##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended March 31, 2007
 Commission File Number 1-13408
 DIGITAL RECORDERS, INC.
 Exact name of Registrant as specified in its Charter)
 North Carolina
    
    56-1362926(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)
 5949 Sherry Lane, Suite 1050
Dallas, Texas 75225  (Address of principal executive offices, Zip Code)
 (214) 378-8992
 þ o
  o o þ
 o þ
  Common Stock, par value $.10 per share
    
    10,387,055(Class of Common Stock)
    
    Number of Shares




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##### Table of Contents



DIGITAL RECORDERS, INC. AND SUBSIDIARIES
 INDEX
 Page No.PART I - FINANCIAL INFORMATIONItem 1.
    
    Financial StatementsConsolidated Balance Sheets  March 31, 2007 (Unaudited) and December 31, 2006
    
    
    3Consolidated Statements of Operations  Three Months Ended March 31, 2007 and 2006 (Unaudited)
    
    
    4Consolidated Statements of Cash Flows  Three Months Ended March 31, 2007 and 2006 (Unaudited)
    
    
    5Notes to Unaudited Consolidated Financial Statements
    
    
    7Item 2.
    
    Management's Discussion and Analysis of Financial Conditions and Results of Operations
    
    
    17Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    24Item 4T.
    
    Controls and Procedures
    
    
    24PART II - OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    26Item 1A.
    
    Risk Factors
    
    
    26Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    33Item 3.
    
    Defaults Upon Senior Securities
    
    
    33Item 4.
    
    Submission of Matters to a Vote of Securityholders
    
    
    33Item 5.
    
    Other Information
    
    
    33Item 6.
    
    Exhibits
    
    
    34SIGNATURES
    
    
    37Share Purchase AgreementPromissory NoteWaiver and ConsentSection 302 Certification of David L. TurneySection 302 Certification of Stephen P. SlaySection 906 Certification of David L. TurneySection 906 Certification of Stephen P. Slay
 2




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS
  
   March 31, 2007
    
    
    December 31, 2006(Unaudited)
    
    
    (Note 1)ASSETSCurrent AssetsCash and cash equivalents
    
    $
    604
    
    
    $
    611Trade accounts receivable, net
    
    
    9,228
    
    
    
    10,368Other receivables
    
    
    376
    
    
    
    147Inventories
    
    
    9,525
    
    
    
    9,324Prepaids and other current assets
    
    
    357
    
    
    
    429Total current assets
    
    
    20,090
    
    
    
    20,879Property and equipment, net
    
    
    2,924
    
    
    
    3,131Goodwill
    
    
    11,016
    
    
    
    11,250Intangible assets, net
    
    
    1,058
    
    
    
    1,110Deferred tax assets, net
    
    
    186
    
    
    
    191Other assets
    
    
    657
    
    
    
    797Total assets
    
    $
    35,931
    
    
    $
    37,358LIABILITIES AND SHAREHOLDERS EQUITYCurrent LiabilitiesLines of credit
    
    $
    7,235
    
    
    $
    7,608Notes payable, net
    
    
    1,596
    
    
    
    1,584Current portion of long-term debt
    
    
    254
    
    
    
    254Current portion of foreign tax settlement
    
    
    420
    
    
    
    393Accounts payable
    
    
    5,278
    
    
    
    5,620Accrued expenses
    
    
    3,178
    
    
    
    2,935Preferred stock dividends payable
    
    
    22
    
    
    
    23Total current liabilities
    
    
    17,983
    
    
    
    18,417Long-term debt and capital leases, long-term
    
    
    35
    
    
    
    42Foreign tax settlement, long-term
    
    
    1,122
    
    
    
    1,087Deferred tax liabilities
    
    
    366
    
    
    
    383Minority interest in consolidated subsidiary
    
    
    209
    
    
    
    234Commitments
and contingencies (Notes 6 and 7)Shareholders EquitySeries E Redeemable, Nonvoting, Convertible Preferred Stock, $.10 par value,
liquidation preference of $5,000 per share; 500 shares authorized; 183 shares
issued and outstanding at March 31, 2007, and December 31, 2006; redeemable
at the discretion of the Company at any time.
    
    
    495
    
    
    
    495Series G Redeemable, Convertible Preferred Stock, $.10 par value,
liquidation preference of $5,000 per share; 600 shares authorized; 386 and 379
shares issued and outstanding at March 31, 2007 and December 31, 2006,
respectively; redeemable at the discretion of the Company after five years
from date of issuance.
    
    
    1,648
    
    
    
    1,613Series H Redeemable, Convertible Preferred Stock, $.10 par value,
liquidation preference of $5,000 per share; 600 shares authorized; 55 and 54
shares issued and outstanding at March 31, 2007, and December 31, 2006,
respectively; redeemable at the discretion of the Company after five years
from date of issuance.
    
    
    227
    
    
    
    222Series I Redeemable, Convertible Preferred Stock, $.10 par value,
liquidation preference of $5,000 per share; 200 shares authorized; 0 and 104
shares issued and outstanding at March 31, 2007, and December 31, 2006,
respectively; redeemable at the discretion of the Company after five years
from date of issuance.
    
    
    
    
    
    
    471Series AAA Redeemable, Nonvoting, Convertible Preferred Stock, $.10 par value,
liquidation preference of $5,000 per share; 20,000 shares authorized; 178 shares
issued and outstanding at March 31, 2007 and December 31, 2006; redeemable at
the discretion of the Company at any time.
    
    
    890
    
    
    
    890Common stock, $.10 par value, 25,000,000 shares authorized; 10,387,055 and
10,045,675 shares issued and outstanding at March 31, 2007 and December
31, 2006, respectively.
    
    
    1,039
    
    
    
    1,004Additional paid-in capital
    
    
    31,907
    
    
    
    31,517Accumulated other comprehensive income  foreign currency translation
    
    
    3,194
    
    
    
    3,397Accumulated deficit
    
    
    (23,184
    )
    
    
    (22,414
    )Total shareholders equity
    
    
    16,216
    
    
    
    17,195Total liabilities and shareholders equity
    
    $
    35,931
    
    
    $
    37,358
  3




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Three Months Ended March 31,2007
    
    
    2006Net sales
    
    $
    12,168
    
    
    $
    11,112Cost of sales
    
    
    8,521
    
    
    
    7,669Gross profit
    
    
    3,647
    
    
    
    3,443Operating expensesSelling, general and administrative
    
    
    3,747
    
    
    
    3,673Research and development
    
    
    332
    
    
    
    258Total operating expenses
    
    
    4,079
    
    
    
    3,931Operating loss
    
    
    (432
    )
    
    
    (488
    )Other income (loss)
    
    
    11
    
    
    
    (76
    )Foreign currency gain (loss )
    
    
    (25
    )
    
    
    26Interest expense
    
    
    (315
    )
    
    
    (213
    )Total other income and expense
    
    
    (329
    )
    
    
    (263
    )Loss before income tax expense
    
    
    (761
    )
    
    
    (751
    )Income tax expense
    
    
    (34
    )
    
    
    (46
    )Loss before minority interest in loss of consolidated
subsidiary
    
    
    (795
    )
    
    
    (797
    )Minority interest in loss of consolidated subsidiary
    
    
    25
    
    
    
    48Net loss
    
    
    (770
    )
    
    
    (749
    )Provision for preferred stock dividends
    
    
    (76
    )
    
    
    (68
    )Amortization for discount on preferred stock
    
    
    
    
    
    
    (49
    )Net loss applicable to common shareholders
    
    $
    (846
    )
    
    $
    (866
    )Net loss per share applicable to common shareholdersBasic and diluted
    
    $
    (0.08
    )
    
    $
    (0.09
    )Weighted average number of common shares and common
share equivalent outstandingBasic and diluted
    
    
    10,173,578
    
    
    
    9,751,290
  4




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Three Months Ended March 31,2007
    
    
    2006Cash flows from operating activitiesNet loss
    
    $
    (770
    )
    
    $
    (749
    )Adjustments to reconcile net loss to net cash
provided by (used in) operating activitiesDeferred income taxes
    
    
    (15
    )
    
    
    2Depreciation and amortization of property and equipment
    
    
    317
    
    
    
    337Amortization of intangible assets
    
    
    30
    
    
    
    27Amortization of deferred financing costs
    
    
    83
    
    
    
    94Amortization of the fair value of warrants
    
    
    69
    
    
    
    25Stock issued in lieu of cash compensation
    
    
    21
    
    
    
    Stock-based compensation expense
    
    
    9
    
    
    
    Loss on sale of fixed assets
    
    
    1
    
    
    
    5Other, primarily effect of foreign currency gain/loss
    
    
    (8
    )
    
    
    57Minority interest in loss of consolidated subsidiary
    
    
    (25
    )
    
    
    (48
    )Changes in operating assets and liabilities(Increase ) decrease in trade accounts receivable
    
    
    1,151
    
    
    
    (1,080
    )(Increase ) decrease in other receivables
    
    
    (225
    )
    
    
    12(Increase ) decrease in inventories
    
    
    (181
    )
    
    
    488(Increase ) decrease in prepaids and other current assets
    
    
    71
    
    
    
    (63
    )Increase in other assets
    
    
    
    
    
    
    (7
    )Increase (decrease) in accounts payable
    
    
    (306
    )
    
    
    66Increase (decrease) in accrued expenses
    
    
    235
    
    
    
    (231
    )Increase in foreign tax settlement
    
    
    39
    
    
    
    Net cash provided by (used in) operating activities
    
    
    496
    
    
    
    (1,065
    )Cash flows from investing activitiesProceeds from sale of fixed assets
    
    
    39
    
    
    
    2Purchases of property and equipment
    
    
    (80
    )
    
    
    (63
    )Investments in software development
    
    
    (98
    )
    
    
    (48
    )Net cash used in investing activities
    
    
    (139
    )
    
    
    (109
    )Cash flows from financing activitiesProceeds from bank borrowings and lines of credit
    
    
    16,633
    
    
    
    15,885Principal payments on bank borrowings and lines of credit
    
    
    (16,975
    )
    
    
    (14,910
    )Proceeds from issuance of Preferred stock, net of costs
    
    
    
    
    
    
    485Payments related to financing of new line of credit
    
    
    
    
    
    
    (329
    )Payment of dividends on Preferred stock
    
    
    (36
    )
    
    
    (29
    )Net cash provided by (used in) financing activities
    
    
    (378
    )
    
    
    1,102Effect of exchange rate changes on cash and cash equivalents
    
    
    14
    
    
    
    32Net decrease in cash and cash equivalents
    
    
    (7
    )
    
    
    (40
    )Cash and cash equivalents at beginning of period
    
    
    611
    
    
    
    807Cash and cash equivalents at end of period
    
    $
    604
    
    
    $
    767
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Three Months Ended March 31,2007
    
    
    2006Supplemental disclosures of non-cash investing and financing activities:Conversion of preferred stock to common stock
    
    $
    520
    
    
    $
    120Relative fair value allocated to warrants issued in connection with sale
of preferred stock
    
    $
    
    
    
    $
    49Amortization of preferred stock beneficial conversion feature
    
    $
    
    
    
    $
    49Amortization of convertible subordinated debenture beneficial
conversion feature
    
    $
    
    
    
    $
    81Fair value of warrants issued in connection with financing of new line of
credit
    
    $
    
    
    
    $
    590
  6




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DIGITAL RECORDERS, INC. AND SUBSIDIARIES
 
 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
   (1) BASIS OF PRESENTATION AND DISCLOSURE
      7




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Product Warranties
  Three Months ended March 31,2007
    
    
    2006Balance at beginning of period
    
    $
    384
    
    
    $
    214Additions charged to costs and expenses
    
    
    
    
    
    
    Deductions
    
    
    (20
    )
    
    
    Foreign exchange translation (gain) loss
    
    
    (2
    )
    
    
    4Balance at end of period
    
    $
    362
    
    
    $
    218
 Recent Accounting Pronouncements
   (2) GOODWILL AND OTHER INTANGIBLE ASSETS
  8




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(3) INVENTORIES
 March 31,
    
    
    December 31,2007
    
    
    2006(In thousands)Raw materials and system components
    
    $
    6,478
    
    
    $
    6,162Work in process
    
    
    134
    
    
    
    144Finished goods
    
    
    2,913
    
    
    
    3,018Total inventories
    
    $
    9,525
    
    
    $
    9,324
 (4) PROPERTY AND EQUIPMENT
 EstimatedDepreciable
    
    March 31,
    
    
    December 31,Lives (years)
    
    2007
    
    
    2006(In thousands)Leasehold improvements
    
    5 - 9
    
    $
    276
    
    
    $
    276Automobiles
    
    5
    
    
    16
    
    
    
    16Computer and telecommunications equipment
    
    3
    
    
    1,300
    
    
    
    1,296Software
    
    3 - 5
    
    
    4,858
    
    
    
    4,912Test equipment
    
    3 - 5
    
    
    275
    
    
    
    273Furniture and fixtures
    
    3 - 7
    
    
    2,531
    
    
    
    2,526Software projects in progress
    
    
    
    
    152
    
    
    
    549,408
    
    
    
    9,353Less accumulated depreciation and amortization
    
    
    
    
    6,484
    
    
    
    6,222Total property and equipment, net
    
    
    
    $
    2,924
    
    
    $
    3,131
 (5) ACCRUED EXPENSES
 March 31,
    
    
    December 31,2007
    
    
    2006(In thousands)Salaries, commissions, and benefits
    
    $
    1,408
    
    
    $
    1,187Taxes  payroll, sales, income, and other
    
    
    588
    
    
    
    623Warranties
    
    
    362
    
    
    
    384Current portion of capital leases
    
    
    22
    
    
    
    22Interest payable
    
    
    68
    
    
    
    51Deferred revenue
    
    
    484
    
    
    
    196Other
    
    
    246
    
    
    
    472Total accrued expenses
    
    $
    3,178
    
    
    $
    2,935
 (6) LINES OF CREDIT AND NOTES PAYABLE
 (a) Domestic lines of credit and notes payable
 U.S. Working Capital Line of Credit.
 9




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b) International lines of credit
 10




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March 31,
    
    
    December 31,2007
    
    
    2006(In thousands)Line of credit with Laurus Master Fund dated March 16, 2006; payable in full June
30, 2008; secured by a ll tangible and intangible U.S. assets of the Company; bears
average interest rate of 9.17% and 9.69% in 2007 and 2006, respectively.
    
    $
    4,284
    
    
    $
    4,406Line of credit with Swedish bank, certain borrowings dated December 31, 2006
which renew annually and certain borrowings dated March 31, 2007 which renew
at various periods agreed-to by the bank and the Company; expiration dates of
December 31, 2007 for borrowings under annual renewal and June 30, 2007 for
borrowings renewing at various periods; secured by certain assets of the Swedish
subsidiary, Mobitec AB; bears average interest rate of 4.04% and 3.23% in 2007
and 2006, respectively.
    
    
    1,180
    
    
    
    1,450Line of credit with Swedish bank dated December 31, 2006; expires on December
31, 2007; secured by accounts receivable of the Swedish subsidiary, Mobitec AB;
bears average interest rate of 4.85% and 4.23% in 2007 and 2006, respectively.
    
    
    1,115
    
    
    
    1,116Line of credit with German bank dated June 23, 2004; open-ended term; secured by
accounts receivable and inventory of the German subsidiary, Mobitec GmbH
(formerly known as Transit Media-Mobitec GmbH); bears average interest rate of
4.85% and 4.12% in 2007 and 2006, respectively.
    
    
    656
    
    
    
    636Total lines of credit
    
    $
    7,235
    
    
    $
    7,608
 11




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(7) LONG-TERM DEBT
  March 31,
    
    
    December 31,2007
    
    
    2006(In thousands)Convertible debenture to a director dated August 26, 2002, payable
in full August 26, 2009, with an interest rate of 8%.
    
    $
    250
    
    
    $
    250Other long-term debt
    
    
    7
    
    
    
    8Total long-term debt
    
    
    257
    
    
    
    258Less current portion
    
    
    254
    
    
    
    2543
    
    
    
    4Long-term portion of capital leases
    
    
    32
    
    
    
    38Total long-term debt and capital leases, less current portion
    
    $
    35
    
    
    $
    42
  (8) PREFERRED STOCK
    (9) PER SHARE AMOUNTS
   12




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(10) COMPREHENSIVE INCOME (LOSS)
  Three Months Ended March 31,2007
    
    
    2006Net loss
    
    $
    (770
    )
    
    $
    (749
    )Foreign currency translation adjustment
    
    
    (203
    )
    
    
    284Total comprehensive loss
    
    $
    (973
    )
    
    $
    (465
    )
 (11) SEGMENT INFORMATION
   13




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Three Months Ended March 31,2007
    
    
    2006(In thousands)Net salesTransportation communications
    
    $
    12,000
    
    
    $
    10,755Law enforcement and surveillance
    
    
    168
    
    
    
    357$
    12,168
    
    
    $
    11,112Operating income (loss)Transportation communications
    
    $
    1,037
    
    
    $
    835Law enforcement and surveillance
    
    
    (176
    )
    
    
    (39
    )Parent entities (Corporate overhead)
    
    
    (1,293
    )
    
    
    (1,284
    )$
    (432
    )
    
    $
    (488
    )Geographic information  net salesNorth America
    
    $
    6,116
    
    
    $
    6,261Europe
    
    
    3,626
    
    
    
    2,517Asia-Pacific
    
    
    1,088
    
    
    
    1,031Middle East
    
    
    299
    
    
    
    417South America
    
    
    1,039
    
    
    
    886$
    12,168
    
    
    $
    11,112
 March 31,
    
    
    December 31,2007
    
    
    2006Long -lived assetsNorth America
    
    $
    4,021
    
    
    $
    4,203Europe
    
    
    11,404
    
    
    
    11,870Asia-Pacific
    
    
    31
    
    
    
    31South America
    
    
    199
    
    
    
    184$
    15,655
    
    
    $
    16,288
 (12) INCOME TAXES
    14




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(13) SUBSEQUENT EVENTS
    Current AssetsTrade accounts receivable, net
    
    $
    55Inventories
    
    
    318Prepaids and other current assets
    
    
    3Total current assets
    
    
    376Property and equipment, net
    
    
    176Goodwill
    
    
    961Total assets
    
    $
    1,513Current LiabilitiesAccounts payable
    
    $
    75Accrued expenses
    
    
    53Total current liabilities
    
    
    128Total liabilities
    
    $
    128
  Three Months Ended March 31,2007
    
    2006(Unaudited)
    
    (Unaudited)Net sales
    
    $
    168
    
    
    $
    357Loss before income tax expense
    
    
    (176
    )
    
    
    (39
    )
 15




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16




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
  Business  General
  ® ® TM ®
   Critical Accounting Policies and Estimates
  
    
    Allowance for doubtful accounts
    
    Inventory valuation
    
    Warranty reserve
    
    Intangible assets and goodwill
    
    Income taxes, including deferred tax assets
    
    Revenue recognition
    
    Stock-based compensation
  17




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Results of Operations
  Three Months Ended March 31,2007
    
    2006Net sales
    
    
    100.0
    %
    
    
    100.0
    %Cost of sales
    
    
    70.0
    
    
    
    69.0Gross profit
    
    
    30.0
    
    
    
    31.0Operating expenses:Selling, general and administrative
    
    
    30.8
    
    
    
    33.1Research and development
    
    
    2.7
    
    
    
    2.3Total operating expenses
    
    
    33.5
    
    
    
    35.4Operating loss
    
    
    (3.5
    )
    
    
    (4.4
    )Other income and expense
    
    
    (2.7
    )
    
    
    (2.4
    )Loss before income tax expense
    
    
    (6.2
    )
    
    
    (6.8
    )Income tax expense
    
    
    (0.3
    )
    
    
    (0.4
    )Loss before minority interest in loss
of consolidated subsidiary
    
    
    (6.5
    )
    
    
    (7.2
    )Minority interest in loss of consolidated subsidiary
    
    
    0.2
    
    
    
    0.4Net loss
    
    
    (6.3
    )%
    
    
    (6.8
    )%
 COMPARISON OF OUR RESULTS FOR THE THREE MONTHS ENDED MARCH 31, 2007 AND 2006
 Net Sales and Gross Profit.
 Transportation Communications Segment .
  18




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.
   Law Enforcement and Surveillance Segment .
  Selling, General and Administrative.
 Research and Development Expenses .
  19




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Operating Income (Loss).
 Other Income, Foreign Currency Gain (Loss), and Interest Expense.
 Income Tax Expense.
 Net Loss Applicable to Common Shareholders.
 Future Outlook
   OUR LIQUIDITY AND CAPITAL RESOURCES
 Cash Flows For the Three months Ended March 31, 2007 and 2006
  20




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Credit Agreements
       Note Payable.
 21




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Long-term Debt.
 Divestiture of Digital Audio Corporation and Use of Proceeds
   Management Conclusion
     Impact of Inflation
 22




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FORWARD-LOOKING STATEMENTS
   
    
    our ability to meet our capital requirements;
 
    
    our ability to meet and maintain our existing debt obligations, including obligations to make payments under such debt
instruments;
 
    
    our future cash flow position;
 
    
    our ability to obtain lender financing sufficient to meet our working capital requirements;
 
    
    our efforts to manage and effect certain necessary fixed cost reductions;
 
    
    our ability to achieve other expense reductions;
 
    
    the timing or amount of future revenues;
 
    
    product sales in future periods;
 
    
    the effectiveness of any of managements strategic objectives or initiatives or the implications thereof on our
shareholders, creditors, or other constituencies;
 
    
    expected results;
 
    
    current trends and indicators;
 
    
    our ability to implement plans for complying with Section 404 of the Sarbanes-Oxley Act of 2002;
 
    
    recent legislative action affecting the transportation and/or security industry, including, without limitation, the
Safe, Accountable, Flexible, Efficient, Transportation Equity Act  A Legacy for Users, and any successor legislation;
 
    
    the impact of the recent passage of the Safe, Accountable, Flexible, Efficient, Transportation Equity Act  A Legacy
for Users;
 
    
    changes in federal or state funding for transportation and or security-related funding;
 
    
    possible growth through acquisitions;
 
    
    future sources of capital to fund such growth, including sources of additional equity financing;
 
    
    anticipated advancements in technology related to our products and services;
 
    
    future product and service offerings;
 
    
    the success of product and service introductions;
 
    
    the ability to include additional security features to existing products and services;
 
    
    the potential positive effect such additional security features may have on revenues;
 
    
    the expected contribution of sales of new and modified security related products to our profitability;
 
    
    future events or expectations including the expected timing of order deliveries;
 
    
    the expected customer acceptance of products;
 
    
    potential benefits our security features may have for our customers;
 
    
    the success of special alliances with various product partners;
 
    
    the availability of alternate suppliers of the component parts required to manufacture our products; and
 
    
    our intellectual property rights and our efforts to protect and defend such rights.
  
    
    our ability to continue as a going concern;
 
    
    our ability to meet our capital requirements;
 23




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##### Table of Contents




    
    our ability to meet and maintain our debt obligations, including obligations to make payments under such debt instruments;
 
    
    our future cash flow position;
 
    
    our ability to obtain lender financing sufficient to meet our working capital requirements;
 
    
    our ability to effect desired and planned reductions in certain fixed costs;
 
    
    our ability to achieve other expense reductions;
 
    
    managements strategic objectives or initiatives that may not be effective;
 
    
    assumptions behind future revenue timing or amounts that may not prove accurate over time;
 
    
    current trends and indicators that may not be indicative of future results;
 
    
    loss of customers or decline in customer demand for our products and services;
 
    
    reductions in federal and/or state funding for the transportation and/or security industry;
 
    
    our ability to grow through acquisitions;
 
    
    our ability to secure additional sources of capital to fund growth, including our ability to secure additional equity financing;
 
    
    future technological advances that may not occur when anticipated or future technological advances that will make our current
product and service offerings obsolete;
 
    
    potential benefits our security products may have for our customers that do not materialize;
 
    
    our ability to meet expected timing of order deliveries;
 
    
    product and service offerings that may not be accepted by our customers;
 
    
    product and service introductions that may not produce desired revenue results;
 
    
    our ability to create meaningful security product features in either new or existing products;
 
    
    the uncertainties surrounding our anticipated success of special alliances with various product partners;
 
    
    our ability to address and remediate any deficiencies in our internal controls over financial reporting and/or our disclosure
controls;
 
    
    insufficient internal controls over financial reporting that may cause us to fail to meet our reporting obligations, result in
material misstatements in our financial statements, and negatively affect investor confidence;
 
    
    our efforts to implement plans to comply with Section 404 of the Sarbanes-Oxley Act of 2002;
 
    
    our ability to obtain alternate suppliers of our component parts if our current suppliers are no longer available or cannot
meet our future needs for such parts; and
 
    
    our efforts to protect and defend our intellectual property rights.
   
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 ITEM 4T. CONTROLS AND PROCEDURES
 Introduction
  24




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##### Table of Contents



Evaluation of Disclosure Controls and Procedures
   Required Reporting on Internal Control Over Financial Reporting
   25




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##### Table of Contents



PART II  OTHER INFORMATION
 
 ITEM 1. LEGAL PROCEEDINGS
    
 ITEM 1A. RISK FACTORS
  Risks Related to Indebtedness, Financial Condition and Results of Operations
 There is substantial doubt concerning our ability to continue as a going concern
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##### Table of Contents



Our substantial debt could adversely affect our financial position, operations and ability to
grow.
 
    
    we could be required to dedicate a substantial portion of our cash flow from
operations to payments on our debt, which would reduce amounts available for working
capital, capital expenditures, research and development and other general corporate
purposes;
    
    our flexibility in planning for, or reacting to, changes in our business and
the industries in which we operate could be limited;
    
    we may be more vulnerable to general adverse economic and industry conditions;
    
    we may be at a disadvantage compared to our competitors that may have less debt than we do;
    
    it may be more difficult for us to obtain additional financing that may be necessary in connection with our business;
    
    it may be more difficult for us to implement our business and growth strategies; and
    
    we may have to pay higher interest rates on future borrowings.
 Some of our debt bears interest at variable rates, which may have material adverse effects on
our business if they increase.
 Future cash requirements or restrictions on cash could adversely affect our financial
position, and an event of default under our outstanding debt instruments could impair our ability
to conduct business operations.
 
    
    triggering of certain payment obligations, or acceleration of payment
obligations, under our revolving credit facilities or our outstanding convertible
debentures;
    
    triggering of redemption obligations under our outstanding convertible debentures;
    
    costs associated with unanticipated litigation relating to our intellectual property or other matters;
    
    taxes due upon the transfer of cash held in foreign locations; and
    
    taxes assessed by local authorities where we conduct business.
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##### Table of Contents



Our operating results may continue to fluctuate.
 
    
    customer demand and market acceptance of our products and solutions;
    
    new product introductions;
    
    variations in product mix;
    
    delivery due-date changes; and
    
    other factors.
  Risks Related to Our Operations and Product Development
 A significant portion of our sales is derived from sales to a small number of customers. If we
are not able to obtain new customers or repeat business from existing customers, our business could
be seriously harmed.
 We depend on third parties to supply components we need to produce our products.
 28




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##### Table of Contents



Many of our customers rely, to some extent, on government funding, and that subjects us to
risks associated with governmental budgeting and authorization processes.
  We must continually improve our technology to remain competitive.
 We operate in several international locations and, in one case, with less than full ownership
control.
 We cannot assure you that any new products we develop will be accepted by customers.
 We may not be able to recruit or retain a qualified workforce.
  29




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##### Table of Contents



Risks Related to Our International Operations
 There are numerous risks associated with international operations, which represent a
significant part of our business.
 Complying with foreign tax laws can be complicated, and we may incur unexpected tax
obligations in some jurisdictions
 Risks Related to Internal Controls
 Required reporting on internal control over financial reporting.
 Risks Related to Intellectual Property
 We may not be able to defend successfully against claims of infringement against the
intellectual property rights of others, and such defense could be costly.
 Risks Related to Our Equity Securities and Convertible Debentures
 The public market for our Common Stock may be volatile.
 
    
    Actual or anticipated variations in our quarterly operating results;
 30




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##### Table of Contents




    
    Historical and anticipated operating results;
    
    Announcements of new product or service offerings;
    
    Technological innovations;
    
    Competitive developments in the public transit industry;
    
    Changes in financial estimates by securities analysts;
    
    Conditions and trends in the public transit industry;
    
    Funding initiatives and other legislative developments affecting the transit industry;
    
    Adoption of new accounting standards affecting the technology industry or the public transit industry; and
    
    General market and economic conditions and other factors.
  Our preferred stock and convertible debentures have preferential rights over our Common Stock.
 Risks Related to Anti-Takeover Provisions
 Our articles of incorporation, bylaws and North Carolina law contain provisions that may make
takeovers more difficult or limit the price third parties are willing to pay for our stock.
 31




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##### Table of Contents



The adoption of our shareholder rights agreement may discourage third parties from making
takeover offers, including takeover offers that might result in a premium being paid for shares of
our common stock.
  Provisions of our bylaws limit the ability of shareholders to call special meetings of
shareholders and therefore could discourage, delay or prevent a merger, acquisition or other change
in control of our company.
  Risks Associated with Potential Growth
 We may not be able to obtain the financing we will need to implement our operating strategy.
 32




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##### Table of Contents



There are many risks associated with potential acquisitions.
 
    
    It may be difficult to assimilate the operations and personnel of an acquired business into our own business;
    
    Management information and accounting systems of an acquired business must be integrated into our current systems;
    
    Our management must devote its attention to assimilating the acquired business,
which diverts attention from other business concerns;
    
    We may enter markets in which we have limited prior experience; and
    
    We may lose key employees of an acquired business.
 
 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 SECURITYHOLDERS
  
 ITEM 5. OTHER INFORMATION
  33




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##### Table of Contents



ITEM 6. EXHIBITS
  Exhibit No.
    
    Document3.1
    
    Amended and Restated Articles of Incorporation of the Company
(incorporated herein by reference from the Companys
Registration Statement on Form S-3, filed with the SEC on
December 23, 2003)3.2
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Certificate of Designation of Series E
Redeemable Nonvoting Convertible Stock (incorporated herein by
reference from the Companys Report on Form 8-K, filed with
the SEC on November 12, 2003)3.3
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Amended and Restated Certificate of
Designation of Series F Convertible Preferred Stock
(incorporated herein by reference from the Companys Report on
Form 8-K, filed with the SEC on April 14, 2004)3.4
    
    Articles of Amendment to the Articles of Incorporation of the
Company containing Series AAA Preferred Stock Change in
Quarterly Dividend Accrual and Conversion Price (incorporated
herein by reference to the Companys Report on Form 10-K for
the year ended December 31, 2004)3.5
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Amended and Restated Certificate of
Designation of Series G Redeemable Convertible Preferred Stock
(incorporated herein by reference to the Companys Report on
Form 8-K filed on June 28, 2005)3.6
    
    Articles of Correction of Articles of Amendment to the
Articles of Incorporation of the Company containing a
correction to an error in the Amended Certificate of
Designation of Series G Redeemable Convertible Preferred Stock
(incorporated herein by reference to the Companys Report on
Form 10-Q for the quarter ended June 30, 2005)3.7
    
    Articles of Amendment to the Articles of Incorporation of the
Company containing an amendment to eliminate a staggered
election of Board members (incorporated herein by reference to
the Companys Report on Form 10-Q for the quarter ended June
30, 2005)3.8
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Amended and Restated Certificate of
Designation of Series H Convertible Preferred Stock
(incorporated herein by reference to the Companys Report on
Form 8-K filed on November 4, 2005)3.9
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Certificate of Designation of Series I
Convertible Preferred Stock (incorporated herein by reference
to the Companys Report on Form 8-K filed on March 23, 2006)3.10
    
    Amended and Restated Bylaws of the Company (incorporated
herein by reference from the Companys Registration Statement
on Form SB-2)3.11
    
    Amendment to Amended and Restated Bylaws of the Company
(incorporated herein by reference from the Companys Proxy
Statement for the Annual Meeting of Shareholders for fiscal
year 2000, filed with the SEC on June 6, 2001)3.12
    
    Amended and Restated Bylaws of the Company (incorporated
herein by reference to the Companys Report on Form 8-K filed
on September 18, 2006)3.13
    
    Amendment No. 1 to the Companys Certificate of Designation
with respect to its Series D Junior Participating Preferred
Stock (incorporated herein by reference to the Companys
Report on Form 8-K filed with the SEC on September 28, 2006)
 34




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##### Table of Contents



Exhibit No.
    
    Document4.5
    
    Rights Agreement, dated as of September 22, 2006, between the
Company and American Stock Transfer & Trust Company, as Rights
Agent, together with the following exhibits thereto: Exhibit A
 Certificate of Designation of Series D Junior Participating
Preferred Stock of Digital Recorders, Inc. and the Amendment
to Certificate of Designation of Series D Junior Participating
Preferred Stock of Digital Recorders, Inc.; Exhibit B  Form
of Right Certificate; and Exhibit C  Summary of Rights to
Purchase Shares (incorporated herein by reference to the
Companys Registration Statement on Form 8-A filed with the
Securities and Exchange Commission on October 2, 2006)4.6
    
    Omnibus Amendment dated as of January 10, 2007, effective
December 31, 2006, by and among the Company, TwinVision of
North America, Inc., Digital Audio Corporation,
Robinson-Turney International, Inc., and Laurus Master Fund,
Ltd. (incorporated herein by reference to the Companys report
on Form 8-K filed with the SEC on January 16, 2007)4.7
    
    Amended and Restated Secured Term Note dated as of January 10,
2007, effective December 31, 2006, by and between the Company,
TwinVision of North America, Inc., Digital Audio Corporation,
Robinson-Turney International, Inc., and Laurus Master Fund,
Ltd. (incorporated herein by reference to the Companys Report
on Form 8-K filed with the SEC on January 16, 2007)4.8
    
    Second Amended and Restated Registration Rights Agreement
dated as of January 10, 2007, effective December 31, 2006, by
and between the Company and Laurus Master Fund, Ltd.
(incorporated herein by reference to the Companys Report on
Form 8-K filed with the SEC on January 16, 2007)10.1
    
    Secured Non-Convertible Revolving Note between the Company and
Laurus Master Fund, Ltd., dated March 16, 2006 (incorporated
herein by reference to the Companys Report on Form 8-K filed
on March 21, 2006)10.2
    
    Security Agreement (with Schedules) between the Company and
Laurus Master Fund, Ltd. dated March 16, 2006 (incorporated
herein by reference to the Companys Report on Form 8-K filed
on March 21, 2006)10.3
    
    Grant of Security Interest in Patents and Trademarks (with
Schedules) between the Company and Laurus Master Fund, Ltd.,
dated March 16, 2006 (incorporated herein by reference to the
Companys Report on Form 8-K filed on March 21, 2006)10.4
    
    Stock Pledge Agreement (with Schedules) between the Company
and Laurus Master Fund, Ltd., dated March 16, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 21, 2006)10.5
    
    Registration Rights Agreement between the Company and Laurus
Master Fund, Ltd., dated March 16, 2006 (incorporated herein
by reference to the Companys Report on Form 8-K filed on
March 21, 2006)10.6
    
    Common Stock Purchase Warrant between the Company and Laurus
Master Fund, Ltd., dated March 16, 2006 (incorporated herein
by reference to the Companys Report on Form 8-K filed on
March 21, 2006)10.7
    
    Share Purchase Agreement between the Company and Transit
Vehicle Technology Investments, Inc., dated March 21, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 23, 2006)10.8
    
    Stock Purchase Warrant between the Company and Transit Vehicle
Technology Investments, Inc., dated March 21, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 23, 2006)10.9
    
    Registration Rights Agreement between the Company and Transit
Vehicle Technology Investments, Inc., dated March 21, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 23, 2006)
 35




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##### Table of Contents



Exhibit No.
    
    Document10.10
    
    Securities Purchase Agreement dated as of April 28, 2006, by
and between Digital Recorders, Inc., TwinVision of North
America, Inc., Digital Audio Corporation, and Robinson-Turney
International, Inc., and Laurus Master Fund, Ltd.
(incorporated herein by reference to the Companys Report on
Form 8-K filed on May 4, 2006)10.11
    
    Secured Term Note by Digital Recorders, Inc., TwinVision of
North America, Inc., Digital Audio Corporation, and
Robinson-Turney International, Inc., issued to Laurus Master
Fund, Ltd., in the original principal amount of $1,600,000
(incorporated herein by reference to the Companys Report on
Form 8-K filed on May 4, 2006)10.12
    
    Common Stock Purchase Warrant dated as of April 28, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on May 4, 2006)10.13
    
    Amended and Restated Registration Rights Agreement dated as of
April 28, 2006, by and between Digital Recorders, Inc. and
Laurus Master Fund, Ltd. (incorporated herein by reference to
the Companys Report on Form 8-K filed on May 4, 2006)10.14
    
    Share Purchase Agreement, dated as of April 30, 2007, entered
into by and among Dolphin Direct Equity Partners, LP, Digital
Audio Corporation and Digital Recorders, Inc. (filed herewith)10.15
    
    Promissory Note, dated April 30, 2007, by Dolphin Direct
Equity Partners, LP issued to Digital Recorders, Inc. in the
original principal sum of $285,000 (filed herewith)10.16
    
    Waiver and Consent, dated as of April 30, 2007, entered into
by and between Digital Recorders, Inc., TwinVision of North
America, Inc., Digital Audio Corporation, Robinson-Turney
International, Inc. and Laurus Master Fund, Ltd. (filed
herewith)31.1
    
    Section 302 Certification of David L. Turney (filed herewith)31.2
    
    Section 302 Certification of Stephen P. Slay (filed herewith)32.1
    
    Section 906 Certification of David L. Turney (filed herewith)32.2
    
    Section 906 Certification of Stephen P. Slay (filed herewith)
 36




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##### Table of Contents



SIGNATURES
  DIGITAL RECORDERS, INC.
 Signature:
    
    /s/ STEPHEN P. SLAYBy:
    
    Stephen P. SlayTitle:
    
    Chief Financial Officer (Principal Financial and Accounting Officer)Date:
    
    May 15, 2007
 37




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##### Table of Contents



Exhibit Index
 Exhibit No.
    
    Document3.1
    
    Amended and Restated Articles of Incorporation of the Company
(incorporated herein by reference from the Companys
Registration Statement on Form S-3, filed with the SEC on
December 23, 2003)3.2
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Certificate of Designation of Series E
Redeemable Nonvoting Convertible Stock (incorporated herein by
reference from the Companys Report on Form 8-K, filed with
the SEC on November 12, 2003)3.3
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Amended and Restated Certificate of
Designation of Series F Convertible Preferred Stock
(incorporated herein by reference from the Companys Report on
Form 8-K, filed with the SEC on April 14, 2004)3.4
    
    Articles of Amendment to the Articles of Incorporation of the
Company containing Series AAA Preferred Stock Change in
Quarterly Dividend Accrual and Conversion Price (incorporated
herein by reference to the Companys Report on Form 10-K for
the year ended December 31, 2004)3.5
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Amended and Restated Certificate of
Designation of Series G Redeemable Convertible Preferred Stock
(incorporated herein by reference to the Companys Report on
Form 8-K filed on June 28, 2005)3.6
    
    Articles of Correction of Articles of Amendment to the
Articles of Incorporation of the Company containing a
correction to an error in the Amended Certificate of
Designation of Series G Redeemable Convertible Preferred Stock
(incorporated herein by reference to the Companys Report on
Form 10-Q for the quarter ended June 30, 2005)3.7
    
    Articles of Amendment to the Articles of Incorporation of the
Company containing an amendment to eliminate a staggered
election of Board members (incorporated herein by reference to
the Companys Report on Form 10-Q for the quarter ended June
30, 2005)3.8
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Amended and Restated Certificate of
Designation of Series H Convertible Preferred Stock
(incorporated herein by reference to the Companys Report on
Form 8-K filed on November 4, 2005)3.9
    
    Articles of Amendment to Articles of Incorporation of the
Company containing Certificate of Designation of Series I
Convertible Preferred Stock (incorporated herein by reference
to the Companys Report on Form 8-K filed on March 23, 2006)3.10
    
    Amended and Restated Bylaws of the Company (incorporated
herein by reference from the Companys Registration Statement
on Form SB-2)3.11
    
    Amendment to Amended and Restated Bylaws of the Company
(incorporated herein by reference from the Companys Proxy
Statement for the Annual Meeting of Shareholders for fiscal
year 2000, filed with the SEC on June 6, 2001)3.12
    
    Amended and Restated Bylaws of the Company (incorporated
herein by reference to the Companys Report on Form 8-K filed
on September 18, 2006)3.13
    
    Amendment No. 1 to the Companys Certificate of Designation
with respect to its Series D Junior Participating Preferred
Stock (incorporated herein by reference to the Companys
Report on Form 8-K filed with the SEC on September 28, 2006)4.5
    
    Rights Agreement, dated as of September 22, 2006, between the
Company and American Stock Transfer & Trust Company, as Rights
Agent, together with the following exhibits thereto: Exhibit A
 Certificate of Designation of Series D Junior Participating
Preferred Stock of Digital Recorders,




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##### Table of Contents



Exhibit No.
    
    DocumentInc. and the Amendment
to Certificate of Designation of Series D Junior Participating
Preferred Stock of Digital Recorders,
Inc.; Exhibit B  Form
of Right Certificate; and Exhibit C  Summary of Rights to
Purchase Shares (incorporated herein by reference to the
Companys Registration Statement on Form 8-A filed with the
Securities and Exchange Commission on October 2, 2006)4.6
    
    Omnibus Amendment dated as of January 10, 2007, effective
December 31, 2006, by and among the Company, TwinVision of
North America, Inc., Digital Audio Corporation,
Robinson-Turney International, Inc., and Laurus Master Fund,
Ltd. (incorporated herein by reference to the Companys report
on Form 8-K filed with the SEC on January 16, 2007)4.7
    
    Amended and Restated Secured Term Note dated as of January 10,
2007, effective December 31, 2006, by and between the Company,
TwinVision of North America, Inc., Digital Audio Corporation,
Robinson-Turney International, Inc., and Laurus Master Fund,
Ltd. (incorporated herein by reference to the Companys Report
on Form 8-K filed with the SEC on January 16, 2007)4.8
    
    Second Amended and Restated Registration Rights Agreement
dated as of January 10, 2007, effective December 31, 2006, by
and between the Company and Laurus Master Fund, Ltd.
(incorporated herein by reference to the Companys Report on
Form 8-K filed with the SEC on January 16, 2007)10.1
    
    Secured Non-Convertible Revolving Note between the Company and
Laurus Master Fund, Ltd., dated March 16, 2006 (incorporated
herein by reference to the Companys Report on Form 8-K filed
on March 21, 2006)10.2
    
    Security Agreement (with Schedules) between the Company and
Laurus Master Fund, Ltd. dated March 16, 2006 (incorporated
herein by reference to the Companys Report on Form 8-K filed
on March 21, 2006)10.3
    
    Grant of Security Interest in Patents and Trademarks (with
Schedules) between the Company and Laurus Master Fund, Ltd.,
dated March 16, 2006 (incorporated herein by reference to the
Companys Report on Form 8-K filed on March 21, 2006)10.4
    
    Stock Pledge Agreement (with Schedules) between the Company
and Laurus Master Fund, Ltd., dated March 16, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 21, 2006)10.5
    
    Registration Rights Agreement between the Company and Laurus
Master Fund, Ltd., dated March 16, 2006 (incorporated herein
by reference to the Companys Report on Form 8-K filed on
March 21, 2006)10.6
    
    Common Stock Purchase Warrant between the Company and Laurus
Master Fund, Ltd., dated March 16, 2006 (incorporated herein
by reference to the Companys Report on Form 8-K filed on
March 21, 2006)10.7
    
    Share Purchase Agreement between the Company and Transit
Vehicle Technology Investments, Inc., dated March 21, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 23, 2006)10.8
    
    Stock Purchase Warrant between the Company and Transit Vehicle
Technology Investments, Inc., dated March 21, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 23, 2006)10.9
    
    Registration Rights Agreement between the Company and Transit
Vehicle Technology Investments, Inc., dated March 21, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on March 23, 2006)10.10
    
    Securities Purchase Agreement dated as of April 28, 2006, by
and between Digital Recorders, Inc., TwinVision of North
America, Inc., Digital Audio Corporation, and Robinson-Turney
International, Inc., and Laurus Master Fund, Ltd.
(incorporated herein by reference to the Companys Report on
Form 8-K filed on May 4, 2006)




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##### Table of Contents



Exhibit No.
    
    Document10.11
    
    Secured Term Note by Digital Recorders, Inc., TwinVision of
North America, Inc., Digital Audio Corporation, and
Robinson-Turney International, Inc., issued to Laurus Master
Fund, Ltd., in the original principal amount of $1,600,000
(incorporated herein by reference to the Companys Report on
Form 8-K filed on May 4, 2006)10.12
    
    Common Stock Purchase Warrant dated as of April 28, 2006
(incorporated herein by reference to the Companys Report on
Form 8-K filed on May 4, 2006)10.13
    
    Amended and Restated Registration Rights Agreement dated as of
April 28, 2006, by and between Digital Recorders, Inc. and
Laurus Master Fund, Ltd. (incorporated herein by reference to
the Companys Report on Form 8-K filed on May 4, 2006)10.14
    
    Share Purchase Agreement, dated as of April 30, 2007, entered
into by and among Dolphin Direct Equity Partners, LP, Digital
Audio Corporation and Digital Recorders, Inc. (filed herewith)10.15
    
    Promissory Note, dated April 30, 2007, by Dolphin Direct
Equity Partners, LP issued to Digital Recorders, Inc. in the
original principal sum of $285,000 (filed herewith)10.16
    
    Waiver and Consent, dated as of April 30, 2007, entered into
by and between Digital Recorders, Inc., TwinVision of North
America, Inc., Digital Audio Corporation, Robinson-Turney
International, Inc. and Laurus Master Fund, Ltd. (filed
herewith)31.1
    
    Section 302 Certification of David L. Turney (filed herewith)31.2
    
    Section 302 Certification of Stephen P. Slay (filed herewith)32.1
    
    Section 906 Certification of David L. Turney (filed herewith)32.2
    
    Section 906 Certification of Stephen P. Slay (filed herewith)