** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

----

**(Mark One)**

**x**                              ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe fiscal year ended March 31, 2006**

**OR**

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

**For the transition periodfrom                to                **

** **

**Commission file number 001-08762**

** **

**ITERIS, INC.**

(Exact Name of Registrantas Specified in Its Charter)
| **Delaware**                                                    | **95-2588496**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or Other Jurisdiction  of Incorporation or Organization) | (I.R.S. Employer  Identification No.) |

 

**1515South Manchester Avenue, Anaheim, California 92802**

(Address ofPrincipal Executive Offices) (Zip Code)

Registrant’sTelephone Number, Including Area Code: **(714)774-5000**

Securitiesregistered pursuant to Section 12(b) of the Act:
| Title of each class           | ** ** | **Name of each exchange on which registered** |
|-------------------------------|------------|-----------------------------------------------|
| Common Stock, $0.10 par value |       | American Stock  Exchange                      |

 

Securities registered pursuant to Section 12(g) ofthe Act: **None**

 

----

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or Section 15(d) ofthe Act.  Yes o Nox

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes  x  No  o

Indicate by a check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, and willnot be contained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

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

Large accelerated filer  o      Accelerated filer  o      Non-accelerated filer  x

Indicate by check mark whether the registrant is ashell company (as defined in Exchange Act Rule 12b-2). Yes o No x

Based on the closing sale price of the registrant’scommon stock on September 30, 2005, the last business day of theregistrant’s most recently completed second fiscal quarter, the aggregatemarket value of the voting common stock held by nonaffiliates of the registrantwas $55,322,000. For the purposes of this calculation, shares owned by officers,directors and 10% stockholders known to the registrant have been deemed to beowned by affiliates. This determination of affiliate status is not necessarilya conclusive determination for other purposes.

As of June 28, 2006, there were 28,790,767 sharesof common stock outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

Part III incorporates by reference certaininformation from the registrant’s definitive proxy statement for the 2006Annual Meeting of Stockholders, which will be filed with the Securities andExchange Commission not later than 120 days after the end of the fiscal yearended March 31, 2006. Except with respect to information specificallyincorporated by reference in this report, the registrant’s proxy statement isnot deemed to be filed as part hereof.

 

----

**ITERIS,INC.**

**ANNUALREPORT ON FORM 10-K**

**FOR THEFISCAL YEAR ENDED MARCH 31, 2006**

**TABLE OF CONTENTS**
| **PART I**   |   |
|-------------------|--------|
|              |   |   |   |
| ITEM 1.           |   | BUSINESS |   |
|              |   |   |   |
| ITEM 1A.          |   | RISK  FACTORS |   |
|              |   |   |   |
| ITEM 1B.          |   | UNRESOLVED STAFF COMMENTS |   |
|              |   |   |   |
| ITEM 2.           |   | PROPERTIES |   |
|              |   |   |   |
| ITEM 3.           |   | LEGAL  PROCEEDINGS |   |
|              |   |   |   |
| ITEM 4.           |   | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |   |
|              |   |   |   |
| **PART II**  |
|              |   |   |   |
| ITEM 5.           |   | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED  STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |   |
|              |   |   |   |
| ITEM 6.           |   | SELECTED CONSOLIDATED FINANCIAL DATA |   |
|              |   |   |   |
| ITEM 7.           |   | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS |   |
|              |   |   |   |
| ITEM 7A.          |   | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET  RISK |   |
|              |   |   |   |
| ITEM 8.           |   | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA |   |
|              |   |   |   |
| ITEM 9.           |   | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON  ACCOUNTING AND FINANCIAL DISCLOSURE |   |
|              |   |   |   |
| ITEM 9A.          |   | CONTROLS AND PROCEDURES |   |
|              |   |   |   |
| ITEM  9B.         |   | OTHER  INFORMATION |   |
|              |   |   |   |
| **PART III** |
|              |   |   |   |
| ITEM 10.          |   | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT |   |
|              |   |   |   |
| ITEM 11.          |   | EXECUTIVE COMPENSATION |   |
|              |   |   |   |
| ITEM 12.          |   | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND  MANAGEMENT AND RELATED STOCKHOLDER MATTERS |   |
|              |   |   |   |
| ITEM 13.          |   | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS |   |
|              |   |   |   |
| ITEM 14.          |   | PRINCIPAL ACCOUNTING FEES AND SERVICES |   |
|              |   |   |   |
| **PART IV**  |
|              |   |   |   |
| ITEM 15.          |   | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES |   |

 

Unlessotherwise indicated in this report, the “registrant,” “we,” “us” and “our”collectively refers to Iteris, Inc. (formerly known as Iteris Holdings, Inc.and Odetics, Inc.) and its former subsidiary, Meyer, Mohaddes Associates, Inc.,which was dissolved effective April 3, 2006.

AutoVue®, Iteris® and Vantage® are among theregistered trademarks of Iteris, Inc. Any other trademarks or trade namesmentioned herein are the property of their respective owners.

2

----

**Cautionary Statement**

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

**PART I**

**ITEM 1.****                             BUSINESS**

**Overview**

Iteris, Inc.,formerly known as Iteris Holdings, Inc., is a leading provider of outdoormachine vision systems and sensors that optimize the flow of traffic andenhance driver safety. Using proprietary software and IntelligentTransportation Systems (“ITS”) industry expertise, we provide video sensor systems,transportation management and traveler information systems and otherengineering and consulting services to the ITS industry. The ITS industry iscomprised of companies applying a variety of technologies to enable the safeand efficient movement of people and goods. We use our outdoor imagerecognition software expertise to develop proprietary algorithms for videosensor systems that improve vehicle safety and the flow of traffic. Using ourknowledge of the ITS industry, we design and implement transportationmanagement systems that help public agencies reduce traffic congestion andprovide greater access to traveler information.

Wewere originally incorporated in Delaware in 1987 as Odetics, Inc. and in September 2003changed our name to Iteris Holdings, Inc. to reflect our focus on the ITSindustry and our capital structure at that time. On October 22, 2004, wecompleted a merger with our majority-owned subsidiary, Iteris, Inc. (the “IterisSubsidiary”), and officially changed our corporate name from Iteris Holdings, Inc.to Iteris, Inc.

Our proprietary image recognition systems include Vantage and AutoVue. Vantageis a video vehicle detection system that detects the presence of vehicles onroadways. 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. AutoVue LaneDeparture Warning (“LDW”) systems consist of a small windshield mounted sensorthat uses proprietary software to detect and warn drivers of unintended lanedepartures. To date, we and our strategic partner have sold over 50,000production AutoVue LDW systems for use on car and truck platforms in the NorthAmerican and European markets. We believe that our AutoVue LDW technology is abroad sensor platform that, through additional software development, may beexpanded to incorporate additional safety and convenience features.

Our transportationmanagement systems business includes transportation engineering and consultingservices focused on the planning, design, development and implementation ofsoftware-based systems that integrate sensors, video surveillance, computersand advanced communications equipment to enable public agencies to monitor, controland direct traffic flow, assist in the quick dispatch of emergency crews anddistribute real-time information about traffic conditions. Our services includeplanning 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.

We currentlyoperate in three reportable segments: Roadway Sensors, Automotive Sensors andTransportation Systems. The Roadway Sensors segment includes our Vantagevehicle detection systems for traffic intersection control, incidentdetection and certain highway traffic data collection applications. TheAutomotive Sensors segment is comprised of all activities related to ourAutoVue LDW systems for vehicle safety. The Transportation Systems segmentincludes transportation engineering and consulting services and the developmentof transportation management and traveler 

3

----

information systems forthe ITS industry. See Note 13 to the accompanying consolidated financialstatements for further discussion of our operating segments.

**Sales, Marketing and Principal Customers**

We sell our Vantagevehicle detection systems primarily through indirect sales channels comprisedof independent dealers in the United States and Canada who sell integratedsystems and related products to the traffic management market. Our independentdealers are primarily responsible for sales, installation and support ofVantage systems. These dealers maintain an inventory of demonstration trafficproducts from various manufacturers including our Vantage vehicle detectionsystems and sell directly to government agencies and installation contractors.These dealers often have long-term arrangements with the government agencies intheir territory for the supply of various products for the construction andrenovation of traffic intersections. We hold technical training classes fordealers and end users and maintain a full-time staff of customer supporttechnicians to provide technical assistance when needed.

Our marketingstrategy for AutoVue is to establish it as the leading platform for in-vehiclevideo sensing for heavy trucks and passenger cars. We sell AutoVue LDW systemsdirectly to heavy truck manufacturers and to U.S. truck fleets, and our AutoVueLDW system is currently offered as an option on certain Mercedes, MAN,Freightliner and International trucks. We market the licensing of our LDWtechnology to manufacturers of passenger automobiles through a strategicrelationship with Valeo Schalter and Sensuren GmbH (“Valeo”), an independentautomotive supplier. In connection with this marketing effort, we providespecific contract engineering services, technical marketing and sales supportto Valeo which to date has enabled the launch of our LDW technology on threeInfiniti platforms, the FX, M and Q, where our LDW system is offered as part ofthe technology option package. We plan to continue to provide technicalmarketing and sales support to Valeo in our efforts to win new OEM customersfor the passenger car market as well as contract engineering services relatedto the possible launch of new Infiniti platforms that include our AutoVue LDWsystem.

We market and sellour transportation management systems and traveler information servicesdirectly to government agencies pursuant to negotiated contracts that involvecompetitive bidding and specific qualification requirements. Most of ourcontracts with federal, state and municipal customers provide for cancellationor renegotiation at the option of the customer upon reasonable notice and feespaid for modification. We use selected members of our engineering team dividedon a regional basis to serve in sales and business development functions. We donot engage in sales of transportation management systems and travelerinformation services outside of the U.S. Sales of our transportation managementsystems contracts generally involve long lead times and require extensivespecification development, evaluation and price negotiations.

Our largest customeraccounted for 11.5% of total net sales and contract revenues in the fiscal yearended March 31, 2006 (“Fiscal 2006”).

**Manufacturing and Materials**

We use contractmanufacturers to build subassemblies that are used in our Vantage products.Additionally, we procure certain components from qualified suppliers, bothglobally and locally, and use multi-sourcing strategies when technically andeconomically feasible to mitigate supply risk. These subassemblies andcomponents are delivered to our Anaheim facility where they go through finalassembly and testing prior to shipment to our customers. Our manufacturingactivities are conducted in approximately 8,000 square feet of space at ourAnaheim facility. Production volume at our subcontractors is based uponquarterly forecasts that we adjust on a monthly basis to control inventory. Forsales of AutoVue LDW systems to the truck market, we subcontract themanufacture of our AutoVue LDW systems to two manufacturers, and our internalprocesses are limited primarily to testing and final verification. For AutoVueLDW sales to the passenger car market, we anticipate that all manufacturingwill be done by Valeo; however, we plan to continue to provide engineeringsupport to Valeo. We currently do not manufacture any of the hardware used inthe transportation management and traveler information systems that we designand implement. Our production facility is currently ISO 9001 certified.

**Customer Support and Services**

We providewarranty service and support for our Vantage and AutoVue products as well asfollow-up service and support for which we charge separately. Service revenueaccounted for less than 1.0% of total net sales and contract revenues forFiscal 2006. We believe customer support is a key competitive factor.

**Backlog**

Our backlog ofunfulfilled firm orders was approximately $20.3 million as of March 31,2006, which was comprised of $1.5 million related to Roadway Sensors, $3.0million related to Automotive Sensors and $15.8 million related toTransportation Systems. The backlog for Roadway Sensors and Automotive Sensorsis expected to be recognized as revenue in the fiscal year ending March 31,2007 (“Fiscal 2007”) while approximately 84.0% of Transportation Systemsbacklog is expected to be recognized as revenue in Fiscal 2007. At March 31,2005, we had backlog of approximately $18.9 million, which was comprised of$1.7 million related to Roadway Sensors, $3.4 million related to AutomotiveSensors and $13.8 

4

----

millionrelated to Transportation Systems. All March 31, 2005 backlog for RoadwaySensors and Automotive Sensors was recognized as revenue in Fiscal 2006 while71.0% of Transportation Systems March 31, 2005 backlog was recognized asrevenue in Fiscal 2006. Pursuant to the customary terms of our agreements withgovernment contractors and other customers, customers can generally cancel orreschedule orders with little or no penalties. Lead times for the releaseof purchase orders often depend upon the scheduling and forecasting practicesof our individual customers, which also can affect the timing of the conversionof our backlog into revenues. For these reasons, among others, our backlog at aparticular date may not be indicative of our future revenues.

**Product Development**

Most of our development activities are conducted at our principalfacilities in Anaheim, California. Our company-sponsored research anddevelopment costs and expenses were approximately $5.1 million for Fiscal 2006,$4.2 million for the fiscal year ended March 31, 2005 (“Fiscal 2005”), and$3.9 million for the fiscal year ended March 31, 2004 (“Fiscal 2004”). Weexpect to continue to pursue significant product development programs and incursignificant research and development expenditures.

**Competition**

We generally face significant competition in each of our targetmarkets. Increased competition may result in price reductions, reduced grossmargins and loss of market share, any of which could have a material adverseeffect on our business, financial condition and results of operations. Webelieve that AutoVue is the only established commercially-available lanedeparture warning system used in the U.S. and in Europe in the heavy truckmarket. Potential competitors of AutoVue include Delphi Automotive SystemsCorporation domestically, NEC Corporation and Hitachi Ltd. in Japan and RobertBosch GmbH in Europe, as well as Siemens, Continental Tavis, Visteon andCognex, which could be currently developing video sensor technologies for thevehicle industry that could be used for lane departure warning systems. In themarket for our Vantage vehicle detection systems, we compete with manufacturersof other “above ground” video camera detection systems such as EconoliteControl Products, Inc., Traficon, N.V., Quixote, and other non-intrusivedetection devices including microwave, infrared, ultrasonic and magneticdetectors, as well as manufacturers and installers of in-pavement inductiveloop products.

The transportation management and traveler information systems marketis highly fragmented and is subject to evolving national and regional qualityand safety standards. Our competitors vary in number, scope and breadth of theproducts and services they offer. Our competitors in advanced transportationmanagement and traveler information systems include national corporations suchas Transcore, Siemens, PB Farradyne, Inc., Kimley-Horn and Associates, Inc.and National Engineering Technology, Inc. Our competitors intransportation engineering, planning and design include major firms such asParsons Brinkerhoff, Inc., URS, HNTB and Parsons Transportation Group, Inc.,as well as many smaller regional engineering firms.

In general, the markets for the products and services offered by ourbusinesses are highly competitive and are characterized by rapidly changingtechnology and evolving standards. Many of our current and prospectivecompetitors have longer operating histories, greater name recognition, accessto larger customer bases and significantly greater financial, technical,manufacturing, distribution and marketing resources than us. As a result, theymay be able to adapt more quickly to new or emerging standards or technologiesor to devote greater resources to the promotion and sale of their products. Itis also possible that new competitors or alliances among competitors couldemerge and rapidly acquire significant market share. We believe that ourability to compete effectively in our target markets will depend on a number offactors, including the success and timing of our new product development, thecompatibility of our products with a broad range of computing systems, productquality and performance, reliability, functionality, price, and service andtechnical support. Our failure to provide services and develop and marketproducts that compete successfully with those of other suppliers andconsultants in our target markets would have a material adverse effect on ourbusiness, financial condition and results of operations.

**Intellectual Property and ProprietaryRights**

Our ability to compete effectively depends in part on our ability todevelop and maintain the proprietary aspects of our technology. Our policy isto obtain appropriate proprietary rights protection for any potentiallysignificant new technology acquired or developed by us. We currently hold tenU.S. patents, which expire commencing in 2008, and have two****U.S.patent applications pending relating to our outdoor image processing techniquesused in our AutoVue systems. Nine of our patents relate specifically to ourAutoVue technology and provide a basis for enhanced functionality for rainsensing and improved performance. We believe that our other patents, whileimportant for our technology platforms, are less critical to our near termproduct strategy. We cannot assure you that any new patents will be grantedpursuant to any outstanding or subsequent applications.

5

----

In addition to patent laws, we rely on copyright and trade secret lawsto protect our proprietary rights. We attempt to protect our trade secrets andother proprietary information through agreements with customers and suppliers,proprietary information agreements with our employees and consultants, andother similar measures. We do not have any material licenses or trademarksother than those relating to product names. We cannot be certain that we willbe successful in protecting our proprietary rights. While we believe ourpatents, patent applications, software and other proprietary know-how havevalue, changing technology makes our future success dependent principally uponour employees’ technical competence and creative skills for continuinginnovation.

Litigation may be necessary in the future to enforce our proprietaryrights, to determine the validity and scope of the proprietary rights ofothers, or to defend us against claims of infringement or invalidity by others.An adverse outcome in such litigation or similar proceedings could subject usto significant liabilities to third parties, require disputed rights to belicensed from others or require us to cease marketing or using certainproducts, any of which could have a material adverse effect on our business,financial condition and results of operations. In addition, the cost ofaddressing any intellectual property litigation claim, both in legal fees andexpenses, as well as from the diversion of management’s resources, regardlessof whether the claim is valid, could be significant and could have a materialadverse effect on our business, financial condition and results of operations.

**Employees**

We refer to our employees as associates. As of June 6, 2006, weemployed an aggregate of 219 associates, including 45 associates in generalmanagement, administration and finance; 23 associates in sales and marketing; 117associates in engineering and product development; 24 associates in operations,manufacturing and quality; and 10 associates in customer service. None of ourassociates are represented by a labor union, and we have never experienced awork stoppage.

**Government Regulation**

Our manufacturing operations are subject to various federal, state andlocal laws and regulations, including those restricting the discharge ofmaterials into the environment. We are not involved in any pending or, to ourknowledge, threatened governmental proceedings, which would require curtailmentof our operations because of such laws and regulations. We continue to expendfunds in connection with our compliance with applicable environmentalregulations. These expenditures have not, however, been significant in thepast, and we do not expect any significant expenditure in the near future.Currently, compliance with foreign laws has not had a material impact on ourbusiness and is not expected to have a material impact in the near future.

6

----

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

*Ourbusiness is subject to a number of risks, some of which are discussed below. Otherrisks are presented elsewhere in this report and in the informationincorporated by reference into this report. 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 Forms 10-Qand 8-K, before deciding to buy, sell or hold our common stock. The risksand uncertainties described below are not the only ones facing our company. Additionalrisks and uncertainties not presently known to us or that we currently deemimmaterial may also affect our business operations. If any of these risksactually occurs, our business, financial condition or results of operationscould be seriously harmed. In that event, the market price for our common stockcould decline and you may lose all or part of your investment.*

**We HaveExperienced Substantial Losses And May Continue To Experience Losses ForThe Foreseeable Future.**Although we had net income of $80,000from continuing operations in the year ended March 31, 2006, weexperienced net losses from continuing operations of $11.3 million and $1.9million in the years ended March 31, 2005 and 2004, respectively. While wehave divested other business units, we cannot assure you that our efforts todownsize our operations or reduce our operating expenses will improve ourfinancial performance, or that we will be able to achieve profitability on aquarterly or annual basis in the future. Most of our expenses are fixed inadvance. As such, we generally are unable to reduce our expenses significantlyin the short-term to compensate for any unexpected delay or decrease inanticipated revenues. As a result, we may continue to experience operatinglosses and net losses, which would make it difficult to fund our operations andachieve our business plan, and could cause the market price of our common stockto decline.

**We May Need To Raise Additional Capital InThe Future, Which May Not Be Available On Terms Acceptable To Us, Or AtAll.**We have generated significant net losses and operatinglosses in recent periods, and have experienced volatility in our cash flowsfrom operations ranging from positive cash flows from operations of $590,000 inthe year ended March 31, 2005 to negative cash flows from operations of $718,000in the year ended March 31, 2004. Additionally, we failed to meet certaindebt covenants under our credit agreement with our bank in two of our last fourfiscal quarters. Our line of credit under this credit agreement expires on July 31,2006; and we cannot assure you that we will be able to renew this line ofcredit facility on acceptable terms, in a timely manner or at all.

Although we completed a $10.1 million convertibledebenture financing and our Iteris Subsidiary closed a $5.0 million termloan in May 2004, the majority of the proceeds from such financings wereused to purchase the Series A preferred stock of our Iteris Subsidiarywhich were held by outside investors. At March 31, 2006, we had $131,000of cash and cash equivalents and an outstanding balance of $2.7 million on ourline of credit, which is used to fund our operations. We may need to raiseadditional capital in the near future to fund our operations or to repayindebtedness. Such additional capital may be raised through bank borrowings, orother 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 ourstockholders.

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

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

·                                       ourability to control costs;

·                                       thesupply of key components for our products;

·                                       ourability to generate net income;

·                                       increasedresearch and development expenses;

·                                       increasedsales and marketing expenses;

·                                       technologicaladvancements and our competitors’ response to our products;

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

·                                       potentialacquisitions of businesses and product lines;

·                                       ourrelationships with customers and suppliers;

7

----

·                                       governmentbudgets, political agendas and other funding issues;

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

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

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

**If OurInternal Controls Over Financial Reporting Do Not Comply With The RequirementsOf The Sarbanes-Oxley Act, Our Business And Stock Price Could Be AdverselyAffected.**Along with our independent registered publicaccounting firm, we will be evaluating the effectiveness of our internalcontrols over financial reporting to comply with Section 404 of theSarbanes-Oxley Act of 2002. Section 404 currently requires us to evaluatethe effectiveness of our internal controls over financial reporting at the endof each fiscal year beginning in our fiscal year ending March 31, 2008 atthe earliest, and to include a management report assessing the effectiveness ofour internal controls over financial reporting in all annual reports beginningwith our Annual Report on Form 10-K for the fiscal year ending March 31,2008 at the earliest. Section 404 also requires our independent accountantto attest to, and report on, management’s assessment of our internal controlsover financial reporting. We may not be able to complete our Section 404compliance 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 andoperated, can provide only reasonable, not absolute, assurance that the controlsystem’s objectives will be met. Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the company have been, or will be detected. These inherent limitationsinclude the realities that judgments in decision-making can be faulty and thatbreakdowns can occur because of simple error or mistake. Controls can also becircumvented by the individual acts of some persons, by collusion of two ormore people, or by management override of the controls. The design of any systemof controls is based in part on certain assumptions about the likelihood offuture events, and we cannot assure you that any design will succeed inachieving its stated goals under all potential future conditions. Over time,our controls may become inadequate because of changes in conditions ordeterioration in the degree of compliance with policies or procedures. Becauseof the inherent limitations in a cost-effective control system, misstatementsdue to error or fraud may occur and not be detected.

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

**We May Experience Production Gaps Or DelaysIn 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 of transitioningto production of a next generation LDW system and experienced a significantdecline in orders from our largest AutoVue OEM customer for the heavy truck marketas a result of this transition. Although we have qualified our next generationsystem with our largest customer, we must continue to qualify the new systemwith our other customers. We cannot assure you that such qualifications will besuccessful or that we will not experience a decline in demand as a result ofthis transition. As a result, we could experience a gap or delay in productionas we transition to this next generation system. In some cases, such gaps ordelays may be driven by customer transition issues. In addition, we have runout of certain components used in the manufacture of our legacy AutoVue LDWsystem for the heavy truck market. As such, a timely 

8

----

completionof these qualifications and the successful transition will be critical to ourfuture success. Additionally, it is possible that we could experienceunforeseen quality control issues as we ramp up to full production of our nextgeneration LDW system. Should any such delay or disruption occur intransitioning to production of our next generation LDW system, our future saleswill likely be materially and adversely affected.

**We Depend On Government Contracts AndSubcontracts, And Because Many Of Our Government Contracts Are Fixed PriceContracts, Higher Than Anticipated Costs Will Reduce Our Profit And CouldAdversely Impact Our Operating Results.**A significant portionof our sales were derived from contracts with governmental agencies, either asa general contractor, subcontractor or supplier. Government contractsrepresented approximately 38.3%, 37.4% and 48.2% of our total net sales andcontract revenues for the years ended March 31, 2006, 2005 and 2004,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. These fixed price contracts require us toestimate the total project cost based on preliminary projections of the project’srequirements. The financial viability of any given project depends in largepart on our ability to estimate these costs accurately and complete the projecton a timely basis. In the event our costs on these projects exceed the fixedcontractual amount, we will be required to bear the excess costs. Suchadditional costs would adversely affect our financial condition and results ofoperations. Moreover, certain of our government contracts are subject totermination or renegotiation at the convenience of the government, which couldresult in a large decline in our net sales in any given quarter. Our inabilityto address any of the foregoing concerns or the loss or renegotiation of anymaterial government contract could seriously harm our business, financialcondition and results of operations.

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

**We May Be Unable To Attract And Retain KeyPersonnel, Which Could Seriously Harm Our Business.**Due tothe specialized nature of our business, we are highly dependent on thecontinued service of our executive officers and other key management,engineering and technical personnel. The loss of any of our executive officersor key members of management could adversely affect our business, financialcondition or results of operations. Our success will also depend in large partupon our ability to continue to attract, retain and motivate qualifiedengineering and other highly skilled technical personnel. In particular, thefuture success of our Transportation Systems business will depend on ourability to hire additional qualified engineers and planners. Competition forqualified employees, particularly development engineers, is intense. We may notbe able to continue to attract and retain sufficient numbers of such highlyskilled employees. Our inability to attract and retain additional key employeesor the loss of one or more of our current key employees could adversely affectour business, financial condition and results of operations.

**We HaveExperienced Growth In Recent Periods. If We Fail To Manage Our GrowthEffectively, We May Be Unable To Execute Our Business Plan And May ExperienceFuture Weaknesses In Our Internal Controls.**We have expandedour overall business, particularly in our Vantage and AutoVue product lines. Inorder to achieve our business 

9

----

objectives, we will needto continue to expand our business and add additional qualified personnel. Suchexpansion has placed and is expected to continue to place, a significant strainon our managerial, administrative, operational, financial and other resources. Ifwe are unable to successfully manage our growth, our business, financialcondition and results of operations will be adversely affected.

To accommodatethis growth, we launched a new ERP system in April 2006. Accordingly, wemay experience problems commonly experienced by other companies in connectionwith such implementations, including but not limited to, potential bugs in thesystem, component or supply delays, training requirements and other integrationchallenges and delays. Any difficulties we might experience in connection withour new ERP system could have a material adverse effect on our financialreporting system and internal controls.

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

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 technological developmentsor changing customer requirements. We cannot assure you that any suchinvestments in research and development will lead to any corresponding increasein revenue.

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

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

Our business andresults of operations could also be seriously harmed by any significant delaysin our new product development. Certain of our new products could containundetected design faults and software errors or “bugs” when first released byus, despite our testing. We may not discover these faults or errors until aftera product has been installed and used by our customers. Any faults or errors inour existing products or in any new products may cause delays in productintroduction and shipments, require design modifications or harm customerrelationships, any of which could adversely affect our business and competitiveposition.

**The Markets In Which We Operate Are HighlyCompetitive And Have Many More Established Competitors, Which Could AdverselyAffect Our Sales Or The Market Acceptance Of Our Products.**Wecompete with numerous other companies in our target markets including, but notlimited to, large, multinational corporations, which include tier oneautomotive suppliers, and many smaller regional engineering firms. We expectsuch competition to increase due to technological advancements, industryconsolidations and reduced barriers to entry. Increased competition is likelyto result in price reductions, reduced gross margins and loss of market share,any of which could seriously harm our business, financial condition and resultsof operations. We may experience more competition in our Vantage business inFiscal 2007 as the department of transportation in one of our largest salesterritories is moving to a multisource contracting environment from one inwhich Iteris is the preferred supplier. In addition, one of the otherdevelopers of LDW systems was recently acquired by a larger company. While thisdeveloper has not been a material competitor to date, we may experience morecompetition from this provider as a result of its greater access to resourcesfrom its acquirer, and additional competitors may enter this market in thefuture.

10

----

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

**An Economic Slowdown And Related UncertaintiesCould Adversely Impact The Demand For Our Products.**Concernsabout inflation, decreased consumer confidence, reduced corporate profits andcapital spending, and recent international conflicts and terrorist and militaryactions have resulted in a downturn in worldwide economic conditions,particularly in the United States. These unfavorable economic conditions mayhave a negative impact on customer orders, cancellations and rescheduling ofbacklog. In addition, recent political and social turmoil related tointernational conflicts and terrorist acts can be expected to put furtherpressure on economic conditions in the U.S. and worldwide. These political,social and economic conditions make it extremely difficult for our customers,our suppliers and us to accurately forecast and plan future business activities.If such conditions continue or worsen, our business, financial condition andresults of operations will likely be materially and adversely affected.

**We May Engage In Acquisitions Of Companies OrTechnologies That May Require Us To Undertake Significant CapitalInfusions And Could Result In Disruptions Of Our Business And Diversion OfResources And Management Attention.**We have historicallyacquired, and may in the future acquire, complementary businesses, products andtechnologies. Acquisitions may require significant capital infusions and, ingeneral, acquisitions also involve a number of special risks, including:

·                                          potentialdisruption of our ongoing business and the diversion of our resources 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 acquiredcompanies;

·                                          increasedcosts to improve managerial, operational, financial and administrative systemsand to eliminate duplicative services;

·                                          theincurrence of unforeseen obligations or liabilities;

·                                          potentialimpairment of relationships with employees or customers as a result of changesin management; and

·                                          increasedinterest expense and amortization of acquired intangible assets.

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

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

·                                          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;

11

----

·                                          marketacceptance of the products incorporating our technologies and products;

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

·                                          theintroduction of new products by competitors;

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

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

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

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

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

·                                          rapidtechnological advances;

·                                          downwardprice pressure in the marketplace as technologies mature;

·                                          changesin customer requirements;

·                                          frequentnew product introductions and enhancements; and

·                                          evolvingindustry standards and changes in the regulatory environment.

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

**We May Not Be Able To Adequately Protect OrEnforce Our Intellectual Property Rights, Which Could Harm Our CompetitivePosition.**If we are not able to adequately protect or enforcethe proprietary aspects of our technology, competitors could be able to accessour proprietary technology and our business, financial condition and results 

12

----

ofoperations will likely be seriously harmed. We currently attempt to protect ourtechnology through a combination of patent, copyright, trademark and tradesecret laws, employee and third party nondisclosure agreements and similarmeans. Despite our efforts, other parties may attempt to disclose, obtain oruse our technologies or systems. Our competitors may also be able toindependently develop products that are substantially equivalent or superior toour products or design around our patents. In addition, the laws of someforeign countries do not protect our proprietary rights as fully as do the lawsof the United States. As a result, we may not be able to protect ourproprietary rights adequately in the United States or abroad.

Litigation may benecessary in the future to enforce our intellectual property rights or todetermine the validity and scope of the proprietary rights of others.Litigation may also be necessary to defend against claims of infringement orinvalidity by others. An adverse outcome in litigation or any similarproceedings could subject us to significant liabilities to third parties,require us to license disputed rights from others or require us to ceasemarketing or using certain products or technologies. We may not be able toobtain any licenses on terms acceptable to us, or at all. We also may have toindemnify certain customers or strategic partners if it is determined that wehave infringed upon or misappropriated another party’s intellectual property.Any of these results could adversely affect our business, financial conditionand results of operations. In addition, the cost of addressing any intellectualproperty litigation claim, including legal fees and expenses, and the diversionof management’s attention and resources, regardless of whether the claim isvalid, could be significant and could seriously harm our business, financialcondition and results of operations.

**The Trading Price Of Our Common Stock Is HighlyVolatile.**The trading price of our common stock has beensubject to wide fluctuations in the past. Since January 2000, our Class Acommon stock (now known as our common 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 commonstock could continue to fluctuate in the future in response to various factors,including, but not limited to:

·                                          quarterlyvariations in operating results;

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

·                                          ourability to raise additional capital;

·                                          shortagesannounced by suppliers;

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

·                                          transitionsto new products or product enhancements;

·                                          acquisitionsof businesses, products or technologies;

·                                          theimpact of any litigation;

·                                          changesin investor perceptions;

·                                          governmentfunding, political agendas and other budgetary issues;

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

·                                          internationalconflicts, political unrest and acts of terrorism.

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 been unrelatedto 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.

13

----

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

·                                          currencyfluctuations and restrictions;

·                                          political,social and economic instability;

·                                          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;

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

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

**We Could Experience Negative Financial ImpactsArising From Developments In Contingencies Created Under Our Previous StructureOr By Former Subsidiaries.**Although we divested ourselves ofall business units, with the exception of our Iteris business, from time totime we could experience unforeseen developments in contingencies related toour former subsidiaries. In particular, we are presently party to a lawsuitbrought against Mariner Networks, Inc., one of our former subsidiaries(refer to Note 7 to the consolidated financial statements). The outcome of thislawsuit is presently uncertain. Although we are not aware of any other materialcontingencies, it is possible that other matters could be brought against us inconnection with activities related to former subsidiaries and that such matterscould materially and adversely affect our financial results and cash flows.

**Some Of Our Directors, Officers And TheirAffiliates Can Control The Outcome Of Matters That Require The Approval Of OurStockholders, And Accordingly We Will Not Be Able To Engage In CertainTransactions Without Their Approval.**As of March 31,2006, our officers and directors owned approximately 16% of the outstandingshares of our common stock (and approximately 25% of our common stock whenincluding options, warrants and other convertible securities held by them whichare currently exercisable or convertible or will become exercisable orconvertible within 60 days after March 31, 2006). As a result oftheir stock ownership, our management will be able to significantly influencethe election of our directors and the outcome of corporate actions requiringstockholder approval, such as mergers and acquisitions, regardless of how ourother stockholders may vote. This concentration of voting control may have asignificant effect in delaying, deferring or preventing a change in ourmanagement or change in control and may adversely affect the voting or otherrights of other holders of common stock.

**Certain Anti-Takeover Provisions May AffectThe Price Of Our Common Stock And Discourage A Third Party From Acquiring Us.**Certainprovisions of our certificate of incorporation and our stockholder rights plancould make it difficult for a third party to acquire us, even though anacquisition might be beneficial to our stockholders. Such provisions couldlimit the price that investors might be willing to pay in the future for sharesof our common stock. Under the terms of our certificate of incorporation, ourBoard of Directors is authorized to issue, without stockholder approval, up to2,000,000 shares of preferred stock with voting, conversion and other rightsand preferences superior to those of our common stock. Our future issuance ofpreferred stock could be used to discourage an unsolicited acquisitionproposal. In addition, in March 1998, we adopted a stockholder rights planand declared a dividend of preferred stock purchase rights to our stockholders.We amended this plan in May 2004. In the event a third party acquires morethan 15% of the outstanding voting control of our company or 15% of ouroutstanding common stock, the holders of these rights will be able to purchasethe junior participating preferred stock at a substantial discount off of thethen current market price. The exercise of these rights and purchase of asignificant amount of stock at below market prices could cause substantialdilution to a particular acquirer and discourage the acquirer from pursuing ourcompany. The mere existence of a stockholder rights plan often delays or makesa merger, tender offer or proxy contest more difficult.

14

----

**ITEM 1B.****                    UNRESOLVED STAFF COMMENTS**

Not applicable.

**ITEM 2.****                             PROPERTIES**

Our headquarters and principal operations are housed in approximately94,000 square feet of leased space located at 1515 South Manchester Boulevardin Anaheim, California, for which we pay a monthly lease rate of $84,000. TheAnaheim facility includes our operations and administrative offices(approximately 84,000 dedicated square feet) and the operations of our formersubsidiary, MAXxess Systems, Inc. (approximately 10,000 dedicated squarefeet). The portion of the facility occupied by MAXxess is subleased at a rateof $10,000 per month. The lease for the Anaheim facility does not contain anyrenewal options and expires on October 31, 2007.

For additional information regarding our obligations under propertyleases, see Note 7 of Notes to Consolidated Financial Statements, included in Part IV,Item 15 of this Report.

**ITEM 3.****                             LEGAL PROCEEDINGS**

The information set forth under Note 7 of Notes to ConsolidatedFinancial Statements, included in Part IV, Item 15 of this report, isincorporated herein by reference.

**ITEM 4.****                             SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

No matters were submitted to a vote of our security holders during thethree months ended March 31, 2006.

15

----

**PART II**

**ITEM 5.****                        MARKET FOR REGISTRANT’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY SECURITIES**

In October 2004, we amended our certificate ofincorporation to (a) change the voting rights of our Class A commonstock from one-tenth to one vote per share, (b) remove the ability toissue any further shares of Class B common stock, and (c) rename our Class Acommon stock as common stock. As a result, we currently have only one class ofcommon stock outstanding, the common stock. Our Class A common stock and Class Bcommon stock were delisted from the Nasdaq SmallCap Market in August 2003and April 2003, respectively, and were quoted on the OTC Bulletin Boardthereafter until December 9, 2004, when our common stock began trading onthe American Stock Exchange (“AMEX”) under the symbol “ITI.”
| ** **                            | ** ** | **Class A Common Stock** | ** ** | **Class B Common Stock** | ** ** |
|---------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| ** **                            | ** ** | **High**                                | ** ** | **Low**                                 | ** ** | **High** | ** ** | **Low** | ** ** |
| **Fiscal  2005**                      |       |                                    |       |                                    |       |   |   |   |   |
| Quarter Ended June 30, 2004      |       | $                                       | 4.10       |                                    | $          | 2.60 |   | $ | 3.00 |   | $ | 3.00 |   |
| Quarter Ended September 30, 2004 |       | 3.60                                    |       | 2.85                                    |       | 3.00 |   | 3.00 |   |
| Quarter Ended December 31, 2004  |       | 3.87                                    |       | 2.90                                    |       | 3.00 |   | 3.00 |   |
| Quarter Ended March 31, 2005     |       | 3.43                                    |       | 2.30                                    |       | N/A |   | N/A |   |
|                                  |       |                                    |       |                                    |       |   |   |   |   |
| **Fiscal  2006**                      | ** ** | ** **                              | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter Ended June 30, 2005      |       | $                                       | 2.89       |                                    | $          | 2.00 |   | N/A |   | N/A |   |
| Quarter Ended September 30, 2005 |       | 3.40                                    |       | 2.57                                    |       | N/A |   | N/A |   |
| Quarter Ended December 31, 2005  |       | 2.80                                    |       | 2.02                                    |       | N/A |   | N/A |   |
| Quarter  Ended March 31, 2006    |       | 2.80                                    |       | 1.85                                    |       | N/A |   | N/A |   |
|                                       |            |                                         |            |                                         |            |  |  |  |  |  |  |  |  |

 

On June 28, 2006, the last reported sale price of our common stockon the AMEX was $2.20. As of June 28, 2006, we had 580 holders of recordof our common stock according to information furnished by our transfer agent.

**Dividend Policy**

We have never paid or declared cash dividends on our common stock, andhave no current plans to pay such dividends in the foreseeable future. Wecurrently intend to retain any earnings for working capital and generalcorporate purposes. The payment of any future dividends will be at thediscretion of our Board of Directors and will depend upon a number of factors,including, but not limited to, future earnings, the success of our business,our capital requirements, our general financial condition and future prospects,general business conditions, the consent of our lender and such other factorsas the Board of Directors may deem relevant.

16

----

**ITEM 6.  SELECTEDCONSOLIDATED FINANCIAL DATA**

The followingtable sets forth selected consolidated financial data for each of the fivefiscal years ended March 31, 2006. The statement of operations and balancesheet data for the years ended and as of March 31, 2006, 2005, 2004, 2003and 2002 are derived from our audited consolidated financial statements. Theaccompanying consolidated financial statements have been restated to reflectthe classification and presentation of our former subsidiaries, Broadcast, Inc.,Zyfer Inc., Mariner Networks, Inc., Gyyr, Inc. and MAXxess Systems, Inc.,as discontinued operations for all periods presented. See Note 1 to theaccompanying consolidated financial statements. The following informationshould be read in conjunction with “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and with our consolidatedfinancial statements and the related notes thereto included elsewhere in thisreport.

17

----

 
| ** **                                                                          | ** ** | **Fiscal Year Ended March 31**                 | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                          | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated  Statement of Operations Data:**                                     | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  sales and contract revenues:                                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net sales                                                                           |       | $                                                                  | 31,156     |   | $ | 29,062 |   | $ | 23,470 |   | $ | 19,112 |   | $ | 17,104 |   |
| Contract revenues                                                                   |       | 19,330                                                             |       | 17,335 |   | 21,813 |   | 22,283 |   | 20,205 |   |
| Total net sales and contract  revenues                                              |       | 50,486                                                             |       | 46,397 |   | 45,283 |   | 41,395 |   | 37,309 |   |
| Costs  and expenses:                                                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of net sales                                                                   |       | 16,465                                                             |       | 15,645 |   | 12,758 |   | 9,366 |   | 8,401 |   |
| Cost of contract revenues                                                           |       | 12,395                                                             |       | 11,398 |   | 14,712 |   | 15,110 |   | 12,043 |   |
| Selling, general and  administrative expenses                                       |       | 14,999                                                             |       | 13,964 |   | 12,844 |   | 14,105 |   | 14,627 |   |
| Research and development  expenses                                                  |       | 5,088                                                              |       | 4,193 |   | 3,923 |   | 3,908 |   | 3,434 |   |
| Stock-based compensation                                                            |       | 725                                                                |       | 11,777 |   | — |   | — |   | — |   |
| Amortization of intangible  assets                                                  |       | 147                                                                |       | 114 |   | — |   | — |   | — |   |
| Deferred compensation expense  (benefit)                                            |       | 48                                                                 |       | (484 | ) | 868 |   | — |   | — |   |
| Disposal of fixed assets                                                            |       | —                                                             |       | 422 |   | — |   | — |   | — |   |
| Acquired in-process research  and development                                       |       | —                                                             |       | 140 |   | — |   | — |   | — |   |
| Restructuring charges                                                               |       | —                                                             |       | — |   | — |   | — |   | 1,142 |   |
| Total costs and expenses                                                            |       | 49,867                                                             |       | 57,169 |   | 45,105 |   | 42,489 |   | 39,647 |   |
| Income (loss) from operations                                                       |       | 619                                                                |       | (10,772 | ) | 178 |   | (1,094 | ) | (2,338 | ) |
| Non-operating  income (expense):                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Other income (expense), net                                                         |       | 35                                                                 |       | 1,054 |   | 1,003 |   | 417 |   | (1,365 | ) |
| Interest expense, net                                                               |       | (1,459                                                             | )          | (1,178 | ) | (123 | ) | (761 | ) | (4,190 | ) |
| Income (loss) from continuing operations before income taxes and  minority interest |       | (805                                                               | )          | (10,896 | ) | 1,058 |   | (1,438 | ) | (7,893 | ) |
| Income tax benefit (provision)                                                      |       | 885                                                                |       | 94 |   | (100 | ) | — |   | 785 |   |
| Minority interest in earnings of subsidiary                                         |       | —                                                             |       | (526 | ) | (2,813 | ) | (3,818 | ) | (1,910 | ) |
| Income (loss) from continuing operations                                            |       | 80                                                                 |       | (11,328 | ) | (1,855 | ) | (5,256 | ) | (9,018 | ) |
| Income (loss) from discontinued operations, net of taxes                            |       | —                                                             |       | — |   | 1,215 |   | (7,892 | ) | (17,120 | ) |
| Extraordinary loss from early extinguishment of debt, net of taxes                  |       | —                                                             |       | — |   | — |   | — |   | (450 | ) |
| Net income (loss)                                                                   |       | $                                                                  | 80         |   | $ | (11,328 | ) | $ | (640 | ) | $ | (13,148 | ) | $ | (26,588 | ) |
|                                                                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic  earnings (loss) per share:                                                   |       |                                                               |       |   |   |   |   |   |   |   |   |
| Continuing operations                                                               |       | $                                                                  | 0.00       |   | $ | (0.45 | ) | $ | (0.09 | ) | $ | (0.37 | ) | $ | (0.80 | ) |
| Discontinued operations                                                             |       | —                                                             |       | — |   | 0.06 |   | (0.55 | ) | (1.52 | ) |
| Extraordinary loss                                                                  |       | —                                                             |       | — |   | — |   | — |   | (0.04 | ) |
| Basic earnings (loss) per  share                                                    |       | $                                                                  | 0.00       |   | $ | (0.45 | ) | $ | (0.03 | ) | $ | (0.92 | ) | $ | (2.36 | ) |
|                                                                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Diluted  earnings (loss) per share:                                                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Continuing operations                                                               |       | $                                                                  | 0.00       |   | $ | (0.45 | ) | $ | (0.09 | ) | $ | (0.37 | ) | $ | (0.80 | ) |
| Discontinued operations                                                             |       | —                                                             |       | — |   | 0.06 |   | (0.55 | ) | (1.52 | ) |
| Extraordinary loss                                                                  |       | —                                                             |       | — |   | — |   | — |   | (0.04 | ) |
| Diluted earnings (loss) per  share                                                  |       | $                                                                  | 0.00       |   | $ | (0.45 | ) | $ | (0.03 | ) | $ | (0.92 | ) | $ | (2.36 | ) |
| Shares used in calculating basic earnings (loss) per share                          |       | 28,182                                                             |       | 25,284 |   | 19,454 |   | 14,276 |   | 11,267 |   |
| Shares  used in calculating diluted earnings (loss) per share                       |       | 32,737                                                             |       | 25,284 |   | 19,454 |   | 14,276 |   | 11,267 |   |

 
| ** **                                 | ** ** | **At March 31,** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **2006**                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                 | ** ** | **(in thousands)**    | ** ** |
| **Consolidated  Balance Sheet Data:**      | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Working capital (deficit)                  |       | $                          | 3,293      |   | $ | 2,197 |   | $ | 9,369 |   | $ | 3,368 |   | $ | (7,349 | ) |
| Total assets                               |       | 49,633                     |       | 46,656 |   | 30,065 |   | 34,842 |   | 52,238 |   |
| Long-term debt (less current portion)      |       | 11,374                     |       | 10,315 |   | 891 |   | 1,265 |   | 2,042 |   |
| Accumulated deficit                        |       | (110,356                   | )          | (110,436 | ) | (99,108 | ) | (98,468 | ) | (85,320 | ) |
| Total  stockholders’ equity (deficit) |       | 18,635                     |       | 17,462 |   | (1,076 | ) | (5,340 | ) | 4,203 |   |
|                                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

18

----

**ITEM 7.****                                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

*You should read the followingdiscussion and analysis in conjunction with our Consolidated FinancialStatements and related Notes thereto included in Part IV, Item 15 of thisreport and the “Risk Factors” section in Item 1A, as well as othercautionary statements and risks described elsewhere in this report, beforedeciding to purchase, hold or sell our common stock.*

**Overview**

We are a leading provider of outdoor machine vision systems and sensorsthat optimize the flow of traffic and enhance driver safety. Using ourproprietary software and ITS industry expertise, we provide video sensorsystems, transportation management and traveler information systems and other engineeringand consulting services to the ITS industry. We use our outdoor imagerecognition software expertise to develop proprietary algorithms for videosensor systems that improve vehicle safety and the flow of traffic. Using ourknowledge 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 sensing system that detects thepresence of vehicles on roadways. Vantage systems are used at signalizedintersections to enable a more efficient allocation of green signal time andare also used for incident detection and highway traffic data collectionapplications. We sell and distribute our Vantage products primarily tocommercial customers and municipal agencies.

Our AutoVue LDW systems consist of a small windshield mounted sensorthat uses proprietary software to detect and warn drivers of unintended lanedepartures. Approximately 50,000 production AutoVue LDW units have been soldfor car and truck platforms in the North American and European markets. OurAutoVue LDW systems are currently offered as an option on certain Mercedes,MAN, Freightliner and International trucks. In September 2003, we enteredinto an agreement with Valeo, pursuant to which we granted Valeo the exclusiveright to sell and manufacture our AutoVue LDW systems to the worldwidepassenger car market in exchange for royalty payments for each AutoVue LDW unitsold. To date, royalty payments from Valeo have not been significant. Pursuantto this agreement, we also generate revenues from Valeo by providing specificcontract engineering services, technical marketing and sales support to Valeoto enable the launch of our LDW technology on three Infiniti platforms, the FX,M and Q, where the device is offered as part of the technology option package. Valeois currently in discussions to provide our LDW system to other passenger carOEMs; however, we cannot assure you that such discussions will be successful. Weplan to continue to provide technical marketing and sales support to Valeo inour efforts to win new OEM customers for the passenger car market, as well ascontract engineering services related to the possible launch of new Infinitiplatforms that include our LDW system. We believe that AutoVue is a broadsensor platform that, through additional software development, may be expandedto incorporate additional safety and convenience features.

Our transportationmanagement systems business includes transportation engineering and consultingservices focused on the planning, design, development and implementation ofsoftware-based systems that integrate sensors, video surveillance, computersand advanced communications equipment to enable public agencies to monitor,control and direct traffic flow, assist in the quick dispatch of emergencycrews and distribute real-time information about traffic conditions. Ourservices include 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 are sold to local, state and nationaltransportation agencies in the United States. Our transportation managementsystems business is largely dependent upon governmental funding and budgetaryissues. The Federal Highway Bill was passed in August 2005, which providesfor a significant increase in transportation funding over the next six years. Historically,there have been significant delays between the passage of funding bills and theallocation of related funding to specific contracts. Accordingly, while we haveseen an increase in activity following the passage of the bill, we cannotcurrently predict the full impact that this bill will have on ourtransportation management systems business. We anticipate that the success ofour transportation systems business will continue to be dependent in part ongovernment spending and the budgetary process.

We have historically operated multiple business units. During thefiscal year ended March 31, 2003 (“Fiscal 2003”), we operated in threebusiness segments consisting of ITS, video products, and telecom products. TheITS segment consisted of our current operations, which was previously conductedby the Iteris Subsidiary. The video products segment consisted of our formerwholly-owned subsidiaries, MAXxess Systems, Inc. (“MAXxess,” previouslyknown as Gyyr Incorporated), which designed and manufactured securitymanagement systems, and Broadcast, Inc. (“Broadcast”), which developed andsupplied software based systems to automate and control the multiple classes ofequipment used in broadcast studios and satellite uplink facilities. Ourtelecom segment consisted of our wholly-owned subsidiary, Zyfer, Inc. (“Zyfer”),which 

19

----

developed and manufactured timing and synchronizationproducts and which, prior to its incorporation, was operated as ourCommunications division.

Beginning inFiscal 2003, we began divesting certain of our business units in order toreduce our operating expenses and to focus on the operations of our IterisSubsidiary. These divestitures and related restructuring activities includedthe following transactions:

· In March 2003,we ceased the development and sale of any new Broadcast products and in September 2003,we sold the balance of our Broadcast business.

· In May 2003,we sold the assets of Zyfer for a purchase price of $2.3 million in cash andthe assumption of liabilities, plus future incentive payments based on therevenues generated by the sale of Zyfer’s products or the license of itstechnologies. In October 2004, we received an incentive payment of$135,000 related to the twelve month period ended April 30, 2004, and in September 2005,we received an incentive payment of $83,000 related to the twelve month periodended April 30, 2005.

· In September 2003,we sold substantially all of the assets of MAXxess to an investor group thatincluded one of our directors and certain members of the MAXxess managementgroup. The consideration for the sale consisted of the assumption of $2.7million of liabilities, resulting in a net gain of $2.3 million on this sale.

· In May 2004,we repurchased all of the outstanding shares of Series A preferred stockof the Iteris Subsidiary for an aggregate purchase price of approximately $17.5million in cash, and we purchased 548,000 shares of the Iteris Subsidiarycommon stock from DaimlerChrysler Ventures GmbH (“DCV”) in consideration forthe issuance of 1.2 million shares of our common stock. We financed thepurchase price for the Iteris Subsidiary Series A preferred stock throughthe issuance of convertible debentures in the original principal amount of$10.1 million, a $5.0 million term note payable to our bank and $2.4 million incash.

· In June 2004,we issued 2.6 million shares of our common stock valued at $8.6 million at thedate of issuance in exchange for an aggregate of 1.3 million shares of commonstock of the Iteris Subsidiary, which had the effect of reducing the residualminority interest in our Iteris Subsidiary to 8.1%.

· In October 2004,we merged the Iteris Subsidiary into us and the remaining minority interest inthe Iteris Subsidiary (consisting of 1.2 million shares of common stock of theIteris Subsidiary) was converted to 2.5 million  shares of our common stock valued at $7.6million at the merger date. Immediately following the merger, we converted allof our outstanding Class B common stock (922,000 shares) into 1.0 millionshares of our common stock (which was formerly designated as Class Acommon stock). In connection with this merger, we also assumed 3.1 millionoutstanding options and 327,000 warrants to purchase common stock of the IterisSubsidiary, which became options and warrants to purchase an aggregate of 6.1million  and 654,000 shares,respectively, of our common stock.

· In October 2004,we amended our certificate of incorporation to (a) change the votingrights of our Class A common stock from one-tenth to one vote per share, (b) removethe ability to issue any further shares of Class B common stock, and (c) renameour Class A common stock to common stock. As a result, we currently haveonly one class of capital stock outstanding, the common stock.

Our financialstatements for all periods presented in this report have been restated toreflect the discontinuation of the operations of Broadcast, Zyfer and MAXxess.

We currentlyoperate in three reportable segments: Roadway Sensors, Automotive Sensors andTransportation Systems. The Roadway Sensors segment includes our Vantagevehicle detection systems for traffic intersection control, incidentdetection and certain highway traffic data collection applications. TheAutomotive Sensors segment is comprised of all activities related to ourAutoVue LDW systems for vehicle safety. The Transportation Systems segmentincludes transportation engineering and consulting services and the developmentof transportation management and traveler information systems for the ITSindustry.

**Critical Accounting Policies and Estimates**

Management’sDiscussion and Analysis of Financial Condition and Results of Operations isbased on our consolidated financial statements included herein, which have beenprepared in accordance with generally accepted accounting principles in theUnited States (“GAAP”). 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, therecoverability of long-lived assets and goodwill, the realizability of deferredtax assets, and warranty reserves. We base these estimates on historicalexperience and on various other factors that we believe to be reasonable underthe circumstances, the results of which form the basis for making judgmentsabout the carrying values of assets and liabilities that are not readilyapparent from other sources. These estimates and assumptions by their natureinvolve risks and uncertainties, and may prove to be inaccurate. In the eventthat any of our estimates or 

20

----

assumptions areinaccurate in any material respect, it could have a material adverse effect onour reported amounts of assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.

The followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our consolidated financial statements.

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

Contract revenuesare derived primarily from long-term contracts with governmental agencies. Contractrevenues include costs incurred plus a portion of estimated fees or profitsdetermined using the percentage of completion method of accounting based on therelationship of costs incurred to total estimated costs. Any anticipated losseson contracts are charged to earnings when identified. Changes in jobperformance and estimated profitability, including those arising from contractpenalty provisions and final contract settlements, may result in revisions torecognized costs and revenues and are recognized in the period in which therevisions are determined. Profit incentives are included in revenue when theirrealization is reasonably assured.

In addition toproduct and contract revenues, we derive revenue from technology access fees,the provision of specific non-recurring contract engineering services relatedto our AutoVue LDW system, and royalties related to unit sales of our AutoVueLDW systems by our strategic partner Valeo to the passenger car market.Technology access fee revenues are recognized evenly over the period in whichthey are earned. Non-recurring contract engineering revenues are recognized inthe period in which the related services are performed. Royalty revenues arerecorded based on unit sales of our products by Valeo and are recognized in theperiod in which such sales occur. Technology access fee revenues, contractengineering revenues and royalty revenues are included in net sales in theaccompanying consolidated statements of operations.

Revenues fromfollow-on service and support, for which we charge separately, are recorded inthe period in which the services are performed.

*AccountsReceivable*. We estimate the collectibility of customerreceivables on an ongoing basis by periodically reviewing invoices outstandinggreater than a certain period of time. We have recorded reserves forreceivables deemed to be at risk for collection as well as a general reservebased on our historical collections experience. A considerable amount ofjudgment is required in assessing the ultimate realization of tradereceivables, including the current credit-worthiness of each customer. If thefinancial condition of our customers deteriorates, resulting in an impairmentof their ability to make required payments, additional allowances may berequired 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 reserves for potentially excess and obsolete inventory.In assessing the ultimate realization of inventories, we make judgments as tofuture demand requirements and compare that with the current or committedinventory levels. Reserves are established for inventory levels that exceedfuture demand. It is possible that reserves over and above those alreadyestablished may be required in the future if market conditions for our productsdeteriorate.

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

*Warranty.*Unless otherwise stated, we provide a one to three yearwarranty from the original invoice date on all products, materials andworkmanship. Products sold to certain OEM customers sometimes carry longerwarranties. Defective products are either repaired or replaced, at our option,upon meeting certain criteria. We accrue a provision for the estimated coststhat may be incurred for product warranties relating to a product as acomponent of cost of sales at the time revenue for that product is recognized. Theaccrued warranty provision is included within accrued expenses on theaccompanying consolidated balance sheets. Should our actual experience ofwarranty returns be higher than anticipated, additional warranty reserves maybe required, which may adversely affect our operating results.

21

----

*Taxes.*We recorded a valuation allowance to reduce our deferred taxassets to amounts that we believe are more likely than not to be realized.Realization of deferred tax assets (such as net operating loss carryforwards)is dependent on future taxable earnings and is therefore uncertain. On aquarterly basis, we assess the likelihood that our deferred tax asset balancewill be recovered from future taxable income. To the extent we believe thatrecovery is not likely, we establish a valuation allowance against our deferredtax asset, increasing our income tax expense in the period such determinationis made.

On an interimbasis, we estimate what our anticipated annual effective tax rate will be andrecord a quarterly income tax provision in accordance with this anticipatedrate. As the fiscal year progresses, we refine our estimates based upon actualevents and earnings during the year. This estimation process can result insignificant changes to our expected effective tax rate. When this occurs, weadjust the income tax provision during the quarter in which the change inestimate occurs so that the year-to-date provision reflects the expected annualrate. The changes described in the preceding sentence and the recording ofvaluation allowances may create fluctuations in our overall effective tax ratefrom quarter to quarter.

**Resultsof 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.
| ** **                                                                 | ** ** | **Fiscal Year Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales and contract  revenues:                                          |       |                                                |       |   |   |   |   |
| Net sales                                                                  |       | 61.7                                                | %          | 62.6 | % | 51.8 | % |
| Contract revenues                                                          |       | 38.3                                                |       | 37.4 |   | 48.2 |   |
| Total net sales and contract  revenues                                     |       | 100.0                                               | %          | 100.0 | % | 100.0 | % |
|                                                                       |       |                                                |       |   |   |   |   |
| Costs  and expenses:                                                       |       |                                                |       |   |   |   |   |
| Cost of net sales                                                          |       | 32.6                                                |       | 33.7 |   | 28.2 |   |
| Cost of contract revenues                                                  |       | 24.6                                                |       | 24.6 |   | 32.5 |   |
| Selling, general and  administrative expenses                              |       | 29.7                                                |       | 30.1 |   | 28.4 |   |
| Research and development  expenses                                         |       | 10.1                                                |       | 9.0 |   | 8.6 |   |
| Stock-based compensation  expense (benefit)                                |       | 1.4                                                 |       | 25.4 |   | — |   |
| Amotization of intangible  assets                                          |       | 0.3                                                 |       | 0.2 |   | — |   |
| Deferred compensation                                                      |       | 0.1                                                 |       | (1.0 | ) | 1.9 |   |
| Disposal of fixed assets                                                   |       | —                                              |       | 0.9 |   | — |   |
| Acquired in-process research  and development                              |       | —                                              |       | 0.3 |   | — |   |
| Total costs and expenses                                                   |       | 98.8                                                |       | 123.2 |   | 99.6 |   |
| Income (loss) from operations                                              |       | 1.2                                                 |       | (23.2 | ) | 0.4 |   |
|                                                                       |       |                                                |       |   |   |   |   |
| Non-operating  income (expense):                                           |       |                                                |       |   |   |   |   |
| Other income, net                                                          |       | 0.1                                                 |       | 2.2 |   | 2.2 |   |
| Interest expense, net                                                      |       | (2.9                                                | )          | (2.5 | ) | (0.3 | ) |
| Loss from continuing operations before income taxes and minority  interest |       | (1.6                                                | )          | (23.5 | ) | 2.3 |   |
| Income tax benefit (provision)                                             |       | 1.8                                                 |       | 0.2 |   | (0.2 | ) |
| Minority interest in earnings of subsidiary                                |       | —                                              |       | (1.1 | ) | (6.2 | ) |
| Income (loss) from continuing operations                                   |       | 0.2                                                 |       | (24.4 | ) | (4.1 | ) |
| Income from discontinued operations, net of income taxes                   |       | —                                              |       | — |   | 2.7 |   |
| Net  income (loss)                                                         |       | 0.2                                                 | %          | (24.4 | )% | (1.4 | )% |

 

**Years Ended March 31, 2006, 2005, and 2004**

*Net Sales and Contract Revenues*. Net salesconsist principally of sales of our Vantage video detection systems and AutoVueLDW systems, as well as technology access fees, contract engineering revenueand royalty revenue generated from AutoVue related activities. Contract revenueconsists principally of revenue derived from systems integration and ITSconsulting services with state, county and municipal agencies. We currentlyhave a diverse customer base with our largest customer constituting 11.5% oftotal net sales and contract revenues in Fiscal 2006. Total net sales andcontract revenues increased 8.8% to $50.5 million in Fiscal 2006 compared to$46.4 million in Fiscal 2005, and increased 2.5% in Fiscal 2005 compared to$45.3 million in Fiscal 2004.

22

----

Net sales increased 7.2% to $31.2 million in Fiscal2006 compared to $29.1 million in Fiscal 2005, and increased 23.8% in Fiscal2005 compared to $23.5 million in Fiscal 2004. The increase in net sales in eachof the periods reflected increased unit sales of our Vantage vehicle detectionsystems and increased unit sales of our AutoVue LDW systems. Net sales fromAutoVue products and services increased 22.0% in Fiscal 2006 compared to Fiscal2005, and represented 28.0% of our total net sales in Fiscal 2006 versus 24.6%of our total net sales in Fiscal 2005. The increase in sales of AutoVueproducts was principally related to increased unit sales of LDW systems in theEuropean and North American commercial heavy truck markets which increased35.6% in Fiscal 2006 compared to Fiscal 2005. While overall unit sales ofAutoVue LDW systems increased in Fiscal 2006, AutoVue revenues in the fourthquarter of Fiscal 2006 declined slightly primarily as a result of OEM volumediscounts provided to our largest customer and the impact of the transition toour next generation AutoVue production unit for the heavy truck market in thelatter part of Fiscal 2006. AutoVue unit sales in Fiscal 2007 may be adverselyimpacted due to slower than expected adoption rates for such next generationproduction unit by our largest customer and other OEMs as well as potentialadditional OEM volume discounts.

Vantage sales comprised 72.0%, 75.4% and 82.1% of netsales in Fiscal 2006, Fiscal 2005 and Fiscal 2004, respectively. The majorityof Vantage revenues were derived from sales within North America. Vantage salesgrowth was 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. Vantage salesgrowth in the fourth quarter of Fiscal 2006 was primarily the result of strongsales in the sun-belt states and less seasonality due to more moderate winterweather conditions in the current period. We may experience more competition inour Vantage business in Fiscal 2007 as the department of transportation in oneof our largest sales territories is moving to a multisource contractingenvironment from one in which Iteris is the preferred supplier. Additionally,we have experienced increased lead times in procuring components, which couldadversely effect net sales in the future.

Contract revenues increased 11.5% to $19.3 million inFiscal 2006 compared to $17.3 million in Fiscal 2005, and decreased 20.5% inFiscal 2005 compared to $21.8 million in Fiscal 2004. Contract revenues reflecta broad range of fixed price and cost plus fixed fee contracts for engineeringstudy and design, systems integration and system implementation. Contractrevenues are dependent upon the continued availability of funding at both thestate and federal levels from the various departments of transportation. All ofour contract revenue is currently derived from work performed in North America.

We believe the increase in Fiscal 2006 contractrevenues compared to Fiscal 2005 was largely the result of the passage of theFederal Highway Bill in August 2005, as well as increased spending at thestate and local levels. The increase in contract revenues in Fiscal 2006 wasalso due to continued growth in the California market and stronger sales in theEastern U.S. market. The decrease in Fiscal 2005 from Fiscal 2004 was primarilydue to budgetary constraints in both the federal and California markets, wherea significant portion of our contract revenues have been derived during thelast several years. We believe these constraints were exacerbated by the delayin the adoption of the Federal Highway Bill.

*Gross Profit*. Totalgross profit increased 11.7% to $21.6 million in Fiscal 2006 compared to $19.4million in Fiscal 2005, and increased 8.7% from $17.8 million in Fiscal 2004compared to Fiscal 2005. Total gross profit as a percent of net sales andcontract revenues increased to 42.8% in Fiscal 2006 compared to 41.7% in Fiscal2005 and 39.3% in Fiscal 2004.

Gross profit as a percentage of net sales was 47.2% inFiscal 2006 compared to 46.2% in Fiscal 2005 and 45.6% in Fiscal 2004. The 100basis point increase in gross profit in Fiscal 2006 compared to Fiscal 2005 wasprimarily a result of increased margins on Roadway Sensor products due toproduct improvements aimed at reducing the cost of goods sold, better overheadabsorption on higher unit sales and a change in our Roadway Sensor businessmodel in California to a direct sales model.

The increase in gross profit as a percent of net salesin Fiscal 2005 compared to Fiscal 2004 was primarily a result of increasedmargins on AutoVue activities due to better overhead absorption on higher unitsales of LDW systems to the heavy truck market as well as the recognition oftechnology access fee revenue and royalty revenue from Valeo, both of whichprovide a 100% gross margin. These increases were somewhat offset by decliningmargins related to the sales of Vantage products due to lower unit pricing onlarge, high volume state contracts and increased price pressure in theindustry.

Gross profit as a percent of contract revenuesincreased to 35.9% in Fiscal 2006 compared to 34.2% in Fiscal 2005 and 32.6% inFiscal 2004. We recognize contract revenues and related gross profit usingpercentage of completion contract accounting and the underlying mix of contractactivity affects the related gross profit recognized in any given year. Theincrease in Fiscal 2006 reflects a mix of higher margin contracts in Fiscal2006 as compared to Fiscal 2005 and Fiscal 2004.

*Selling, General and AdministrativeExpense*. Selling, general and administrative expenseincreased 7.4% to $15.0 million (or 29.7% of total net sales and contractrevenues) in Fiscal 2006 compared to $14.0 million (or 30.1% of total net salesand contract revenues) in Fiscal 2005, and increased 8.7% in Fiscal 2005compared to $12.8 million (or 28.4% of total net sales and contract revenues)in Fiscal 2004. The increase in Fiscal 2006 compared to Fiscal 2005 wasprincipally related 

23

----

to additional accounting and legal fees incurred inthe first and second quarter of Fiscal 2006 related to a change in audit firms,costs incurred in anticipation of compliance with the Sarbanes-Oxley Act of2002, additional common area charges incurred in connection with our Anaheim headquartersand increased outside sales commissions paid in connection with our RoadwaySensor business due to the business model change in California. The increase inFiscal 2005 compared to Fiscal 2004 was principally related to $807,000 ofseverance charges recorded in connection with the merger and acquisition of theIteris Subsidiary in October 2004, as well as increased costs to supportexpanded sales and marketing efforts for our Vantage and AutoVue products inFiscal 2005. We are expecting the Mariner Networks, Inc. matter described inNote 7 to the accompanying consolidated financial statements to go totrial in the second quarter of Fiscal 2007 and, accordingly, we may experiencean increase in selling, general and administrative expenses due to increasedlegal fees over the next couple quarters.

*Research and Development Expense*. Researchand development expense increased 21.3% to $5.1 million (or 10.1% of total netsales and contract revenues) in Fiscal 2006 compared to $4.2 million (or 9.0%of total net sales and contract revenues) in Fiscal 2005, and increased 6.9% inFiscal 2005 compared to $3.9 million (or 8.6% of total net sales and contractrevenues) in Fiscal 2004. The increase in research and development expense inFiscal 2006 compared to Fiscal 2005 reflects increased spending for both ourVantage video detection products and our AutoVue LDW system for the heavy truckmarket. Additional development funds were allocated to the Roadway Sensorsbusiness to introduce new products during the current year, refresh theexisting product line and enhance cost reduction activities. Additional fundsallocated to the Automotive Sensors business were primarily used to develop thenext generation AutoVue LDW system for the heavy truck market in Europe and NorthAmerica. We anticipate incurring additional research and development expensesin Fiscal 2007 in connection with the qualification of such systems for otherOEMs.

Theincrease in research and development expense in Fiscal 2005 compared to Fiscal2004 reflects increased spending to support the development of AutoVueproducts, which was partially offset by decreased spending to support thedevelopment of Vantage products. AutoVue product development related largely tothe development of the next generation LDW unit for the heavy truck market,which consisted of product re-engineering and qualification of a new imager.The increases were primarily in the areas of personnel costs and relatedbenefits and overhead, prototype material costs, and consulting fees. Vantageproduct development primarily reflects activities for product line extensionsto support new communications platforms and to accommodate new camera designs.

Forcompetitive reasons, we closely guard the confidentiality of specificdevelopment projects.

*Stock-Based Compensation.* On October 22,2004, we recorded an $11.3 million charge for stock-based compensation inconnection with the assumption and exchange of vested Iteris Subsidiary stockoptions for stock options immediately exercisable into our common stock. Thischarge was based on the differences between the fair market value of our commonstock on the merger date and the exercise prices of the modified stock options.Additionally, we recorded approximately $1.4 million in deferred compensationexpense related to the unvested Iteris Subsidiary stock options also assumed aspart of the merger, which will be amortized to stock-based compensation expenseas the options vest. We amortized $725,000 and $508,000 of the $1.4 million ofdeferred compensation to stock-based compensation expense in Fiscal 2006 and2005, respectively. Beginning with our fiscal quarter ending June 30,2006, we will incur additional stock-based compensation charges in connectionwith our adoption of SFAS No. 123 (revised 2004), *Share-BasedPayment* (“SFAS 123R”).

*Deferred Compensation Expense(Benefit).* Deferred compensation expense (benefit)represents changes in the fair value of assets, primarily shares of our commonstock, held by our deferred compensation savings plan under which certainsenior executives may defer compensation. Prior to the merger of the IterisSubsidiary into us in Fiscal 2005, the plan held shares of Iteris Subsidiarycommon stock. In connection with the Fiscal 2005 merger of the IterisSubsidiary into us, shares of Iteris Subsidiary common stock held by the planwere exchanged for shares of our common stock. Changes in the value of commonstock held by the plan resulted in an expense of $48,000 in Fiscal 2006, abenefit of $484,000 in Fiscal 2005 and an expense of $868,000 in Fiscal 2004. Nocompensation was deferred into the plan in Fiscal 2006, Fiscal 2005 and Fiscal2004.

***Disposalof Fixed Assets.*** After the October 22, 2004 merger of theIteris Subsidiary into us, we conducted a review of our property and equipmentand determined that certain corporate property and equipment would not providevalue to our on-going operations. These assets primarily consisted of furnitureand fixtures and computer equipment. Accordingly, we recorded a $422,000 losson disposal of fixed assets in Fiscal 2005. No such disposals were made inFiscal 2006.

*Other Income, Net*. Other income, netreflects the following:

|                                      | ** ** | **Year Ended March 31,** | ** ** |
|--------------------------------------|------------|-----------------------------------------|------------|
| ** **                           | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                           | ** ** | **(In thousands)**                 | ** ** |
| Gain on sale of  real estate         |       | $                                       | —     |   | $ | — |   | $ | 970 |   |
| Loss on sale of  Iteris common stock |       | —                                  |       | — |   | — |   |
| Gain on  settlement of lawsuit       |       | —                                  |       | 949 |   | — |   |
| Other                                |       | 35                                      |       | 105 |   | 33 |   |
| Other income,  net                   |       | $                                       | 35         |   | $ | 1,054 |   | $ | 1,003 |   |

** **

24

----

**Other income, net in Fiscal 2005primarily reflects a $949,000 gain recognized on the settlement of litigation. Wewere a beneficiary of, but not a party to, litigation between RockwellInternational and the Michigan Department of Transportation. Other income, netin Fiscal 2004 includes a gain of $970,000 recognized on the sale and leasebackof our Anaheim, California facility, which was consummated in May 2002.**

*Interest Expense, Net*. Interest expense,net reflects the net of interest expense and interest income as follows:

|                        | ** ** | **Year Ended March 31,** | ** ** |
|------------------------|------------|-----------------------------------------|------------|
| ** **             | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **             | ** ** | **(In thousands)**                 | ** ** |
| Interest expense       |       | $                                       | 1,461      |   | $ | 1,180 |   | $ | 125 |   |
| Interest income        |       | (2                                      | )          | (2 | ) | (2 | ) |
| Interest  expense, net |       | $                                       | 1,459      |   | $ | 1,178 |   | $ | 123 |   |

** **

25

----

**Interest expense increased 23.8%in Fiscal 2006 compared to Fiscal 2005 and increased 844.0% in Fiscal 2005compared to Fiscal 2004. The increase in interest expense in Fiscal 2006compared to Fiscal 2005 is mainly related to an increase in the interest rateon our line of credit and term debt as well as an increase on average borrowingson the line. The increase in Fiscal 2005 was due to additional interest expenseincurred related to the $5.0 million term debt entered into by the IterisSubsidiary on May 28, 2004 (which was assumed by us in October 2004),interest expense related to the $10.1 million convertible debentures issued byus on May 19, 2004, the amortization of debt discounts associated with theissuance of the convertible debentures and related warrants, and increasedborrowings on our line of credit.**

*Income Taxes*. During Fiscal 2006, werecognized an income tax benefit of $885,000, and at March 31, 2006, ourbalance sheet included net deferred tax assets of $1.6 million. The ability torecord the deferred tax asset was based on the more likely than not criteria ofStatement of Financial Accounting Standards (“SFAS”) No. 109, *Accounting for Income Taxes*. During Fiscal 2005, werecognized an income tax benefit of $94,000 and at March 31, 2005, werecorded a net deferred tax asset of $660,000.

At March 31,2006, we had $49.2 million of federal net operating loss carryforwards and $22.6 millionof state net operating loss carryforwards that begin to expire in 2019 and2007, respectively. Due to changes in stock ownership, our federal netoperating loss carryforwards are subject to a Section 382 limitationestimated at approximately $2.9 million annually which can be utilized tooffset federal consolidated taxable income. As a result of this limitation, aportion of our carryforwards are expected to expire before becoming availableto reduce future income tax liabilities.

Althoughthe impact cannot be precisely determined, we believe that our net operatingloss carryforwards and the valuation allowance we have recorded against our netdeferred tax assets in our consolidated balance sheet will cause us to havefuture income tax payments and income tax expense that are substantially lowerthan the income tax liability and income tax expense calculated using statutorytax 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’s Series Apreferred stock. On October 22, 2004, we completed the merger of theIteris Subsidiary into us. As a result of the completion of the merger in thethird quarter of Fiscal 2005, the minority interest in earnings of subsidiarydecreased from $2.8 million in Fiscal 2004 to $526,000 in Fiscal 2005, and wedid not incur any charge for minority interest during Fiscal 2006. No futurecharges for minority interest are anticipated.

*Income(Loss) from Discontinued Operations, Net of Income Taxes*. Asdiscussed in the Overview to Management’s Discussion and Analysis of FinancialCondition and Results of Operations, the results of operations related tocertain businesses discontinued by us in Fiscal 2004 are reflected asdiscontinued operations in our consolidated financial statements. As of the endof Fiscal 2004, we had completed all such restructuring activities so that wecould focus our efforts in the ITS marketplace.

**Liquidityand Capital Resources**

*CashFlows*

We havehistorically financed our operations with a combination of cash flows from operations,borrowings under credit facilities and the sale of equity securities. Wecurrently rely on cash flows from operations and borrowings on a line of creditfacility to fund our operations, which we believe to be sufficient to fund ouroperations for at least the next twelve months. However, should a shortfalloccur, we believe we could obtain additional funds through additionalborrowings or the sale of equity securities. At March 31, 2006, we had$3.3 million in working capital, which included borrowings of $2.7 million onour revolving line of credit and $131,000 in cash and cash equivalents. Thiscompares to working capital of $2.2 million at March 31, 2005, whichincluded borrowings of $945,000 on our revolving line of credit and $46,000 incash. Our operations provided $218,000 of cash during Fiscal 2006, primarily asa result of planned decreases in inventory and the timing of payments onaccrued expenses and payables. These were partially offset by increases inaccounts receivable and net costs and estimated earnings in excess of billingson uncompleted contracts, both as a result of sales growth. During Fiscal 2005,our operations provided $590,000 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 partybeneficiary. We used cash in operations of $718,000 in Fiscal 2004, which wasprimarily the result of our loss from continuing operations.

Investingactivities for Fiscal 2006, Fiscal 2005 and Fiscal 2004 consisted primarily ofpurchases of property and equipment, which aggregated $1.3 million, $670,000and $558,000, respectively. In the current fiscal year, capital expenditureshave increased significantly primarily due to hardware, software and relatedlabor costs to implement a new enterprise resource management system, whichwill be put into use at the beginning of our next fiscal year. We expect tocontinue to incur substantial additional cost, which could amount to severalhundred thousand dollars, in the next three to six months related to this newsystem. Most of this cost will be in the form of training and supportactivities, which will be recorded as expense when incurred.

26

----

Cash provided byfinancing activities was $1.1 million in Fiscal 2006, which was the resultof net borrowings of $403,000 and cash inflows of $333,000 from the exercise ofoutstanding stock options and warrants to purchase our common stock. DuringFiscal 2005, financing activities used $2.5 million of cash, which wascomprised of net cash outflows of approximately $3.1 million related to themerger activities described more fully above in the Overview to Management’sDiscussion and Analysis of Financial Condition and Results of Operations and inNote 3 to the accompanying consolidated financial statements, partially offsetby $501,000 in proceeds from the exercise of stock options and warrants topurchase our common stock. We generated $3.4 million in cash from financingactivities in Fiscal 2004, primarily as a result of $3.8 million raised fromthe sale of our common stock and related warrants, offset by $467,000 in netpayments against borrowings.

*Borrowings*

The following tablesummarizes our borrowings and long-term debt:

|                              | ** ** | **At March 31, 2006** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **(In thousands)**              | ** ** |
| Convertible  debentures, net |       | $                                    | 9,203      |   |
| Bank term note               |       | 2,708                                |       |
| Promissory note  to landlord |       | 1,292                                |       |
| Other long-term  debt        |       | 140                                  |       |
| Revolving line  of credit    |       | 2,662                                |       |
|                         |       | $                                    | 16,005     |   |

 

Effective August 1,2005, we renewed our credit agreement with our bank. This credit agreement,which expires on July 31, 2006, provides for borrowings of up to $5.0million subject to a borrowing formula based upon qualified accounts receivableand inventories as defined in the credit agreement. At March 31, 2006, wefailed to meet a financial covenant under this agreement that limits the amountof capital expenditures we may make in any fiscal year. On May 19, 2006,our bank waived its right of default regarding this covenant violation for theyear ended March 31, 2006. We are currently in the process ofrenegotiating this credit agreement; however, we cannot assure you that we willbe able to complete these negotiations successfully, on acceptable terms, or atall. At March 31, 2006, we had $3.8 million available under the revolvingline of credit, of which $1.1 million was unused. Assuming the line of creditis renewed or replaced, we believe the combination of available borrowings onour line of credit and our internally generated cash flows will be sufficientto enable us to execute our operating plans and meet our obligations on atimely basis for at least the next twelve months.

**ContractualObligations**

Our contractual obligations are as follows at March 31,2006:
| ** **              | ** ** | **Payments Due by Period** | ** ** |
|-------------------------|------------|-------------------------------------------|------------|
| ** **              | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **              | ** ** | **(In thousands)**                   | ** ** |
| Lines of credit         |       | $                                         | 2,662      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 2,662 |   |
| Notes payable           |       | 1,969                                     |       | 1,946 |   | 225 |   | — |   | — |   | — |   | 4,140 |   |
| Convertible  debentures |       | —                                    |       | — |   | — |   | 9,850 |   | — |   | — |   | 9,850 |   |
| Operating leases        |       | 1,305                                     |       | 792 |   | 116 |   | 85 |   | 43 |   | — |   | 2,341 |   |
| Total                   |       | $                                         | 5,936      |   | $ | 2,738 |   | $ | 341 |   | $ | 9,935 |   | $ | 43 |   | $ | — |   | $ | 18,993 |   |

 

At March 31,2006, we had firm commitments to purchase inventory in the amount of $1.3 millionduring the first and second quarters of Fiscal 2007.

**Off BalanceSheet Arrangements**

In connection with the restructuring and mergeractivities described in the Overview to Management’s Discussion and Analysis ofFinancial Condition and Resultsof Operations and in Notes 3, 5 and 9 to the accompanying consolidatedfinancial statements, in May 2004 we issued subordinated convertible debenturesin an aggregate original principal amount of $10.1 million. Thesedebentures are due in full on May 19, 2009 and are convertible into shares ofour common stock at a conversion price of $3.61 per share. At March 31, 2006,$9.9 million of these convertible debentures remained outstanding. Becausethese debentures are conventionally convertible, we have not separatelyaccounted for the conversion feature and, accordingly, no separate amounts arepresented in our consolidated financial statements in connection with thisconversion feature.

At March 31, 2006, outstanding warrants to purchase1,250,000 shares of our common stock at an exercise price of $1.64 per shareand outstanding warrants to purchase an aggregate of 62,500 shares ofcommon stock at an exercise price of $1.95 per share are callable by us if themarket price of our common stock trades for 20 consecutive days at a priceequal to or greater than two times the exercise price of the warrants. Outstandingwarrants to purchase an aggregate of 75,000 shares of our commonstock at an exercise price of $5.00 per share are callable by us if the marketprice of our common stock trades for 20 consecutive days at a price equalto or greater than one and a half times the exercise price of the warrants.

Inconnection with the issuance of warrants to purchase 1,250,000 shares of ourcommon stock at $1.64 per share and 426,667 shares of our common stock at $3.00per share, we are a party to certain registration rights agreements thatcontain provisions under which we could be subjected to liquidated damagesshould we fail to maintain effective registration statements for the underlyingshares of common stock.  These warrants have been accounted for withinequity in our consolidated balance sheets in accordance with EITF 00-19 *Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock*, and, accordingly, noliabilities have been recorded in connection therewith.  The warrants to purchase 426,667 shares ofour common stock and the related rights to liquidated damages expiredunexercised on May 31, 2006.  As of thedate of this filing, no liquidated damages are payable under the provisions ofthe registration rights agreements associated with these warrants.

**10b5-1 Plan**

In June 2006, Abbas Mohaddes, our Executive VicePresident and General Manager, entered into a 10b5-1 plan covering 200,000shares of our common stock. Pursuant to this plan, Mr. Mohaddes may sell up to17,000 shares each month provided that the stock price is at least $2.50 pershare.

27

----

**RecentAccounting Pronouncements**

In November 2004,the FASB issued SFAS No. 151, *Inventory Costs*(“SFAS151”), which clarifies the accounting for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material. SFAS 151 will beeffective for inventory costs incurred during fiscal years beginning afterJune 15, 2005. We do not believe the adoption of SFAS 151 will have amaterial impact on our financial statements.

On December 16,2004, the FASB issued SFAS No. 123, which replaced SFAS No. 123, *Accounting for Stock-Based Compensation*(“SFAS 123”),supersedes Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*, and amends SFAS No. 95,*Statement of Cash Flows*. Generally, theapproach in SFAS 123R is similar to the approach described in SFAS 123. However,SFAS 123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the financial statements based ontheir fair values (i.e., pro forma disclosure is no longer an alternative tofinancial statement recognition). In accordance with SEC Release No. 33-8568,SFAS 123R became effective for us on April 1, 2006. We plan to use themodified-prospective method of recognition of compensation expense related toshare-based payments.

The adoption of the SFAS 123R fair value methodwill have a significant adverse impact on our reported results of operations,although it will have no impact on our overall financial position. The balanceof unearned stock-based compensation to be included in our fiscal years ending March 31,2007 through 2010 related to share-based awards unvested at March 31,2006, as previously calculated under the disclosure-only requirements ofSFAS 123, is approximately $521,000. If there are any modifications orcancellations of the underlying unvested securities, we may be required toaccelerate, increase or cancel any remaining unearned stock-based compensationexpense. To the extent that we grant additional equity securities, ourstock-based compensation expense will be increased by the additional unearnedcompensation resulting from those additional grants. Had we adoptedSFAS 123R in prior periods, the magnitude of the impact on our results ofoperations would have approximated the impact of SFAS 123 assuming theapplication of the Black-Scholes option pricing model as described in thedisclosure of pro forma net loss and pro forma net loss per share inNote 1 to the accompanying consolidated financial statements.

28

----

**ITEM 7A.****                    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Our exposure to interestrate risk is limited to our line of credit, bank term note and a promissorynote to our landlord. Our line of credit, bank term note and promissory note toour landlord bear interest based on the prevailing prime rate (7.75% at March 31,2006). A 10% increase in the interest rate on our line of credit, bank termnote and promissory note to our landlord (from 10.75% to 11.83% on the line ofcredit, from 8.00% to 8.80% on the bank term note and from 9.75% to 10.73% onthe promissory note to our landlord) would not have a material impact on ourfinancial position, operating results, or cash flows. In addition, we believethat the carrying value of our outstanding debt approximates fair value.

**ITEM 8.****                             FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

The financial statementsand supplementary data required by Regulation S-X are included in Part IV,Item 15 of this report.

**ITEM 9.****                             CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM 9A.****                    CONTROLS ANDPROCEDURES**

**Evaluation of Disclosure Controls andProcedures**

As of the end of theperiod covered by this report, we carried out an evaluation, under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures, as such term isdefined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective to ensure thatinformation required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’srules and forms and are effective in ensuring that information required to bedisclosed by us in the reports that we file or submit under the Exchange Act isaccumulated and communicated to our management, including our Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. In designing and evaluating the disclosurecontrols and procedures, our management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives. Ourmanagement necessarily applied its judgment in evaluating the cost-benefitrelationship of such controls and procedures.

**Changes in Internal Controls**

During the most recentcompleted fiscal quarter covered by this report, there has been no change inour internal controls over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act of 1934) that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrols over financial reporting.

**ITEM 9B**.                    **OTHER INFORMATION**

None.

29

----

**PART III**

**ITEM 10.****                      DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

(a)  *Identification of Directors.*Theinformation under the caption “Election of Directors,” appearing in our proxystatement for the 2006 Annual Meeting of Stockholders, is incorporated hereinby reference.

(b)  *Identification of Executive Officers.*Theinformation under the caption “Executive Officers,” appearing in our proxystatement for the 2006 Annual Meeting of Stockholders, is incorporated hereinby reference.

(c)  *Compliance with Section 16(a) of theExchange Act.*The information under the caption “Section 16(a) BeneficialOwnership Reporting Compliance” appearing in our proxy statement for the 2006Annual Meeting of Stockholders is incorporated herein by reference.

(d)  *Code of Ethics*. The information under thecaption “Corporate Governance,” appearing in our proxy statement for the 2006Annual Meeting of Stockholders, is incorporated herein by reference.

**ITEM 11.****                      EXECUTIVECOMPENSATION**

The informationunder the caption “Executive Compensation and Other Information,” appearing inour proxy statement for the 2006 Annual Meeting of Stockholders, isincorporated herein by reference.

**ITEM12.**                      SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The informationunder the captions “Equity Compensation Plans” and “Principal Stockholders andCommon Stock Ownership of Certain Beneficial Owners and Management,” appearingin our proxy statement for the 2006 Annual Meeting of Stockholders, is incorporatedherein by reference.

**ITEM13.**                      CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS

The informationunder the caption “Certain Transactions,” appearing in our proxy statement forthe 2006 Annual Meeting of Stockholders, is incorporated herein by reference.

**ITEM14.**                      PRINCIPALACCOUNTING FEES AND SERVICES

The informationunder the caption “Fees Paid to Independent Registered Public Accounting Firm,”appearing in our proxy statement for the 2006 Annual Meeting of Stockholders,is incorporated herein by reference.

30

----

**PART IV**

**ITEM15.**                      EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

(a)               Documents filed aspart of this report:

1.*Financial Statements.* The followingfinancial statements of Iteris, Inc. are included in a separatesection of this Annual Report on Form 10-K commencing on the pages referencedbelow:
| Report of Independent  Registered Public Accounting Firm, McGladrey & Pullen, LLP                             |   | 37 |   |
|------------------------------------------------------------------------------------------------------------------------|--------|----|--------|
| Report of Independent Registered Public Accounting  Firm, Ernst & Young LLP                                   |   | 38 |   |
| Consolidated  Balance Sheets as of March 31, 2006 and 2005                                                        |   | 39 |   |
| Consolidated Statements of Operations for the years  ended March 31, 2006, 2005 and 2004                          |   | 41 |   |
| Consolidated Statements of Stockholders’ Equity  (Deficit) for the years ended March 31, 2006, 2005 and 2004 |   | 42 |   |
| Consolidated Statements of Cash Flows for the years  ended March 31, 2006, 2005 and 2004                          |   | 43 |   |
| Notes to Consolidated Financial Statements                                                                             |   | 44 |   |

 

2.             *FinancialStatement Schedules*.
| Schedule II — Valuation  and Qualifying Accounts |   | 62 |   |
|------------------------------------------------------------|--------|----|--------|

 

All other schedules havebeen omitted because they are not required or the required information isincluded in our consolidated financial statements and notes thereto.

3.             *Exhibits*.

The followingexhibits are filed herewith or incorporated by reference to the locationindicated below:
| 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 the 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*                     |
|             |       |                                                                                                      | * *   | * *                                                                                                                                                                               |
| 4.1              |       | Specimen of common stock certificate                                                                      | * *   | *Exhibit 4.1 to registrant’s Registration  Statement on Form 8-A as filed with the SEC on December 8, 2004*                                                             |
|             |       |                                                                                                      | * *   | * *                                                                                                                                                                               |
| 4.2              |       | Form of rights certificate for preferred stock  purchase rights                                      | * *   | *Exhibit A of Exhibit 4 to the  registrant’s Current Report on Form 8-K as filed with the SEC on  May 1, 1998*                                                |
|             |       |                                                                                                      | * *   | * *                                                                                                                                                                               |
| 10.1*            |       | Profit Sharing Plan and Trust                                                                             | * *   | *Exhibit 10.3 to the registrant’s Amendment  No. 2 to the Registration Statement on Form S-8 (Reg.  No. 002-98656) as filed with the SEC on May 5, 1988* |

31

----

 
| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                                                            | ** ** | **Where Located**                                                                                                                                                                                           |   |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 10.2*            |       | Amendment Nos. 3 and 4 to the Profit Sharing Plan  and Trust                                                                                                                                                                                               | * *   | *Exhibits 4.3.1 and 4.3.2,  respectively, to Amendment No. 3 to the registrant’s Registration  Statement on Form S-3 (Reg. No. 002-86220) as filed  with the SEC on June 13, 1990* |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.3*            |       | Form of Executive Deferral Plan between the  registrant and certain employees of the registrant                                                                                                                                                       | * *   | *Exhibit 10.4 to the  registrant’s Annual Report on Form 10-K for the year ended March 31,  1988*                                                                                       |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.4             |       | Form of Indemnity Agreement entered into by the  registrant and certain of its officers and directors                                                                                                                                                 | * *   | *Exhibit 19.4 to the  registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30,  1988*                                                                             |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.5             |       | Form of Indemnification Agreement entered into  by the registrant and certain of its officers and directors                                                                                                                                           | * *   | *Exhibit 10.5 to the  registrant’s Annual Report on Form 10-K for the year ended March 31,  2004 as filed with the SEC on June 29, 2004*                                           |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.6*            |       | 1997 Stock Incentive Plan (as amended on May 3,  2003, as further amended on December 15, 2004)                                                                                                                                                  | * *   | *Exhibit 10.32 to the  registrant’s Annual Report on Form 10-K for the year ended March 31,  2005 as filed with the SEC on July 14, 2005*                                          |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.7*            |       | Form of Notice of Grant of Stock Option for the  following executive officers: Jack Johnson, Richard D. Crawshaw, Gregory  McKhann, Francis Memole, James S. Miele and Stephen Edwin Rowe                                                             | * *   | *Exhibit 99.2 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                                            |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.8*            |       | Form of Stock Option Agreement                                                                                                                                                                                                                        | * *   | *Exhibit 99.3 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                                            |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.9*            |       | Form of Addendum to Stock Option  Agreement—Involuntary Termination Following Corporate Transaction or Change  in Control                                                                                                                        | * *   | *Exhibit 99.4 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                                            |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.10*           |       | Form of Addendum to Stock Option  Agreement—Limited Stock Appreciation Rights                                                                                                                                                                    | * *   | *Exhibit 99.5 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                                            |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.11*           |       | Form of Stock Issuance Agreement                                                                                                                                                                                                                      | * *   | *Exhibit 99.6 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                                            |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.12*           |       | Form of Addendum to Stock Issuance  Agreement—Involuntary Termination Following Corporate Transaction/Change in  Control                                                                                                                         | * *   | *Exhibit 99.7 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                                            |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.13*           |       | Form of Notice of Grant of Automatic Stock  Option—Initial Grant for the following directors: Richard Char                                                                                                                                       | * *   | *Exhibit 99.8 to Exhibit 99.8  to registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                           |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.14*           |       | Form of Notice of Grant of Automatic Stock  Option—Annual Grant for the following directors: Kevin C. Daly, Ph.D., Gary  Hernandez, Dr. Hartmut Marwitz, Gregory A. Miner, John W. Seazholtz, Joel Slutzky,  Thomas L. Thomas and Paul E. Wright | * *   | *Exhibit 99.9 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 14, 2000*                                            |
|             |       |                                                                                                                                                                                                                                                       | * *   | * *                                                                                                                                                                                                    |   |
| 10.15*           |       | Form of Automatic Stock Option Agreement.                                                                                                                                                                                                             | * *   | *Exhibit 99.10 to the  registrant’s Registration Statement on Form S-8 (File No. 333-30396)  as filed with the SEC on February 19, 2000*                                           |
|                  |            |                                                                                                                                                                                                                                                            |            |                                                                                                                                                                                                             |        |  |

32

----

 
| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                                                                                                                                  | ** ** | **Where Located**                                                                                                                                                        |   |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 10.16            |       | Amended and Restated Rights Agreement, dated as of May 10,  2004, by and between the registrant and U.S. Stock Transfer Corporation,  including the 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.*                                    |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.17            |       | Amended and Restated Agreement of Purchase and Sale  and Escrow Instructions, dated February 19, 2002, by and between Iteris, Inc.  and 1515 South Manchester, LLC                                                                                                                                                     | * *   | *Exhibit 2.1 to the registrant’s  Current Report on Form 8-K as filed with the SEC on June 12,  2002*                                                |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.18*           |       | Change in Control Agreement dated May 8, 2003  by and between the registrant and Gregory A. Miner                                                                                                                                                                                                                           | * *   | *Exhibit 10.1 to the  registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30,  2003 as filed with the SEC on August 14, 2003* |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.19*           |       | Change in Control Agreement dated May 20, 2003  by and between the registrant and Jack E. Johnson                                                                                                                                                                                                                           | * *   | *Exhibit 10.23 to Amendment No. 1  to the registrant’s Registration Statement on Form S-1 as filed  with the SEC on February 17, 2004*          |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.20*           |       | Iteris Inc. 1998 Stock Incentive Plan (as amended on  February 7, 2000)                                                                                                                                                                                                                                                     | * *   | *Exhibit 10.24 to the  registrant’s Annual Report on Form 10-K for the year ended March 31,  2005 as filed with the SEC on July 14, 2005*       |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.21*           |       | Form of Notice of Grant, including forms of Option  Agreement and Stock Purchase Agreement for the following directors and  executive officers: Gary Hernandez, Dr. Hartmut Marwitz, Paul E. Wright, Jack  Johnson, Richard D. Crawshaw, Gregory McKhann, Francis Memole, James S.  Miele, Abbas Mohaddes and Stephen Edwin Rowe | * *   | *Exhibit 99.2 to the registrant’s  Registration Statement on   Form S-8 (File No. 333-126834) as filed with the SEC on July** 22, 2005*              |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |
| 10.22*           |       | Form of Addendum to Stock Option Agreement                                                                                                                                                                                                                                                                                       | * *   | *Exhibit 99.3 to the registrant’s  Registration Statement on   Form S-8 (File No. 333-126834) as filed with the SEC on July** 22, 2005*              |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |
| 10.23*           |       | Form of 1997 Stock Option Agreements                                                                                                                                                                                                                                                                                             | * *   | *Exhibit 99.4 to the registrant’s  Registration Statement on   Form S-8 (File No. 333-126834) as filed with the SEC on July** 22, 2005*              |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |
| 10.24            |       | Wells Fargo Bank Credit Agreement dated May 27,  2004                                                                                                                                                                                                                                                                       | * *   | *Exhibit 10.25 to the  registrant’s Annual Report on Form 10-K for the year ended  March 31, 2005 as filed with the SEC on July 14, 2005*       |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.25            |       | Wells Fargo Bank Assumption and Amendment Agreement  dated October 20, 2004                                                                                                                                                                                                                                                 | * *   | *Exhibit 10.26 to the  registrant’s Annual Report on Form 10-K for the year ended  March 31, 2005 as filed with the SEC on July 14, 2005*       |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.26            |       | Wells Fargo Bank Revolving Line of Credit Note dated  May 27, 2004                                                                                                                                                                                                                                                          | * *   | *Exhibit 10.27 to the  registrant’s Annual Report on Form 10-K for the year ended  March 31, 2005 as filed with the SEC on July 14, 2005*       |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.27            |       | Wells Fargo Bank Term Note dated May 27, 2004                                                                                                                                                                                                                                                                               | * *   | *Exhibit 10.28 to the  registrant’s Annual Report on Form 10-K for the year ended  March 31, 2005 as filed with the SEC on July 14, 2005*       |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.28            |       | Wells Fargo Bank Continuing Security Agreement  Rights to Payment and Inventory dated May 27, 2004                                                                                                                                                                                                                          | * *   | *Exhibit 10.29 to the registrant’s  Annual Report on Form 10-K for the year ended March 31, 2005  as filed with the SEC on July 14, 2005*       |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.29            |       | Wells Fargo Bank Security Agreement Equipment dated  May 27, 2004                                                                                                                                                                                                                                                           | * *   | *Exhibit 10.30 to the  registrant’s Annual Report on Form 10-K for the year ended  March 31, 2005 as filed with the SEC on July 14, 2005*       |
|             |       |                                                                                                                                                                                                                                                                                                                             | * *   | * *                                                                                                                                                                 |   |
| 10.30*           |       | Iteris, Inc. Deferred Compensation Savings Plan  and Grantor Trust                                                                                                                                                                                                                                                          | * *   | *Exhibit 10.31 to the  registrant’s Annual Report on Form 10-K for the year ended  March 31, 2005 as filed with the SEC on July 14, 2005*       |
|                  |            |                                                                                                                                                                                                                                                                                                                                  |            |                                                                                                                                                                          |        |  |

33

----

 
| Exhibit   Number | ** ** | **Description**                                                                                                                                                                                                          | ** ** | **Where Located**                                                                                                                                                             |   |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 10.31+           |       | Cooperative Agreement for Development, Manufacture,  Marketing and Sale of Products to the Class 1 and Class 2 Vehicle  Markets Incorporating Iteris’ LDWS Technology (Valeo Schalter and Sensoren  GmbH) | * *   | *Exhibit 10.1 to the  registrant’s Quarterly Report on Form 10-Q for the quarter ended June 30,  2004 as filed with the SEC on August 16, 2004*      |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 10.32            |       | Second Amendment to Credit Agreement, dated August 1,  2005, by and between the registrant and Wells Fargo Bank, National  Association                                                                              | * *   | *Exhibit 10.1 to the  registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31,  2005 as filed with the SEC on February 8, 2006* |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 10.33            |       | Revolving Line of Credit Note, dated August 1,  2005, by and between the registrant and Wells Fargo Bank, National  Association                                                                                     | * *   | *Exhibit 10.2 to the  registrant’s Quarterly Report on Form 10-Q for the quarter ended December 31,  2005 as filed with the SEC on February 8, 2006* |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 21               |       | Subsidiaries of the registrant                                                                                                                                                                                           | * *   | *Filed Herewith*                                                                                                                                                              |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 23.1             |       | Consent of Independent Registered Public Accounting  Firm, McGladrey & Pullen, LLP                                                                                                                              |       | *Filed Herewith*                                                                                                                                                              |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 23.2             |       | Consent of Independent Registered Public Accounting  Firm, Ernst & Young, LLP                                                                                                                                   |       | *Filed Herewith*                                                                                                                                                              |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 31.1             |       | Certification of the Chief Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                             | * *   | *Filed Herewith*                                                                                                                                                              |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 31.2             |       | Certification of the Chief Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                             | * *   | *Filed Herewith*                                                                                                                                                              |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 32.1             |       | Certification of the Chief Executive Officer  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                        | * *   | *Filed Herewith*                                                                                                                                                              |
|             |       |                                                                                                                                                                                                                     | * *   | * *                                                                                                                                                                      |   |
| 32.2             |       | Certification of the Chief Financial Officer  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                                                        | * *   | *Filed Herewith*                                                                                                                                                              |
|                  |            |                                                                                                                                                                                                                          |            |                                                                                                                                                                               |        |  |

----

* Indicates a management contract or compensatory planor arrangement

+ Confidential treatment has been requested forcertain confidential portions of this exhibit pursuant to Rule 24b-2of the Securities Exchange Act of 1934, as amended. In accordance with Rule 24b-2,these confidential portions have been omitted from the exhibit and filedseparately with the SEC.

 

34

----

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the registrant has duly caused this Reportto be signed on its behalf by the undersigned, thereunto duly authorized.
|        | ** ** | **ITERIS, INC.** |
|--------|------------|------------------|
|   |       | (Registrant)     |
|   |       |             |   |   |
|   |       | By               |   | /s/ JACK JOHNSON |
|   |       |             |   | Jack Johnson |
|   |       |             |   | President and Chief Executive Officer |

 

##### **POWER OF ATTORNEY**

We, theundersigned officers and directors of Iteris, Inc., do hereby constituteand appoint James S. Miele and Jack Johnson, and each of them, our true andlawful attorneys-in-fact and agents, each with full power of substitution andresubstitution, for him and in his name, place and stead, in any and allcapacities, to sign any and all amendments to this report, and to file thesame, with exhibits thereto, and other documents in connection therewith, withthe Securities and Exchange Commission, granting unto said attorneys-in-factand agents, and each of them, full power and authority to do and perform eachand every act and thing requisite or necessary to be done in and about thepremises, as fully to all intents and purposes as he might or could do inperson, hereby, ratifying and confirming all that each of saidattorneys-in-fact and agents, or his substitute or substitutes, may lawfully door cause to be done by virtue hereof.

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant in thecapacities and on the dates indicated:
| Signature               | ** ** | **Title**                                       | ** ** | **Date**           |
|-------------------------|------------|-------------------------------------------------|------------|--------------------|
|                    |       |                                            |       |               |
| /s/ JACK JOHNSON        |       | Director, President and Chief Executive Officer |       | June 29, 2006 |
| Jack Johnson            |       | (principal executive officer)                   |       |               |
|                    |       |                                            |       |               |
| /s/ JAMES S.  MIELE     |       | Chief Financial Officer                         |       | June 29, 2006 |
| James S. Miele          |       | (principal financial and accounting officer)    |       |               |
|                    |       |                                            |       |               |
| /s/ GREGORY A.  MINER   |       | Chairman of the Board                           |       | June 29, 2006 |
| Gregory A. Miner        |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ RICHARD CHAR        |       | Director                                        |       | June 29, 2006 |
| Richard Char            |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ KEVIN C.  DALY      |       | Director                                        |       | June 29, 2006 |
| Kevin C. Daly,  Ph.D.   |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ GARY  HERNANDEZ     |       | Director                                        |       | June 29, 2006 |
| Gary Hernandez          |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ HARTMUT  MARWITZ    |       | Director                                        |       | June 29, 2006 |
| Hartmut Marwitz,  Ph.D. |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ JOHN  SEAZHOLTZ     |       | Director                                        |       | June 29, 2006 |
| John Seazholtz          |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ JOEL SLUTZKY        |       | Director                                        |       | June 29, 2006 |
| Joel Slutzky            |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ THOMAS L.  THOMAS   |       | Director                                        |       | June 29, 2006 |
| Thomas L. Thomas        |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ PAUL E.  WRIGHT     |       | Director                                        |       | June 29, 2006 |
| Paul E. Wright          |       |                                            |       |               |
|                    |       |                                            |       |               |
| /s/ ABBAS  MOHADDES     |       | Director, Assistant Secretary and Executive     |       | June 29, 2006 |
| Abbas Mohaddes          |       | Vice President                                  |       |               |

 

35

----

**Iteris, Inc.**

**Index to ConsolidatedFinancial Statements**
| Report of Independent  Registered Public Accounting Firm, McGladrey & Pullen, LLP                              |   |   |   |
|-------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
|                                                                                                                    |   |   |   |
| Report of Independent Registered Public Accounting  Firm, Ernst & Young LLP                                    |   |   |   |
|                                                                                                                    |   |   |   |
| Consolidated  Balance Sheets as of March 31, 2006 and 2005                                                         |   |   |   |
|                                                                                                                    |   |   |   |
| Consolidated Statements of Operations for the years  ended March 31, 2006, 2005, and 2004                          |   |   |   |
|                                                                                                                    |   |   |   |
| Consolidated Statements of Stockholders’ Equity  (Deficit) for the years ended March 31, 2006, 2005, and 2004 |   |   |   |
|                                                                                                                    |   |   |   |
| Consolidated Statements of Cash Flows for the years  ended March 31, 2006, 2005, and 2004                          |   |   |   |
|                                                                                                                    |   |   |   |
| Notes to Consolidated Financial Statements                                                                              |   |   |   |

 

36

----

**Reportof Independent Registered Public Accounting Firm**

To the Board ofDirectorsIteris, Inc.Anaheim, California

We have audited the consolidated balance sheets ofIteris, Inc. as of March 31, 2006 and 2005, and the relatedconsolidated statements of operations, stockholders’ equity (deficit) and cashflows for the years then ended. Our audits also included the 2006 and 2005financial statement schedules of Iteris, Inc. listed at Item 15(a).These financial statements and the financial statement schedules are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedules based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provided a reasonable basis for our opinion.

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Iteris, Inc. as of March 31,2006 and 2005, and the results of its operations and its cash flows for theyears then ended, in conformity with U.S. generally accepted accountingprinciples. Also, in our opinion, the related financial statement schedules,when considered in relation to the basic consolidated financial statementstaken as a whole, present fairly in all material respects the information setforth therein.
| /s/ McGladrey & Pullen, LLP |   |   |
|--------------------------------------|--------|--------|
| Irvine, California                   |   |   |
| June 28, 2006                   |   |   |

 

37

----

** **

**Report of Independent Registered Public AccountingFirm, Ernst & Young LLP**

Stockholders andBoard of DirectorsIteris, Inc.

Wehave audited the accompanying consolidated statements of operations,stockholders’ equity (deficit), and cash flows for the year ended March 31,2004. Our audit also included the financial statement schedule listed inthe index at Item 15(a). These financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audit.

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. We were not engaged toperform an audit of the Company’s internal control over financial reporting.Our audit included consideration of internal control over financial reportingas a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.Accordingly, we express no such opinion. An audit also includes examining, on atest basis, evidence supporting the amounts and disclosures in the financialstatements, assessing the accounting principles used and significant estimatesmade by management, and evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Iteris, Inc. at March 31, 2004, and the consolidated resultsof its operations and its cash flows for the year ended March 31, 2004, inconformity with accounting principles generally accepted in the United States. Also,in our opinion, the related financial statement schedule, when considered inrelation to the basic financial statements taken as a whole, presents fairly inall material respects the information set-forth therein.
| /s/ Ernst & Young LLP                                                |   |   |
|--------------------------------------------------------------------------|--------|--------|
| Orange County, California                                                |   |   |
| June 8, 2004,                                                       |   |   |
| except for Note 7 - Deferred Compensation Plan, as  to which the date is |   |
| July 13, 2005                                                       |   |

 

38

----

**Iteris, Inc.**

**Consolidated Balance Sheets**

**(In thousands)**
| ** **                                                                                                                          | ** ** | **March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                          | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Assets                                                                                                                              |       |               |       |   |   |
| Current assets:                                                                                                                     |       |               |       |   |   |
| Cash and cash equivalents                                                                                                           |       | $                  | 131        |   | $ | 46 |   |
| Trade accounts receivable, net of allowance for  doubtful accounts of $429 and $239 at March 31, 2006 and 2005,  respectively. |       | 11,426             |       | 8,866 |   |
| Costs and estimated earnings in excess of billings  on uncompleted contracts                                                        |       | 2,693              |       | 2,086 |   |
| Deferred income taxes                                                                                                               |       | 790                |       | 101 |   |
| Inventories, net of reserve for inventory  obsolescence of $592 and $514 at March 31, 2006 and 2005, respectively              |       | 2,814              |       | 4,344 |   |
| Prepaid expenses and other current assets                                                                                           |       | 368                |       | 384 |   |
| Total current  assets                                                                                                               |       | 18,222             |       | 15,827 |   |
|                                                                                                                                |       |               |       |   |   |
| Property and equipment:                                                                                                             |       |               |       |   |   |
| Leasehold improvements                                                                                                              |       | 112                |       | 105 |   |
| Equipment                                                                                                                           |       | 6,638              |       | 5,281 |   |
| Accumulated depreciation                                                                                                            |       | (4,967             | )          | (4,283 | ) |
|                                                                                                                                |       | 1,783              |       | 1,103 |   |
|                                                                                                                                |       |               |       |   |   |
| Deferred income  taxes                                                                                                              |       | 818                |       | 559 |   |
| Intangible  assets, net of accumulated amortization of $261 and $114 at March 31,  2006 and 2005, respectively            |       | 551                |       | 698 |   |
| Goodwill                                                                                                                            |       | 27,774             |       | 27,774 |   |
| Other assets                                                                                                                        |       | 485                |       | 695 |   |
| Total assets                                                                                                                        |       | $                  | 49,633     |   | $ | 46,656 |   |

 

See accompanyingnotes.

39

----

**Iteris, Inc.**

**Consolidated Balance Sheets**

**(Inthousands, except share and per share amounts)**
| ** **                                                                                                     | ** ** | **March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                     | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Liabilities and  stockholders’ equity                                                                     |       |               |       |   |   |
| Current liabilities:                                                                                           |       |               |       |   |   |
| Trade accounts payable                                                                                         |       | $                  | 3,620      |   | $ | 3,936 |   |
| Accrued payroll and related expenses                                                                           |       | 3,481              |       | 3,007 |   |
| Accrued liabilities                                                                                            |       | 2,304              |       | 790 |   |
| Revolving line of credit                                                                                       |       | 2,662              |       | 945 |   |
| Billings in excess of costs and estimated earnings  on uncompleted contracts                                   |       | 893                |       | 944 |   |
| Current portion of long-term debt                                                                              |       | 1,969              |       | 4,008 |   |
| Total current  liabilities                                                                                     |       | 14,929             |       | 13,630 |   |
|                                                                                                           |       |               |       |   |   |
| Non-current  payroll related liability                                                                         |       | 12                 |       | 330 |   |
|                                                                                                           |       |               |       |   |   |
| Deferred  compensation plan liability                                                                          |       | 820                |       | 772 |   |
|                                                                                                           |       |               |       |   |   |
| Deferred gain on  sale of building                                                                             |       | 449                |       | 733 |   |
|                                                                                                           |       |               |       |   |   |
| Long-term debt                                                                                                 |       | 2,171              |       | 1,319 |   |
|                                                                                                           |       |               |       |   |   |
| Convertible  debentures, net                                                                                   |       | 9,203              |       | 8,996 |   |
|                                                                                                           |       |               |       |   |   |
| Commitments and  contingencies                                                                                 |       |               |       |   |   |
|                                                                                                           |       |               |       |   |   |
| Redeemable common stock                                                                                        |       |               |       |   |   |
| Issued and outstanding shares — 1,219,445 at  March 31, 2006 and 2005                                |       | 3,414              |       | 3,414 |   |
|                                                                                                           |       |               |       |   |   |
| Stockholders’ equity:                                                                                     |       |               |       |   |   |
| Preferred stock:                                                                                               |       |               |       |   |   |
| Authorized  shares — 2,000,000                                                                            |       |               |       |   |   |
| Issued and outstanding — none                                                                             |       | —             |       | — |   |
| Common stock,  $.10 par value:                                                                                 |       |               |       |   |   |
| Authorized  shares — 50,000,000                                                                           |       |               |       |   |   |
| Issued and outstanding shares — 27,431,502 at  March 31, 2006 and 27,089,661 at  March 31, 2005 |       | 2,743              |       | 2,709 |   |
| Additional paid-in capital                                                                                     |       | 126,743            |       | 126,534 |   |
| Deferred stock-based compensation                                                                              |       | (79                | )          | (925 | ) |
| Common stock held in trust — 310,510 shares at  March 31, 2006 and 2005                              |       | (374               | )          | (374 | ) |
| Treasury stock — none at March 31, 2006 and 93  shares at March 31, 2005                        |       | —             |       | (1 | ) |
| Notes receivable from employees                                                                                |       | (49                | )          | (45 | ) |
| Accumulated deficit                                                                                            |       | (110,356           | )          | (110,436 | ) |
| Accumulated other comprehensive income                                                                         |       | 7                  |       | — |   |
| Total  stockholders’ equity                                                                               |       | 18,635             |       | 17,462 |   |
| Total liabilities and  stockholders’ equity                                                               |       | $                  | 49,633     |   | $ | 46,656 |   |

 

See accompanying notes.

40

----

**Iteris, Inc.**

**Consolidated Statements of Operations**

**(In thousands, exceptper share amounts)**
| ** **                                                                          | ** ** | **Year Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                          | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales and contract  revenues:                                                   |       |                                    |       |   |   |   |   |
| Net sales                                                                           |       | $                                       | 31,156     |   | $ | 29,062 |   | $ | 23,470 |   |
| Contract revenues                                                                   |       | 19,330                                  |       | 17,335 |   | 21,813 |   |
| Total net sales  and contract revenues                                              |       | 50,486                                  |       | 46,397 |   | 45,283 |   |
|                                                                                |       |                                    |       |   |   |   |   |
| Costs and expenses:                                                                 |       |                                    |       |   |   |   |   |
| Cost of net sales                                                                   |       | 16,465                                  |       | 15,645 |   | 12,758 |   |
| Cost of contract revenues                                                           |       | 12,395                                  |       | 11,398 |   | 14,712 |   |
| Selling, general and administrative expenses                                        |       | 14,999                                  |       | 13,964 |   | 12,844 |   |
| Research and development expenses                                                   |       | 5,088                                   |       | 4,193 |   | 3,923 |   |
| Stock-based compensation                                                            |       | 725                                     |       | 11,777 |   | — |   |
| Amortization of intangible assets                                                   |       | 147                                     |       | 114 |   | — |   |
| Deferred compensation expense (benefit)                                             |       | 48                                      |       | (484 | ) | 868 |   |
| Disposal of fixed assets                                                            |       | —                                  |       | 422 |   | — |   |
| Acquired in-process research and development                                        |       | —                                  |       | 140 |   | — |   |
| Total costs and  expenses                                                           |       | 49,867                                  |       | 57,169 |   | 45,105 |   |
| Income (loss)  from operations                                                      |       | 619                                     |       | (10,772 | ) | 178 |   |
|                                                                                |       |                                    |       |   |   |   |   |
| Non-operating income  (expense):                                                    |       |                                    |       |   |   |   |   |
| Other income, net                                                                   |       | 35                                      |       | 1,054 |   | 1,003 |   |
| Interest expense, net                                                               |       | (1,459                                  | )          | (1,178 | ) | (123 | ) |
| Income (loss)  from continuing operations before income taxes and minority interest |       | (805                                    | )          | (10,896 | ) | 1,058 |   |
| Income tax  benefit (provision)                                                     |       | 885                                     |       | 94 |   | (100 | ) |
| Minority  interest in earnings of subsidiary                                        |       | —                                  |       | (526 | ) | (2,813 | ) |
| Income (loss)  from continuing operations                                           |       | 80                                      |       | (11,328 | ) | (1,855 | ) |
| Income from  discontinued operations, net of taxes of $0                            |       | —                                  |       | — |   | 1,215 |   |
| Net income  (loss)                                                                  |       | $                                       | 80         |   | $ | (11,328 | ) | $ | (640 | ) |
|                                                                                |       |                                    |       |   |   |   |   |
| Basic and diluted  earnings (loss) per share:                                       |       |                                    |       |   |   |   |   |
| Continuing operations                                                               |       | $                                       | 0.00       |   | $ | (0.45 | ) | $ | (0.09 | ) |
| Discontinued operations                                                             |       | —                                  |       | — |   | 0.06 |   |
| Basic and  diluted earnings (loss) per share                                        |       | $                                       | 0.00       |   | $ | (0.45 | ) | $ | (0.03 | ) |
|                                                                                |       |                                    |       |   |   |   |   |
| Shares used in  computing basic earnings (loss) per share                           |       | 28,182                                  |       | 25,284 |   | 19,454 |   |
| Shares used in  computing diluted earnings (loss) per share                         |       | 32,737                                  |       | 25,284 |   | 19,454 |   |

 

See accompanying notes*.*

41

----

**Iteris, Inc.**

**Consolidated Statements of and Stockholders’Equity (Deficit)**

**(In thousands)**
| ** **                                                               | ** ** | **Common Stock  Shares Outstanding** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **                       | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** **          | ** ** | ** **                             | ** ** | ** **               | ** ** | ** **                                    | ** ** | ** **                                       | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------|------------|--------------------------|------------|------------|------------|----------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|---------------------|------------|----------------------------------------|------------|--------------------------|------------|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                               | ** ** | **Class A  Shares**                       | ** ** | **Class B  Shares** | ** ** | **Amount** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Deferred  Stock-Based  Compensation** | ** ** | **Common  Stock  Held in  Trust** | ** ** | **Treasury  Stock** | ** ** | **Notes  Receivable  From  Employees** | ** ** | **Accumulated  Deficit** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Total  Stockholder’s  Equity  (Deficit)** | ** ** | **Comprehensive  Income  (Loss)** | ** ** |
| Balance at March 31, 2003                                           |       | 14,081                                         |       | 1,036                    |       | $          | 1,512      |                             | $          | 91,767                                  |       | $                                      | —     |                | $          | —                                 |       | $                        | (1         | )                                             | $          | (51                                              | )          | $ | (98,468 | ) | $ | (99 | ) | $ | (5,340 | ) |   |   |
| Issuance of Class A common stock and warrants                       |       | 6,288                                          |       | —                   |       | 629        |       | 4,170                            |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 4,799                                            |       |   |   |
| Conversion of Class B common stock                                  |       | 108                                            |       | (108                     | )          | —     |       | —                           |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | —                                           |       |   |   |
| Payments on notes receivable                                             |       | —                                         |       | —                   |       | —     |       | —                           |       | —                                  |       | —                                 |       | —              |       | 6                                      |       | —                   |       | —                                        |       | 6                                                |       |   |   |
| Foreign currency translation adjustments                                 |       | —                                         |       | —                   |       | —     |       | —                           |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | 99                                            |       | 99                                               |       | 99 |   |
| Net loss                                                                 |       | —                                         |       | —                   |       | —     |       | —                           |       | —                                  |       | —                                 |       | —              |       | —                                 |       | (640                     | )          | —                                        |       | (640                                             | )          | (640 | ) |
| Balance at March 31, 2004                                           |       | 20,477                                         |       | 928                      |       | 2,141      |       | 95,937                           |       | —                                  |       | —                                 |       | (1                  | )          | (45                                    | )          | (99,108                  | )          | —                                        |       | (1,076                                           | )          | (541 | ) |
| Warrant exercises                                                        |       | 402                                            |       | —                   |       | 40         |       | 344                              |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 384                                              |       |   |   |
| Stock option exercises                                              |       | 25                                             |       | —                   |       | 2          |       | 49                               |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 51                                               |       |   |   |
| Issuance of warrants in connection with convertible  debentures          |       | —                                         |       | —                   |       | —     |       | 1,101                            |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 1,101                                            |       |   |   |
| Conversion of Class B common stock                                  |       | 1,020                                          |       | (928                     | )          | 9          |       | (9                               | )          | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | —                                           |       |   |   |
| Convertible debenture conversion to common stock                         |       | 69                                             |       | —                   |       | 7          |       | 205                              |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 212                                              |       |   |   |
| Issuance of common stock in connection with merger of  Iteris Subsidiary |       | 4,787                                          |       | —                   |       | 479        |       | 14,722                           |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 15,201                                           |       |   |   |
| Issuance of warrants                                                |       | —                                         |       | —                   |       | —     |       | 26                               |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 26                                               |       |   |   |
| Assumption of Iteris subsidiary stock options and  warrants              |       | —                                         |       | —                   |       | —     |       | 13,816                           |       | (1,433                                  | )          | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 12,383                                           |       |   |   |
| Common stock held in trust                                               |       | 310                                            |       | —                   |       | 31         |       | 343                              |       | —                                  |       | (374                                   | )          | —              |       | —                                 |       | —                   |       | —                                        |       | —                                           |       |   |   |
| Amortization of deferred stock-based compensation                        |       | —                                         |       | —                   |       | —     |       |                             |       | 508                                     |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 508                                              |       |   |   |
| Net loss                                                                 |       | —                                         |       | —                   |       | —     |       | —                           |       | —                                  |       | —                                 |       | —              |       | —                                 |       | (11,328                  | )          | —                                        |       | (11,328                                          | )          | (11,328 | ) |
| Balance at March 31, 2005                                           |       | 27,090                                         |       | —                   |       | 2,709      |       | 126,534                          |       | (925                                    | )          | (374                                   | )          | (1                  | )          | (45                                    | )          | (110,436                 | )          | —                                        |       | 17,462                                           |       | (11,328 | ) |
| Warrant exercises                                                        |       | 98                                             |       | —                   |       | 9          |       | 28                               |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 37                                               |       |   |   |
| Stock option exercises                                              |       | 244                                            |       | —                   |       | 25         |       | 275                              |       | —                                  |       | —                                 |       | —              |       | (4                                     | )          | —                   |       | —                                        |       | 296                                              |       |   |   |
| Issuance of warrants                                                |       | —                                         |       | —                   |       | —     |       | 28                               |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 28                                               |       |   |   |
| Deferred stock-based compensation, net                              |       | —                                         |       | —                   |       | —     |       | (121                             | )          | 846                                     |       | —                                 |       | —              |       | —                                 |       | —                   |       | —                                        |       | 725                                              |       |   |   |
| Retirement of treasury stock                                             |       | —                                         |       | —                   |       | —     |       | (1                               | )          | —                                  |       | —                                 |       | 1                   |       | —                                 |       | —                   |       | —                                        |       | —                                           |       |   |   |
| Foreign currency translation adjustments                                 |       | —                                         |       | —                   |       | —     |       | —                           |       | —                                  |       | —                                 |       | —              |       | —                                 |       | —                   |       | 7                                             |       | 7                                                |       | 7 |   |
| Net income                                                               |       | —                                         |       | —                   |       | —     |       | —                           |       | —                                  |       | —                                 |       | —              |       | —                                 |       | 80                       |       | —                                        |       | 80                                               |       | 80 |   |
| Balance at March 31, 2006                                           |       | 27,432                                         |       | —                   |       | $          | 2,743      |                             | $          | 126,743                                 |       | $                                      | (79        | )                   | $          | (374                                   | )          | $                        | —     |                                          | $          | (49                                              | )          | $ | (110,356 | ) | $ | 7 |   | $ | 18,635 |   | $ | 87 |   |
|                                                                          |            |                                                |            |                          |            |            |            |                                  |            |                                         |            |                                        |            |                     |            |                                        |            |                          |            |                                               |            |                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes.

42

----

**Iteris, Inc.**

**Consolidated Statements of Cash Flows**

**(In thousands)**
| ** **                                                                                          | ** ** | **Year Ended March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating activities**                                                                            |       |                                    |       |   |   |   |   |
| Net income (loss) from  continuing operations                                                       |       | $                                       | 80         |   | $ | (11,328 | ) | $ | (1,855 | ) |
| Net income from  discontinued operations                                                            |       | —                                  |       | — |   | 1,215 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                                    |       |   |   |   |   |
| Change in deferred tax  assets                                                                      |       | (948                                    | )          | (200 | ) | — |   |
| Depreciation and  amortization                                                                      |       | 684                                     |       | 787 |   | 857 |   |
| Stock-based  compensation                                                                           |       | 725                                     |       | 11,777 |   | — |   |
| Amortization of  deferred gain on sale-leaseback                                                    |       | (284                                    | )          | (609 | ) | (855 | ) |
| Amortization of debt  discounts                                                                     |       | 207                                     |       | 184 |   | — |   |
| Amortization of  intangible assets                                                                  |       | 147                                     |       | 114 |   | — |   |
| Amortization of  deferred financing costs                                                           |       | 138                                     |       | 121 |   | — |   |
| Minority interest in  earnings of subsidiary                                                        |       | —                                  |       | 526 |   | 2,813 |   |
| Loss on disposal of  assets                                                                         |       | —                                  |       | 422 |   | — |   |
| Write-off of acquired  in-process research and development                                          |       | —                                  |       | 140 |   | — |   |
| Fair value of warrants  issued for services                                                         |       | —                                  |       | 26 |   | — |   |
| Changes in operating assets and liabilities:                                                        |       |                                    |       |   |   |   |   |
| Accounts receivable                                                                                 |       | (2,560                                  | )          | (611 | ) | (88 | ) |
| Net costs and estimated  earnings in excess of billings                                             |       | (658                                    | )          | 961 |   | (10 | ) |
| Inventories                                                                                         |       | 1,530                                   |       | (746 | ) | 305 |   |
| Prepaid expenses and  other assets                                                                  |       | 109                                     |       | 41 |   | 1,454 |   |
| Deferred gain on sale  of building                                                                  |       | —                                  |       | — |   | (3,396 | ) |
| Accounts payable and  accrued expenses                                                              |       | 1,048                                   |       | (789 | ) | (1,625 | ) |
| Deferred revenue                                                                                    |       | —                                  |       | (226 | ) | 226 |   |
| Net assets of  discontinued operations                                                              |       | —                                  |       | — |   | 241 |   |
| Net cash provided by  (used in) operating activities                                                |       | 218                                     |       | 590 |   | (718 | ) |
|                                                                                                |       |                                    |       |   |   |   |   |
| **Investing activities**                                                                            |       |                                    |       |   |   |   |   |
| Purchases of property  and equipment                                                                |       | (1,258                                  | )          | (670 | ) | (558 | ) |
| Notes receivable                                                                                    |       | —                                  |       | 125 |   | — |   |
| Acquisition costs                                                                                   |       | —                                  |       | (80 | ) | — |   |
| Other                                                                                               |       | —                                  |       | — |   | 99 |   |
| Net cash used in  investing activities                                                              |       | (1,258                                  | )          | (625 | ) | (459 | ) |
|                                                                                                |       |                                    |       |   |   |   |   |
| **Financing activities**                                                                            |       |                                    |       |   |   |   |   |
| Proceeds (payments)  from borrowings on lines of credit, net                                        |       | 1,717                                   |       | 845 |   | (1,385 | ) |
| Proceeds from long-term  debt                                                                       |       | —                                  |       | 5,000 |   | 918 |   |
| Payments on long-term  debt                                                                         |       | (1,314                                  | )          | (1,038 | ) | — |   |
| Checks drawn in excess  of available bank balances                                                  |       | 389                                     |       | 268 |   | — |   |
| Proceeds from issuance  of convertible debentures                                                   |       | —                                  |       | 9,436 |   | — |   |
| Purchase of Iteris  subsidiary Series A preferred stock                                        |       | —                                  |       | (17,543 | ) | — |   |
| Proceeds from stock  option and warrant exercises                                                   |       | 333                                     |       | 501 |   | — |   |
| Proceeds from issuance  of common stock and related warrants                                        |       | —                                  |       | — |   | 3,813 |   |
| Payments on notes  receivable from employees                                                        |       | —                                  |       | — |   | 6 |   |
| Net cash provided by  (used in) financing activities                                                |       | 1,125                                   |       | (2,531 | ) | 3,352 |   |
| Increase (decrease) in  cash                                                                        |       | 85                                      |       | (2,566 | ) | 2,175 |   |
| Cash and cash  equivalents at beginning of year                                                     |       | 46                                      |       | 2,612 |   | 437 |   |
| Cash and cash  equivalents at end of year                                                           |       | $                                       | 131        |   | $ | 46 |   | $ | 2,612 |   |
|                                                                                                |       |                                    |       |   |   |   |   |
| **Supplemental cash flow information:**                                                             | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid (received) during the period:                                                             |       |                                    |       |   |   |   |   |
| Interest                                                                                            |       | $                                       | 1,095      |   | $ | 747 |   | $ | 123 |   |
| Income taxes                                                                                        |       | (2                                      | )          | 624 |   | 320 |   |
|                                                                                                |       |                                    |       |   |   |   |   |
| **Supplemental schedule of non-cash investing  and financing activities:**                     | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Property and equipment  financing                                                                   | ** ** | $                                       | 127        | ** ** | $ | — | ** ** | $ | — | ** ** |
| Fair value of warrants  issued in settlement of liabilities                                         |       | 28                                      |       | — |   | — |   |
| Exercises of stock  options via notes receivable from employees                                     |       | 4                                       |       | — |   | — |   |
| Retirement of treasury  stock                                                                       |       | 1                                       |       | — |   | — |   |
| Increase in promissory  note to landlord to settle lease obligation                                 |       | —                                  |       | 432 |   | — |   |
| Acquisition of minority interest of the Iteris  subsidiary                                          |       |                                    |       |   |   |   |   |
| Intangible assets                                                                                   |       | —                                  |       | 812 |   | — |   |
| Deferred tax  liabilities                                                                           |       | —                                  |       | 360 |   | — |   |
| Goodwill                                                                                            |       | —                                  |       | 17,887 |   | — |   |
| Reduction of minority  interest                                                                     |       | —                                  |       | 1,253 |   | — |   |
| Issuance of warrants in  connection with Debenture and Warrant Purchase Agreement                   |       | —                                  |       | 1,101 |   | — |   |
| Conversion of convertible  debt to equity                                                           |       | —                                  |       | 250 |   | — |   |
| Issuance of common  stock to settle liabilities                                                     |       | —                                  |       | — |   | 416 |   |
| Contribution of common stock to 401(k) plan to  settle employer match                          |       | —                                  |       | — |   | 578 |   |

 

See accompanying notes.

43

----

**Iteris, Inc.Notes to Consolidated Financial StatementsMarch 31,2006**

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

**Descriptionof Business**

Iteris, Inc.,formerly known as Iteris Holdings, Inc. (the “Company”), is a leading providerof outdoor machine vision systems and sensors that optimize the flow of trafficand enhance driver safety. Using proprietary software and IntelligentTransportation Systems (“ITS”) industry expertise, the Company provides videosensor systems, transportation management and traveler information systems andother engineering and consulting services to the ITS industry. The ITS industryis comprised of companies applying a variety of technologies to enable the safeand efficient movement of people and goods. The Company uses its outdoor imagerecognition software expertise to develop proprietary algorithms for videosensor systems that improve vehicle safety and the flow of traffic. Using itsknowledge of the ITS industry, the Company designs and implementstransportation management systems that help public agencies reduce trafficcongestion and provide greater access to traveler information. On October 22,2004, the Company completed the merger with its majority-owned subsidiary,Iteris, Inc. (the “Iteris Subsidiary”), and officially changed the Company’scorporate name from Iteris Holdings, Inc. to Iteris, Inc. (Note 3). TheCompany was originally incorporated in Delaware in 1987 as Odetics, Inc.and in September 2003 changed its name to Iteris Holdings, Inc. toreflect its focus on the ITS industry and its capital structure at that time.

**Basis ofPresentation**

The accompanying consolidated financial statementsinclude the accounts of the Company and its subsidiaries. All significantintercompany accounts and transactions have been eliminated in consolidation.

As discussed further in Note 11, in 2003 the Companydiscontinued the operations of its Broadcast, Inc. subsidiary (“Broadcast”),its Zyfer, Inc. subsidiary (“Zyfer”), and its MAXxess Systems, Inc.subsidiary (“MAXxess”), so that the Company could focus on its ITS business. Theresults of operations for these businesses are presented as discontinuedoperations in the accompanying consolidated financial statements.

**Use ofEstimates**

The preparation of consolidated financial statementsin conformity with accounting principles generally accepted in the UnitedStates requires management to make certain estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosures of contingentassets and liabilities at the date of the financial statements, and reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates. Significant estimates made in thepreparation of the consolidated financial statements include the allowance fordoubtful accounts, deferred tax assets, inventory and warranty reserves, coststo complete long-term contracts, overhead rates used in cost-plus contracts,contract reserves and estimates of future cash flows used to assess therecoverability of long-lived assets, the valuation of equity instruments andthe realization of goodwill.

**Reclassifications**

Certain reclassificationshave been made to the prior year financial statements to conform to the currentyear presentation.

**Revenue Recognition**

Product revenues and related costs of sales arerecognized upon the transfer of title, which generally occurs upon shipment or,if required, upon acceptance by the customer, provided that the Companybelieves collectibility of the net sales amount is reasonably assured. Accordingly,at the date revenue is recognized, the significant uncertainties concerning thesale have been resolved.

Contract revenues are derived primarily from long-termcontracts with governmental agencies. Contract revenues include costs incurredplus a portion of estimated fees or profits determined on the percentage ofcompletion method of accounting based on the relationship of costs incurred tototal estimated costs. Any anticipated losses on contracts are charged toearnings when identified. Changes in job performance and estimatedprofitability, including those arising from contract penalty provisions andfinal contract settlements, may result in revisions to costs and revenues andare recognized in the period in which the revisions are determined. Profitincentives are included in revenue when their realization is reasonablyassured.

In addition to product and contract revenue, theCompany derives revenue from technology access fees, the provision of specificnon-recurring contract engineering services and royalties. Technology accessfee revenues are recognized evenly over the period in which they are earned. Non-recurringcontract engineering revenues are recognized in the period in which the relatedservices are performed. Royalty revenues are recorded in the period in whichthe royalty is earned, based on unit sales of the Company’s products. Technologyaccess fee revenues, contract engineering revenues and royalty revenues areincluded in net sales in the accompanying consolidated statements ofoperations.

44

----

Revenues from follow-on service and support, for whichthe Company charges separately, are recorded in the period in which theservices are performed.

**Concentrationof Credit Risk**

Accounts receivable are derived from revenues earnedfrom customers located throughout North America and Europe. The Companygenerally does not require collateral or other security from customers.Collectibility of receivable balances is estimated through review of invoicesoutstanding greater than a certain period of time and ongoing creditevaluations of customers’ financial condition. Reserves are maintained forpotential credit losses, and such losses have historically been withinmanagement’s expectations.

At March 31, 2006 and 2005, accounts receivablefrom governmental agencies and prime government contractors were approximately$4.4 million and $3.5 million, respectively. No customer or government agencyhad a receivable balance greater than 10% of our total net sales or contractrevenues at March 31, 2006 and 2005.

**FairValues of Financial Instruments**

The fair value of cashand cash equivalents, receivables, inventories, accounts payable and accruedexpenses approximate carrying value because of the short period of time tomaturity. The fair value of line of credit agreements and long-term debtapproximate carrying value because the related rates of interest approximatecurrent market rates. The fair value of convertible debentures approximatescarrying value because the effective interest rate, taking into accountrecorded debt discounts, approximates current market rates. At March 31,2005, the fair value of redeemable common stock approximated carrying valuesince these shares were not tradable in any public equity markets. At March 31,2006, the estimated fair value of the redeemable shares was $3.2 million, basedon the closing price of the Company’s common stock on that date.

**Cash andCash Equivalents**

Cash and cash equivalents consist of cash andshort-term investments with initial maturities of ninety days or less.

**Inventories**

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

**Propertyand Equipment**

Property and equipment are recorded at cost and aredepreciated 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.

**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. The performance of the testinvolves a two-step process. The first step of the impairment test involvescomparing the fair value of the Company’s reporting units with the reportingunit’s carrying amount, including goodwill. The fair value of reporting unitsis generally determined using the income approach. If the carrying amount of areporting unit exceeds the reporting unit’s fair value, the second step of thegoodwill impairment test is performed to determine the amount of any impairmentloss. The second step of the goodwill impairment test involves comparing theimplied fair value of the reporting unit’s goodwill with the carrying amount ofthat goodwill.

The Company evaluates long-lived assets for impairmentin accordance with SFAS No. 144, *“Accounting for theImpairment or Disposal of Long-Lived Assets,”* which requiresimpairment evaluation on long-lived assets used in operations when indicatorsof impairment are present. Reviews are performed to determine whether thecarrying value of assets is impaired, based on comparison to undiscountedexpected future cash flows. If this comparison indicates that there isimpairment, the impaired asset is written down to fair value, which istypically calculated using discounted expected future cash flows using adiscount rate based upon the Company’s weighted average cost of capitaladjusted for risks associated with the related operations. Impairment is basedon the excess of the carrying amount over the fair value of those assets.

**Income Taxes**

TheCompany utilizes the liability method of accounting for income taxes as setforth in SFAS No. 109, *Accounting for IncomeTaxes* (“SFAS 109”). Under the liability method, deferred taxes aredetermined based on the temporary differences between the financial statementand tax bases of assets and liabilities using enacted tax rates. A valuationallowance is recorded when it is more likely than not that some of the deferredtax assets will not be realized. See Note 6.

## **Stock-Based Compensation**

TheCompany accounts for stock-based employee compensation arrangements inaccordance with Accounting Principles Board Opinion No. 25, *Accounting for Stock-Issued to Employees*(“APB25”) and related interpretations, and

45

----

complies with the disclosure-only provisions of SFAS No. 123,*Accounting for Stock-Based Compensation*(“SFAS123”) and SFAS 148, *Accounting for Stock-BasedCompensation — Transition and Disclosure* (“SFAS 148”). Under APB 25,compensation cost is recognized based on the difference, if any, on the date ofthe grant between the fair value of the Company’s stock and the amount theemployee must pay to acquire the stock.

Inaccordance with the requirements of the disclosure-only alternative of SFAS 123and SFAS 148, set forth below are the assumptions used and the pro formastatement of operations data of the Company giving effect to valuingstock-based awards to employees using the Black-Scholes option pricing modelinstead of the guidelines provided by APB 25. 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.

Theper share fair value of stock options granted in connection with stock optionplans has been estimated with the following weighted average assumptions:  

|                             | ** ** | **Years Ended March 31,** | ** ** |
|-----------------------------|------------|------------------------------------------|------------|
| ** **                  | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|                        |       |                                     |       |   |   |   |   |
| Dividend rate               |       | 0.0                                      |       | 0.0 |   | 0.0 |   |
| Expected life —  years |       | 7.0                                      |       | 7.0 |   | 7.0 |   |
| Risk-free  interest rate    |       | 5.5                                      |       | 4.5 |   | 2.0 |   |
| Volatility of common  stock |       | 0.5                                      |       | 0.5 |   | 0.4 |   |

 

For purposes of pro forma disclosures, the estimatedfair value of the options is amortized to expense over the options’ vestingperiod. The Company’s pro forma information follows:

|                                                                                         | ** ** | **Year Ended March 31,**                               | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net income  (loss) — as reported                                                   |       | $                                                                     | 80         |   | $ | (11,328 | ) | $ | (640 | ) |
| Add: Stock-based  compensation expense included in net income (loss) — as reported |       | 725                                                                   |       | 11,777 |   | — |   |
| Deduct:  Stock-based compensation expense determined under fair value method            |       | (1,108                                                                | )          | (12,806 | ) | (385 | ) |
| Net loss — pro  forma                                                              |       | $                                                                     | (303       | ) | $ | (12,357 | ) | $ | (1,025 | ) |
| Basic and  diluted income (loss) per share — as reported                           |       | $                                                                     | 0.00       |   | $ | (0.45 | ) | $ | (0.03 | ) |
| Basic and diluted loss  per share — pro forma                                      |       | $                                                                     | (0.01      | ) | $ | (0.49 | ) | $ | (0.05 | ) |

 

**Researchand Development Expenditures**

Research and developmentexpenditures are charged to expense in the period incurred.

**Shippingand Handling Costs**

Shippingand handling costs are included as cost of sales in the period during which theproducts ship.

**AdvertisingExpenses**

Advertisingcosts are expensed in the period incurred and totaled $185,000, $112,000 and$127,000 in the years ended March 31, 2006, 2005 and 2004, respectively.

**Warranty**

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

46

----

**Repairand Maintenance Costs**

TheCompany incurs repair and maintenance costs in the normal course of business.Should the activity result in a permanent improvement to one of the Company’sleased facilities, the cost is capitalized as a leasehold improvement andamortized over its useful life or the remainder of the lease period, whicheveris shorter. Non-permanent repair and maintenance costs are charged to expenseas incurred.

**Comprehensive Income**

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

**RecentAccounting Pronouncements**

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs* (“SFAS 151”), whichclarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material. SFAS 151 will be effective forinventory costs incurred during fiscal years beginning after June 15, 2005.Management does not believe the adoption of SFAS 151 will have a materialimpact on the Company’s consolidated financial statements.

On December 16,2004, the FASB issued SFAS No. 123 (revised 2004), *Share-BasedPayment* (“SFAS 123R”) which replaces SFAS 123, supersedesAPB 25 and amends SFAS No. 95, *Statement of Cash Flows*.Generally, the approach in SFAS 123R is similar to the approach described inSFAS 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 SECRelease No. 33-8568, SFAS 123R became effective for the Company on April 1,2006. The Company plans to use the modified-prospective method of recognitionof compensation expense related to share-based payments.

The adoption of the SFAS 123R fair value methodwill have a significant adverse impact on reported results of operations,although it will have no impact on the Company’s overall financial position.The balance of unearned stock-based compensation to be included in the yearsending March 31, 2007 through 2010 related to share-based awards unvestedat March 31, 2006, as previously calculated under the disclosure-onlyrequirements of SFAS 123, is approximately $521,000. If there are anymodifications or cancellations of the underlying unvested securities, theCompany may be required to accelerate, increase or cancel any remainingunearned stock-based compensation expense. To the extent that the Companygrants additional equity securities, stock-based compensation expense will beincreased by the additional unearned compensation resulting from thoseadditional grants. Had the Company adopted SFAS 123R in prior periods, themagnitude of the impact on results of operations would have approximated theimpact of SFAS 123 assuming the application of the Black-Scholes optionpricing model as described in the disclosure above of pro forma net loss andpro forma net loss per share.

**2.****             Supplementary Financial Information**

**Inventories**

The following table presents details of the Company’sinventories:

|                         | ** ** | **March 31,**      | ** ** |
|-------------------------|------------|-------------------------|------------|
| ** **              | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **              | ** ** | **(In thousands)** | ** ** |
| Materials and  supplies |       | $                       | 2,258      |   | $ | 3,204 |   |
| Work in process         |       | 217                     |       | 558 |   |
| Finished goods          |       | 339                     |       | 582 |   |
|                    |       | $                       | 2,814      |   | $ | 4,344 |   |

 

**Goodwill and Identifiable IntangibleAssets**

|                                             | ** ** | **March 31, 2006** | ** ** | **March 31, 2005**  | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **Gross  Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                  | ** ** | **(In thousands)**      | ** ** |
| Intangible assets  subject to amortization: |       |                         |       |                          |       |   |   |   |   |
| Developed Technology                        |       | $                            | 495        |                          | $          | (179 | ) | $ | 495 |   | $ | (78 | ) |
| Patents                                     |       | 317                          |       | (82                           | )          | 317 |   | (36 | ) |
| Total                                       |       | $                            | 812        |                          | $          | (261 | ) | $ | 812 |   | $ | (114 | ) |

 

47

----

Amortizationexpense for intangible assets subject to amortization was $147,000 and $114,000for the years ended March 31, 2006 and 2005, respectively. Futureestimated amortization expense for the next five years and thereafter is asfollows:
| **Year ending March 31:** | ** ** | ** ** | ** ** |
|------------------------------------------|------------|------------|------------|
| **(In thousands)**                  | ** ** | ** ** | ** ** |
| 2007                                     |       | $          | 147        |   |
| 2008                                     |       | 147        |       |
| 2009                                     |       | 147        |       |
| 2010                                     |       | 58         |       |
| 2011                                     |       | 46         |       |
| Thereafter                               |       | 6          |       |
|                                     |       | $          | 551        |   |

 

At March 31, 2005,goodwill was comprised of $18.0 million associated with the October 2004merger of the Iteris Subsidiary (Note 3); $9.6 million associated with theacquisitions of the Rockwell International Transportation Systems Group, MeyerMohaddes Associates and the Viggen Systems Consulting Group; and $200,000associated with the purchase of the assets of Mil-Lektron, a complimentaryproduct to the Company’s Vantage video detection business.

**Warranty Reserve Activity**

Thefollowing table presents activity in accrued warranty obligations:

|                                    | ** ** | **March 31,**      | ** ** |
|------------------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                         | ** ** | **(In thousands)** | ** ** |
| Balance at  beginning of year      |       | $                       | 326        |   | $ | 192 |   | $ | 256 |   |
| Additions charged to cost of sales |       | 517                     |       | 614 |   | 161 |   |
| Warranty claims                    |       | (324                    | )          | (480 | ) | (225 | ) |
|                               |       |                    |       |   |   |   |   |
| Balance at end of year             |       | $                       | 519        |   | $ | 326 |   | $ | 192 |   |

 

**Earnings (Loss) Per Share**

The following table sets forth the computation ofbasic and diluted income (loss) per share:
| ** **                                        | ** ** | **Year Ended March 31,**                               | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                        |       |                                                                  |       |   |   |   |   |
| Income (loss) from continuing operations          |       | $                                                                     | 80         |   | $ | (11,328 | ) | $ | (1,855 | ) |
| Income from discontinued operations               |       | —                                                                |       | — |   | 1,215 |   |
| Net income (loss)                                 |       | $                                                                     | 80         |   | $ | (11,328 | ) | $ | (640 | ) |
|                                              |       |                                                                  |       |   |   |   |   |
| Denominator:                                      |       |                                                                  |       |   |   |   |   |
| Denominator for basic earnings (loss) per share   |       | 28,182                                                                |       | 25,284 |   | 19,454 |   |
| Effect of  dilutive securities:                   |       |                                                                  |       |   |   |   |   |
| Stock options                                     |       | 3,818                                                                 |       | — |   | — |   |
| Warrants                                          |       | 737                                                                   |       | — |   | — |   |
| Denominator for diluted earnings (loss) per share |       | 32,737                                                                |       | 25,284 |   | 19,454 |   |
|                                              |       |                                                                  |       |   |   |   |   |
| Basic and diluted  earnings (loss) per share:     |       |                                                                  |       |   |   |   |   |
| Income (loss) from continuing operations          |       | $                                                                     | 0.00       |   | $ | (0.45 | ) | $ | (0.09 | ) |
| Income from discontinued operations               |       | —                                                                |       | — |   | 0.06 |   |
| Net income  (loss)                                |       | $                                                                     | 0.00       |   | $ | (0.45 | ) | $ | (0.03 | ) |

 

48

----

The followingshares were excluded from the computation of diluted earnings (loss) per shareas their effect would have been anti-dilutive:

|                        | ** ** | **Year Ended March 31,** | ** ** |
|------------------------|------------|-----------------------------------------|------------|
| ** **             | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **             | ** ** | **(In thousands)**                 | ** ** |
| ** **             | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options          |       | 470                                     |       | 4,560 |   | 162 |   |
| Warrants               |       | 1,265                                   |       | 1,095 |   | 64 |   |
| Convertible debentures |       | 2,729                                   |       | 2,729 |   | — |   |

 

**3.****             Mergerof the Company and the Iteris Subsidiary**

On May 28,2004 (the “Closing Date”), in order to simplify the Company’s capital structureand facilitate the merger of the Iteris Subsidiary into the Company, theCompany completed the purchase of all of the outstanding shares of the Series Apreferred stock of the Iteris Subsidiary (the “Series A preferred stock”),which were held by DaimlerChrysler Ventures GmbH (“DCV”) and HockenheimInvestment Pte. Ltd. (“Hockenheim”), in exchange for approximately $17.5million in cash. In addition, the Company acquired all of the 547,893 shares ofcommon stock of the Iteris Subsidiary held by DCV in exchange for the issuanceof 1,219,445 shares of the Company’s Class A common stock (now known asthe 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 stock on the OTCBulletin Board averaged over a five-day period. The purchase and exchange ofthe shares were made pursuant to a Stock Purchase and Exchange Agreement dated March 31,2004, by and among the Company, the Iteris Subsidiary, DCV and Hockenheim (the “Purchaseand Exchange Agreement”).

Pursuantto the Purchase and Exchange Agreement, the Company purchased 3,124,913 sharesof the Series A preferred stock of the Iteris Subsidiary from DCV andHockenheim for a purchase price of $5.61 per share. The purchase pricerepresented the stated redemption value of the Series A preferred stock. Thepurchase of the shares was financed primarily with a $10.1 million convertibledebenture financing completed in May 2004 with a group of accreditedinvestors, in addition to a $5.0 million senior credit facility arrangedthrough a bank and $2.4 million in cash (Note 5).

On June 30,2004, the Company and certain minority stockholders of the Iteris Subsidiary(including certain officers and directors) entered into an exchange agreementwhereby an aggregate of 1,319,541 shares of common stock of the IterisSubsidiary were exchanged for 2,639,082 shares of the Company’s newly issuedcommon stock valued at $8.6 million at the date of issuance. The fair value ofthe Company’s stock issued in the transaction was based on the quoted marketprice of the Company’s common stock on the OTC Bulletin Board averaged over afive-day period. The effect of this exchange was to reduce the residualminority interest in the Iteris Subsidiary to 8.1%.

On October 22,2004, the Iteris Subsidiary was merged into the Company. The remaining 8.1%minority interest in the Iteris Subsidiary (consisting of 1,228,981 shares ofcommon stock of the Iteris Subsidiary) was converted to 2,457,962 shares of theCompany’s common stock valued at $7.6 million at the merger date. Immediatelyfollowing the merger, the Company converted all of its outstanding Class Bcommon stock (921,917 shares) into 1,014,108 shares of its common stock(formerly designated as Class A common stock). The exchange ratio used inconversion was determined by the Company’s Board of Directors. The fair valueof the Company’s common stock issued in the transaction was based on the quotedmarket price of the Company’s common stock on the OTC Bulletin Board averagedover a five-day period. In October 2004, the Company also amended itscertificate of incorporation to (a) change the voting rights of its commonstock from one-tenth to one vote per share, (b) remove the ability toissue any further shares of Class B common stock, and (c) rename its Class Acommon stock to common stock. As a result, the Company currently has only oneclass of common stock outstanding, the common stock.

Inconnection with the merger, the Company assumed all outstanding options andwarrants to purchase shares of common stock of the Iteris Subsidiary that wereoutstanding immediately prior to the merger, whether vested or unvested,together with the Iteris Subsidiary’s 1998 Stock Incentive Plan. Each suchoption and warrant assumed by the Company shall continue to have, and besubject to, the same terms and conditions as were applicable immediately priorto the merger, provided that (A) such option or warrant shall beexercisable for that number of whole shares of the Company’s common stock equalto the product of the number of shares of the Company’s common stock that wereissuable upon exercise of such assumed option or warrant immediately prior tothe merger multiplied by two (2) (the “Exchange Ratio”) rounded down tothe nearest whole number of shares and (B) the per share exercise pricefor the shares of the Company’s common stock issuable upon exercise of suchassumed option or warrant is equal to the quotient determined by dividing theexercise price per share at which such option or warrant was exercisableimmediately prior to the merger by the Exchange Ratio (rounded up to thenearest 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 654,000 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-basedcompensation expense of $11.3 million was recorded in connection with theassumption and exchange of vested Iteris Subsidiary stock options for stockoptions immediately exercisable into the Company’s common stock based on thedifference between the

49

----

fairmarket value of the Company’s common stock on the October 22, 2004, mergerdate and the exercise price of the modified stock option. Additionally, theCompany recorded approximately $1.4 million in deferred compensation related tothe assumption of unvested stock options to purchase common stock of the IterisSubsidiary. Deferred compensation is being amortized to stock-basedcompensation expense as the options vest; and at March 31, 2006, $79,000of deferred compensation remained to be amortized. The Company also recorded$1.1 million of goodwill and additional paid-in-capital in connection with the654,000 vested warrants assumed in the merger and acquisition of the IterisSubsidiary. The $1.1 million value was based on the difference between the fairmarket value of the Company’s common stock on the October 22, 2004, mergerdate and modified exercise price of the assumed warrant awards.

The excess of the purchase price over theproportionate amount of minority interest acquired was allocated to acquiredintangible assets based on the estimated fair values with the residualallocated to goodwill. Accordingly, the Company recorded goodwill of $18.0million, which represents the excess of the purchase price over the fair valueof the proportionate identifiable net assets acquired. The estimated fair valueof the intangible assets was determined using the income method and discountingfuture expected returns. The estimated useful life for each of the acquiredintangible assets is provided below:

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

 

50

----

The following tablesummarizes fair values of the assets acquired and liabilities assumed and theallocation of the purchase price at the date of acquisition (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 deductable for tax purposes)                   |   | 17,967 |   |
| Total purchase price  allocation                             |   | $      | 37,354 |   |

 

On October 22, 2004, in connection with theCompany’s merger with the Iteris Subsidiary, the Chief Executive Officer of theIteris Subsidiary, Mr. Jack Johnson, was promoted to President and ChiefExecutive Officer of the Company, replacing Mr. Gregory Miner. This mergertriggered certain obligations under the Company’s change-in-control agreementwith Mr. Miner. Accordingly, the Company recorded approximately $807,000in severance expense, which included $57,000 for related payroll taxes, as acharge to operations for the year ended March 31, 2005. The severanceamount will be paid to Mr. Miner in bi-weekly installments over the next30 months. Mr. Miner is not required to render any services to the Companyin connection with this agreement.

**4.****             Costs and Estimated Earnings on UncompletedContracts**

Costs incurred,estimated earnings and billings on uncompleted long-term contracts are asfollows:
| ** **                                                                   | ** ** | **March 31,**      | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **(In thousands)** | ** ** |
| Total estimated  contract value                                              |       | $                       | 74,990     |   | $ | 71,835 |   |
|                                                                         |       |                    |       |   |   |
| Costs incurred  on uncompleted contracts                                     |       | $                       | 18,233     |   | $ | 16,553 |   |
| Estimated earnings                                                           |       | 1,823                   |       | 1,655 |   |
|                                                                         |       | 20,056                  |       | 18,208 |   |
| Less billings to date                                                        |       | (18,256                 | )          | (17,066 | ) |
|                                                                         |       | $                       | 1,800      |   | $ | 1,142 |   |
|                                                                         |       |                    |       |   |   |
| Included in  accompanying consolidated balance sheets:                       |       |                    |       |   |   |
| Costs and estimated earnings in excess of billings  on uncompleted contracts |       | $                       | 2,693      |   | $ | 2,086 |   |
| Billings in excess of costs and estimated earnings  on uncompleted contracts |       | (893                    | )          | (944 | ) |
|                                                                         |       | $                       | 1,800      |   | $ | 1,142 |   |

 

Costs and estimated earnings in excess of billings at March 31,2006 and 2005 include $806,000 and $481,000, respectively, that were notbillable as certain milestone objectives specified in the contracts had notbeen attained. Substantially all costs and estimated earnings in excess ofbillings at March 31, 2006 are expected to be billed and collected duringthe year ending March 31, 2007.

**5.****             Revolving Lines of Credit and Long-Term Debt**

**Revolving Lines of Credit**

On May 28, 2004, the Iteris Subsidiary enteredinto a line of credit agreement with a bank, which expires on July 31,2006, and provides for a maximum available credit line of $5.0 million. Thisline of credit was assumed by the Company in October 2004 and amended in November 2005.Under the terms of this agreement, the Company may borrow against its eligibleaccounts receivable and the value of its eligible inventory, as defined in thecredit agreement. Interest on borrowed amounts is payable monthly at thecurrent stated prime rate. Additionally, the Company is obligated to pay anunused line fee of 0.25% per annum applied to the amount by which the maximumcredit amount exceeds the average daily principal balance during the precedingmonth.

There are no monthly collateral management fees and nopre-payment or early termination fees. On March 31, 2006, the availablecredit under this line of credit agreement was $3.8 million, of which $1.1million was unused.

51

----

**Long-TermDebt**

Long-term debtconsists of the following:

|                              | ** ** | **March 31,**      | ** ** |
|------------------------------|------------|-------------------------|------------|
| ** **                   | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                   | ** ** | **(In thousands)** | ** ** |
| Convertible  debentures, net |       | $                       | 9,203      |   | $ | 8,996 |   |
| Bank term note               |       | 2,708                   |       | 3,958 |   |
| Promissory note  to landlord |       | 1,292                   |       | 1,292 |   |
| Other                        |       | 140                     |       | 77 |   |
|                         |       | 13,343                  |       | 14,323 |   |
| Less current  portion        |       | (1,969                  | )          | (4,008 | ) |
|                         |       | $                       | 11,374     |   | $ | 10,315 |   |

 

*Convertible Debentures, Net.*Inorder to finance the purchase of the Iteris Subsidiary Series A preferredstock (Note 3), the Company entered into a Debenture and Warrant PurchaseAgreement dated May 19, 2004 (the “Debenture and Warrant PurchaseAgreement”), with a group of accredited investors, which included certainofficers of the Company, pursuant to which the Company sold and issuedsubordinated convertible debentures in the aggregate original principal amountof $10.1 million. In connection with the issuance of the convertibledebentures, the Company issued detachable warrants to purchase an aggregate of639,847 shares of its common stock (Note 9), the value of which was recorded asa debt discount against the face amount of the debentures on the date ofissuance and is being amortized to interest expense over the term of theconvertible debentures.

The debentures are due in full on May 19, 2009,provide for 6.0% annual interest, payable quarterly, and are convertible intothe Company’s common stock at an initial conversion price of $3.61 per share,subject to certain adjustments, including adjustments for dilutive issuances. FromMay 19, 2007, until May 18, 2008, the debentures may be redeemed bythe Company, at its option, at 120% of the principal amount being redeemed; andfrom May 19, 2008, until the maturity date, the debentures may be redeemedat 110% of the principal amount being redeemed. During the year ended March 31,2005, $250,000 of convertible debentures were converted into 69,252 shares ofcommon stock leaving $9.9 million of the originally issued convertibledebentures outstanding at March 31, 2006 and 2005.

*Bank Term Note.*Concurrentwith the Company’s issuance of the convertible debentures, the IterisSubsidiary entered into a $5.0 million term note payable with a bank. This notewas assumed by the Company in October 2004. The proceeds from the notewere used to purchase the Series A preferred stock of the IterisSubsidiary (Note 3). The note is due on May 27, 2008, and provides formonthly principal payments of approximately $104,000. Interest accrues at thecurrent stated prime rate plus 0.25% (8.00% at March 31, 2006).

Both the term note payable and the line of credit areheld by one bank under the same credit agreement and are secured bysubstantially all of the assets of the Company. At March 31, 2006, theCompany failed to meet a financial covenant under this agreement that limitsthe amount of capital expenditures the Company may make in any fiscal year. OnMay 19, 2006, the bank waived its right of default regarding this covenantviolation for the year ended March 31, 2006. At March 31, 2005, theCompany failed to meet certain financial covenants under the credit agreement. OnMay 12, 2005, the bank waived its right of default regarding the covenantviolations for the quarter ended March 31, 2005 only. Because atMarch 31, 2005 the bank did not waive its default rights for a period ofat least twelve months, the entire balance of the bank term note is presentedas a current liability in the accompanying March 31, 2005 consolidatedbalance sheet.

*Promissory Note to Landlord.*Asdiscussed further in Note 7, on July 1, 2003, the Company amended theterms of its lease for its headquarters and entered into a $811,000 unsecuredpromissory note payable to its landlord. On November 1, 2004, $432,000 wasadded to the principal balance of this note to settle prior lease obligations,bringing the total principal balance to $1.3 million. Under the terms of thenote agreement, interest is payable quarterly and accrues at a rate of primeplus 2.0% (9.75% at March 31, 2006). Beginning on October 1, 2006,the Company is required to make four equal quarterly payments of principal andaccrued interest. All outstanding accrued interest and principal shall bepayable in full on July 2, 2007.

Scheduled aggregate maturities of long-term debtprincipal as of March 31, 2006 were as follows:

| Year ending March 31, | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
| **(In thousands)**              | ** ** | ** ** | ** ** |
| 2007                                 |       | $          | 1,969      |   |
| 2008                                 |       | 1,946      |       |
| 2009                                 |       | 225        |       |
| 2010                                 |       | 9,850      |       |
|                                 |       | 13,990     |       |
| Less:  unamortized debt discount     |       | (647       | )          |
|                                 |       | $          | 13,343     |   |

 

52

----

**6.****             Income Taxes**

The reconciliation of the income tax provision(benefit) from continuing operations to taxes computed at U.S. federalstatutory rates is as follows:

|                                                                            | ** ** | **Year Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                 | ** ** |
| Income tax  (benefit) provision at statutory rates                         |       | $                                       | (284       | ) | $ | (3,705 | ) | $ | 360 |   |
| State income  taxes net of federal benefit                                 |       | (85                                     | )          | (72 | ) | 20 |   |
| Change in  valuation allowance associated with federal deferred tax assets |       | (892                                    | )          | (755 | ) | (316 | ) |
| Compensation  charges                                                      |       | 222                                     |       | 3,692 |   | — |   |
| Adjustment to  prior year deferred taxes                                   |       | —                                  |       | 229 |   | — |   |
| Expiration of  unused credits                                              |       | —                                  |       | 266 |   | — |   |
| AMT and foreign  taxes                                                     |       | 46                                      |       | — |   | — |   |
| Other permanent  differences                                               |       | 108                                     |       | 251 |   | 36 |   |
|                                                                       |       | $                                       | (885       | ) | $ | (94 | ) | $ | 100 |   |

 

The components of deferred tax assets and liabilitiesare as follows:

|                                          | ** ** | **March 31,**      | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                               | ** ** | **(In thousands)** | ** ** |
| Deferred tax assets:                     |       |                    |       |   |   |
| Net operating losses                     |       | $                       | 18,061     |   | $ | 19,880 |   |
| Property and equipment                   |       | 623                     |       | 1,695 |   |
| Credit carry forwards                    |       | 1,356                   |       | 1,914 |   |
| Deferred compensation and payroll        |       | 1,770                   |       | 1,626 |   |
| Bad debt allowances and other reserves   |       | 410                     |       | 422 |   |
| Other, net                               |       | 124                     |       | 204 |   |
| Total deferred  tax assets               |       | 22,344                  |       | 25,741 |   |
| Valuation  allowance                     |       | (20,516                 | )          | (24,417 | ) |
| Net deferred tax  assets                 |       | 1,828                   |       | 1,324 |   |
|                                     |       |                    |       |   |   |
| Deferred tax  liabilities:               |       |                    |       |   |   |
| Capitalized interest and taxes           |       | —                  |       | (369 | ) |
| Acquired intangibles                     |       | (220                    | )          | (295 | ) |
| Total deferred  tax liabilities          |       | (220                    | )          | (664 | ) |
| Net deferred tax  assets                 |       | $                       | 1,608      |   | 660 |   |
|                                     |       |                    |       |   |   |
| Current portion  of net deferred taxes   |       | 790                     |       | 101 |   |
| Long-term  portion of net deferred taxes |       | 818                     |       | 559 |   |
| Net deferred tax assets                  |       | $                       | 1,608      |   | $ | 660 |   |

 

53

----

The components of current and deferred federal andstate income tax benefits and provisions are as follows:

|                                          | ** ** | **Year Ended March 31,** | ** ** |
|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                               | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                               | ** ** | **(In thousands)**                 | ** ** |
| Current income tax  (benefit) provision  |       |                                    |       |   |   |   |   |
| Federal                                  |       | $                                       | 9          |   | $ | 91 |   | $ | 891 |   |
| State                                    |       | 3                                       |       | 14 |   | 30 |   |
| Foreign                                  |       | 46                                      |       | — |   | — |   |
| Deferred income tax  (benefit) provision |       |                                    |       |   |   |   |   |
| Federal                                  |       | (812                                    | )          | (75 | ) | (821 | ) |
| State                                    |       | (131                                    | )          | (124 | ) | — |   |
| Net income tax  (benefit) provision      |       | $                                       | (885       | ) | $ | (94 | ) | $ | 100 |   |

 

At March 31,2006, the Company had approximately $637,000 in federal general business creditcarryforwards that begin to expire in 2007 and $709,000 in state general businesscredit carryforwards that can be carried forward indefinitely. The Company had$49.2 million of federal net operating loss carryforwards at March 31,2006, that begin to expire in 2019 and $22.6 million of state net operatingloss carryforwards that begin to expire in 2007.

Priorto May 28, 2004, the Iteris Subsidiary was required to file a separatefederal income tax return. On May 28, 2004, the Company acquired a greaterthan 80% ownership interest in the Iteris Subsidiary. From that date forward,income taxes are provided on a consolidated basis for federal income taxpurposes. Due to changes in stock ownership, the prior year $49.8 million of federalnet operating loss carryforwards and other federal tax attributes of theCompany are subject to a Section 382 limitation estimated at approximately$2.9 million annually which can be utilized to offset federal consolidatedtaxable income. To the extent such limitation is not exceeded in a particularyear, the excess limitation accumulates and adds to subsequent years’limitations. As a result of the annual limitation, a portion of the Company’scarryforwards will expire before ultimately becoming available to reduce futureincome tax liabilities.

At March 31,2006, the Company recorded a valuation allowance against its net deferred taxassets of approximately $20.5 million for that portion of deferred taxassets that it is more likely than not will not be realized. In making suchdetermination, a review of all available positive and negative evidence wasconsidered, including scheduled reversal of deferred tax liabilities, potentialcarryback, projected future taxable income, tax planning strategies, and recentfinancial performance. Any future benefits recognized from the reduction of thevaluation allowance will result in a reduction of income tax expense.

**7.****             Commitmentsand Contingencies**

**Litigation**

On June 29,2004, a supplier to Mariner Networks, Inc., a former subsidiary of theCompany that was discontinued in the fiscal year ended March 31, 2002,filed a complaint in Orange County Superior Court against the Company allegingvarious breaches of written contract claims arising out of alleged purchaseorders. The plaintiff in this lawsuit seeks monetary damages aggregatingapproximately $850,000 plus attorney fees and related costs. Discovery hascommenced, and a trial date has been set for July 2006. The Companyintends to vigorously defend itself against these allegations. Due to theuncertainty of the outcome, the Company has not recorded any amounts in theaccompanying consolidated financial statements in connection with this matter;however, should the ultimate resolution of this claim be unfavorable, it couldhave an adverse material impact on the Company’s consolidated financialposition, results of operations and cash flows.

In June 2004, the Company received $949,000 aspart of a settlement between Rockwell International and the MichiganDepartment of Transportation, pursuant to which the Company was a third partybeneficiary. This amount was recorded in other income in the consolidatedstatement of operations for the year ended March 31, 2005.

From time to time, theCompany has been involved in litigation relating to claims arising out of itsoperations in the normal course of business. The Company currently is not aparty to any legal proceedings except as described above, the adverse outcomeof which, in management’s opinion, individually or in the aggregate, would havea material adverse effect on its consolidated results of operations, financialposition or cash flows.

Furthermore, from time totime, the Company has experienced unforeseen developments in contingenciesrelated to its former subsidiaries. In addition to the lawsuit mentioned above,the Company has been the subject of a number of routine tax audits for timeperiods and jurisdictions related to the businesses of its former subsidiaries,some of which are still in process. Although the development and ultimateoutcome of these and other unforeseen matters cannot be predicted with anycertainty, management does not believe that the Company is presently involvedin any matters related to its former 

54

----

subsidiaries, except as described above, that wouldhave a material adverse effect on the Company’s consolidated results ofoperations, financial position or cash flows.

**Operating Leases**

In May 2002, the Company completed the sale andleaseback of its headquarters in Anaheim, California whereby the Companyentered into a lease with an initial term of ten years. In connection with thesale leaseback transaction, the Company originally recorded a deferred gain ofapproximately $7.6 million that was being amortized against operating expensesover the term of the initial lease. On July 1, 2003, the Companyrenegotiated the terms of this lease whereby the square footage under lease wasreduced and the initial lease term of ten years was reduced to four years. As aresult of the new lease agreement, $2.5 million of restricted cash was releasedto the Company and paid to the landlord, the Company entered into a promissorynote agreement with the landlord for $811,000 (Note 5), and the deferred gainon the sale of the building was adjusted. On November 1, 2004, the Companyagain amended this lease and increased the note payable to the landlord by$432,000 as a settlement to release the Company from its obligations under theexisting lease related to the separation of buildings located at the Anaheimfacility and other facility improvements to be made at the location. The $432,000was recorded as a reduction of the deferred gain on the sale of the building. Theremaining deferred gain was $449,000 at March 31, 2006 which will beamortized through October 2007.

The Company has lease commitments for facilities invarious locations throughout the United States. Future minimum rental paymentsunder noncancelable operating leases are as follows at March 31, 2006 (inthousands):

| 2007   |   | $   | 1,305  |   |
|--------|--------|-----|--------|--------|
| 2008   |   | 792 |   |
| 2009   |   | 116 |   |
| 2010   |   | 85  |   |
| 2011   |   | 43  |   |
|   |   | $   | 2,341  |   |

Rent expense under operating leases totaled$1,947,000, $1,722,000 and $2,241,000, respectively, for the years ended March 31,2006, 2005 and 2004.

The Company subleases 10,000 of the 94,000 square feetthat it leases in Anaheim, California at a monthly rate of $10,000. Aggregatefuture minimum rental income from this sublease agreement is $120,000 and$70,000 for the years ending March 31, 2007 and 2008, respectively.

**Inventory Purchase Commitments**

At March 31, 2006, the Company had firmcommitments to purchase inventory in the amount of $1.3 million during thefirst and second quarters of its fiscal year ending March 31, 2007.

**Deferred Compensation Plan**

In 1986, the Company adopted the Executive DeferralPlan (the “1986 Plan”) under which certain executives were able to defer aportion of their annual compensation into the 1986 Plan. All deferred amountsearned interest, generally with no guaranteed rate of return.

During the year ended March 31, 2003, the IterisSubsidiary adopted the Deferred Compensation Plan for the sole purpose oftransferring Iteris Subsidiary common stock and cash out of the 1986 Plan. Allassets of the 1986 Plan were distributed prior to March 31, 2003. Certainof these assets, consisting of 133,333 shares of the Iteris Subsidiary’s commonstock and $14,000 in cash, were transferred to the Deferred Compensation Planduring the year ended March 31, 2003. No compensation withholdings weredeferred under the 1986 Plan or the Deferred Compensation Plan in the yearsended March 31, 2006, 2005 and 2004.

During the year ended March 31, 2005, the Companyassumed the Deferred Compensation Plan as part of the October 2004 mergerand acquisition of the Iteris Subsidiary. In accordance with the merger (Note3) the Company exchanged the original 133,333 shares of Iteris Subsidiarycommon stock held in the Deferred Compensation Plan and an additional 21,922shares of the Iteris Subsidiary’s common stock subsequently purchased withdeferred wages for 310,510 shares of the Company’s common stock. All shares ofIteris Subsidiary stock held in the plan were purchased with funds earned bythe executives and deferred to the plan at the estimated fair value and thesame price that was paid by outside investors at that time, or approximately$374,000.

At March 31, 2006, the Deferred Compensation Planheld 310,510 shares of the Company’s common stock and $14,000 in cash, whichthe Company has presented as an aggregated $820,000 deferred compensation planliability in the accompanying consolidated balance sheet. Changes in the valueof Company common stock held by the Deferred Compensation Plan are determinedbased on changes in the quoted market price of the Company’s common stock atthe close of each reporting period and presented within operating expenses in theaccompanying consolidated statements of operations. The original $374,000 costbasis of shares of Company common stock held in the Deferred Compensation Planhas been recorded as a contra-equity account in the accompanying consolidatedfinancial statements.

55

----

**8.****            RedeemableCommon Stock**

As discussed in Note 3,the Company issued 1,219,445 shares of its Class A common stock (now knownas common stock) (“Exchange Shares”) in connection with the merger of theIteris Subsidiary into the Company. Beginning on November 28, 2005, DCVmay require the Company to repurchase up to 50% of the Exchange Shares at apurchase price of $1.438 per share; and beginning on May 28, 2007, DCV mayrequire the Company to repurchase up to 100% of the Exchange Shares at apurchase price of $1.438 per share. All such rights to require the repurchaseof the Exchange Shares expire on September 28, 2007. Because this right isoutside the control of the Company, the Company has classified the $3.4 millionvalue of the 1,219,445 shares as redeemable common stock on the accompanying March 31,2006 and 2005 consolidated balance sheets. On February 1, 2005, DCVannounced that its investment portfolio, which included its ownership in Iteris, Inc.,was sold to European-based Cipio Partners for an undisclosed sum. Allrepurchase rights associated with the DCV shares inured to the benefit of CipioPartners.

**9.****            Stockholders’Equity**

**Preferred Stock**

The Company’s certificate of incorporation providesfor the issuance of up to 2,000,000 shares of preferred stock. As of March 31,2006 and 2005, there were no outstanding shares of preferred stock, and theCompany does not have any plans to issue any shares of preferred stock. TheCompany’s Board of Directors is authorized to issue from time to time suchauthorized but unissued shares of preferred stock in one or more series and tofix or alter the designations, preferences, rights and any qualifications,limitations or restrictions of the shares of each such series, including thedividend, conversion, voting, redemption and liquidation rights.

**Common Stock and Common StockWarrants**

As discussed inNote 3, on October 22, 2004, the Iteris Subsidiary was merged into theCompany. Also in October 2004, the Company amended its certificate ofincorporation to (a) change the voting rights of its Class A commonstock from one-tenth to one vote per share, (b) remove the ability toissue any further shares of Class B common stock, and (c) rename its Class Acommon stock to common stock. As a result, the Company currently has only oneclass of common stock outstanding, the common stock. Previously, the Companyhad two classes of common stock outstanding — the Class A common stock andthe Class B common stock.

Subject to the rights specifically granted to holdersof any then outstanding shares of the Company’s preferred stock, the Company’scommon stockholders are entitled to any dividends that may be declared by theBoard of Directors. Upon dissolution, liquidation or winding up, holders ofcommon stock are entitled to share ratably in net assets after payment orprovision for all liabilities and any preferential liquidation rights ofpreferred stock then outstanding. Common stockholders generally do not havepreemptive or redemption rights, except for the Exchange Shares issued to DCVin exchange for shares of the Iteris Subsidiary (Notes 3 and 8). The rights,preferences and privileges of holders of common stock will be subject to thoseof the holders of any shares of common stock and preferred stock the Companymay issue in the future.

Pursuant to the Debenture and Warrant PurchaseAgreement discussed in Note 5, each individual investor also received twowarrants to purchase shares of the Company’s common stock. For every dollar ofdebenture purchased, each investor received one warrant to purchaseapproximately 0.03235 shares of the Company’s common stock at an exercise priceof $3.86 per share and a second warrant to purchase approximately 0.03100shares of the Company’s common stock at an exercise price of $4.03 per share. Theexercise prices are subject to certain adjustments, including adjustments fordilutive issuances. The warrants to purchase 639,847 shares of common stockwere immediately exercisable and expire on May 18, 2009. Debt discountcosts related to the fair value of the warrants issued in connection with theconvertible debentures were calculated based on the fair value of the warrantsdetermined using the Black-Scholes valuation model and are being amortized tointerest expense over the five-year term of the debentures. Significantvaluation estimates used in the determination of the value of the warrantsinclude an expected life of five years, no dividends, a risk-free interest rateof 4.5% and a stock volatility factor of 0.5. Unamortized debt discountaggregated $647,000 and $854,000 at March 31, 2006 and 2005, respectively,and is presented within convertible debentures, net on the accompanyingconsolidated balance sheets.

Also in connection with the Debenture and WarrantPurchase Agreement, the Company issued warrants to the investment bankers, as acommission, to purchase 34,036 shares of its common stock at an exercise priceof $3.86 per share. The warrants were immediately exercisable and expire on May 18,2009. The estimated fair value of these warrants of $40,000 was recorded as adeferred financing cost and is being amortized to interest expense over thefive-year life of the debentures. Additionally, the Company incurred $621,000in transaction costs associated with the debenture offering, which have alsobeen capitalized as deferred financing costs and are being amortized tointerest expense over the five-year term of the debentures. Unamortizeddeferred financing costs aggregated $430,000 and $568,000 at March 31,2006 and 2005, respectively, and are presented within other assets on theaccompanying consolidated balance sheets.

56

----

Duringthe year ended March 31, 2004, the Company issued 657,132 shares of its Class Acommon stock valued at $578,000 and 89,332 shares of its Class A commonstock valued at $151,000 to settle 401(k) match liabilities and priortrade liabilities in Company stock, respectively.

In September 2003,the Company issued 425,000 shares of its Class A common stock, valued at$255,000, and a warrant to purchase 75,000 shares of common stock at anexercise price of $5.00 per share, to settle liabilities related to the salelease-back of the Anaheim facility and the renegotiation of the related lease. Thewarrant was immediately exercisable and expires in July 2010. The fairvalue of the warrant was $5,000 calculated using the Black Scholes Model. Thevalue of the warrant was recorded as a reduction of the deferred gain on thesale of the building.

In July 2003,the Company completed a private placement of 3,666,666 shares of its Class Acommon stock to seven accredited investors for net proceeds of $1.9 million incash. In connection with this offering, the Company also issued warrants topurchase an additional 366,666 shares of common stock at an exercise price of$1.50 per share. The fair value of these warrants was $55,000 calculated usingthe Black Scholes Model. The warrants are considered a cost of raising capitaland were recorded in equity as an offset to additional paid-in capital. Thewarrants expire in July 2006 and became exercisable in January 2003.

The following table summarizes information regardingoutstanding warrants to purchase the Company’s common stock as of March 31,2006:

| Range of Exercise Prices | ** ** | **Warrants Outstanding  at March 31, 2006**       | ** ** | **Weighted Avg.  Remaining  Contractual Life** | ** ** | **Weighted Avg.  Exercise Price** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
| $1.40 to $1.95                |       | 2,073                                                                 |       | 1.11                                                     |       | $                                           | 1.58       |   |
| $3.00 to $4.03                |       | 1,150                                                                 |       | 1.94                                                     |       | $                                           | 3.56       |   |
| $5.00 to $5.26                |       | 230                                                                   |       | 3.66                                                     |       | $                                           | 5.18       |   |
|                                    |       | 3,453                                                                 |       | 1.56                                                     |       | $                                           | 2.48       |   |

 

Allof the warrants were exercisable at March 31, 2006.  Warrants to purchase an aggregate of 1,250,000shares of common stock at an exercise price of $1.64 per share and warrants topurchase an aggregate of 62,500 shares of common stock at an exercise priceof $1.95 per share are callable by the Company if the market price of theCompany’s common stock trades for 20 consecutive days at a price equal to orgreater than two times the exercise price of the warrants. Warrants to purchasean aggregate of 75,000 shares of common stock at an exercise price of$5.00 per share are callable by the Company if the market price of theCompany’s common stock trades for 20 consecutive days at a price equal toor greater than one and a half times the exercise price of the warrants.

Inconnection with the issuance of warrants to purchase 1,250,000 shares of ourcommon stock at $1.64 per share and 426,667 shares of our common stock at $3.00per share, the Company is a party to certain registration rights agreementsthat contain provisions under which the Company could be subjected toliquidated damages should it fail to maintain effective registration statementsfor the underlying shares of common stock. These warrants have been accounted for within equity in the consolidatedbalance sheets in accordance with EITF 00-19 *Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock*, and, accordingly, no liabilities have beenrecorded in connection therewith.  As ofthe March 31, 2006, no liquidated damages were payable under the provisions ofthe registration rights agreements associated with these warrants.

Commonstock reserved for future issuance at March 31, 2006:

|                                         | ** ** | **(In thousands)** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| Issuable under stock  options plans     |       | 7,234                   |       |
| Issuable upon  the exercise of warrants |       | 3,453                   |       |
|                                    |       | 10,687                  |       |

**10.****          Associate Benefit Plans**

**StockOption Plan**

TheCompany has adopted the 1997 Stock Incentive Plan (the “Plan”), which providesthat options for shares of the Company’s unissued common stock may be grantedto directors, associates and consultants to the Company. Options granted enablethe option holder to purchase shares of the Company’s common stock at priceswhich are equal to or greater than the fair market value of the shares at thedate of grant. Options expire ten years after the date of grant or 90 daysafter termination of employment and generally vest ratably at the rate of 25%on each of the first four anniversaries of the grant date. In connection withthe merger of the Company and the Iteris Subsidiary, the Company assumed theoutstanding options of the Iteris Subsidiary (Note 3).

57

----

Asummary of all Company stock option activity is as follows:
| ** **                                      | ** ** | **Year Ended March 31,**                               | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | **Options**                                                           | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
| ** **                                      | ** ** | ** **                                                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Options  outstanding at beginning of year       |       | 7,323                                                                 |       | $ | 1.42 |   | 1,132 |   | $ | 2.98 |   | 962 |   | $ | 3.73 |   |
| Granted                                         |       | 168                                                                   |       | 3.02 |   | 163 |   | 3.34 |   | 230 |   | 0.78 |   |
| Assumed in merger (Note 3)                      |       | —                                                                |       | — |   | 6,133 |   | 1.09 |   | — |   | — |   |
| Exercised                                       |       | (244                                                                  | )          | 1.24 |   | (25 | ) | 2.10 |   | — |   | — |   |
| Cancelled                                       |       | (270                                                                  | )          | 2.60 |   | (80 | ) | 1.29 |   | (60 | ) | 6.76 |   |
| Options  outstanding at end of year             |       | 6,977                                                                 |       | $ | 1.42 |   | 7,323 |   | $ | 1.42 |   | 1,132 |   | $ | 2.98 |   |
| Exercisable at  end of year                     |       | 6,418                                                                 |       |   |   | 6,446 |   |   |   | 778 |   |   |   |
| Available for  grant at end of year             |       | 257                                                                   |       |   |   | 356 |   |   |   | 519 |   |   |   |
| Weighted average fair  value of options granted |       |                                                                  |       | $ | 1.77 |   |   |   | $ | 1.83 |   |   |   | $ | 0.55 |   |

 

The following tablesummarizes information regarding the Company’s stock options at March 31, 2006:
| ** **                                  | ** ** | **Options Outstanding**                                          | ** ** | **Options Exercisable**                             | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Options Outstanding  at March 31, 2006**        | ** ** | **Weighted Avg.  Remaining  Contractual Life** | ** ** | **Weighted Avg.  Exercise Price** | ** ** | **Options  Exercisable At   March 31, 2006** | ** ** | **Weighted Avg.  Exercise Price** | ** ** |
| ** **                                  | ** ** | **(In thousands, except per share amounts)** | ** ** |
|   $0.53  to $  0.80     |       | 1,813                                                                 |       | 2.27                                                     |       | $ | 0.56 |   | 1,737 |   | $ | 0.56 |   |
|   $0.95  to $  1.40     |       | 4,498                                                                 |       | 4.36                                                     |       | 1.25 |   | 4,259 |   | 1.25 |   |
|   $1.50  to $  2.11     |       | 121                                                                   |       | 3.86                                                     |       | 1.76 |   | 116 |   | 1.75 |   |
|   $2.28  to $  3.26     |       | 223                                                                   |       | 8.92                                                     |       | 3.00 |   | 50 |   | 2.59 |   |
|   $3.60  to $  4.63     |       | 186                                                                   |       | 5.39                                                     |       | 4.13 |   | 120 |   | 4.41 |   |
|   $5.69  to $  8.00     |       | 18                                                                    |       | 2.61                                                     |       | 6.33 |   | 18 |   | 6.33 |   |
| $10.31 to $15.63                            |       | 118                                                                   |       | 3.98                                                     |       | 12.67 |   | 118 |   | 12.67 |   |
|                                        |       | 6,977                                                                 |       | 3.97                                                     |       | $ | 1.42 |   | 6,418 |   | $ | 1.36 |   |

** **

**AssociateIncentive Programs**

Underthe terms of a Profit Sharing Plan, the Company contributes to a trust fundsuch amounts as are determined annually by the Board of Directors. Nocontributions were made during the years ended March 31, 2006, 2005 and2004.

In May 1990, the Company adopted a 401(k) Planas an amendment and replacement of the former Associate Stock Purchase Planthat was an additional feature of the Profit Sharing Plan. Under the 401(k) Plan,eligible associates voluntarily contribute to the plan up to 15% of theirsalary through payroll deductions. The Company matches 50% of contributions upto a stated limit. Under the provisions of the 401(k) Plan, associateshave thirteen investment choices, one of which is the purchase of Iteris, Inc.common stock at market price. Company matching contributions were approximately$317,000, $409,000 and $403,000 for the years ended March 31, 2006, 2005,and 2004, respectively.

58

----

**11.****          Discontinued Operations**

In September 2003, the Company sold substantiallyall of the assets of MAXxess to an investor group that included certain membersof the MAXxess management group. The consideration for the assets consisted ofthe assumption of $2.7 million of liabilities, resulting in a net gain of $2.4million from the sale.

On May 9, 2003, the Company completed the sale ofsubstantially all of the assets of Zyfer for $2.3 million in cash plus theassumption of certain liabilities. The asset purchase agreement provided forfuture incentive payments of up to $1.0 million in each of the twelve monthperiods ended April 30, 2004 and 2005, based on the achievement of certainrevenue goals related to the sale of Zyfer products or the licensing of itstechnologies. Incentive payments of $83,000 and $135,000 were received in theyears ended March 31, 2006 and 2005, respectively, and are presentedwithin other income, net in the accompanying consolidated statements ofoperations.

In March 2003, the Company ceased the developmentand sale of products of Broadcast and reduced the headcount in Broadcast toonly support the existing customer contracts for service and support throughtheir expiration dates.

Asset write-downs and accrued costs are included inincome from discontinued operations in the year ended March 31, 2004. Theresults of operations of Broadcast, Zyfer and MAXxess for all periods presentedhave been reclassified and presented as discontinued operations in theaccompanying consolidated statements of operations. Interest expense was notreclassified to discontinued operations because the discontinuances did noteliminate any of the Company’s debt.

Net sales andincome from discontinued operations are as follows:
| ** **                                         | ** ** | **Year Ended March 31,** | ** ** |
|----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                         | ** ** | **(In thousands)**                 | ** ** |
| Net sales and contract  revenues:                  |       |                                    |       |   |   |   |   |
| MAXxess                                            |       | $                                       | —     |   | $ | — |   | $ | 1,747 |   |
| Broadcast                                          |       | —                                  |       | — |   | 385 |   |
| Total net sales  and contract revenues             |       | $                                       | —     |   | $ | — |   | $ | 2,132 |   |
|                                               |       |                                    |       |   |   |   |   |
| Net income (loss) from  discontinued operations:   |       |                                    |       |   |   |   |   |
| MAXxess                                            |       | $                                       | —     |   | $ | — |   | $ | 199 |   |
| Broadcast                                          |       | —                                  |       | — |   | (122 | ) |
|                                               |       | —                                  |       | — |   | 77 |   |
| Loss recognized  upon discontinuance of operations |       | —                                  |       | — |   | (1,226 | ) |
| Gain on sale of  assets of discontinued operations |       | —                                  |       | — |   | 2,364 |   |
| Income from  discontinued operations               |       | $                                       | —     |   | $ | — |   | $ | 1,215 |   |

 

The Company had no assetsor liabilities of discontinued operations at March 31, 2006.

**12.****          Disposal of Fixed Assets**

After the mergerof the Iteris Subsidiary into the Company on October 2004, the Companyreviewed and determined certain corporate property and equipment would notprovide value to its on-going operations. These assets primarily consisted offurniture and fixtures and computer equipment. Accordingly, the Companyrecorded a $422,000 loss on disposal of fixed assets in the year ended March 31,2005.

59

----

**13.****          Business Segment and Geographic Information**

TheCompany currently operates in three reportable segments: Roadway Sensors,Automotive Sensors and Transportation Systems. The Roadway Sensors segmentincludes Vantage vehicle detection systems for trafficintersection control and certain highway traffic data collectionapplications. The Automotive Sensors segment is comprised of all activitiesrelated to AutoVue lane departure warning systems. The Transportation Systemssegment includes transportation engineering and consulting services and thedevelopment of transportation management and traveler information systems forthe ITS industry. The accounting policies of the reportable segments are thesame as those described in the summary of significant accounting policiesexcept that certain expenses, such as interest, amortization of certain intangiblesand certain corporate expenses are not allocated to the segments. In addition,certain assets including cash and cash equivalents, deferred taxes and certainlong-lived and intangible assets are not allocated to the segments. Thereportable segments are each managed separately because they manufacture anddistribute distinct products or provide services with different processes. Allsegment revenues are derived from external customers.

Selected financial information for the Company’sreportable segments as of and for the years ended March 31, 2006, 2005 and2004 is as follows:
| ** **                                         | ** ** | **Roadway  Sensors**    | ** ** | **Automotive  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------|------------|-----------|------------|
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| **Year Ended March 31, 2006**                 |       |                    |       |                    |       |                        |       |      |       |
| Product revenue  from external customers           |       | $                       | 22,446     |                    | $          | 5,865                       |       | $         | —     |   | $ | 28,311 |   |
| Service and  other revenue from external customers |       | —                  |       | 2,845                   |       | 19,330                      |       | 22,175    |       |
| Depreciation and  amortization                     |       | 132                     |       | 189                     |       | 266                         |       | 587       |       |
| Allocated  goodwill                                |       | 8,197                   |       | 4,671                   |       | 14,906                      |       | 27,774    |       |
| Segment income                                     |       | 3,597                   |       | (2,375                  | )          | 2,184                       |       | 3,406     |       |
|                                               |       |                    |       |                    |       |                        |       |      |       |
| **Year Ended March 31, 2005**                 |       |                    |       |                    |       |                        |       |      |       |
| Product revenue  from external customers           |       | $                       | 21,920     |                    | $          | 4,326                       |       | $         | —     |   | $ | 26,246 |   |
| Service and  other revenue from external customers |       | —                  |       | 2,816                   |       | 17,335                      |       | 20,151    |       |
| Depreciation and  amortization                     |       | 117                     |       | 116                     |       | 415                         |       | 648       |       |
| Allocated  goodwill                                |       | 8,197                   |       | 4,671                   |       | 14,906                      |       | 27,774    |       |
| Segment income                                     |       | 3,632                   |       | (1,604                  | )          | 1,531                       |       | 3,559     |       |
|                                               |       |                    |       |                    |       |                        |       |      |       |
| **Year Ended March 31, 2004**                 |       |                    |       |                    |       |                        |       |      |       |
| Product revenue  from external customers           |       | $                       | 19,273     |                    | $          | 2,308                       |       | $         | —     |   | $ | 21,581 |   |
| Service and  other revenue from external customers |       | —                  |       | 1,889                   |       | 21,813                      |       | 23,702    |       |
| Depreciation and  amortization                     |       | 117                     |       | 116                     |       | 440                         |       | 673       |       |
| Allocated  goodwill                                |       | 200                     |       | —                  |       | 9,607                       |       | 9,807     |       |
| Segment income                                     |       | 2,629                   |       | (2,343                  | )          | 2,207                       |       | 2,493     |       |

 

TheRoadway Sensors segment had one customer with revenue representing 25.9% oftotal segment revenue for the year ended March 31, 2006; two customerswith combined revenue representing 38.0% of total segment revenue for the yearended March 31, 2005; and four customers with combined revenue representing59.5% of total segment revenue for the year ended March 31, 2004. TheAutomotive Sensors segment had two customers with combined revenue representing70.7% of total segment revenue for the year ended March 31, 2006; twocustomers with combined revenue representing 85.2% of total segment revenue forthe year ended March 31, 2005; and two customers with combined revenuerepresenting 85.3% of total segment revenue for the year ended March 31,2004. The Transportation Systems segment had one customer with revenuerepresenting 14.9% of total segment revenue for the year ended March 31,2005; and one customer with revenue representing 20.0% of total segment revenuefor the year ended March 31, 2004.

Inconnection with the October 2004 merger of the Iteris Subsidiary into theCompany (Note 3), goodwill of $8.0 million, $4.7 million and $5.3 million wasallocated to the Roadway Sensors, Automotive Sensors and Transportation Systemssegments, respectively. This allocation was determined based on the respectivefair value of each segment as calculated using the income approach.

60

----

Thefollowing reconciles segment income to consolidated income (loss) fromcontinuing operations before income taxes and minority interest and segmentassets to consolidated assets:
| ** **                                                                                     | ** ** | **March 31,**      | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                     | ** ** | **(In thousands)** | ** ** |
| Segment income                                                                                 |       |                    |       |   |   |   |   |
| Total income for  reportable segments                                                          |       | $                       | 3,406      |   | $ | 3,559 |   | $ | 2,493 |   |
| Unallocated amounts:                                                                           |       |                    |       |   |   |   |   |
| Corporate and other expenses                                                                   |       | (1,867                  | )          | (2,362 | ) | (1,447 | ) |
| Stock-based compensation                                                                       |       | (725                    | )          | (11,777 | ) | — |   |
| Amortization of intangible assets                                                              |       | (147                    | )          | (114 | ) | — |   |
| Deferred compensation (expense) benefit                                                        |       | (48                     | )          | 484 |   | (868 | ) |
| Disposal of fixed assets                                                                       |       | —                  |       | (422 | ) | — |   |
| Acquired in-process research and development                                                   |       | —                  |       | (140 | ) | — |   |
| Other income, net                                                                              |       | 35                      |       | 1054 |   | 1,003 |   |
| Interest expense, net                                                                          |       | (1,459                  | )          | (1,178 | ) | (123 | ) |
| Income (loss) from continuing operations before  income taxes and minority interest  |       | $                       | (805       | ) | $ | (10,896 | ) | $ | 1,058 |   |
|                                                                                           |       |                    |       |   |   |   |   |
| Assets                                                                                         |       |                    |       |   |   |   |   |
| Total assets for  reportable segments                                                          |       | $                       | 47,520     |   | $ | 44,833 |   | $ | 28,856 |   |
| Assets held at  Corporate                                                                      |       | 2,113                   |       | 1,823 |   | 1,209 |   |
| Total assets                                                                                   |       | $                       | 49,633     |   | $ | 46,656 |   | $ | 30,065 |   |

 

The Company’s revenues from continuingoperations are generated and the Company’s assets are held substantially in theUnited States.

**14.          Quarterly Financial Data (Unaudited)**
| ** **               | ** ** | **Net  Sales**                                                        | ** ** | **Gross  Profit** | ** ** | **Income (Loss)  from  Continuing  Operations** | ** ** | **Net Income  (loss)** | ** ** | **Income (Loss)  per Share  from  Continuing  Operations** | ** ** |
|--------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|------------------------------------------------------|------------|-----------------------------|------------|----------------------------------------------------------------------|------------|
| ** **               | ** ** | **(In thousands, except per share amounts)** | ** ** |
| June 30,  2005      |       | $                                                                     | 12,079     |              | $          | 5,434                                                |       | $                           | (726       | )                                                                    | $          | (726 | ) | (0.03 | ) |
| September 30,  2005 |       | 12,715                                                                |       | 5,518             |       | (155                                                 | )          | (155                        | )          | (0.01                                                                | )          |
| December 31,  2005  |       | 12,183                                                                |       | 5,021             |       | 136                                                  |       | 136                         |       | 0.00                                                                 |       |
| March 31,  2006     |       | 13,509                                                                |       | 5,653             |       | 825                                                  |       | 825                         |       | 0.03                                                                 |       |
|                     |       | $                                                                     | 50,486     |              | $          | 21,626                                               |       | $                           | 80         |                                                                 | $          | 80 |   | $ | 0.00 | * |
|                     |       |                                                                  |       |              |       |                                                 |       |                        |       |                                                                 |       |
| June 30, 2004       |       | $                                                                     | 11,441     |              | $          | 4,949                                                |       | $                           | 966        |                                                                 | $          | 966 |   | 0.04 |   |
| September 30,  2004 |       | 11,760                                                                |       | 4,695             |       | (4                                                   | )          | (4                          | )          | 0.00                                                                 |       |
| December 31,  2004  |       | 11,714                                                                |       | 5,044             |       | (12,233                                              | )          | (12,233                     | )          | (0.44                                                                | )          |
| March 31,  2005     |       | 11,482                                                                |       | 4,666             |       | (57                                                  | )          | (57                         | )          | (0.00                                                                | )          |
|                     |       | $                                                                     | 46,397     |              | $          | 19,354                                               |       | $                           | (11,328    | )                                                                    | $          | (11,328 | ) | $ | (0.45 | )* |

----

*            Annual per shareamounts may not agree to the sum of the quarterly per share amounts due todifferences between average shares outstanding during the periods.

61

----

**Schedule II**

**Valuation and Qualifying Accounts (In thousands)**
| **Description**                     | ** ** | **Balance at  Beginning of  Period** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Charged to  Accounts** | ** ** | **Balance at End  of Period** | ** ** |
|-------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------|------------|----------------------------------------------|------------|
| ** **                          | ** ** | ** **                                     | ** ** | ** **                                    | ** ** | ** **                    | ** ** | ** **                                   | ** ** |
| **Year Ended March 31, 2006**  |       |                                           |       |                                          |       |                          |       |                                         |       |
| Deducted from  asset accounts:      |       |                                           |       |                                          |       |                          |       |                                         |       |
| Allowance for  doubtful accounts    |       | $                                              | 239        |                                          | $          | 275                           |       | $                                            | (85        | ) | $ | 429 |   |
| Reserve for  inventory obsolescence |       | 514                                            |       | 312                                           |       | (234                          | )          | 592                                          |       |
| **Year Ended March 31, 2005**  |       |                                           |       |                                          |       |                          |       |                                         |       |
| Deducted from  asset accounts:      |       |                                           |       |                                          |       |                          |       |                                         |       |
| Allowance for  doubtful accounts    |       | $                                              | 204        |                                          | $          | 37                            |       | $                                            | (2         | ) | $ | 239 |   |
| Reserve for  inventory obsolescence |       | 399                                            |       | 367                                           |       | (252                          | )          | 514                                          |       |
| **Year Ended March 31, 2004**  |       |                                           |       |                                          |       |                          |       |                                         |       |
| Deducted from  asset accounts:      |       |                                           |       |                                          |       |                          |       |                                         |       |
| Allowance for  doubtful accounts    |       | $                                              | 156        |                                          | $          | 87                            |       | $                                            | (39        | ) | $ | 204 |   |
| Reserve for inventory  obsolescence |       | 248                                            |       | 251                                           |       | (100                          | )          | 399                                          |       |

 

62

----