,130 |   |
| Contract revenues                               | ** ** | **4,907**                            | ** ** | 4,138                              |       | **14,201** | ** ** | 12,785 |   |
| Total net sales and contract revenues           | ** ** | **12,183**                           | ** ** | 11,714                             |       | **36,977** | ** ** | 34,915 |   |
|                                            |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Costs and  expenses:                            |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Cost of sales                                   | ** ** | **3,893**                            | ** ** | 4,000                              |       | **11,866** | ** ** | 11,878 |   |
| Cost of contract revenues                       | ** ** | **3,269**                            | ** ** | 2,670                              |       | **9,138** | ** ** | 8,349 |   |
| Gross profit                                    | ** ** | **5,021**                            | ** ** | 5,044                              |       | **15,973** | ** ** | 14,688 |   |
| Operating  expenses:                            |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Selling, general and administrative             | ** ** | **3,555**                            | ** ** | 4,002                              |       | **11,194** | ** ** | 10,803 |   |
| Research and development                        | ** ** | **1,153**                            | ** ** | 1,055                              |       | **4,176** | ** ** | 2,719 |   |
| Stock-based compensation                        | ** ** | **103**                              | ** ** | 11,490                             |       | **626** | ** ** | 11,490 |   |
| Disposal of fixed assets                        | ** ** | **—**                           | ** ** | 422                                |       | **—** | ** ** | 422 |   |
| Acquired in-process research and  development   | ** ** | **—**                           | ** ** | 25                                 |       | **—** | ** ** | 140 |   |
| Deferred compensation plan                      | ** ** | **(90**                              | **)**      | —                             |       | **(12** | **)** | — |   |
| Amortization of intangible assets               | ** ** | **37**                               | ** ** | 44                                 |       | **110** | ** ** | 78 |   |
| Total operating expenses                        | ** ** | **4,758**                            | ** ** | 17,038                             |       | **16,094** | ** ** | 25,652 |   |
| Operating  income (loss)                        | ** ** | **263**                              | ** ** | (11,994                            | )          | **(121** | **)** | (10,964 | ) |
| Non-operating  income (expense):                |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Other income (expense), net                     | ** ** | **(6**                               | **)**      | 60                                 |       | **32** | ** ** | 1,040 |   |
| Interest expense, net                           | ** ** | **(377**                             | **)**      | (298                               | )          | **(1,087** | **)** | (838 | ) |
| Loss before  income taxes and minority interest | ** ** | **(120**                             | **)**      | (12,232                            | )          | **(1,176** | **)** | (10,762 | ) |
| Income tax  (expense) benefit                   | ** ** | **256**                              | ** ** | 51                                 |       | **431** | ** ** | (24 | ) |
| Minority  interest in earnings of subsidiary    | ** ** | **—**                           | ** ** | (52                                | )          | **—** | ** ** | (485 | ) |
| Net income  (loss)                              | ** ** | **$**                                | **136**    | ** **                         | $          | (12,233 | ) | **$** | **(745** | **)** | $ | (11,271 | ) |
|                                            |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Earnings  (loss) per common share:              |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Basic                                           | ** ** | **$**                                | **0.00**   | ** **                         | $          | (0.44 | ) | **$** | **(0.03** | **)** | $ | (0.45 | ) |
| Diluted                                         | ** ** | **$**                                | **0.00**   | ** **                         | $          | (0.44 | ) | **$** | **(0.03** | **)** | $ | (0.45 | ) |
| Weighted  average common shares outstanding:    |       |                                 | ** ** |                               |       |   | ** ** |   |   |
| Basic                                           | ** ** | **28,246**                           | ** ** | 27,614                             |       | **28,138** | ** ** | 25,168 |   |
| Diluted                                         | ** ** | **32,700**                           | ** ** | 27,614                             |       | **28,138** | ** ** | 25,168 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

4

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**ITERIS, INC.**

**UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                        | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                        | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities**                                         | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Net loss                                                                          | ** ** | **$**                               | **(745**   | **)** | $ | (11,271 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities:  |       |                                | ** ** |   |   |
| Depreciation and amortization of property  and equipment                          | ** ** | **506**                             | ** ** | 604 |   |
| Write-off of in-process research and  development                                 | ** ** | **—**                          | ** ** | 140 |   |
| Minority interest in earnings of subsidiary                                       | ** ** | **—**                          | ** ** | 485 |   |
| Amortization of deferred gain on  sale—leaseback transaction                 | ** ** | **(213**                            | **)**      | (535 | ) |
| Amortization of intangible assets                                                 | ** ** | **110**                             | ** ** | 78 |   |
| Amortization of debt discount                                                     | ** ** | **155**                             | ** ** | 132 |   |
| Amortization of deferred financing costs                                          | ** ** | **103**                             | ** ** | 83 |   |
| Stock-based compensation                                                          | ** ** | **626**                             | ** ** | 11,490 |   |
| Loss on disposal of fixed assets                                                  | ** ** | **—**                          | ** ** | 422 |   |
| Change in deferred tax assets                                                     | ** ** | **(472**                            | **)**      | (172 | ) |
| Changes in operating assets and  liabilities:                                     |       |                                | ** ** |   |   |
| Accounts receivable                                                               | ** ** | **26**                              | ** ** | (53 | ) |
| Net costs and estimated earnings in excess  of billings                           | ** ** | **(474**                            | **)**      | 442 |   |
| Inventories                                                                       | ** ** | **1,692**                           | ** ** | 71 |   |
| Prepaid expenses and other assets                                                 | ** ** | **(98**                             | **)**      | (335 | ) |
| Accounts payable and accrued expenses                                             | ** ** | **(275**                            | **)**      | (544 | ) |
| Deferred revenue                                                                  | ** ** | **—**                          | ** ** | (226 | ) |
| Net cash provided by operating activities                                         | ** ** | **941**                             | ** ** | 811 |   |
|                                                                              |       |                                | ** ** |   |   |
| **Cash  flows from investing activities**                                         |       |                                | ** ** |   |   |
| Purchases of property and equipment                                               | ** ** | **(716**                            | **)**      | (425 | ) |
| Notes receivable from sale of business  units                                     | ** ** | **—**                          | ** ** | 50 |   |
| Net cash  used in investing activities                                            | ** ** | **(716**                            | **)**      | (375 | ) |
|                                                                              |       |                                | ** ** |   |   |
| **Cash  flows from financing activities**                                         |       |                                | ** ** |   |   |
| Proceeds from borrowings on line of credit,  net                                  | ** ** | **444**                             | ** ** | 450 |   |
| Proceeds from long-term debt                                                      | ** ** | **—**                          | ** ** | 5,000 |   |
| Payments on long-term debt and capital  lease obligations                         | ** ** | **(980**                            | **)**      | (814 | ) |
| Costs from issuance of common stock                                               | ** ** | **—**                          | ** ** | (97 | ) |
| Proceeds from issuance of convertible  debentures                                 | ** ** | **—**                          | ** ** | 9,479 |   |
| Purchase of Iteris Subsidiary Series A  preferred stock                      | ** ** | **—**                          | ** ** | (17,543 | ) |
| Proceeds from stock option and warrant  exercises                                 | ** ** | **265**                             | ** ** | 494 |   |
| Net cash used  in financing activities                                            | ** ** | **(271**                            | **)**      | (3,031 | ) |
| Decrease in  cash                                                                 | ** ** | **(46**                             | **)**      | (2,595 | ) |
| Cash at  beginning of period                                                      | ** ** | **46**                              | ** ** | 2,612 |   |
| Cash at end  of period                                                            | ** ** | **$**                               | **—** | ** ** | $ | 17 |   |
|                                                                              |       |                                | ** ** |   |   |
| **Supplemental  cash flow information:**                                          |       |                                | ** ** |   |   |
| Cash paid (received) during the period:                                           |       |                                | ** ** |   |   |
| Interest                                                                          | ** ** | **$**                               | **795**    | ** ** | $ | 464 |   |
| Income taxes                                                                      | ** ** | **(2**                              | **)**      | 583 |   |
| **Supplemental  schedule of non-cash investing and financing activities:**   |       |                                | ** ** |   |   |
| Increase in  promissory note to landlord to settle lease obligations              | ** ** | **—**                          | ** ** | 432 |   |
| Acquisition  of minority interest of the Iteris Subsidiary                        |       |                                | ** ** |   |   |
| Intangible assets                                                                 | ** ** | **—**                          | ** ** | 813 |   |
| Goodwill                                                                          | ** ** | **—**                          | ** ** | 19,121 |   |
| Reduction of minority interest                                                    | ** ** | **—**                          | ** ** | 753 |   |
| Issuance of  warrants in connection with Debenture and Warrant Purchase Agreement | ** ** | **—**                          | ** ** | 1,100 |   |
| Conversion  of convertible debt to equity                                         | ** ** | **—**                          | ** ** | 250 |   |

 

See accompanying notes to unaudited condensedconsolidated financial statements.

 

5

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**ITERIS,INC.**

**NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**December31, 2005**

 

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

 

**Description of Business**

 

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

 

**Basis of Presentation**

 

The unaudited condensedconsolidated financial statements of the Company have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Securities andExchange Commission (“SEC”) Form 10-Q and Article 10 of SECRegulation S-X. In the opinion of management, the accompanying unauditedcondensed consolidated financial statements contain all adjustments, consistingof normal recurring adjustments, necessary to present fairly the consolidatedfinancial position of the Company as of December 31, 2005, theconsolidated results of operations for the three and nine month periods ended December 31,2005, and 2004, and the consolidated cash flows for the nine month periodsended December 31, 2005, and 2004. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith accounting principles generally accepted in the United States (“U.S. GAAP”)have been condensed or omitted pursuant to the rules and regulations ofthe SEC. The results of operations for the three and nine month periods ended December 31,2005, are not necessarily indicative of those to be expected for the entireyear. The accompanying unaudited condensed consolidated financial statementsshould be read in conjunction with the Company’s Annual Report on Form 10-Kfor the year ended March 31, 2005, which was filed with the SEC on July 14,2005.

 

# **Useof Estimates**

#  

The preparation ofconsolidated financial statements in conformity with U.S. GAAP requiresmanagement to make certain estimates and assumptions that affect the reportedamounts of assets and liabilities, disclosures of contingent assets andliabilities at the date of the financial statements, and the reported amountsof revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.  Significant estimates made inthe preparation of the consolidated financial statements include the allowancefor doubtful accounts, deferred tax assets, inventory and warranty reserves,costs to complete long-term contracts, overhead rates used in cost-pluscontracts, contract reserves and estimates of future cash flows used to assessthe recoverability of long-lived assets, the valuation of debt and equityinstruments and the realization of goodwill.

 

# **RevenueRecognition**

#  

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

 

Contract revenues arederived primarily from long-term contracts with governmental agencies.  Contract revenues include costs incurred plusa portion of estimated fees or profits determined on the percentage ofcompletion method of accounting based on the relationship of costs incurred todate to total estimated costs.  Anyanticipated losses on contracts are

 

6

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charged to earnings whenidentified.  Changes in job performanceand estimated profitability, including those arising from contract penaltyprovisions and final contract settlements, may result in revisions to costs andrevenues and are recognized in the period in which the revisions aredetermined.  Profit incentives areincluded in revenue when their realization is reasonably assured.

 

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

 

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

 

**Concentrationof Credit Risk**

 

Accounts receivable are primarilyderived from revenues earned from customers located throughout North Americaand Europe.  The Company generally doesnot require collateral or other security from customers. Collectibility ofreceivable balances is estimated through review of invoices outstanding greaterthan a certain period of time and 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.  The fair value of convertible debenturesapproximates carrying value because the effective interest rate, taking intoaccount recorded debt discounts, approximates current market rates.  Prior to December 31, 2005, the fair value ofredeemable common stock approximated carrying value since these shares were nottradable in any public equity markets. At December 31, 2005, the estimated fair value of the redeemable shareswas $2.9 million, based on the closing price of the Company’s common stock onthat date.

 

# **Inventories**

#  

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

 

**Property and Equipment**

 

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

 

**Goodwill and Long-Lived Assets**

 

In accordance with Statement of Financial AccountingStandards (“SFAS”) No. 142, *Goodwill and IntangibleAssets*(“SFAS 142”), goodwill is tested for impairment at thereporting unit level (operating segment or one level below an operatingsegment) on an annual basis in the Company’s fourth fiscal quarter or morefrequently if indicators of impairment exist, of which none have beenidentified.  The performance of the testinvolves a two-step process.  The first stepof the impairment test involves comparing the fair value of the Company’sreporting units with each respective reporting unit’s carrying amount,including goodwill.  The fair value ofreporting units is generally determined using the income approach.  If the carrying amount of a reporting unitexceeds the reporting unit’s fair value, the second step of the goodwillimpairment test is performed to determine the amount of any impairmentloss.  The second step of the goodwillimpairment test involves comparing the implied fair value of the reporting unit’sgoodwill with the carrying amount of that goodwill.

 

The Company evaluates long-lived assets forimpairment in accordance with SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets,* which requiresimpairment evaluation on long-lived assets used in operations when indicatorsof impairment are present.  Reviews areperformed to determine whether the carrying value of assets is impaired, basedon a comparison to undiscounted expected future cash flows.  If this comparison indicates that there is

 

7

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impairment,the impaired asset is written down to fair value, which is typically calculatedusing discounted expected future cash flows and a discount rate based upon theCompany’s weighted average cost of capital adjusted for risks associated withthe related operations.  Impairment isbased on the excess of the carrying amount over the fair value of those assets.

 

**Income Taxes**

 

The Company utilizes the liability method ofaccounting for income taxes as set forth in SFAS No. 109, *Accounting for Income Taxes.* Under the liability method, deferred taxes are determined based on thetemporary differences between the financial statement and tax bases of assetsand liabilities using enacted tax rates. A valuation allowance is recorded when it is more likely than not thatall or a portion of the deferred tax assets will not be realized.

 

**Stock-Based Compensation**

 

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

 

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

 

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

 
| ** **                  | ** ** | **Three and Nine Months  Ended December 31,** | ** ** |
|-----------------------------|------------|----------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                           | ** ** | **2004** | ** ** |
|                        |       |                                               |       |   |   |
| Dividend  rate              | ** ** | **0.0**                                            |       | 0.0 |   |
| Expected  life – years | ** ** | **7.0**                                            |       | 7.0 |   |
| Risk-free  interest rate    | ** ** | **5.5**                                            |       | 4.5 |   |
| Volatility  of common stock | ** ** | **0.5**                                            |       | 0.5 |   |

 

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

 
| ** **                                                                              | ** ** | **Three Months Ended  December 31,**          | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                              | ** ** | **2005**                                      | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                              | ** ** | **(In  thousands, except per share amounts)** | ** ** |
| Net income  (loss) – as reported                                                   | ** ** | **$**                                         | **136**    |                                | $          | (12,233 | **)** | **$** | **(745** | ) | $ | (11,271 | ) |
| Add: Stock-based compensation expense  included in net income (loss) – as reported | ** ** | **103**                                       |       | 11,490                              | ** ** | **626** |   | 11,490 |   |
| Deduct: Stock-based compensation expense  under fair value method                       | ** ** | **(177**                                      | )          | (12,163                             | **)**      | **(912** | ) | (12,443 | ) |
| Net income  (loss) – pro forma                                                     | ** ** | **$**                                         | **62**     |                                | $          | (12,906 | **)** | **$** | **(1,031** | ) | $ | (12,224 | ) |
|                                                                                    |       |                                          |       |                                |       |   |   |   |   |
| Basic and diluted earnings (loss) per share  – as reported                         | ** ** | **$**                                         | **0.00**   |                                | $          | (0.44 | **)** | **$** | **(0.03** | ) | $ | (0.45 | ) |
| Basic and diluted earnings (loss) per share  – pro forma                           | ** ** | **$**                                         | **0.00**   |                                | $          | (0.47 | **)** | **$** | **(0.04** | ) | $ | (0.49 | ) |

 

8

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**Research and DevelopmentExpenditures**

 

Research anddevelopment expenditures are charged to expense in the period incurred.

 

**Shipping and Handling Costs**

 

Shipping andhandling costs are included in cost of sales in the period during whichproducts ship.

 

**Warranty**

 

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

 

**Repair and Maintenance Costs**

 

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

 

**Reclassifications**

** **

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

 

**Recent Accounting Pronouncements**

 

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

 

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

 

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

 

9

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**2.   Supplemental FinancialInformation**

 

**Inventories**

 

The following tablepresents details of the Company’s inventories:

 
| ** **              | ** ** | **December 31,  2005** | ** ** | **March 31,  2005** | ** ** |
|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **              | ** ** | **(In  thousands)**         | ** ** |
| Materials  and supplies | ** ** | **$**                       | **2,091**  |                     | $          | 3,204 |   |
| Work in  process        | ** ** | **280**                     |       | 558                      |       |
| Finished  goods         | ** ** | **281**                     |       | 582                      |       |
| ** **              |       | **$**                       | **2,652**  |                     | $          | 4,344 |   |

 

**Goodwill and Identifiable Intangible Assets**

 

The following table sets forth the Company’s intangible assets that aresubject to amortization:

 
| ** **            | ** ** | **December 31, 2005**  | ** ** | **March 31, 2005**       | ** ** |
|-----------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **            | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **            | ** ** | **(In thousands)**          | ** ** |
| Developed  technology | ** ** | **$**                       | **495**    | ** **                    | **$**      | **(156** | ) | $ | 495 |   | $ | (78 | ) |
| Patents               | ** ** | **317**                     | ** ** | **(68**                       | )          | 317 |   | (36 | ) |
| Total                 | ** ** | **$**                       | **812**    | ** **                    | **$**      | **(224** | ) | $ | 812 |   | $ | (114 | ) |

 

Amortization expense for intangible assets subject to amortization was$37,000 and $110,000 for the three and nine month periods ended December 31,2005, respectively, and $44,000 and $78,000 for the three and nine monthperiods ended December 31, 2004, respectively. Future estimatedamortization expense for the remainder of the current fiscal year, the nextfour fiscal years and thereafter is as follows:

 
| **Fiscal Year Ending March 31:** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|
| **(In  thousands)**                   | ** ** | ** ** | ** ** |
| Remainder of  2006                    |       | $          | 37         |   |
| 2007                                  |       | 147        |       |
| 2008                                  |       | 147        |       |
| 2009                                  |       | 147        |       |
| 2010                                  |       | 58         |       |
| Thereafter                            |       | 52         |       |
|                                  |       | $          | 588        |   |

 

At December 31, 2005, goodwill of $27.8 million was comprised of$18.0 million associated with the October 2004 merger of the IterisSubsidiary (Note 3); $9.6 million associated with the acquisitions of theRockwell International Transportation Systems Group, Meyer Mohaddes Associatesand the Viggen Systems Consulting Group; and $200,000 associated with thepurchase of the assets of Mil-Lektron, a complementary product to the Company’sVantage video detection business.

 

**Warranty Reserve Activity**

 

The following table presents activity in accrued warrantyobligations:

 
| ** **                         | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|------------------------------------------|------------|
| ** **                         | ** ** | **2005**                             | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                         | ** ** | **(In  thousands)**                  | ** ** |
| Balance at  beginning of period    | ** ** | **$**                                | **441**    |                                     | $          | 400 | ** ** | **$** | **326** |   | $ | 192 |   |
| Additions charged to cost of sales | ** ** | **80**                               |       | 61                                       | ** ** | **345** |   | 502 |   |
| Warranty claims                    | ** ** | **(92**                              | **)**      | (129                                     | )          | **(242** | **)** | (362 | ) |
|                               |       |                                 |       |                                     |       |   |   |   |   |
| Balance at  end of period          | ** ** | **$**                                | **429**    |                                     | $          | 332 | ** ** | **$** | **429** |   | $ | 332 |   |

 

10

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**Earnings (Loss) Per Share**

 

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

 
| ** **                                                   | ** ** | **Three Months Ended  December 31,**         | ** ** | **Nine Months Ended  December 31,** | ** ** |
|--------------------------------------------------------------|------------|----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                   | ** ** | **2005**                                     | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                   |       |                                         |       |                                |       |   |   |   |   |
| Net income (loss)                                            | ** ** | **$**                                        | **136**    |                                | $          | (12,233 | ) | **$** | **(745** | **)** | $ | (11,271 | ) |
|                                                         |       |                                         |       |                                |       |   |   |   |   |
| Denominator:                                                 |       |                                         |       |                                |       |   |   |   |   |
| Weighted average common shares used in  basic computation    | ** ** | **28,246**                                   |       | 27,614                              | ** ** | **28,138** |   | 25,168 |   |
| Dilutive stock options                                       | ** ** | **3,725**                                    |       | —                              | ** ** | **—** |   | — |   |
| Dilutive warrants                                            | ** ** | **729**                                      |       | —                              | ** ** | **—** |   | — |   |
| Weighted average common shares used in  dilutive computation | ** ** | **32,700**                                   |       | 27,614                              | ** ** | **28,138** |   | 25,168 |   |
|                                                         |       |                                         |       |                                |       |   |   |   |   |
| Basic and  diluted earnings (loss) per share                 | ** ** | **$**                                        | **0.00**   |                                | $          | (0.44 | ) | **$** | **(0.03** | **)** | $ | (0.45 | ) |

 

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

 
| ** **              | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **              | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **              | ** ** | **(In thousands)**                   | ** ** |
| Stock  options          | ** ** | **—**                           |       | 4,681                               | ** ** | **3,970** |   | 4,662 |   |
| Warrants                | ** ** | **—**                           |       | 852                                 | ** ** | **824** |   | 844 |   |
| Convertible  debentures | ** ** | **2,729**                            |       | 2,798                               | ** ** | **2,729** |   | 2,798 |   |

 

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

 

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

 

On June 30, 2004, the Company and certainminority stockholders of the Iteris Subsidiary (including certain officers and directors)entered into an exchange agreement whereby an aggregate of 1,319,541 shares ofcommon stock of the Iteris Subsidiary were exchanged for 2,639,082 shares ofthe Company’s newly issued common stock valued at $8.6 million at the date ofissuance. The fair value of the Company’s stock issued in the transaction wasbased on the quoted market price of the Company’s common stock on the OTCBulletin Board averaged over a five-day period. The effect of this exchange wasto reduce the residual minority interest in the Iteris Subsidiary to 8.1%.

 

On October 22, 2004,the Iteris Subsidiary was merged into the Company. The remaining 8.1% minorityinterest in the

 

11

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Iteris Subsidiary(consisting of 1,228,981 shares of common stock of the Iteris Subsidiary) wasconverted to 2,457,962 shares of the Company’s common stock valued at $7.6million at the merger date. Immediately following the merger, the Companyconverted all of its outstanding Class B common stock (921,917 shares)into 1,014,108 shares of its common stock (formerly designated as Class Acommon stock). The exchange ratio used in the conversion was determined by theCompany’s Board of Directors.  The fairvalue of the Company’s common stock issued in the transaction was based on thequoted market price of the Company’s common stock on the OTC Bulletin Boardaveraged over a five-day period. In October 2004, the Company also amendedits certificate of incorporation to (a) change the voting rights of its Class Acommon stock from one-tenth to one vote per share, (b) remove the abilityto issue any further shares of Class B common stock, and (c) renameits Class A common stock to common stock. As a result, the Companycurrently has only one class of common stock outstanding, the common stock.

 

In connection with themerger, the Company assumed all outstanding options and warrants to purchaseshares of common stock of the Iteris Subsidiary that were outstandingimmediately prior to the merger, whether vested or unvested, together with theIteris Subsidiary’s 1998 Stock Incentive Plan (the “Option Plan”). Each suchoption and warrant assumed by the Company continues to have, and be subject to,the same terms and conditions as were applicable immediately prior to themerger, provided that (A) such option or warrant is exercisable for thatnumber of whole shares of the Company’s common stock equal to the product ofthe number of shares of the Company’s common stock that were issuable uponexercise of such assumed option or warrant immediately prior to the mergermultiplied by two (the “Exchange Ratio”) rounded down to the nearest wholenumber of shares and (B) the per share exercise price for the shares ofthe Company’s common stock issuable upon exercise of such assumed option orwarrant is equal to the quotient determined by dividing the exercise price pershare at which such option or warrant was exercisable immediately prior to themerger by the Exchange Ratio (rounded up to the nearest whole cent).  As a result, options and warrants to purchaseapproximately 3.1 million shares and 327,000 shares, respectively, ofcommon stock of the Iteris Subsidiary assumed in the merger became options andwarrants to purchase approximately 6.1 million and 655,000 shares ofcommon stock of the Company, respectively. The weighted-average exercise pricesof the assumed options and warrants were $1.09 and $2.32, respectively.  Stock-based compensation expense of $11.3million was recorded in connection with the assumption and exchange of vestedIteris Subsidiary stock options for stock options immediately exercisable intothe Company’s common stock based on the difference between the fair marketvalue of the Company’s common stock on the October 22, 2004, merger dateand the exercise price of the modified stock option. Additionally, the Companyrecorded approximately $1.4 million in deferred compensation related to theassumption of unvested stock options to purchase common stock of the IterisSubsidiary. Deferred compensation is being amortized to stock-basedcompensation expense as the options vest. The Company also recorded $1.1 million of goodwill and additionalpaid-in-capital in connection with the 655,000 vested warrants assumed in themerger and acquisition of the Iteris Subsidiary.  The $1.1 million value was based on thedifference between the fair market value of the Company’s common stock on the October 22,2004, merger date and the modified exercise price of the assumed warrants.

 

The excess of the purchaseprice over the proportionate amount of minority interest acquired was allocatedto acquired intangible assets based on the estimated fair values with theresidual allocated to goodwill. Accordingly, the Company recorded goodwill of$18.0 million, which represents the excess of the purchase price over the fairvalue of the proportionate identifiable net assets acquired. The estimated fairvalue of the intangible assets was determined using the income method anddiscounting future expected returns. The estimated useful life for each of theacquired intangible assets is provided below:

 

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

 

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

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

 

12

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On October 22, 2004, inconnection with the Company’s merger with the Iteris Subsidiary, the ChiefExecutive Officer of the Iteris Subsidiary, Mr. Jack Johnson, was promotedto President and Chief Executive Officer of the Company, replacing Mr. GregoryMiner. This merger triggered certain obligations under the Company’schange-in-control agreement with Mr. Miner. Accordingly, the Companyrecorded approximately $807,000 in severance expense, which included $57,000for related payroll taxes, as a charge to earnings for the year ended March 31,2005.  The severance amount is being paidto Mr. Miner in bi-weekly installments over a 30 month period that beganin October 2004. Mr. Miner is not required to render any services tothe Company in connection with this agreement.

 

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

 

**RevolvingLine of Credit**

 

Effective August 1, 2005,the Company renewed its line of credit agreement with its primary bank.  This line of credit agreement expires on July31, 2006 and provides for borrowings of up to $5.0 million.  Under the terms of this agreement, the Companymay borrow against its eligible accounts receivable and the value of itseligible inventory, as defined in the credit agreement. Interest on borrowedamounts is payable monthly at the current stated prime rate plus 3.0%.  Additionally, the Company is obligated to payan unused line fee of 0.25% per annum applied to the amount by which themaximum credit amount exceeds the average daily principal balance during thepreceding month.

 

There are nomonthly collateral management fees and no pre-payment or early terminationfees. On December 31, 2005, the available credit under this line of creditagreement was $3.3 million, of which $1.9 million was unused.

 

**Long-TermDebt**

 

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

 
| ** **                   | ** ** | **December 31  2005** | ** ** | **March 31,  2005** | ** ** |
|------------------------------|------------|-----------------------|------------|--------------------------|------------|
| ** **                   | ** ** | **(In thousands)**    | ** ** |
| ** **                   | ** ** | ** **            | ** ** | ** **               | ** ** |
| Convertible  debentures, net |       | $                     | 9,151      |                     | $          | 8,996 |   |
| Bank term  note              |       | 3,021                 |       | 3,958                    |       |
| Promissory  note to landlord |       | 1,292                 |       | 1,292                    |       |
| 4% note  payable             |       | 34                    |       | 67                       |       |
| Capital  lease obligation    | ** ** | **—**            |       | 10                       |       |
|                         |       | 13,498                |       | 14,323                   |       |
| Less current  portion        |       | (1,607                | )          | (4,008                   | )          |
|                         |       | $                     | 11,891     |                     | $          | 10,315 |   |

 

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

 

The debentures are due infull on May 19, 2009, provide for 6.0% annual interest, payable quarterly,and are convertible into the Company’s common stock at an initial conversionprice of $3.61 per share, subject to certain adjustments, including adjustmentsfor dilutive issuances.  From May 19,2007 until May 18, 2008, the debentures may be redeemed by the Company, atits option, at 120% of the principal amount; and from May 19, 2008, untilthe maturity date, the debentures may be redeemed at 110% of the principalamount.  As of December 31, 2005,$250,000 of convertible debentures had been converted into 69,252 shares ofcommon stock leaving $9.9 million of the originally issued convertibledebentures outstanding at December 31, 2005.

 

13

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*Bank Term Note.*  Concurrent with the issuance of theconvertible debentures, the Iteris Subsidiary entered into a $5.0 million termnote payable with a bank. This note was assumed by the Company in October 2004.  The proceeds from the note were used topurchase the Series A preferred stock of the Iteris Subsidiary (Note 3).The note is due on May 27, 2008, and provides for monthly principal paymentsof approximately $104,000.  Interestaccrues at the current stated prime rate plus 0.25% (7.50% at December 31,2005).

 

Both the term notepayable and the line of credit are held by one bank under the same creditagreement and are secured by substantially all of the assets of theCompany.  At March 31, 2005, theCompany failed to meet certain financial covenants under the previous creditagreement.  Accordingly, the entire March31, 2005 balance of the bank term note is presented as a current liability inthe accompanying condensed consolidated balance sheet.

 

*Promissory Note to Landlord.*  The Company has a $1.3 million unsecuredpromissory note payable to its landlord. Under the terms of the note agreement, interest is payable quarterly andaccrues at a rate of prime plus 2.0% (9.25% at December 31, 2005).  Beginning on October 1, 2006, theCompany is required to make four equal quarterly payments of principal andaccrued interest.  All outstandingaccrued interest and principal becomes payable in full on July 2, 2007.

 

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

 

Scheduled aggregatematurities of long-term debt principal as of December 31, 2005 were as follows:

 

| **Year Ending March 31,** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|
| **(In thousands)**             | ** ** | ** ** | ** ** |
| Remainder of  2006             |       | $          | 324        |   |
| 2007                           |       | 1,918      |       |
| 2008                           |       | 1,896      |       |
| 2009                           |       | 208        |       |
| 2010                           |       | 9,850      |       |
|                           |       | $          | 14,196     |   |
|                                |            |            |            |  |  |

 

**5.  Commitments and Contingencies**

 

**Litigation and Other Contingencies**

 

On June 29, 2004, asupplier to Mariner Networks, Inc., the Company’s former subsidiary, fileda complaint in Orange County Superior Court against the Company allegingvarious breaches of written contract claims arising out of alleged purchaseorders.  The plaintiff in this lawsuitseeks monetary damages aggregating approximately $850,000 plus attorney feesand related costs.  Discovery hascommenced, and a trial date has been set for May 2006.  The Company intends to vigorously defenditself against these allegations.  Due tothe uncertainty of the outcome, the Company has not recorded any amounts in theaccompanying condensed consolidated financial statements in connection withthis matter; however, should the ultimate resolution of this claim beunfavorable, it could have an adverse material impact on the Company’s consolidatedfinancial position, results of operations and cash flows.

 

In June 2004, theCompany received $949,000 in cash as part of a settlement between RockwellInternational and the Michigan Department of Transportation, pursuant to whichthe Company was a third party beneficiary. This amount is reflected in other income in the condensed consolidatedstatement of operations for the nine month period ended December 31, 2004.

 

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

 

Furthermore, from time to time, the Companyhas experienced unforeseen developments in contingencies related to its formersubsidiaries.  In addition to the lawsuitmentioned above, the Company has been the subject of a number of routine taxaudits for time periods and jurisdictions related to the businesses of itsformer subsidiaries, some of which are still in process.  Although the development and ultimate outcomeof these and other unforeseen matters cannot be predicted with any certainty,management does not believe that the Company is presently involved in anymatters related to its former subsidiaries, except as described above, that wouldhave a material adverse effect on the Company’s consolidated results of operations,financial position or cash flows.

 

14

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**Operating Lease Commitments**

 

The Company has leasecommitments for facilities in various locations throughout the United States.Future commitments under these non-cancelable operating leases at December 31,2005, including the lease for the Company’s Anaheim facilities were as follows:

 

| **Fiscal Year Ending  March 31,** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------|------------|
| **(In thousands)**                     | ** ** | ** ** | ** ** |
| Remainder of  2006                     | ** ** | **$**      | **349**    | ** ** |
| 2007                                   | ** ** | **1,288**  | ** ** |
| 2008                                   | ** ** | **792**    | ** ** |
| 2009                                   | ** ** | **103**    | ** ** |
| 2010                                   | ** ** | **85**     | ** ** |
| Thereafter                             | ** ** | **43**     | ** ** |
| Total                                  | ** ** | **$**      | **2,660**  | ** ** |

 

**6.  Business Segment Information**

 

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

 

The following table setsforth selected unaudited financial information for the Company’s reportablesegments for the three and nine month periods ended December 31, 2005 and 2004:

 
| ** **                                         | ** ** | **Roadway  Sensors** | ** ** | **Vehicle  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|----------------------|------------|----------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                         | ** ** | ** **           | ** ** | **(In thousands)**   | ** ** | ** **                  | ** ** |
| **Three  Months Ended December 31, 2005**          |       |                 |       |                 |       |                        |       |      |       |
| Product  revenue from external customers           |       | $                    | 5,234      |                 | $          | 1,401                       | ** ** | **$**     | **—** |   | $ | 6,635 |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 641                  |       | 4,907                       |       | 5,548     |       |
| Depreciation  and amortization                     |       | 35                   |       | 52                   |       | 55                          |       | 142       |       |
| Segment  income (loss)                             |       | 709                  |       | (558                 | )          | 411                         |       | 562       |       |
|                                               |       |                 |       |                 |       |                        |       |      |       |
| **Three  Months Ended December 31, 2004**          |       |                 |       |                 |       |                        |       |      |       |
| Product  revenue from external customers           |       | $                    | 5,654      |                 | $          | 1,177                       | ** ** | **$**     | **—** |   | $ | 6,831 |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 745                  |       | 4,138                       |       | 4,883     |       |
| Depreciation  and amortization                     |       | 30                   |       | 30                   |       | 107                         |       | 167       |       |
| Segment  income (loss)                             |       | 1,080                |       | (280                 | )          | 400                         |       | 1,200     |       |
|                                               |       |                 |       |                 |       |                        |       |      |       |
| **Nine  Months Ended December 31, 2005**           |       |                 |       |                 |       |                        |       |      |       |
| Product  revenue from external customers           |       | $                    | 16,380     |                 | $          | 4,600                       | ** ** | **$**     | **—** |   | $ | 20,980 |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 1,796                |       | 14,201                      |       | 15,997    |       |
| Depreciation  and amortization                     |       | 98                   |       | 134                  |       | 206                         |       | 438       |       |
| Segment  income (loss)                             |       | 2,372                |       | (1,866               | )          | 1,507                       |       | 2,013     |       |
|                                               |       |                 |       |                 |       |                        |       |      |       |
| **Nine  Months Ended December 31, 2004**           |       |                 |       |                 |       |                        |       |      |       |
| Product  revenue from external customers           |       | $                    | 16,897     |                 | $          | 2,849                       | ** ** | **$**     | **—** |   | $ | 19,746 |   |
| Service and  other revenue from external customers | ** ** | **—**           |       | 2,384                |       | 12,785                      |       | 15,169    |       |
| Depreciation  and amortization                     |       | 85                   |       | 84                   |       | 300                         |       | 469       |       |
| Segment  income (loss)                             |       | 3,077                |       | (974                 | )          | 937                         |       | 3,040     |       |

 

15

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The following table reconcilessegment income to consolidated loss before income taxes and minority interest:

 
| ** **                                          | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|------------------------------------------|------------|
| ** **                                          | ** ** | **2005**                             | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | ** **                           | ** ** | **(In thousands)**                       | ** ** | ** ** | ** ** |
| Total income  for reportable segments               | ** ** | **$**                                | **562**    |                                     | $          | 1,200 | ** ** | **$** | **2,013** |   | $ | 3,040 |   |
| Unallocated  amounts:                               |       |                                 |       |                                     |       |   |   |   |   |
| Corporate expenses and other income  (expense), net | ** ** | **(305**                             | **)**      | (13,134                                  | )          | **(2,102** | **)** | (12,964 | ) |
| Interest expense, net                               | ** ** | **(377**                             | **)**      | (298                                     | )          | **(1,087** | **)** | (838 | ) |
| Loss before  income taxes and minority interest     | ** ** | **$**                                | **(120**   | **)**                                    | $          | (12,232 | ) | **$** | **(1,176** | **)** | $ | (10,762 | ) |

 

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

 

*This report, including thefollowing discussion and analysis, contains forward-looking statements (withinthe meaning of the Private Securities Litigation Reform Act of 1995) that arebased on our current expectations, estimates and projections about our businessand our industry, and reflect management’s beliefs and certain assumptions madeby us based upon information available to us as of the date of this report.When used in this report and the information incorporated herein by reference,the words “expect(s),” “feel(s),” “believe(s),” “should,” “will,” “may,” “anticipate(s),”“estimate(s)” and similar expressions or variations of these words are intendedto identify forward-looking statements. These forward-looking statementsinclude but are not limited to statements regarding our anticipated sales,revenue, expenses, profits, capital needs, competition, development plans,backlog and manufacturing capabilities, the applications for and acceptance ofour products and services, the status of our facilities and product development,and the impact of pending litigation. These statements are not guarantees offuture performance and are subject to certain risks and uncertainties whichcould cause actual results to differ materially from those projected. Youshould not place undue reliance on these forward-looking statements that speakonly as of the date hereof. We undertake no obligation to republish revisedforward-looking statements to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events. We encourage youto carefully review and consider the various disclosures made by us whichdescribe certain factors which could affect our business, including in* “*Risk Factors” set forth**below, before deciding to invest in our company orto maintain or increase your investment. We undertake no obligation to reviseor update publicly any forward-looking statement for any reason.*

 

**Overview**

 

We are a leading provider of outdoor machine visionsystems and sensors that optimize the flow of traffic and enhance driversafety. Using our proprietary software and ITS industry expertise, we providevideo sensor systems and transportation management systems and travelerinformation and other engineering services to the ITS industry. We use ouroutdoor image recognition software expertise to develop proprietary algorithmsfor video sensor systems that improve vehicle safety and the flow of traffic.Using our knowledge of the ITS industry, we design and implement transportationmanagement systems that help public agencies reduce traffic congestion andprovide greater access to traveler information.

 

Our Vantage product is a video vehicle detection system that detectsthe presence of vehicles on roadways. Vantage systems are used at signalized intersections to enable a moreefficient allocation of green signal time and are also used for incidentdetection and highway traffic data collection applications. We sell anddistribute our Vantage products primarily to commercial customers and municipalagencies.

 

Our AutoVue Lane Departure Warning (“LDW”) systems consist of a smallwindshield mounted sensor that uses proprietary software to detect and warndrivers of unintended lane departures. Approximately 20,000 production AutoVueunits have been sold for truck platforms in the North American and European markets.  Our AutoVue LDW systems are currently offeredas an option on certain Mercedes, MAN, Freightliner and Internationaltrucks.  In September 2003, weentered into an agreement with Valeo Schalter and Sensuren GmbH (“Valeo”), pursuantto which we granted Valeo the exclusive right to sell and manufacture ourAutoVue LDW systems to the worldwide passenger car market in exchange forroyalty payments for each AutoVue LDW unit sold.  To date, royalty payments from Valeo have notbeen significant.  Pursuant to thisagreement, we also provide specific contract engineering services, technicalmarketing and sales support to Valeo to enable the launch of our LDW technologyon three Infiniti platforms, the FX, M and Q, where the device is offered aspart of the technology option package. Valeo is currently in negotiations to provide our LDW system to otherpassenger car OEMs; however, we cannot assure you that such negotiations willbe successful.  We plan to continue to providetechnical marketing and sales support to Valeo in our efforts to win new OEMcustomers for the passenger car market as well as contract engineering servicesrelated to the possible launch of new Infiniti platforms that include our LDWsystem.  We believe that AutoVue is abroad sensor platform that, through additional software development, may beexpanded to incorporate additional safety and convenience features.

 

Our transportation management systems business includes transportationengineering and consulting services focused on the planning, design,development and implementation of software-based systems that integratesensors, video surveillance, computers and advanced communications equipment toenable public agencies to monitor, control and direct traffic flow, assist inthe quick dispatch of emergency crews and distribute real-time informationabout traffic conditions.  Our servicesinclude planning and other engineering for the implementation of transportationinfrastructure and related communications systems, analysis and study relatedto goods movement and commercial vehicle operations, and parking systemsdesigns.  These services and systems aresold to local, state and national transportation agencies in the UnitedStates.  Our transportation managementsystems business is largely dependent upon governmental funding and budgetaryissues.  The

 

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Federal Highway Bill was passed in August2005, which provides for a significant increase in transportation funding overthe next six years.  Historically therehave been significant delays between the passage of funding bills and theallocation of related funding to specific contracts.  Accordingly, we cannot currently predict theimpact that the passage of this bill will have on our transportation managementsystems business.

 

We currently operate in three reportable segments: Roadway Sensors,Vehicle Sensors and Transportation Systems. The Roadway Sensors segmentincludes our Vantage vehicle detection systems for traffic intersection control,incident detection and certain highway traffic data collectionapplications.  The Vehicle Sensorssegment is comprised of all activities related to our AutoVue LDW systems forvehicle safety. The Transportation Systems segment includes transportation engineeringand consulting services and the development of transportation management andtraveler information systems for the ITS industry.

 

**Mergerwith Iteris Subsidiary**

 

During our fiscal year ended March 31, 2005, we completed themerger of our Iteris Subsidiary into us. This merger included the following transactions:

 

•  In May 2004, we repurchased all of theoutstanding shares of Series A preferred stock of the Iteris Subsidiaryfor an aggregate purchase price of approximately $17.5 million in cash, and wepurchased 548,000 shares of the Iteris Subsidiary common stock from DCV inconsideration for the issuance of 1.2 million shares of our common stock.  We financed the purchase price for the IterisSubsidiary Series A preferred stock through the issuance of convertibledebentures in the original principal amount of $10.1 million, a $5.0 millionterm note payable to our bank and $2.4 million in cash.

 

•  In June 2004, we issued 2.6 millionshares of our common stock valued at $8.6 million at the date of issuance inexchange for an aggregate of 1.3 million shares of common stock of the IterisSubsidiary, which had the effect of reducing the residual minority interest inour Iteris Subsidiary to 8.1%.

 

•  In October 2004, we merged the IterisSubsidiary into us and the remaining minority interest in the Iteris Subsidiary(consisting of 1.2 million shares of common stock of the Iteris Subsidiary) wasconverted to 2.5 million shares of our common stock valued at $7.6 million atthe merger date.  Immediately followingthe merger, we converted all of our outstanding Class B common stock(922,000 shares) into 1.0 million shares of our common stock (formerlydesignated as Class A common stock). In connection with this merger, we also assumed all of the outstanding optionsand warrants to purchase common stock of the Iteris Subsidiary, whichaggregated 6.1 million and 655,000 shares, respectively, of our common stock.

 

•  In October 2004, we amended ourcertificate of incorporation to (a) change the voting rights of our Class Acommon stock from one-tenth to one vote per share, (b) remove the abilityto issue any further shares of Class B common stock, and (c) renameour Class A common stock as common stock. As a result, we currently haveonly one class of common stock outstanding, the common stock.

 

**Critical Accounting Policies and Estimates**

 

Management’sDiscussion and Analysis of Financial Conditions 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 thecollectibility of accounts receivable, the valuation of inventories and therecoverability of long-lived assets and goodwill. We base these estimates onhistorical 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 reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of revenues 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.

 

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*Revenue Recognition*.  We record product revenues and related costsof sales upon transfer of title, which is generally upon shipment or, if required, uponacceptance by the customer, provided that we believe collectibility of the netsales amount is reasonably assured. Accordingly, at the date revenue is recognized, the significantuncertainties concerning the sale have been resolved.

 

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

 

Inaddition to product and contract revenues, we derive revenue from technologyaccess fees, the provision of specific non-recurring contract engineeringservices related to our AutoVue LDW system, and royalties related to unit salesof our AutoVue LDW systems by our strategic partner Valeo to the passenger carmarket. Technology access fee revenues are recognized evenly over the period inwhich they are earned.  Non-recurringcontract engineering revenues are recognized in the period in which the relatedservices are performed.  Royalty revenuesare recorded based on unit sales of our products by Valeo and are recognized inthe period in which such sales occur. Technology access fee revenues, contract engineering revenues androyalty revenues are included in net sales in the accompanying condensedconsolidated statements of operations.

 

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

 

*Accounts Receivable*.  We estimate the collectibility of customerreceivables on an ongoing basis by periodically reviewing invoices outstanding greater than acertain period of time.  We have recordedreserves for receivables deemed to be at risk for collection as well as ageneral reserve based on our historical collections experience.  A considerable amount of judgment is requiredin assessing the ultimate realization of trade receivables, including thecurrent credit-worthiness of each customer. If the financial condition of our customers deteriorates, resulting in animpairment of their ability to make required payments, additional allowancesmay be required that could adversely affect our operating results.

 

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

 

*Goodwill*. Goodwill is tested for impairment annually in the fourth fiscal quarterat the reporting unit level unless a change in circumstances indicates thatmore frequent impairment analysis is required. Impairment, if any, is measured based on the estimated fair value of thereporting units with the recorded goodwill. Fair value is determined by using the income approach methodology ofvaluation which utilizes discounted cash flows. Significant management judgment is required in the forecasts of futureoperating results that are used in the discounted cash flow method ofvaluation.  In estimating future cashflows, we generally use the financial assumptions in our current budget and ourcurrent strategic plan, subject to modification as considered necessary,including sales and expense growth rates and the discount rates we estimate torepresent our cost of funds.  It ispossible, however, that the plans and estimates used may be incorrect.  If our actual results, or the plans andestimates used in future impairment analyses, are lower than the originalestimates used to assess the recoverability of goodwill, we could incurimpairment charges.

 

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

 

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

 

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

 

**Results of Operations**

 

The following table sets forth certain statement of operations data asa percentage of total net sales and contract revenues for the periodsindicated. The following table should be read in conjunction with Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

 
| ** **                                      | ** ** | **Three Months  Ended  December 31,** |       | **Nine Months  Ended  December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                      | ** ** | **2005**                              | ** ** | **2004**                             |       | **2005** | ** ** | **2004** | ** ** |
| Net sales and contract revenues:                |       |                                  | ** ** |                                 |       |   | ** ** |   |   |
| Net sales                                       | ** ** | **59.7**                              | **%**      | 64.7                                 | %          | **61.6** | **%** | 63.4 | % |
| Contract revenues                               | ** ** | **40.3**                              | ** ** | 35.3                                 |       | **38.4** | ** ** | 36.6 |   |
| Total net sales and contract revenues           | ** ** | **100.0**                             | ** ** | 100.0                                |       | **100.0** | ** ** | 100.0 |   |
| Costs and expenses:                             |       |                                  | ** ** |                                 |       |   | ** ** |   |   |
| Cost of net sales                               | ** ** | **32.0**                              | ** ** | 34.1                                 |       | **32.1** | ** ** | 34.0 |   |
| Cost of contract revenues                       | ** ** | **26.8**                              | ** ** | 22.8                                 |       | **24.7** | ** ** | 23.9 |   |
| Gross profit                                    | ** ** | **41.2**                              | ** ** | 43.1                                 |       | **43.2** | ** ** | 42.1 |   |
| Operating expenses:                             |       |                                  | ** ** |                                 |       |   | ** ** |   |   |
| Selling, general and administrative             | ** ** | **29.2**                              | ** ** | 34.2                                 |       | **30.3** | ** ** | 30.9 |   |
| Research and development                        | ** ** | **9.5**                               | ** ** | 9.0                                  |       | **11.3** | ** ** | 7.8 |   |
| Stock-based compensation                        | ** ** | **0.8**                               | ** ** | 98.1                                 |       | **1.7** | ** ** | 32.9 |   |
| Disposal of fixed assets                        | ** ** | **—**                            | ** ** | 3.6                                  |       | **—** | ** ** | 1.2 |   |
| Acquired in-process research and  development   | ** ** | **—**                            | ** ** | 0.2                                  |       | **—** | ** ** | 0.4 |   |
| Deferred compensation plan                      | ** ** | **(0.7**                              | **)**      | —                               |       | **(0.0** | **)** | — |   |
| Amortization of intangible assets               | ** ** | **0.3**                               | ** ** | 0.4                                  |       | **0.3** | ** ** | 0.2 |   |
| Total operating expenses                        | ** ** | **39.1**                              | ** ** | 145.4                                |       | **43.5** | ** ** | 73.5 |   |
| Operating income (loss)                         | ** ** | **2.1**                               | ** ** | (102.4                               | )          | **(0.3** | **)** | (31.4 | ) |
| Non-operating income (expense):                 |       |                                  | ** ** |                                 |       |   | ** ** |   |   |
| Other income (expense), net                     | ** ** | **(0.0**                              | **)**      | 0.5                                  |       | **0.0** | ** ** | 3.0 |   |
| Interest expense, net                           | ** ** | **(3.1**                              | **)**      | (2.5                                 | )          | **(2.9** | **)** | (2.4 | ) |
| Loss before income taxes and minority  interest | ** ** | **(1.0**                              | **)**      | (104.4                               | )          | **(3.2** | **)** | (30.8 | ) |
| Income tax (expense) benefit                    | ** ** | **2.1**                               | ** ** | 0.4                                  |       | **1.2** | ** ** | (0.1 | ) |
| Minority interest in earnings of subsidiary     | ** ** | **—**                            | ** ** | (0.4                                 | )          | **—** | ** ** | (1.4 | ) |
| Net income (loss)                               | ** ** | **1.1**                               | **%**      | (104.4                               | )%         | **(2.0** | **)%** | (32.3 | )% |

 

**Analysis of Quarterly Results of Operations**

 

*Net Sales and Contract Revenues*. Net sales consist principally of sales of our Vantage video detection systemsand AutoVue LDW systems, as well as technology access fees, contractengineering revenue and royalty revenue generated from AutoVue relatedactivities.  Contract revenue consists principally of revenue derived fromsystems integration and ITS consulting services with federal, state, county andmunicipal agencies. We currently have a diverse customer base with our largestcustomer constituting 11.2% of total net sales and contract revenues in thethree months ended December 31, 2005 and 11.8% of total net sales and contractrevenues in the nine months ended December 31, 2005.

 

Total net sales and contract revenues increased 4.0% and 5.9% to $12.2million and $37.0 million for the three and nine months ended December 31,2005, respectively, compared to $11.7 million and $34.9 million in thecorresponding periods in the prior fiscal year. These increases were the netresult of increased contract revenues and increased net sales of our AutoVueproducts and services offset by decreased net sales of our Vantage products, asdiscussed below.

 

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Net sales decreased 4.0% to $7.3 million for the three months endedDecember 31, 2005 as compared to the corresponding period of the prior fiscalyear and increased 2.9% to $22.8 million for the nine months ended December 31,2005 compared to $22.1 million in the corresponding period in the prior fiscalyear. The three and nine month periods both reflect increased unit salesof our AutoVue LDW systems.  Net sales from AutoVue products increased 19.6%and 59.8% in the three and nine month periods ended December 31, 2005,respectively, compared to the corresponding periods in the prior year. Theincrease in sales of AutoVue products was principally related to increased unitsales of LDW systems in the European and North American commercial heavy truckmarkets. Overall sales of AutoVue products and services, which also includetechnology access fees, contract engineering revenue and royalty revenue,increased 6.0% in the current quarter to $2.0 million and 22.2% to $6.4 millionfor the nine month period compared to $1.9 million and $5.2 million in thecorresponding periods in the prior fiscal year.

 

The increased sales of our AutoVue products and services were offset bya 7.4% and 3.1% decrease in Vantage video detection systems sales in the threeand nine month periods ended December 31, 2005, respectively, compared to thecorresponding periods in the prior fiscal year.  In unit terms, Vantage sales growth continuesto increase primarily due to increased market adoption of video-based detectiontechnologies for traffic intersection management and our ability to obtainadditional contracts with state departments of transportation.  The effects of increased unit shipments ofVantage products was more than offset by decreased average selling prices dueto the changeover to new lower priced units, an underperforming dealer in theCalifornia market and delays in several significant projects.  We expect Vantage sales to be relatively flatin unit terms for the quarter ending March 31, 2005 as compared to the quarterended December 31, 2005 due to the impact of winter weather conditions in manyof our markets.  The majority of Vantagesales are generated in North America.

 

Contract revenues increased 18.6% to $4.9 million for the three monthsended December 31, 2005 as compared to the corresponding period of the priorfiscal year and increased 11.1% to $14.2 million for the nine months ended December31, 2005 compared to $12.8 million in the corresponding period in the priorfiscal year. The increase in contract revenues was primarily fueled byincreased activity in the California market. Contract revenues reflect a broad range of fixed price and cost plusfixed fee contracts for engineering study and design, systems integration andsystem implementation.  Contract revenues are dependent upon the continuedavailability of funding on both the state and federal levels from the variousdepartments of transportation.  All of our contract revenue is currentlyderived from work performed in North America.

 

*Gross Profit*. Total gross profit was flat at $5.0 million for the three months ended December31, 2005 and increased 8.7% to $16.0 million for the nine months ended December 31,2005 compared to $14.7 million in the corresponding period of the prior fiscalyear.  Total gross profit as a percent ofnet sales and contract revenues decreased to 41.2% for the three months endedDecember 31, 2005 as compared to 43.1% for the three months ended December 31,2004 and increased to 43.2% for the nine months ended December 31, 2005 ascompared to 42.1% in the corresponding period of the prior fiscal year.

 

Gross profit as a percentage of net sales was 46.5% for the threemonths ended December 31, 2005 compared to 47.2% in the corresponding period ofthe prior fiscal year and 47.9% for the nine months ended December 31, 2005compared to 46.3% in the corresponding period of the prior fiscal year.  Forthe three month period ended December 31, 2005, gross profit as a percentage ofsales declined from the same period in the prior fiscal year primarily due toincreased sales of sample AutoVue LDW units in the prior year.  We typically sell such sample units at a muchhigher price point and achieve a higher gross profit.  Both the three and nine month periods endedDecember 31, 2005 benefited from increased margins related to the Vantagebusiness as a result of lower material and sustaining engineering costs onnewer product offerings.

 

Gross profit as a percentage of contract revenues decreased to 33.4%for the three months ended December 31, 2005 compared to 35.5% in thecorresponding period of the prior fiscal year and increased to 35.7% for the ninemonths ended December 31, 2005 compared to 34.7% in the corresponding period ofthe prior fiscal year.  The decrease in gross profit as a percentage ofcontract revenues in the three month period ended December 31, 2005 wasprimarily due to increased payroll costs. For the nine month period ended December 31, 2005, the increase in grossprofit as a percentage of contract revenues reflects a mix of higher margincontracts in the period as compared to the corresponding period of the priorfiscal year.

 

*Selling, General and Administrative Expense*. Selling, general and administrative expense decreased 11.2% to $3.6 million (or29.2% of total net sales and contract revenues) in the three months ended December31, 2005 compared to $4.0 million (or 34.2% of total net sales and contract revenues)in the corresponding period of the prior fiscal year, and increased 3.6% to $11.2million (or 30.3% of total net sales and contract revenues) in the nine monthsended December 31, 2005 compared to $10.8 million (or 30.9% of total net salesand contract revenues) in the corresponding period of the prior fiscal year.

 

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The decrease in selling, general and administrative expenses for thethree month period ended December 31, 2005 as compared to the three monthperiod ended December 31, 2004 was primarily due to a higher level of costsincurred in the prior year in connection with the merger of the IterisSubsidiary into us.  For the nine monthperiod ended December 31, 2005, selling, general and administrative expensesincreased over the prior year largely as a result of increased auditing andaccounting fees incurred by the Company as a direct result of the restatementof the our March 31, 2004, financial statements issued in July 2005,as well as additional consulting fees incurred by us related to preparation forSarbanes-Oxley compliance.  Beginning inthe most recent fiscal quarter, we have significantly reduced our Sarbanes-OxleySection 404 implementation efforts after determining that we will not berequired to comply with Section 404 until our fiscal year endingMarch 31, 2007 at the earliest.  Wewill continue to monitor requirements related to Sarbanes-Oxley Section 404compliance and may determine the need to increase related expenditures again inthe near future to reach compliance by the end of our fiscal year ending March31, 2007.

 

*Research and Development Expense*. Research and development expense increased 9.3% to $1.2 million (or 9.5% oftotal net sales and contract revenues) in the three months ended December 31,2005 compared to $1.1 million (or 9.0% of total net sales and contractrevenues) in the corresponding period of the prior fiscal year and increased 53.6%to $4.2 million (or 11.3% of total net sales and contract revenues) in the ninemonths ended December 31, 2005 compared to $2.7 million (or 7.8% of totalnet sales and contract revenues) in the corresponding period of the priorfiscal year.

 

The increase in research and development expense in the current threeand nine month periods reflects increased spending on development of AutoVueand Vantage products.  AutoVue product development has primarily relatedto the development of our next generation LDW unit for the heavy truck marketand was largely focused on re-engineering and qualification of a newimager.  In October 2005, the nextgeneration LDW unit was approved for production by our largest truck customerand shipments of this new unit began in our third fiscal quarter. Although theAutoVue development team must qualify the new unit for use by each additionalheavy truck customer, we believe the time and cost of future qualificationsshould decrease as additional heavy truck customers adopt this new unit.  Vantage product development primarilyreflects activities for product line extensions to support new communicationsplatforms and to accommodate new camera designs.

 

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

 

*Stock-Based Compensation Expense.*On October 22, 2004, as a result of the merger with our Iteris Subsidiary, werecorded an $11.3 million non-cash charge for stock-based compensation inconnection with the assumption and exchange of vested Iteris Subsidiary stockoptions for stock options immediately exercisable for our common stock.  This charge was based on the differencebetween the fair market value of our common stock on the October 22, 2004merger date and the exercise price of the modified stock options.  At the time of the merger, we also recorded$1.4 million in deferred compensation expense related to the unvested IterisSubsidiary stock options assumed by us. This amount is being amortized to stock-based compensation expense asthe options vest.  Non-cash charges of$103,000 and $626,000 were recorded for the three and nine month periods endedDecember 31, 2005, respectively, and non-cash charges of $221,000 were recordedfor the three and nine month periods ended December 31, 2004, based on thevesting of these assumed unvested options. The remaining deferred stock-based compensation balance of $194,000 atDecember 31, 2005 will be amortized over our next three fiscal quarters.

 

*Deferred Compensation Plan Expense.*  Duringthe three and nine month periods ended December 31, 2005, we recorded non-cash benefitsof $90,000 and $12,000, respectively, related to the depreciation in value of310,510 shares of our common stock held in trust by our deferred compensationsavings plan.  No changes in value wererecorded in the corresponding periods of the prior fiscal year.

 

*Other Income (Expense), Net*. Other income, net reflects the following:

 
| ** **                    | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                    | ** ** | **2005**                                  |       | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                    | ** ** | ** **                                | ** ** | **(In  thousands)**                      | ** ** | ** ** | ** ** |
| Gain on settlement of lawsuit |       | **$**                                     | **—** | ** **                               | $          | — |   | **$** | **—** |   | $ | 949 |   |
| Other                         |       | **(6**                                    | **)**      | 60                                       |       | **32** |   | 91 |   |
| Other income (expense), net   |       | **$**                                     | **(6**     | **)**                                    | $          | 60 |   | **$** | **32** |   | $ | 1,040 |   |

 

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Other income (expense), net for the nine months ended December 31, 2004primarily reflects a $949,000 gain recognized on the settlement of litigationbetween Rockwell International and the Michigan Department of Transportation inwhich we were a third party beneficiary.

 

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

 
| ** **                              | ** ** | **Three Months Ended  December 31,** |       | **Nine Months Ended  December 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                              | ** ** | **2005**                             | ** ** | **2004**                            |       | **2005** | ** ** | **2004** | ** ** |
| ** **                              | ** ** | ** **                           | ** ** | **(in thousands)**                  | ** ** | ** ** | ** ** |
| Interest  expense                       | ** ** | **$**                                | **(292**   | **)**                               | $          | (205 | ) | **$** | **(829** | **)** | $ | (623 | ) |
| Amortization  of deferred finance costs | ** ** | **(34**                              | **)**      | (39                                 | )          | **(103** | **)** | (83 | ) |
| Amortization  of debt discount          | ** ** | **(51**                              | **)**      | (54                                 | )          | **(155** | **)** | (132 | ) |
| Interest  expense, net                  | ** ** | **$**                                | **(377**   | **)**                               | $          | (298 | ) | **$** | **(1,087** | **)** | $ | (838 | ) |

 

Interest expense increased 26.5% for the three month period ended December31, 2005 compared to the corresponding period in the prior fiscal year as aresult of a higher level of borrowings on our line of credit in the currentyear.  Interest expense increased 29.7%for the nine months ended December 31, 2005 compared to the correspondingperiod in the prior fiscal year.  Thisincrease was largely due to additional interest expense incurred related to the$5.0 million term debt entered into by the Iteris Subsidiary on May 28,2004 (which we assumed in October 2004), interest expense related to the$10.1 million convertible debentures issued by us on May 19, 2004, and theamortization of debt discounts anddeferred financing costs associated with the issuance of the convertibledebentures and related warrants.

 

*Income Taxes*. During the three and nine month periods ended December 31, 2005, we recognizedan income tax benefit of $256,000 and $431,000, respectively, as compared to anincome tax benefit of $51,000 in the three month period ended December 31,2004, and income tax expense of $24,000 for the nine month period endedDecember 31, 2004.  The tax benefitrecorded in the three and nine month periods ended December 31, 2005 primarilyreflects a reduction in the valuation allowance recorded against our deferredtax assets as a result of changes in estimates of the future realizability ofthese assets.  As a result, totaldeferred tax assets on our consolidated balance sheet increased from $660,000at March 31, 2005 to $1.1 million at December 31, 2005.  In the future, we may continue to recordsimilar adjustments to our deferred tax asset valuation allowance as ourestimates are updated.  We anticipatethis will likely cause our future effective tax rate in any given period tofluctuate significantly from prior effective tax rates, estimated effective taxrates and statutory tax rates.

 

*Minority Interest in Earnings of Subsidiary*. Minority interest in earnings of subsidiary represents the minoritystockholders’ share of the Iteris Subsidiary’s net income or loss combined withthe accretion of the redemption preference of the Iteris Subsidiary’sSeries A preferred stock.  The elimination of minority interest inthe three and nine month periods ended December 31, 2005 from $52,000 and $485,000in the three and nine month periods ended December 31, 2004, respectively, wasthe result of the merger of the Iteris Subsidiary into us on October 22,2004.

 

**Liquidity and Capital Resources**

 

*Cash Flows*

 

We have historically financed our operations with a combination of cashflows from operations, borrowings under credit facilities and the sale ofequity securities. We currently rely on cash flows from operations andborrowings on a line of credit facility to fund our operations, which webelieve to be sufficient to fund our operations for at least the next twelvemonths.  However, should a shortfalloccur, we believe we could obtain additional funds through additionalborrowings or the sale of equity securities. At December 31, 2005, we had $3.3 million in working capital, whichincluded borrowings of $1.4 million on our revolving line of credit and nocash.  This compares to working capitalof $2.2 million, $46,000 in cash and an outstanding revolving line of creditbalance of $945,000 at March 31, 2005. Our operations provided $941,000 of cash during the nine month periodended December 31, 2005, primarily as a result of planned decreases in inventoryto a level more in line with target inventory levels, partially offset by a netdecrease in accounts payable and accrued expenses and an increase in net costsand estimated earnings in excess of billings on uncompleted contracts.  During the nine months ended December 31,2004, our operations provided $811,000 of cash, primarily due to the receipt of$949,000 related to a legal settlement between Rockwell International and theMichigan Department of Transportation to which we were a third party beneficiary.

 

Our investing activities for the nine month periods ended December 31,2005 and 2004 consisted primarily of purchases of property and equipment, whichaggregated $716,000 and $425,000, respectively. In the current fiscal year, capital expenditures have increasedsignificantly primarily due to hardware, software and related labor costs toimplement a new enterprise resource management system, which is expected to beput into use at the beginning of our next fiscal year.  We expect to continue to invest heavily inthis new system over the next three to six months.

 

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Cash used in financing activities was $271,000 in the nine month periodended December 31, 2005, which was the result of net payments againstborrowings of $536,000 offset by cash inflows of $265,000 from the exercise ofoutstanding stock options and warrants to purchase our common stock.  During the nine month period ended December31, 2004, financing activities used $3.0 million of cash, which was comprisedof net cash outflows of approximately $3.1 million related to the mergeractivities described more fully above under the caption “Merger with IterisSubsidiary” and in Note 3 to the accompanying condensed consolidated financialstatements, partially offset by net payments against borrowings of $364,000 and$494,000 in proceeds from the exercise of stock options and warrants topurchase our common stock.

 

*Borrowings*

 

The following table summarizes our borrowings andlong-term debt:

 
| ** **                   | ** ** | **At December 31, 2005** | ** ** |
|------------------------------|------------|--------------------------|------------|
| ** **                   | ** ** | **(In thousands)**       | ** ** |
| Convertible  debentures, net | ** ** | $                        | 9,151      | ** ** |
| Bank term  note              |       | 3,021                    |       |
| Promissory  note to landlord |       | 1,292                    |       |
| 4% note  payable             |       | 34                       |       |
| Revolving  line of credit    |       | 1,389                    |       |
|                         |       | $                        | 14,887     |   |

 

Effective August 1, 2005, we renewed our credit agreement with ourbank.  This credit agreement, whichexpires on July 31, 2006, provides for borrowings of up to $5.0 million subjectto a borrowing formula based upon qualified accounts receivable and inventoriesas defined in the credit agreement.  At December31, 2005, we had $3.3 million available under the revolving line of credit, ofwhich $1.9 million was unused.  Webelieve the combination of available borrowings on our line of credit and ourinternally generated cash flows will be sufficient to enable us to execute ouroperating plans and meet our obligations on a timely basis for at least thenext twelve months.

 

**Contractual Obligations**

 

Our contractual obligations are as follows at December 31, 2005:

 
| ** **              | ** ** | **Payments Due by Period** | ** ** |
|-------------------------|------------|----------------------------|------------|
| ** **              | ** ** | **2006**                   | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **              | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | **(In thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Lines of  credit        |       | $                          | 1,389      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,389 |   |
| Notes  payable          |       | 324                        |       | 1,918 |   | 1,896 |   | 208 |   | — |   | — |   | 4,346 |   |
| Convertible  debentures |       | —                     |       | — |   | — |   | — |   | 9,850 |   | — |   | 9,850 |   |
| Operating  leases       |       | 349                        |       | 1,288 |   | 792 |   | 103 |   | 85 |   | 43 |   | 2,660 |   |
| Total                   |       | $                          | 2,062      |   | $ | 3,206 |   | $ | 2,688 |   | $ | 311 |   | $ | 9,935 |   | $ | 43 |   | $ | 18,245 |   |
|                         |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Recent Accounting Pronouncements**

 

InNovember 2004, theFASB issued SFAS 151, which clarifies the accounting for abnormal amounts ofidle facility expense, freight, handling costs, and wasted material.  SFAS 151 will be effective for inventorycosts incurred during fiscal years beginning after June 15, 2005.  We do not believe the adoption of SFAS 151will have a material impact on our financial statements.

 

OnDecember 16, 2004, the FASB issued SFAS 123R, which replaces SFAS 123,supersedes APB 25, and amends SFAS 95. Generally, theapproach in SFAS 123R is similar to the approach described in SFAS 123.  However, SFAS 123R requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values (i.e., proforma disclosure is no longer an alternative to financial statement recognition).  In accordance with SEC ReleaseNo. 33-8568, SFAS 123R will be effective for us beginning April 1,2006.  We are currently assessing theimpact of SFAS 123R.  As of the date ofthis filing, we have not yet concluded as to whether we will apply the modifiedprospective or retrospective transition method of application; therefore, theeffect of adoption cannot be determined at this time.

 

In May 2005, the FASB issued SFAS 154, which requires retroactiveapplication of a voluntary change in accounting principle to prior periodfinancial statements unless it is impracticable. SFAS 154 also requires that achange in method of depreciation, amortization, or depletion for long-lived,non-financial assets be accounted for as a change in accounting estimate thatis affected by a change in accounting principle. SFAS 154 replaces APB 20 andSFAS 3.  We are required to adopt theprovisions of SFAS 154 in our fiscal year ending March 31, 2007, and arepresently evaluating what effect the adoption of the provisions of SFAS 154will have on our consolidated financial statements.

 

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**ITEM 3.  QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Ourexposure to interest rate risk is limited to our line of credit. Our line ofcredit bears interest based on the prevailing prime rate (7.25% at December 31,2005). A 10% increase in the interest rate on our line of credit (from 10.25%to 11.28%) would not have a material impact on our financial position,operating results or cash flows. In addition, we believe that the carryingvalue of our outstanding debt approximates fair value.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

Our management is responsible for establishing and maintaining adequateinternal control over financial reporting, as such term is defined in ExchangeAct Rule 13a-15(f). Under the supervision and with the participation ofour management, including our principal executive officer and principalfinancial officer, we conducted an evaluation of the effectiveness of ourinternal control over financial reporting and concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures wereeffective in timely alerting them to the material information involvingtransactions occurring in the normal course of business relating to us requiredto be included in the reports we file or submit under the Securities ExchangeAct of 1934, as amended.  We did,however, conclude that as of March 31, 2004, we had a material weakness relatedto the administration and proper accounting for certain types of contracts andagreements.

 

A material weakness is a control deficiency, or combination of controldeficiencies, that results in more than a remote likelihood that a materialmisstatement of the annual or interim financial statements will not beprevented or detected.  The materialweakness described above resulted in improper accounting treatment for theIteris Subsidiary’s Deferred Compensation Savings Plan and the restatement ofour audited consolidated financial statements for the year ended March 31,2004, with respect to deferred compensation expense and compensation savingsplan liabilities.

 

Management has responded to the above identified material weakness byperforming additional accounting, financial analysis and managerial review ofprocedures in order to ensure that the financial information contained in ourquarterly report on Form 10-Q is reliable. In January 2005, we hired acontroller to supplement our accounting and finance department. In addition, wehold regular disclosure committee meetings to improve communication regardingthe Company’s operations including contract administration.  During the most recent completed fiscalquarter covered by this report, there has been no change in our internalcontrols 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 controls overfinancial reporting.

 

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**PART II. OTHER INFORMATION**

 

**ITEM1.  LEGAL PROCEEDINGS**

 

Theinformation set forth under Note 5 of Notes to Unaudited Condensed ConsolidatedFinancial Statements, included in Part I, Item I of this report, isincorporated herein by reference.

 

**ITEM1A.  RISK FACTORS**

 

*Our business is subject to a number of risks,some of which are discussed below.  Otherrisks are presented elsewhere in this report and in our other filings with theSEC.  You should consider the followingrisks carefully in addition to the other information contained in this reportand our other filings with the SEC, including our subsequent reports on Forms10-Q and 8-K, before deciding to buy, sell or hold our common stock. The risksand uncertainties described below are not the only ones facing ourcompany.  Additional risks anduncertainties not presently known to us or that we currently deem immaterialmay also affect our business operations. If any of these risks actually occurs, our business, financial conditionor results of operations could be seriously harmed.  In that event, the market price for ourcommon stock could decline and you may lose all or part of your investment.*

 

**We HaveExperienced Substantial Losses And May Continue To Experience Losses ForThe Foreseeable Future.**  We experienced net losses from continuingoperations of $11.3 million, $1.9 million and $5.3 million in the years endedMarch 31, 2005, 2004 and 2003, respectively.  While we have divested all of our otherbusiness units and merged with our Iteris Subsidiary, we cannot assure you thatour efforts to downsize our operations or reduce our operating expenses willimprove our financial performance, or that we will be able to achieveprofitability on a quarterly or annual basis in the future. Most of ourexpenses are fixed in advance. As such, we generally are unable to reduce ourexpenses significantly in the short-term to compensate for any unexpected delayor decrease in anticipated revenues. As a result, we may continue to experienceoperating losses and net losses, which would make it difficult to fund ouroperations and achieve our business plan, and could cause the market price ofour common stock to decline.

 

**We May Need To Raise Additional Capital In The Future, WhichMay Not Be Available On Terms Acceptable To Us, Or At All.**  Wehave generated significant net losses and operating losses in recent periods,and have experienced volatility in our cash flows from operations ranging frompositive cash flows from operations of $858,000 in the year endedMarch 31, 2005, to negative cash flows from operations of $718,000 and$4.8 million in the years ended March 31, 2004 and 2003,respectively.  Additionally, we failed tomeet certain debt covenants under our credit agreement with our bank in two ofour last four fiscal quarters.  While wecompleted a $10.1 million convertible debenture financing and our IterisSubsidiary closed a $5.0 million term loan in May 2004, the majorityof the proceeds from such financings were used to purchase the Series Apreferred stock of our Iteris Subsidiary held by outside investors.

 

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

 

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

 

•              market acceptance of our productsand product enhancements, and the overall level of sales of our products;

 

•              our ability to control costs;

 

•              the supply of key components forour products;

 

•              our ability to generate netincome;

 

•              increased research and developmentexpenses;

 

•              increased sales and marketingexpenses;

 

•              technological advancements and ourcompetitors’ response to our products;

 

•              capital improvements to new andexisting facilities and enhancements to our infrastructure and systems;

 

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•              potential acquisitions ofbusinesses and product lines;

 

•              our relationships with customersand suppliers;

 

•              government budgets, politicalagendas and other funding issues;

 

•              our ability to successfullynegotiate credit arrangements with our bank; and

 

•              general economic conditions,including the effects of the current economic slowdown and internationalconflicts.

 

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

 

**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 to evaluate the effectiveness ofour internal controls over financial reporting at the end of each fiscal yearbeginning in our next fiscal year ending March 31, 2007 at the earliest,and to include a management report assessing the effectiveness of our internalcontrols over financial reporting in all annual reports beginning with our AnnualReport on Form 10-K for the fiscal year ending March 31, 2007 at theearliest.  Section 404 also requiresour independent accountant to attest to, and report on, management’s assessmentof our internal controls over financial reporting.  We may not be able to complete our Section404 compliance on a timely basis and even if we timely complete our compliancerequirements, our independent auditors may still conclude that our internalcontrols over financial reporting are not effective.

 

Our management, including our CEO and CFO, does notexpect that our internal controls over financial reporting will prevent allerror and all fraud.  A control system,no matter how well designed and operated, can provide only reasonable, notabsolute, assurance that the control system’s objectives will be met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs.  Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, within the company havebeen, or will be detected.  Theseinherent limitations include the realities that judgments in decision-makingcan be faulty and that breakdowns can occur because of simple error ormistake.  Controls can also becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of the controls.  The design of any system of controls is basedin part on certain assumptions about the likelihood of future events, and wecannot assure you that any design will succeed in achieving its stated goalsunder all potential future conditions. Over time, our controls may become inadequate because of changes inconditions or deterioration in the degree of compliance with policies orprocedures.  Because of the inherentlimitations in a cost-effective control system, misstatements due to error orfraud may occur and not be detected.

 

As of March 31, 2005, we became aware ofa material weakness in our internal controls related to the accounting for theconsolidation of our deferred compensation savings plan and certain contractadministration.  We cannot assure youthat we or our independent registered public accounting firm will not identifyadditional material weaknesses in our internal controls.  A material weakness is a control deficiency,or combination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected. Based on our evaluation, ourmanagement has concluded that, as of March 31, 2004, our internal controlover financial reporting was not effective due to the existence of one materialweakness. We may experience additional material weaknesses in the future.  If our internal controls overfinancial reporting are not considered adequate, we may experience a loss ofpublic confidence, which could have an adverse effect on our business and ourstock price.

 

**We May Experience Production Gaps OrDelays In the Transition To Our Next Generation LDW System And Have ExhaustedComponent Supplies For Our Legacy AutoVue LDW Systems, Which Could MateriallyAnd Adversely Impact Our Sales And Financial Results And The UltimateAcceptance Of AutoVue.** We are in the process

 

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of transitioning to production of a nextgeneration LDW system and have run out of certain components used in themanufacture of our AutoVue LDW units sold to the heavy truck market.  Although we have qualified our nextgeneration system with our largest customer, we must continue to qualify thenew system with our other customers.  Asa result, we could experience a gap or delay in production as we transition tothis next generation system.  In somecases, such gaps or delays may be driven by customer transition issues.  Additionally, it is possible that we couldexperience unforeseen quality control issues as we ramp up to full productionof our next generation LDW system. Should any such delay or disruption occur in transitioning to productionof our next generation LDW system, our sales will likely be materially andadversely affected.

 

**We Depend On Government Contracts And Subcontracts, And Because Many OfOur Government Contracts Are Fixed Price Contracts, Higher Than AnticipatedCosts Will Reduce Our Profit And Could Adversely Impact Our Operating Results.**  Asignificant portion of our sales were derived from contracts with governmentalagencies, either as a general contractor, subcontractor or supplier. Governmentcontracts represented approximately 37.4%, 48.2% and 53.8% of our total netsales and contract revenues for the years ended March 31, 2005, 2004 and2003, respectively. We anticipate that revenue from government contracts willcontinue to increase in the near future. Government business is, in general,subject to special risks and challenges, including:

 

•                                          longpurchase cycles or approval processes;

 

•                                          competitivebidding and qualification requirements;

 

•                                          theimpact of international conflicts;

 

•                                          performancebond requirements;

 

•                                          changesin government policies and political agendas;

 

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

 

•                                          othergovernment budgetary constraints and cut-backs; and

 

•                                          milestonerequirements and liquidated damage provisions for failure to meet contractmilestones

 

In addition, a large number of our governmentcontracts are fixed price contracts. As a result, we may not be able to recoverany cost overruns we may incur.  Thesefixed price contracts require us to estimate the total project cost based onpreliminary projections of the project’s requirements.  The financial viability of any given projectdepends in large part on our ability to estimate these costs accurately andcomplete the project on a timely basis. In the event our costs on these projects exceed the fixed contractualamount, we will be required to bear the excess costs.  Such additional costs would adversely affectour financial condition and results of operations.  Moreover, certain of our government contractsare subject to termination or renegotiation at the convenience of thegovernment, which could result in a large decline in our net sales in any givenquarter.  Our inability to address any ofthe foregoing concerns or the loss or renegotiation of any material governmentcontract could seriously harm our business, financial condition and results ofoperations.

 

**We Depend Upon Valeo To Market Our AutoVue Technologies For The OEMPassenger Car Market.**  We have granted Valeo the exclusiveright to sell and manufacture our AutoVue LDW system to the worldwide passengercar market in exchange for royalty payments for each AutoVue unit sold.  As such, the future success and broad marketacceptance of our AutoVue technologies in the passenger car market will dependupon Valeo’s ability to manufacture, market and sell our technologies, and toconvince more OEM passenger car manufacturers to adopt our technologies.  IfValeo does not devote considerable resources and aggressively pursueopportunities, our expansion into the passenger car market could be adverselyaffected.

 

**If We Are Unable To Develop And Introduce New Products And ProductEnhancements Successfully And In A Cost-Effective And Timely Manner, Or AreUnable To Achieve Market Acceptance Of Our New Products, Our Operating ResultsWould Be Adversely Affected.**  We believe our revenue growthand future operating results will depend on our ability to complete developmentof new products and enhancements, introduce these products in a timely,cost-effective manner, achieve broad market acceptance of these products andenhancements, and reduce our product costs. We cannot guarantee the success ofthese products and we may not be able to introduce any new products or anyenhancements to

 

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our existing products on a timely basis, orat all. In addition, the introduction of any new products could adverselyaffect the sales of certain of our existing products. Our future success willalso depend in part on the success of the vehicles or other products whichincorporate our AutoVue LDW system.

 

We believe that we must continue to make substantialinvestments to support ongoing research and development in order to remaincompetitive. We need to continue to develop and introduce new products thatincorporate the latest technological advancements in outdoor image processinghardware, software and camera technologies in response to evolving customerrequirements. Our business and results of operations could be adverselyaffected if we do not anticipate or respond adequately to technologicaldevelopments or changing customer requirements. We cannot assure you that anysuch investments in research and development will lead to any correspondingincrease in revenue.

 

Market acceptance of our new products dependsupon many factors, including our ability to accurately predict marketrequirements and evolving industry standards, our ability to resolve technicalchallenges in a timely and cost-effective manner and achieve manufacturingefficiencies, the perceived advantages of our new products over traditionalproducts and the marketing capabilities of our independent distributors andstrategic partners, including Valeo’s ability to expand sales of AutoVue in thepassenger car market. The success of our AutoVue system will also depend inpart on the success of the automotive vehicles that incorporate our technology,as well as the success of optional equipment that OEMs bundle with ourtechnologies.

 

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

 

**An Economic Slowdown And Related Uncertainties Could Adversely ImpactThe Demand For Our Products.**  Concerns about inflation,decreased consumer confidence, reduced corporate profits and capital spending,and recent international conflicts and terrorist and military actions haveresulted in a downturn in worldwide economic conditions, particularly in theUnited States.  These unfavorableeconomic conditions may have a negative impact on customer orders,cancellations and rescheduling of backlog. In addition, recent political andsocial turmoil related to international conflicts and terrorist acts can beexpected to put further pressure on economic conditions in the U.S. andworldwide.  These political, social andeconomic conditions make it extremely difficult for our customers, oursuppliers and us to accurately forecast and plan future businessactivities.  If such conditions continueor worsen, our business, financial condition and results of operations willlikely be materially and adversely affected.

 

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

 

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

 

•                                          thefailure to retain or integrate key acquired personnel;

 

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

 

•                                          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.

 

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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.

 

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

 

•                                          ourability to raise additional capital;

 

•                                          ourability to control costs;

 

•                                          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 of components used in the manufacture of our products;

 

•                                          changesin our pricing policies and the pricing policies of our suppliers and competitors,pricing concessions on volume sales, as well as increased price competition ingeneral;

 

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

 

•                                          delaysin the allocation of funds to state and local agencies from the U.S. governmenttransportation bill;

 

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

 

•                                          theeffects of technological changes in our target markets;

 

•                                          ourrelatively small level of backlog at any given time;

 

•                                          seasonalitydue to winter weather conditions;

 

•                                          themix of our sales;

 

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

 

•                                          risksand uncertainties associated with our international business;

 

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

 

•                                          generaleconomic and political conditions.

 

Due to all of the factors listed above as well asother unforeseen factors, our future operating results could be below

 

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the expectations of securitiesanalysts or investors.  If that happens,the trading price of our common stock could decline. As a result of thesequarterly variations, you should not rely on quarter-to-quarter comparisons ofour operating results as an indication of our future performance.

 

**If We Do Not Keep Pace With Rapid Technological Changes And EvolvingIndustry Standards, We Will Not Be Able To Remain Competitive And There Will BeNo Demand For Our Products.**  Our markets are in generalcharacterized by the following factors:

 

•                                          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 our ability toanticipate and adapt to changes in technology and industry standards, and toeffectively develop, introduce, market and gain broad acceptance of newproducts and product enhancements incorporating the latest technologicaladvancements.  In particular, our LDWsystem is incorporated into automobiles and trucks that face significant technologicalchanges in each model year and among different vehicle models.  Accordingly, we must adapt our technologyfrom time to time to function with such changes.

 

**The Markets In Which We Operate Are Highly Competitive And Have ManyMore Established Competitors, Which Could Adversely Affect Our Sales Or TheMarket Acceptance Of Our Products.**  We compete with numerous othercompanies in our target markets including, but not limited to, large,multinational corporations, which include tier one automotive suppliers, andmany smaller regional engineering firms. We expect such competition to increasedue to technological advancements, industry consolidations and reduced barriersto entry. Increased competition is likely to result in price reductions,reduced gross margins and loss of market share, any of which could seriouslyharm our business, financial condition and results of operations. Many of ourcompetitors have far greater name recognition and greater financial,technological, marketing and customer service resources than we do. This mayallow them to respond more quickly to new or emerging technologies and changesin customer requirements. It may also allow them to devote greater resources tothe development, promotion, sale and support of their products than we can.Recent consolidations of end users, distributors and manufacturers in ourtarget markets have exacerbated this problem. As a result of the foregoingfactors, we may not be able to compete effectively in our target markets andcompetitive pressures could adversely affect our business, financial conditionand results of operations.

 

**We May Be Unable To Attract And Retain Key Personnel, Which CouldSeriously Harm Our Business.**  Due to the specialized natureof our business, we are highly dependent on the continued service of ourexecutive officers and other key management, engineering and technicalpersonnel.  The loss of any of ourexecutive officers or key members of management could adversely affect our business,financial condition or results of operations. Our success will also depend in large part upon our ability to continueto attract, retain and motivate qualified engineering and other highly skilledtechnical personnel. Competition for employees, particularly developmentengineers, is intense.  We may not beable to continue to attract and retain sufficient numbers of such highlyskilled employees.  Our inability toattract and retain additional key employees or the loss of one or more of ourcurrent key employees could adversely affect our business, financial conditionand results of operations.

 

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

 

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Fromtime to time, we have received notices that claim we have infringed upon theintellectual property of others. Even if these claims are not valid, they couldsubject us to significant costs. We have engaged in litigation in the past, andlitigation may be necessary in the future to enforce our intellectual propertyrights or to determine the validity and scope of the proprietary rights ofothers. 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 Is Highly Volatile.**  Thetrading price of our common stock has been subject to wide fluctuations in thepast. Since January 2000, our Class A common stock (now known as ourcommon stock) has traded at prices as low as $0.45 per share and as high as$29.44 per share. The market price of our common stock could continue tofluctuate in the future in response to various factors, including, but notlimited to:

 

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

 

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

 

•                                          currencyfluctuations and restrictions;

 

•                                          political,social and economic instability;

 

•                                          reducedprotection for intellectual property rights in some countries;

 

•                                          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;

 

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•              longeraccounts receivable payment cycles;

 

•              difficultiesin managing and staffing international operations;

 

•              potentiallyadverse tax consequences; and

 

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

 

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

 

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

 

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

 

**Some Of Our Directors, Officers And Their Affiliates Can Control TheOutcome Of Matters That Require The Approval Of Our Stockholders, AndAccordingly We Will Not Be Able To Engage In Certain Transactions Without TheirApproval.**  As of December 31, 2005, our officers anddirectors owned approximately 16% of the outstanding shares of our common stock(and approximately 25% of our common stock when including options, warrants andother convertible securities held by them which are currently exercisable orconvertible or will become exercisable or convertible within 60 days afterDecember 31, 2005). As a result of their stock ownership, our management willbe able to significantly influence the election of our directors and theoutcome of corporate actions requiring stockholder approval, such as mergersand acquisitions, regardless of how our other stockholders may vote. Thisconcentration of voting control may have a significant effect in delaying,deferring or preventing a change in our management or change in control and mayadversely affect the voting or other rights of other holders of common stock.

 

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

 

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

 

None.

 

**ITEM 3.  DEFAULTS UPON SENIORSECURITIES**

 

None.

 

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

 

                None.

 

**ITEM5.  OTHER INFORMATION**

 

None.

 

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** **

**ITEM 6.  EXHIBITS**

 

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

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                       | ** ** | **Where Located**                                                                                                                                                              |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                |       | Amended and Restated Certificate of Incorporation of the registrant                                                                                                   | * *   | *Exhibit 3.1 to the registrant’s current  report on Form 8-K as filed with the SEC on October 28, 2004*                                                    |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.2                |       | Bylaws of registrant, as amended                                                                                                                                      | * *   | *Exhibit 4.2 to the registrant’s Registration  Statement on Form S-1 (Reg. No. 033-67932) as filed with the SEC on  July 6, 1993*                     |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.3                |       | Certificates of Amendment to Bylaws of the registrant dated  April 24, 1998 and August 10, 2001                                                             | * *   | *Exhibit 3.4 to the registrant’s Annual  Report on Form 10-K/A for the year ended March 31, 2003 as filed  with the SEC on July 29, 2003*             |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 3.4                |       | Certificate of Amendment to Bylaws of registrant dated  September 9, 2004                                                                                        | * *   | *Exhibit 3.1 to the registrant’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2004 as  filed with the SEC on November 15, 2004* |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 4.1                |       | Specimen of Common Stock Certificate                                                                                                                                  | * *   | *Exhibit 4.1 to the registrant’s Amendment  No. 1 to the Registration Statement on Form 8-A as filed with the  SEC on December 8, 2004*               |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 4.2                |       | Amended and Restated Rights Agreement, dated as of May 10, 2004,  by and between the registrant and U.S. Stock Transfer Corporation, including  exhibits thereto | * *   | *Exhibit 99.1 to the registrant’s  Registration Statement on Form 8-A/A as filed with the SEC on  June 18, 2004*                                           |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 10.1               |       | Second Amendment to Credit Agreement, dated August 1, 2005, by and  between the registrant and Wells Fargo Bank, National Association                                 | * *   | *Filed herewith*                                                                                                                                                               |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 10.2               |       | Revolving Line of Credit Note, dated August 1, 2005, by and between  the registrant and Wells Fargo Bank, National Association                                        | * *   | *Filed herewith*                                                                                                                                                               |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 31.1               |       | Certification of the Principal Executive Officer, as required pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002                                         | * *   | *Filed herewith*                                                                                                                                                               |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 31.2               |       | Certification of the Principal Financial and Accounting Officer, as  required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                          | * *   | *Filed herewith*                                                                                                                                                               |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 32.1               |       | Certification of the Chief Financial Officer, as required pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                                             | * *   | *Filed herewith*                                                                                                                                                               |
| * *           | * *   | * *                                                                                                                                                              | * *   | * *                                                                                                                                                                       |
| 32.2               |       | Certification of the Chief Financial Officer, as required pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                                             | * *   | *Filed herewith*                                                                                                                                                               |

 

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**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 8, 2006 | ITERIS, INC. |
|-------------------------|--------------|
|                    | (Registrant) |
|                    |         |   |
|                    | By           | /s/ JACK JOHNSON |   |
|                    |         | Jack Johnson |
|                    |         | Chief Executive Officer |
|                    |         | (Principal Executive Officer) |
|                    |         |   |
|                    |         |   |
|                    | By           | /s/ JAMES S. MIELE |   |
|                    |         | James S. Miele |
|                    |         | Chief Financial Officer |
|                    |         | (Principal Financial and Accounting Officer) |

 

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