**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-K**

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| **(Mark One)**                                                                                                                                                                                                   |   | ** **                                                                                              |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------|
| **x**                                                                                                                                                                                                            |   | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**     |
| ** **                                                                                                                                                                                                       |   | ** **                                                                                              |
| **For the  fiscal year ended March 31, 2007**                                                                                                                                                               |
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| **OR**                                                                                                                                                                                                           |
| ** **                                                                                                                                                                                                       |   | ** **                                                                                              |
| **o**                                                                                                                                                                                                            |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                       |   | ** **                                                                                              |
| **For the  transition period from                 to              ** |
| ** **                                                                                                                                                                                                       |
| **Commission  file number 001-08762**                                                                                                                                                                            |

 

**ITERIS,INC.**

(Exact Name of 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                      |

 

Securitiesregistered pursuant to Section 12(g) of the Act: **None**

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Indicate by check mark if theregistrant is a well-known seasoned issuer, as defined in Rule 405 of theSecurities Act. Yes o No x

Indicate by check mark if theregistrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act. Yes o No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes  x  No  o

Indicate by a check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Largeaccelerated filer  o      Acceleratedfiler  o      Non-acceleratedfiler  x

Indicate by check markwhether the registrant is a shell company (as defined in Exchange ActRule 12b-2). Yes o No x

Based on the closing saleprice of the registrant’s common stock on September 30, 2006, the lastbusiness day of the registrant’s most recently completed second fiscal quarter,the aggregate market value of the voting common stock held by nonaffiliates ofthe registrant was $54,700,000. For the purposes of this calculation, sharesowned by officers, directors and 10% stockholders known to the registrant havebeen deemed to be owned by affiliates. This determination of affiliate statusis not necessarily a conclusive determination for other purposes.

As of June 18, 2007,there were 32,575,330 shares of common stock outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

Part III incorporates by referencecertain information from the registrant’s definitive proxy statement for the2007 Annual Meeting of Stockholders, which will be filed with the Securitiesand Exchange Commission not later than 120 days after the end of the fiscalyear ended March 31, 2007. Except with respect to information specificallyincorporated by reference in this report, the registrant’s proxy statement isnot deemed to be filed as a part hereof.

 

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**ITERIS,INC.**

**ANNUALREPORT ON FORM 10-K**

**FOR THEFISCAL YEAR ENDED MARCH 31, 2007**

**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,  EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE                                                             |   |   |
|              |   |                                                                                                                |   |   |
| 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, AND DIRECTOR INDEPENDENCE                                          |   |   |
|              |   |                                                                                                                |   |   |
| 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 IterisHoldings, 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.

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**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 inSeptember 2003 changed our name to Iteris Holdings, Inc. to reflectour focus on the ITS industry and our capital structure at that time. OnOctober 22, 2004, we completed a merger with our majority-ownedsubsidiary, Iteris, Inc. (the “Iteris Subsidiary”), and officially changedour corporate name from Iteris Holdings, Inc. to Iteris, Inc.

Our proprietary image recognition systems include Vantage and AutoVue.Vantage is a video vehicle detection system that detects the presence ofvehicles on roadways. Vantage systems are used at signalized intersections toenable a more efficient allocation of green signal time and are also used forincident detection and highway traffic data collection applications. AutoVueLane Departure Warning (“LDW”) systems consist of a small windshield mountedsensor that uses proprietary software to detect and warn drivers of unintendedlane departures. To date, we and our strategic partner have sold approximately83,000 production AutoVue LDW systems for use on car and truck platforms in theNorth American and European markets. We believe that our AutoVue LDW technologyis a broad sensor platform that, through additional software development, maybe expanded to incorporate additional safety and convenience features.

Our transportation management systems business includes transportationengineering and consulting services focused on the planning, design,development and implementation of software-based systems that integratesensors, video surveillance, computers and advanced communications equipment toenable public agencies to monitor, control and direct traffic flow, assist inthe quick dispatch of emergency crews and distribute real-time informationabout traffic conditions. Our services include planning, design andimplementation of surface transportation infrastructure systems.  We perform analysis and study goods movement,commercial vehicle operations, travel demand forecasting and systemsengineering, and identify mitigation measures to reduce trafficcongestion.  These services and systemsare primarily sold to local, state and national transportation agencies in theUnited States.  Our transportationmanagement systems business is largely dependent upon governmental

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funding and budgetary issues.  The Federal Highway Bill that was passed inAugust 2005 provided for a significant increase in transportation funding overthe following six years.  We believe therecent expansion of our transportation management systems business was due inpart to the passage of the Federal Highway Bill, combined with the expansion oftransportation funds at state and local agencies throughout the country.

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, incident detectionand certain highway traffic data collection applications.  The Automotive Sensors segment is comprisedof all activities related to our AutoVue LDW systems for vehicle safety. TheTransportation Systems segment includes transportation engineering andconsulting services and the development of transportation management andtraveler information systems for the ITS industry.  See Note 12 to the accompanying consolidatedfinancial statements for further discussion of our operating segments.

**Sales, Marketing and Principal Customers**

Wesell our Vantage vehicle detection systems through indirect sales channelscomprised of independent dealers in the United States and Canada who sellintegrated systems and related products to the traffic management market, aswell as directly to the traffic management market using a combination of ourown sales personnel and an outside sales organization. Our independent dealersare primarily responsible for sales, installation and support of Vantagesystems. These dealers maintain an inventory of demonstration traffic productsfrom various manufacturers including our Vantage vehicle detection systems andsell directly to government agencies and installation contractors. Thesedealers often have long-term arrangements with the government agencies in theirterritory 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 marketing strategy for AutoVue is to establish it as the leadingplatform for in-vehicle video sensing for heavy trucks and passenger cars.  We sell AutoVue LDW systems directly to heavytruck manufacturers and to U.S. truck fleets, and our AutoVue LDW system iscurrently offered as an option on certain heavy trucks, includingMercedes-Benz, MAN, Iveco, DAF, Scania, Freightliner, International and FUSO,as well as Neoplan and MAN luxury bus and coach lines. We market the licensingof our LDW technology to manufacturers of passenger automobiles through anexclusive strategic relationship with Valeo Schalter and Sensuren GmbH (“Valeo”),an independent automotive supplier. In connection with this marketing effort,we provide specific contract engineering services, technical marketing andsales support to Valeo, which to date has enabled the launch of our LDWtechnology on three Infiniti car platforms, the FX, M and Q, where our LDWsystem is offered as part of the technology option package. We plan to continueto provide technical marketing and sales support to Valeo in our efforts to winnew original equipment manufacturer (“OEM”) customers for the passenger carmarket as well as contract engineering services related to the possible launchof new platforms that include our AutoVue LDW system.

We market and sell our transportation management systems and travelerinformation services directly to government agencies pursuant to negotiatedcontracts that involve competitive bidding and specific qualificationrequirements. Most of our contracts with federal, state and municipal customersprovide for cancellation or renegotiation at the option of the customer uponreasonable notice and fees paid for modification. We use selected members ofour engineering team divided on a regional basis to serve in sales and businessdevelopment functions. We do not engage in sales of transportation managementsystems and traveler information services outside of the U.S. Sales of ourtransportation management systems contracts generally involve long lead timesand require extensive specification development, evaluation and pricenegotiations.

Our largestcustomer accounted for 12.4% of total net sales and contract revenues in thefiscal year ended March 31, 2007 (“Fiscal 2007”).

**Manufacturing and Materials**

We use contract manufacturers to build subassemblies that are used inour Vantage products. Additionally, we procure certain components fromqualified suppliers, both globally and locally, and use multi-sourcingstrategies when technically and economically feasible to mitigate supply risk.These subassemblies and components are delivered to our Anaheim facility wherethey go through final assembly and testing prior to shipment to our customers.Our manufacturing activities are conducted in approximately 8,000 square feetof space at our Anaheim facility. Production volume at our subcontractors isbased upon quarterly forecasts that we adjust on a monthly basis to controlinventory. For sales of AutoVue LDW systems to the truck market, we subcontractthe manufacture of our AutoVue LDW systems to two manufacturers, and ourinternal processes are limited primarily to testing and final verification. ForAutoVue LDW sales to the passenger car market, we

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anticipate that all manufacturing will be done byValeo; however, we plan to continue to provide engineering support to Valeo. Wecurrently do not manufacture any of the hardware used in the transportationmanagement and traveler information systems that we design and implement. Ourproduction facility is currently ISO 9001 certified.

**CustomerSupport 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 2007. We believe customer support is a key competitive factor.

**Backlog**

Our backlog of unfulfilled firm orders was approximately $25.7 millionas of March 31, 2007, which was comprised of $3.5 million related toRoadway Sensors, $2.1 million related to Automotive Sensors and $20.1 millionrelated to Transportation Systems. Substantially all of the backlog for RoadwaySensors and Automotive Sensors is expected to be recognized as revenue in thefiscal year ending March 31, 2008 (“Fiscal 2008”), while approximately75.0% of Transportation Systems backlog is expected to be recognized as revenuein Fiscal 2008. At March 31, 2006, we had backlog of approximately $20.3million, which was comprised of $1.5 million related to Roadway Sensors, $3.0million related to Automotive Sensors and $15.8 million related toTransportation Systems. All backlog as of March 31, 2006 for Roadway Sensorsand Automotive Sensors was recognized as revenue in Fiscal 2007 while 58.9% ofMarch 31, 2006 backlog for Transportation Systems was recognized as revenue inFiscal 2007. Pursuant to the customary terms of our agreements with governmentcontractors 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 $4.0 million for Fiscal 2007,$5.2 million for the fiscal year ended March 31, 2006 (“Fiscal 2006”), and$6.2 million for the fiscal year ended March 31, 2005 (“Fiscal 2005”). 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, NEC Corporation and Hitachi Ltd. in Japan and Robert Bosch GmbH inEurope, as well as Siemens, Continental Tavis, Visteon and Cognex, which couldbe currently developing video sensor technologies for the vehicle industry thatcould be used for lane departure warning systems. In the market for our Vantagevehicle detection systems, we compete with manufacturers of other above groundvideo camera detection systems such as Econolite Control Products, Inc.,Traficon, N.V., Quixote, and other non-intrusive detection devices includingmicrowave, infrared, ultrasonic and magnetic detectors, as well asmanufacturers and installers of in-pavement inductive loop 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, Telvent Farradyne, Kimley-Horn and Associates, Inc.and Delcan. Our competitors in transportation engineering, planning and designinclude major firms such as Parsons Brinkerhoff, Inc., URS, HNTB andParsons Transportation Group, Inc., as well as many smaller regionalengineering firms.

In general, the markets for the products and services we offer arehighly competitive and are characterized by rapidly changing technology andevolving standards. Many of our current and prospective competitors have longeroperating histories, greater name recognition, access to larger customer basesand significantly greater financial, technical, manufacturing, distribution andmarketing resources than us. As a result, they may be able to adapt morequickly to new or emerging standards or technologies or to devote greaterresources to the promotion and sale of their products. It is also possible thatnew competitors or alliances among competitors could emerge and rapidly acquiresignificant market share. We believe that our ability to compete effectively inour target markets will depend on a number of factors, including the successand timing of our new product development, the compatibility of our productswith a broad range of computing systems, product quality and

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performance, reliability, functionality, price, andservice and technical support. Our failure to provide services and develop andmarket products 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 2012, and have six****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.

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 continuing innovation.

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 5, 2007, weemployed an aggregate of 237 associates, including 57 associates in generalmanagement, administration and finance; 31 associates in sales and marketing;113 associates in engineering and product development; 25 associates inoperations, manufacturing and quality; and 11 associates in customer service.None of our associates are represented by a labor union, and we have neverexperienced a work 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.

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

*Ourbusiness is subject to a number of risks, some of which are discussed below.Other risks 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 Forms10-Q and 8-K, before deciding to buy, sell or hold our commonstock. The risks and uncertainties described below are not the only ones facingour company. Additional risks and uncertainties not presently known to us orthat we currently deem immaterial may also affect our business operations. Ifany of these risks actually occurs, our business, financial condition orresults of operations could be seriously harmed. In that event, the marketprice for our common stock could decline and you may lose all or part of yourinvestment.*

**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$2.0 million in the year ended March 31, 2007.  Additionally, we failed to meet certain debtcovenants under our prior credit agreement in two of our last seven fiscalquarters, but replaced that credit facility in October 2006 as furtherdescribed in Note 5 to the accompanying consolidated financial statements.  Furthermore, we have $9.9 million insubordinated convertible debentures that are due in full in May 2009.  Should the holders of the convertibledebentures not elect to convert the principal into shares of our common stock,we may need to raise additional capital to refinance this debt.

At March 31, 2007,we had $35,000 of cash and cash equivalents and relied on our line of credit tofund our operations. We may need to raise additional capital in the near futureto fund our operations or to repay indebtedness. Such additional capital may beraised through bank borrowings, or other debt or equity financings. We cannotassure you that any additional capital will be available on a timely basis, onacceptable terms, or at all, and such additional financing may result infurther dilution to our stockholders.

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;

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

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

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·                                       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.

**We HaveHistorically Experienced Substantial Losses And May Continue To ExperienceLosses For The Foreseeable Future.**Although we have achievednet income in recent periods, we experienced a net loss of $11.3 million in theyear ended March 31, 2005.  Wecannot assure you that we will be able to sustain or improve our financialperformance, or that we will be able to continue 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.

**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 andto include a management report assessing the effectiveness of our internalcontrols over financial reporting in all annual reports beginning with ourAnnual Report on Form 10-K for the fiscal year ending March 31, 2008.Section 404 also requires our independent accountant to attest to, and reporton, management’s assessment of our internal controls over financial reporting.We may not be able to complete our Section 404 compliance on a timelybasis and even if we timely complete our compliance requirements, ourindependent auditors may still conclude that our internal controls overfinancial 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 of controlsmust be considered relative to their costs. Because of the inherent limitationsin all control systems, no evaluation of controls can provide absoluteassurance that all control issues and instances of fraud, if any, within thecompany have been, or will be detected. These inherent limitations include therealities that judgments in decision-making can be faulty and that breakdownscan occur because of simple error or mistake. Controls can also be circumventedby the individual acts of some persons, by collusion of two or more people, orby management override of the controls. The design of any system of controls isbased in part on certain assumptions about the likelihood of future events, andwe cannot assure you that any design will succeed in achieving its stated goalsunder all potential future conditions. Over time, our controls may becomeinadequate because of changes in conditions or deterioration in the degree ofcompliance with policies or procedures. Because of the inherent limitations ina cost-effective control system, misstatements due to error or fraud may occurand not be detected.

As 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, asof March 31, 2004, our internal control over financial reporting was noteffective 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.

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**We May Experience Production Gaps Which CouldMaterially And Adversely Impact Our Sales And Financial Results And The UltimateAcceptance Of Our Products. **Itis possible that we could experience unforeseen quality control issues or partshortages as we increase production to meet current demand of ourproducts.  We have historically usedsingle suppliers for certain of our components in our AutoVue and Vantageproducts. Should any such delay or disruption occur, our future sales willlikely be materially and adversely affected. Additionally, we rely heavily on select contract manufacturers toproduce many of our products.  Althoughwe believe our contract manufacturers have sufficient capacity to meet ourproduction schedules for the foreseeable future and we believe we could findalternative contract manufacturing sources if necessary, we could experience aproduction gap if for any reason our contract manufacturers were unable to meetour production requirements.

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

**We May Be Unable To Attract And 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 segment will depend on our abilityto hire additional qualified engineers and planners. Competition for qualifiedemployees, particularly development engineers, is intense. We may not be ableto continue to attract and retain sufficient numbers of such highly skilledemployees. Our inability to attract and retain additional key employees or theloss of one or more of our current key employees could adversely affect ourbusiness, financial condition and results of operations.

**If We Are Unable To Develop And Introduce NewProducts And Product Enhancements Successfully And In A Cost-Effective AndTimely Manner, Or Are Unable To Achieve Market Acceptance Of Our New Products,Our Operating Results Would Be Adversely Affected.**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.  We cannot assure you thatwe will be able to adequately manage product transition issues.  Our business and results of operations couldbe adversely affected if we do not anticipate or respond adequately totechnological developments or changing customer requirements or if we cannotadequately manage inventory issues typically related to new product transitionsand introductions. We cannot assure you that any such investments in researchand development will lead to any corresponding increase in 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, qualify any new products with OEMs andachieve manufacturing efficiencies, the perceived advantages of our newproducts over traditional products and the marketing capabilities of ourindependent distributors and strategic partners, including Valeo’s ability toexpand sales of AutoVue in the passenger car market. The success of our AutoVuesystem will also depend in part on the success of the automotive vehicles thatincorporate our technology, as well as the success of optional equipment thatOEMs bundle with our technologies.

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Certain of the components used in our Vantage andAutoVue products may need to be re-engineered in the next 12 to 18 months asthe industry is moving towards a standard of using lead-free components. Wecannot assure you as to the timing of the adoption of this new standard or ourability to successfully redesign our products to incorporate compliantcomponents and gain market acceptance of such redesigned products. In addition,if the standard is adopted earlier than anticipated we may experience ashortage of Vantage and AutoVue products as a result of potential scarcity oflead-free components.

Our business and results of operations could also beseriously harmed by any significant delays in our new product development.Certain of our new products could contain undetected design faults and softwareerrors or “bugs” when first released by us, despite our testing. We may notdiscover these faults or errors until after a product has been installed andused by our customers. Any faults or errors in our existing products or in anynew products may cause delays in product introduction and shipments, requiredesign modifications or harm customer relationships, any of which couldadversely affect our business and competitive position.

**The Markets In Which We Operate Are HighlyCompetitive And Have Many More Established Competitors, Which Could AdverselyAffect Our Sales Or The Market Acceptance Of Our Products.**Wecompete with numerous other companies in our target markets including, but notlimited to, large, multinational corporations, which include tier oneautomotive suppliers, and many smaller regional engineering firms. We expectsuch competition to increase due to technological advancements, industryconsolidations and reduced barriers to entry. Increased competition is likelyto result in price reductions, reduced gross margins and loss of market share,any of which could seriously harm our business, financial condition and resultsof operations. We have experienced more competition in our Roadway Sensorssegment in Fiscal 2007 as the Department of Transportation in one of ourlargest sales territories has recently moved to a multi-source contractingenvironment from one in which Iteris was the sole supplier. In addition, one ofthe other developers of LDW systems was recently acquired by a larger company.While this developer has not been a material competitor to date, we mayexperience more competition from this provider as a result of its greateraccess to resources from its acquirer, and additional competitors may enterthis market in the future.

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 Or TheSignificant Military Operations In The Middle East Or Elsewhere May ImpactGovernment Funding Or Consumer Spending, Causing A Decline In Our Revenues.** In the near term, the funding of U.S. militaryoperations in the Middle East or elsewhere may cause disruptions in funding ofgovernment contracts.  Since militaryoperations of such magnitude are not routinely included in U.S. defensebudgets, supplemental legislative funding actions are often required to financesuch operations. Even when such legislation is enacted, it may not be adequatefor ongoing operations, causing other government resources to be temporarily orpermanently diverted.  Since asignificant portion of our sales are derived from contracts with governmentagencies, such diversion of funds could produce interruptions in funding ordelays in receipt of our contracts, causing disruptions and adversely effectingour revenue and operations.

Concerns about the recent international conflicts andterrorist and military actions, as well as concerns about inflation, decreasedconsumer confidence, and reduced corporate profits and capital spending havealso resulted in a downturn in worldwide economic conditions, particularly inthe United States. These unfavorable economic conditions may have a negativeimpact on customer orders (and also may result in decreased sales ofautomobiles and trucks that incorporate our LDW systems).  Such concerns may result in cancellations andrescheduling of backlog.  In addition,the recent decline in the U.S. real estate market, particularly in new homeconstruction, could adversely impact new road construction resulting in adecline in Roadway Sensor and Automotive Sensor net sales and TransportationSystems contract revenues.  Any of theforegoing political, social and economic conditions make it extremely difficultfor our customers, our suppliers and us to accurately forecast and plan futurebusiness activities and could result in a decline in our net sales and contractrevenues. If such conditions continue or worsen, our business, financialcondition and results of operations could be materially and adversely affected.

**New Environmental Regulations MayResult In A Decline In Our AutoVue Sales and Royalties. **Recent environmentalregulations were effected in Europe effective in 2006, which required morestringent emissions compliance in

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newtrucks manufactured in Europe after 2006. These regulations caused the cost of certain trucks to increasesignificantly and could cause a decline in new truck sales in Europe in thenear future.  Similar regulations havebeen announced in North America that may impact diesel engines built afterJanuary 2007, which could similarly impact North American OEM truck sales ingeneral.  We may experience a decline inour LDW sales to truck OEMs related to these stricter regulations.

**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 are derived from contracts with governmental agencies, either as ageneral contractor, subcontractor or supplier. Government contracts representedapproximately 37.8%, 38.3% and 37.4% of our total net sales and contractrevenues for the years ended March 31, 2007, 2006 and 2005, respectively.We anticipate that revenue from government contracts will continue to increasein the near future. Government business is, in general, subject to specialrisks 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. Federal Highway Bill;

·                                          othergovernment budgetary constraints and cut-backs; and

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

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

**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 operating resultshave fluctuated and are likely to continue to vary from quarter to quarter dueto a number of factors, many of which are not within our control. Factors thatcould affect our revenues include, among others, the following:

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

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

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

·                                          ourability to raise additional capital;

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·                                          ourability to control costs;

·                                          themix of our products and services sold in a quarter, which mix has varied and isexpected to continue to vary from time to time;

·                                          seasonalitydue to winter weather conditions;

·                                          internationalconflicts and acts of terrorism;

·                                          declinesin new home construction and related road construction;

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

·                                          marketacceptance of the products incorporating our technologies and products;

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

·                                          theintroduction of new products by competitors;

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

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

·                                          theeffects of technological changes in our target markets;

·                                          theamount of our backlog at any given time;

·                                          thenature of our government contracts;

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

·                                          risksand uncertainties associated with our international business;

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

·                                          generaleconomic and political conditions.

Due 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.

**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;

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·                                          thechallenge of assimilating diverse business cultures, and the difficulties inintegrating the operations, technologies and information system of the acquiredcompanies;

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

·                                          theincurrence of unforeseen obligations or liabilities;

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

·                                          increasedinterest expense and amortization of acquired intangible assets.

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

**We HaveExperienced Growth In Recent Periods. If We Fail To Manage Our GrowthEffectively, We May Be Unable To Execute Our Business Plan AndMay Experience Future Weaknesses In Our Internal Controls.**Wehave expanded our overall business. In order to achieve our businessobjectives, we will need to continue to expand our business and add additionalqualified personnel. Such expansion has placed and is expected to continue toplace, a significant strain on our managerial, administrative, operational,financial and other resources. If we are unable to successfully manage ourgrowth, our business, financial condition and results of operations will beadversely affected.

To accommodate this growth, we launched a new ERPsystem in April 2006. Accordingly, we may experience problems commonlyexperienced by other companies in connection with such implementations,including but not limited to, potential bugs in the system, component or supplydelays, training requirements and other integration challenges and delays. Anydifficulties we might experience in connection with our new ERP system couldhave a material adverse effect on our financial reporting system and internalcontrols.

**If We Do Not Keep Pace With Rapid TechnologicalChanges And Evolving Industry Standards, We Will Not Be Able To Remain CompetitiveAnd There Will Be No Demand For Our Products.**Our markets arein 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 ofoperations

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willlikely be seriously harmed. We currently attempt to protect our technologythrough a combination of patent, copyright, trademark and trade secret laws,employee and third party nondisclosure agreements and similar means. Despiteour efforts, other parties may attempt to disclose, obtain or use ourtechnologies or systems. Our competitors may also be able to independentlydevelop products that are substantially equivalent or superior to our productsor design around our patents. In addition, the laws of some foreign countriesdo not protect our proprietary rights as fully as do the laws of the UnitedStates. As a result, we may not be able to protect our proprietary rightsadequately 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 to obtainany 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, ourClass A common stock (now known as our common stock) has traded at pricesas low as $0.45 per share and as high as $29.44 per share. The market price ofour common stock could continue to fluctuate in the future in response tovarious factors, including, but not limited to:

·                                          quarterlyvariations in operating results;

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

·                                          ourability to raise additional capital;

·                                          shortagesannounced by suppliers;

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

·                                          transitionsto new products or product enhancements;

·                                          acquisitionsof businesses, products or technologies;

·                                          theimpact of any litigation;

·                                          changesin investor perceptions;

·                                          governmentfunding, political agendas and other budgetary issues;

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

·                                          internationalconflicts, political unrest and acts of terrorism.

In addition, as of March 31, 2007, options to purchasean aggregate of 711,000 shares of our common stock at a weighted average priceof $0.53 per share terminate on or prior to September 30, 2007.  Our common stock has traditionally beenthinly traded. The exercise of these options and the sale of a large number ofshares of our common stock could cause our stock price to decline.

The stock market in general has recently experiencedvolatility, which has particularly affected the market prices of equitysecurities of many technology companies. This volatility has often beenunrelated to the operating performance of these

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companies.These broad market fluctuations may adversely affect the market price of ourcommon stock. In the past, companies that have experienced volatility in themarket price of their securities have been the subject of securities classaction litigation. If we were to become the subject of a class action lawsuit,it could result in substantial losses and divert management’s attention andresources from other matters.

**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;

·                                          longeraccounts receivable payment cycles;

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

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

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

·                                          difficultiesin managing and staffing international operations;

·                                          potentiallyadverse tax consequences; and

·                                          reducedprotection for intellectual property rights in some countries.

All of our international sales 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. For example, in July 2006 we entered into a settlementagreement in connection with a lawsuit brought against MarinerNetworks, Inc., one of our former subsidiaries, by one of Mariner’ssuppliers, pursuant to which we issued 88,912 shares of our common stock tothis supplier (valued at $213,000 as of the date of issuance), paid thissupplier $125,000 on October 20, 2006 and are required to pay an additional$350,000 in 36 equal monthly installments of $9,700 beginning in November2006.  Although we are not aware of anyother material contingencies, it is possible that other matters could bebrought against us in connection with activities related to former subsidiariesand that such matters could materially and adversely affect our financialresults and cash flows.

**Some 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, 2007,our officers and directors beneficially owned approximately 12% of theoutstanding shares of our common stock (and approximately 18% of our commonstock when including options, warrants and other convertible securities held bythem which are currently exercisable or convertible or will become exercisableor convertible within 60 days

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afterMarch 31, 2007). As a result of their stock ownership, our management will beable to significantly influence the election of our directors and the outcomeof corporate actions requiring stockholder approval, such as mergers andacquisitions, regardless of how our other stockholders may vote. Thisconcentration of voting control may have a significant effect in delaying,deferring or preventing a change in our management or change in control and mayadversely affect the voting or other rights of other holders of common stock.

**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.

**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 $92,000,exclusive of common area maintenance and certain utility costs. The Anaheimfacility includes our operations and administrative offices (approximately84,000 dedicated square feet) and the operations of our former subsidiary,MAXxess Systems, Inc. (approximately 10,000 dedicated square feet). Thelease for the Anaheim facility is expected to terminate in September 2007.

On May 25, 2007, we entered into an agreement to lease approximately50,000 square feet of space located in Santa Ana, California for a term of 88months, beginning in September  2007. Thislocation will be the new location of our headquarters and principal operations.The monthly lease rate will be $102,000, inclusive of common area maintenancecosts and certain utility costs, during the first year of the lease, and willincrease each year thereafter, up to a maximum of $120,000 during the last yearof the lease.  The lease may be extendedfor a period of five years, at our option, at a lease rate to be based on themarket lease rate for comparable property determined as of the commencement ofthe extension period.  Subject to certainlimitations, we also have a right of first offer with respect to additionalspace at the same location. 

For additional information regarding our obligations under propertyleases, see Note 7 of Notes to Consolidated Financial Statements, included inPart 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, 2007.

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**PART II**

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

Our common stock is traded on the American Stock Exchange (“AMEX”)under the symbol “ITI”.  The followingtable sets forth, for the periods indicated, the high and low sales prices forour common stock as reported by AMEX:  
|                                       | ** ** | **Common Stock** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **High**              | ** ** | **Low** | ** ** |
| **Fiscal 2007**                       |       |                  |       |   |   |
| Quarter Ended June 30, 2006      |       | $                     | 2.69       |   | $ | 2.10 |   |
| Quarter Ended September 30, 2006 |       | 2.69                  |       | 2.26 |   |
| Quarter Ended December 31, 2006  |       | 2.69                  |       | 1.38 |   |
| Quarter Ended March 31, 2007     |       | 2.76                  |       | 2.15 |   |
|                                  |       |                  |       |   |   |
| **Fiscal 2006**                       | ** ** | ** **            | ** ** | ** ** | ** ** |
| Quarter Ended June 30, 2005      |       | $                     | 2.89       |   | $ | 2.00 |   |
| Quarter Ended September 30, 2005 |       | 3.40                  |       | 2.57 |   |
| Quarter Ended December 31, 2005  |       | 2.80                  |       | 2.02 |   |
| Quarter Ended March 31, 2006     |       | 2.80                  |       | 1.85 |   |

 

OnJune 18, 2007, the last reported sales price of our common stock on theAMEX was $2.53.  As of June 18,2007, we had 526 holders of record of our common stock according to informationfurnished 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, ourcapital 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.

**Recent Sales of Unregistered Securities**

The following is a summary of our transactions during the year endedMarch 31, 2007, involving sales of our securities that were not registeredunder the Securities Act of 1933, as amended (the “Securities Act”):

(1)           In August2006, we issued to Delta Networks, Inc. 88,912 shares of our common stockvalued at $213,000 in connection with the settlement of a lawsuit by Deltaagainst one of our former subsidiaries, Mariner Networks, Inc.

(2)           InSeptember 2006, we issued to Special Situations Fund III QP, L.P., SpecialSituations Fund III, L.P., Special Situations Cayman Fund, L.P. and SpecialSituations Private Equity Fund, L.P. (collectively, the “Funds”) warrants topurchase an aggregate of 246,250 shares of our commons stock, subject toadjustment in specified circumstances, in connection with the early exercise bythe Funds of existing warrants to purchase an aggregate of 1,250,000 shares ofcommon stock at an exercise price of $1.61 per share.  We received $2.0 million from the Funds aspayment in full of the aggregate exercise price of such existing warrants.  The new warrants are immediately exercisable,have an exercise price of $3.25 per share, subject to adjustment in specifiedcircumstances, and expire in September 2011. We may redeem all of the warrants, at a price of $0.01 per share ofcommon stock then purchaseable pursuant to the warrants if the closing bidprice of one share of common stock equals or exceeds $6.50 for 20 consecutivetrading days, subject to the rights of the holders thereof to exercise thewarrants prior to the redemption date. In order to exercise this redemption option, we must redeem all of thewarrants on the same terms.

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The issuance of securities in the transactions described in paragraphs1 and 2 above were effected without registration under the Securities Act inreliance on Section 4(2) thereof and Rule 506 of Registration D thereunderbased on the status of each investor as an accredited investor defined underthe Securities Act.  None of the foregoingtransactions was effected using any form of general advertising or generalsolicitation as such terms are used in Regulation D under the Securities Act.

**StockPerformance Graph**

The graph below shows the cumulative total return oninvestment assuming an investment of $100 on March 31, 2002 in our commonstock, the NASDAQ Stock Market Index and the same peer group used by us lastyear, which is made up of the remaining members of the index used by us inprior years, the Media General Industry Group 836 for Diversified Electronics,which is no longer a published index. Our common stock is currently listed on the AMEX under the symbol “ITI”and began trading on such exchange on December 9, 2004.  Our common stock (formerly the Class A commonstock) was listed on the NASDAQ National Market (now called the NASDAQ GlobalMarket) until April 2002 and on the NASDAQ SmallCap Market (now called theNASDAQ Capital Market) from April 2002 to August 2003 and quoted on the OTCBulletin Board from August 2003 to December 2004.  The total stockholder return assumesreinvestment of dividends on a daily basis, although cash dividends have notbeen declared on our common stock.  Thestockholder returns shown in the following graph are not necessarily indicativeof future performance.
| ** **          | ** ** | **Measurement Period** | ** ** |
|---------------------|------------|------------------------|------------|
| ** **          | ** ** | **2002**               | ** ** | **2003** | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** |
| Iteris Common Stock |       | 100.00                 |       | 42.58 |   | 258.06 |   | 157.42 |   | 170.32 |   | 148.39 |   |
| NASDAQ Market Index |       | 100.00                 |       | 72.11 |   | 109.76 |   | 111.26 |   | 132.74 |   | 139.65 |   |
| Peer Group          |       | 100.00                 |       | 62.01 |   | 111.93 |   | 85.59 |   | 112.90 |   | 114.99 |   |

 

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Notwithstanding anythingto the contrary set forth in any of our previous or future filings under theSecurities Act of 1933, as amended, or the Securities Exchange Act of 1934, asamended, that might incorporate this report or future filings made by us underthose statutes, the stock performance graph is not deemed filed with theSecurities and Exchange Commission and shall not be deemed incorporated byreference into any prior filings or into any future filings made by us underthose statutes.

**ITEM 6.****       SELECTED CONSOLIDATED FINANCIAL DATA**

The following table sets forth selected consolidated financial data foreach of the five fiscal years ended March 31, 2007. The statement ofoperations and balance sheet data for the years ended and as of March 31,2007, 2006, 2005, 2004, and 2003 are derived from our audited consolidatedfinancial statements. The accompanying consolidated financial statements havebeen restated to reflect the classification and presentation of our formersubsidiaries, Broadcast, Inc., Zyfer Inc., and MAXxess Systems, Inc.,as discontinued operations for all periods presented.  The following information should be read inconjunction with “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” and with our consolidated financial statements andthe related notes thereto included elsewhere in this report.

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| ** **                                                                          | ** ** | **Fiscal Year Ended March 31,**                | ** ** |
|-------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2007**                                                           | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                          | ** ** | **(in thousands, except per share data)** | ** ** |
| **Consolidated Statement of  Operations Data:**                                     | ** ** | ** **                                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales and contract revenues:                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net  sales                                                                          |       | $                                                                  | 36,248     |   | $ | 31,156 |   | $ | 29,062 |   | $ | 23,470 |   | $ | 19,112 |   |
| Contract  revenues                                                                  |       | 22,049                                                             |       | 19,330 |   | 17,335 |   | 21,813 |   | 22,283 |   |
| Total  net sales and contract revenues                                              |       | 58,297                                                             |       | 50,486 |   | 46,397 |   | 45,283 |   | 41,395 |   |
|                                                                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Costs of net sales and contract revenues:                                           |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost  of net sales (a)                                                              |       | 19,829                                                             |       | 16,493 |   | 15,925 |   | 12,758 |   | 9,366 |   |
| Cost  of contract revenues (a)                                                      |       | 14,460                                                             |       | 12,600 |   | 13,789 |   | 14,712 |   | 15,110 |   |
| Gross  profit                                                                       |       | 24,008                                                             |       | 21,393 |   | 16,683 |   | 17,813 |   | 16,919 |   |
| Operating expenses:                                                                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Selling,  general and administrative (a)                                            |       | 16,094                                                             |       | 15,362 |   | 21,027 |   | 12,844 |   | 14,105 |   |
| Research  and development (a)                                                       |       | 4,030                                                              |       | 5,217 |   | 6,236 |   | 3,923 |   | 3,908 |   |
| Amortization  of intangible assets                                                  |       | 147                                                                |       | 147 |   | 114 |   | — |   | — |   |
| Deferred  compensation expense (benefit)                                            |       | (91                                                                | )          | 48 |   | (484 | ) | 868 |   | — |   |
| Disposal  of fixed assets                                                           |       | —                                                             |       | — |   | 422 |   | — |   | — |   |
| Acquired  in-process research and development                                       |       | —                                                             |       | — |   | 140 |   | — |   | — |   |
| Total  operating expenses                                                           |       | 20,180                                                             |       | 20,774 |   | 27,455 |   | 17,635 |   | 18,013 |   |
| Operating income (loss)                                                             |       | 3,828                                                              |       | 619 |   | (10,772 | ) | 178 |   | (1,094 | ) |
| Non-operating income (expense):                                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Other  income (expense), net                                                        |       | (653                                                               | )          | 35 |   | 1,054 |   | 1,003 |   | 417 |   |
| Interest  expense, net                                                              |       | (1,600                                                             | )          | (1,459 | ) | (1,178 | ) | (123 | ) | (761 | ) |
| Income (loss) from continuing operations before  income taxes and minority interest |       | 1,575                                                              |       | (805 | ) | (10,896 | ) | 1,058 |   | (1,438 | ) |
| Income tax benefit (provision)                                                      |       | 1,343                                                              |       | 885 |   | 94 |   | (100 | ) | — |   |
| Minority interest in earnings of subsidiary                                         |       | —                                                             |       | — |   | (526 | ) | (2,813 | ) | (3,818 | ) |
| Income (loss) from continuing operations                                            |       | 2,918                                                              |       | 80 |   | (11,328 | ) | (1,855 | ) | (5,256 | ) |
| Income (loss) from discontinued operations, net  of taxes                           |       | —                                                             |       | — |   | — |   | 1,215 |   | (7,892 | ) |
| Net income (loss)                                                                   |       | $                                                                  | 2,918      |   | $ | 80 |   | $ | (11,328 | ) | $ | (640 | ) | $ | (13,148 | ) |
|                                                                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic earnings (loss) per share:                                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Continuing  operations                                                              |       | $                                                                  | 0.10       |   | $ | 0.00 |   | $ | (0.45 | ) | $ | (0.09 | ) | $ | (0.37 | ) |
| Discontinued  operations                                                            |       | —                                                             |       | — |   | — |   | 0.06 |   | (0.55 | ) |
| Basic  earnings (loss) per share                                                    |       | $                                                                  | 0.10       |   | $ | 0.00 |   | $ | (0.45 | ) | $ | (0.03 | ) | $ | (0.92 | ) |
|                                                                                |       |                                                               |       |   |   |   |   |   |   |   |   |
| Diluted earnings (loss) per share:                                                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Continuing  operations                                                              |       | $                                                                  | 0.09       |   | $ | 0.00 |   | $ | (0.45 | ) | $ | (0.09 | ) | $ | (0.37 | ) |
| Discontinued  operations                                                            |       | —                                                             |       | — |   | — |   | 0.06 |   | (0.55 | ) |
| Diluted  earnings (loss) per share                                                  |       | $                                                                  | 0.09       |   | $ | 0.00 |   | $ | (0.45 | ) | $ | (0.03 | ) | $ | (0.92 | ) |
| Shares used in calculating basic earnings  (loss) per share                         |       | 29,698                                                             |       | 28,182 |   | 25,284 |   | 19,454 |   | 14,276 |   |
| Shares used in calculating diluted earnings  (loss) per share                       |       | 33,348                                                             |       | 32,737 |   | 25,284 |   | 19,454 |   | 14,276 |   |

 

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| (a) Includes stock-based compensation expense  as follows: |   |   |   |   |   |   |   |   |   |   |   |
|------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Cost of net sales                                          |   | $      | 13     |   | $      | 27     |   | $      | 280    |   | $      | — |   | $ | — |   |
| Cost of contract revenues                                  |   | 60     |   | 205    |   | 2,391  |   | — |   | — |   |
| Selling, general and administrative expense                |   | 195    |   | 364    |   | 7,063  |   | — |   | — |   |
| Research and development expense                           |   | 20     |   | 129    |   | 2,043  |   | — |   | — |   |
| Total stock-based compensation expense                     |   | $      | 288    |   | $      | 725    |   | $      | 11,777 |   | $      | — |   | $ | — |   |

 

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| ** **                                | ** ** | **At March 31,** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|
| ** **                                | ** ** | **2007**                   | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                | ** ** | **(in thousands)**    | ** ** |
| **Consolidated Balance Sheet  Data:**     | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Working capital                           |       | $                          | 6,979      |   | $ | 3,009 |   | $ | 2,197 |   | $ | 9,369 |   | $ | 3,368 |   |
| Total assets                              |       | 55,250                     |       | 49,633 |   | 46,656 |   | 30,065 |   | 34,842 |   |
| Long-term debt (less current portion)     |       | 9,760                      |       | 11,374 |   | 10,315 |   | 891 |   | 1,265 |   |
| Accumulated deficit                       |       | (107,438                   | )          | (110,356 | ) | (110,436 | ) | (99,108 | ) | (98,468 | ) |
| Total stockholders’ equity (deficit) |       | 25,687                     |       | 18,635 |   | 17,462 |   | (1,076 | ) | (5,340 | ) |
|                                           |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**ITEM 7.****         MANAGEMENT’S DISCUSSIONAND 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 otherengineering and consulting services to the ITS industry. We use our outdoorimage recognition software expertise to develop proprietary algorithms forvideo sensor systems that improve vehicle safety and the flow of traffic. Usingour knowledge of the ITS industry, we design and implement transportationmanagement systems that help public agencies reduce traffic congestion andprovide greater access to traveler information.

Our Vantage product is a video vehicle 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 83,000 production AutoVue LDW units have been soldfor truck and car platforms in the North American, European markets and Asianmarkets. Our AutoVue LDW systems are currently offered as an option on certainMercedes-Benz, MAN, Iveco, DAF, Scania, International and Freightliner trucks.In Japan, our LDW system is a standard feature on certain FUSO heavy truckmodels. We provide an aftermarket kit to service the growing number of heavytruck fleet customers in North America. Using our aftermarket kit, our LDWsystems can be installed on a variety of heavy trucks such as Freightliner,Volvo, Kennworth, Peterbilt, International and Mack. In September 2003, weentered into an agreement with Valeo, pursuant to which we granted Valeo theexclusive right to sell and manufacture our AutoVue LDW systems to theworldwide passenger car market in exchange for royalty payments for eachAutoVue LDW unit sold. To date, royalty payments from Valeo have totaled approximately$484,000. Pursuant to this agreement, we also generate revenues from Valeo byproviding specific contract engineering services, technical marketing and salessupport to Valeo related to passenger car development activites and to enablethe launch of our LDW on certain Infiniti vehicles. Valeo is currently indiscussions to provide our LDW system to other passenger car OEMs; however, wecannot assure you that such discussions will be successful. We plan to continueto provide technical marketing and sales support to Valeo in our efforts to winnew OEM customers for the passenger car market, as well as contract engineeringservices related to the possible launch of new Infiniti platforms that includeour LDW system. We believe that AutoVue is a broad sensor platform that,through additional software development, may be expanded to incorporateadditional 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, design and implementation of surface transportationinfrastructure systems.  We perform analysisand study goods movement, commercial vehicle operations, travel demandforecasting and systems engineering and identify mitigation measures to reducetraffic congestion.  These services andsystems are primarily sold to local, state and national transportation agenciesin the United States. Our transportation management systems business is largelydependent upon governmental funding and budgetary issues. The Federal HighwayBill that was passed in August 2005 provided for a significant increase intransportation funding over the following six years. The recent growth in ourtransportation management systems business and our Vantage product business hasbeen enabled in part by this bill, as well as by state transportation bondssuch as the $20 billion infrastructure bond passed in California in November2006. Historically, there have been significant delays between the passage offunding bills and the allocation of related funding to specific contracts.Accordingly, while we have seen an increase in activity following the passageof the Federal Highway Bill, we cannot currently predict the full impact thatthis bill or state bonds will have on our transportation management systemsbusiness. We anticipate that the success of our transportation systems businesswill continue to be dependent in part on government spending and the budgetaryprocess.

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We have historically operated multiple business units. During thefiscal year ended March 31, 2003 (“Fiscal 2003”), we operated in threesegments consisting of ITS, video products, and telecom products. The ITSsegment consisted of our current operations, which was previously conducted bythe 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 developed and manufactured timing and synchronization products and which,prior to its incorporation, was operated as our Communications division.

Beginning in Fiscal 2003, we divested of certain of our business unitsin order to reduce our operating expenses and to focus on the operations of ourIteris Subsidiary. These divestitures and related restructuring activitiesincluded the following transactions:

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

·      In May 2003, we soldthe assets of Zyfer for a purchase price of $2.3 million in cash and theassumption of liabilities, plus incentive payments based on the revenuesgenerated by the sale of Zyfer’s products or the license of its technologiesthrough April 2005. In October 2004, we received an incentive payment of$135,000 related to the twelve month period ended April 30, 2004, and inSeptember 2005, we received an incentive payment of $83,000 related to thetwelve month period ended April 30, 2005.

·      In September 2003, wesold 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.Subsequent to the sale, in 2005, another member of our Board of Directors became the CEO of MAXxess. We currentlysublease to MAXxess 10,000 square feet of space in our Anaheim facility. Thesublease will terminate in September 2007 concurrently with the termination ofthe master lease for our Anaheim facility.

·      In May 2004, werepurchased all of the outstanding shares of Series A preferred stock ofthe 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 issued2.6 million shares of our common stock valued at $8.6 million at the date ofissuance in exchange for an aggregate of 1.3 million shares of common stock ofthe Iteris Subsidiary, which had the effect of reducing the residual minorityinterest in our Iteris Subsidiary to 8.1%.

·      In October 2004, wemerged the Iteris Subsidiary into us and the remaining minority interest in theIteris 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 A commonstock). In connection with this merger, we also assumed options and warrants topurchase an aggregate of 3.1 million and 327,000 shares, respectively, of thecommon stock of the Iteris Subsidiary, which became options and warrants topurchase an aggregate of 6.1 million  and654,000 shares, respectively, of our common stock.

·      In October 2004, weamended our certificate of incorporation to (a) change the voting rightsof our Class A common stock from one-tenth to one vote per share,(b) remove the ability to issue any further shares of Class B commonstock, and (c) rename our Class A common stock to common stock. As aresult, we currently have only one class of capital stock outstanding, thecommon stock.

Our financial statements for all periods presented in this report havebeen restated to reflect 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, 

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incident detection andcertain highway traffic data collection applications. The Automotive Sensorssegment is comprised of all activities related to our AutoVue LDW systems forvehicle safety. The Transportation Systems segment includes transportationengineering and consulting services and the development of transportationmanagement and traveler information systems for the ITS industry.

**Critical Accounting Policies andEstimates**

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, accounting for stock-based compensation, the valuation of equityinstruments, warranty reserves and other contingencies. We base these estimateson historical experience and on various other factors that we believe to bereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. These estimates and assumptions bytheir nature involve risks and uncertainties, and may prove to be inaccurate.In the event that any of our estimates or assumptions are inaccurate in anymaterial respect, it could have a material adverse effect on our reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of revenues and expenses during the reporting period.

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

*Revenue Recognition*.  We record product revenues and related costsof sales upon transfer of title, which is generally upon shipment or, ifrequired, upon acceptance by the customer, provided that we believecollectibility of the net sales amount is reasonably assured.  Accordingly, at the date revenue isrecognized, the significant uncertainties concerning the sale have beenresolved.

Contract revenues are derived primarily from long-termcontracts with governmental agencies. Contract revenues include costs incurred plus a portion of estimatedfees or profits determined using the percentage of completion method ofaccounting based on the relationship of costs incurred to total estimatedcosts.  Any anticipated losses oncontracts are charged to earnings when identified.  Changes in job performance and estimatedprofitability, including those arising from contract penalty provisions andfinal contract settlements, may result in revisions to recognized costs andrevenues and are recognized in the period in which the revisions aredetermined.  Profit incentives areincluded in revenue when their realization is reasonably assured.

In addition to product and contract revenues, wederive revenue from technology access fees, the provision of specificnon-recurring contract engineering services related to our AutoVue LDW systems,and royalties related to unit sales of our AutoVue LDW systems by our strategicpartner Valeo to the passenger car market. Technology access fee revenues arerecognized evenly over the period in which they are earned.  Non-recurring contract engineering revenuesare recognized in the period in which the related services are performed.  Royalty revenues are recorded based on unitsales of our products by Valeo and are recognized in the period in which suchsales occur.  Technology access feerevenues, contract engineering revenues and royalty revenues are included innet sales.

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

*Accounts Receivable*. We estimatethe collectibility of customer receivables on an ongoing basis by periodicallyreviewing invoices outstanding greater than a certain period of time.  We record reserves for receivables deemed tobe at risk for collection as well as a general reserve based on our historicalcollections experience.  A considerableamount of judgment is required in assessing the ultimate realization of tradereceivables, including the current credit-worthiness of each customer.  If the financial condition of our customersdeteriorates, resulting in an impairment of their ability to make requiredpayments, additional allowances may be required that could adversely affect ouroperating results.

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

*Goodwill*.  Goodwill is tested for impairment annually inour fourth fiscal quarter at the reporting unit level unless a change incircumstances indicates that more frequent impairment analysis isrequired.  Impairment, if any, ismeasured based on the estimated fair value of the reporting units with therecorded goodwill.  Fair value isdetermined by using the income approach methodology of valuation which utilizesdiscounted cash flows.  Significantmanagement judgment is required in the forecasts of future operating resultsthat are used in the discounted cash flow method of valuation.  In estimating future cash flows, we generallyuse the financial assumptions in our current budget and our current strategicplan, subject to modification as considered necessary, including sales andexpense growth rates and the discount rates we estimate to represent our cost offunds.  It is possible, however, that theplans and estimates used may be incorrect. If our actual results, or the plans and estimates used in futureimpairment analyses, are lower than the original estimates used to assess therecoverability of goodwill, we could incur impairment charges.

*Warranty.*  We generally provide a one to three yearwarranty from the original invoice date on all products, materials andworkmanship.  Defective products areeither repaired or replaced, at our option, upon meeting certain criteria.  We accrue a provision for the estimated coststhat may be incurred for product warranties relating to a product as acomponent of cost of sales at the time revenue for that product is recognized.  The accrued warranty provision is includedwithin accrued expenses on the accompanying consolidated balance sheets.  Should our actual experience of warrantyreturns be higher than anticipated, additional warranty reserves may berequired, which may adversely affect our operating results.

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

On an interim basis, we estimate what our anticipatedannual effective tax rate will be and record a quarterly income tax provisionin accordance with this anticipated rate. As the fiscal year progresses, werefine our estimates based upon actual events and earnings during the year.This estimation process can result in significant changes to our expectedeffective tax rate. When this occurs, we adjust the income tax provision duringthe quarter in which the change in estimate occurs so that the year-to-dateprovision reflects the expected annual rate. The changes described in thepreceding sentence and adjustments to our valuation allowance may createfluctuations in our overall effective tax rate from quarter to quarter.

*Stock-Based Compensation*.  We adopted Statement of Financial AccountingStandards (“SFAS”) No. 123 (revised 2004), *Share-Based Payment*(“SFAS 123R”), effective April 1, 2006. Prior to April 1, 2006, we followed the disclosure-only provisions ofSFAS No. 123, *Accounting for Stock-Based Compensation*(“SFAS123”), as amended by SFAS No. 148, *Accounting for Stock-BasedCompensation — Transition and Disclosure*, and, accordingly,accounted for our stock-based compensation plans using the intrinsic valuemethod under Accounting Principles Board Opinion No. 25 (“APB 25”) and relatedinterpretations.

SFAS 123R requires all stock-based payments, includinggrants of employee stock options, to be recognized in the statement ofoperations as an expense, based on their grant date fair values with such fairvalues amortized over the requisite service period.  We elected to utilize the modifiedprospective method for the transition to SFAS 123R. Under the modifiedprospective method, SFAS 123R applies to all awards granted or modified afterthe date of adoption. In addition, under the modified prospective method,compensation expense will be recognized for all stock-based compensation awardsgranted prior to but not yet vested as of April 1, 2006, based on grant-datefair values estimated in accordance with the original provisions of SFAS 123.

In implementing SFAS 123R, we have used theBlack-Scholes-Merton (“BSM”) option-pricing formula to estimate the fair valueof stock-based awards granted subsequent to April 1, 2006.  Our assumptions under the BSM formula includethe following:  expected volatilities arebased on the historical volatility of our stock price, the expected life ofoptions is derived based on the historical life of our options, and therisk-free rate for periods within the expected life of the option is based onthe 

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U.S. Treasury interestrates in effect at the time of grant. Additionally, SFAS 123 did not require the estimation of forfeitures inthe calculation of stock compensation expense; however, SFAS 123R does requiresuch estimation and upon adoption of SFAS 123R, we changed our methodology toinclude an estimate of forfeitures. Future stock-based compensation expense in any particular quarter oryear could be affected by changes in our assumptions or changes in marketconditions.

**Results of Operations**

The following table sets forth certain statement of operations data asa percentage of total net sales and contract revenues for the periodsindicated. The following table should be read in conjunction with Management’sDiscussion and Analysis of Financial Condition and Results of Operations.
|                                                         | ** ** | **Fiscal Year Ended March 31,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                              | ** ** | **2007**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales and contract  revenues:                       |       |                                                |       |   |   |   |   |
| Net sales                                               |       | 62.2                                                | %          | 61.7 | % | 62.6 | % |
| Contract revenues                                       |       | 37.8                                                |       | 38.3 |   | 37.4 |   |
| Total net sales and contract  revenues                  |       | 100.0                                               | %          | 100.0 | % | 100.0 | % |
|                                                    |       |                                                |       |   |   |   |   |
| Costs of net  sales and contract revenues:              |       |                                                |       |   |   |   |   |
| Cost of net sales (a)                                   |       | 34.0                                                |       | 32.7 |   | 34.3 |   |
| Cost of contract revenues (a)                           |       | 24.8                                                |       | 24.9 |   | 29.7 |   |
| Gross profit                                            |       | 41.2                                                |       | 42.4 |   | 36.0 |   |
| Operating expenses:                                     |       |                                                |       |   |   |   |   |
| Selling, general and  administrative (a)                |       | 27.6                                                |       | 30.4 |   | 45.3 |   |
| Research and development (a)                            |       | 6.9                                                 |       | 10.3 |   | 13.4 |   |
| Amotization of intangible  assets                       |       | 0.3                                                 |       | 0.3 |   | 0.2 |   |
| Deferred compensation expense  (benefit)                |       | (0.2                                                | )          | 0.1 |   | (1.0 | ) |
| Disposal of fixed assets                                |       | —                                              |       | — |   | 0.9 |   |
| Acquired in-process research  and development           |       | —                                              |       | — |   | 0.3 |   |
| Total operating expenses                                |       | 34.6                                                |       | 41.1 |   | 59.2 |   |
| Operating income (loss)                                 |       | 6.6                                                 |       | 1.2 |   | (23.2 | ) |
| Non-operating income (expense):                         |       |                                                |       |   |   |   |   |
| Other income (expense), net                             |       | (1.1                                                | )          | 0.1 |   | 2.2 |   |
| Interest expense, net                                   |       | (2.7                                                | )          | (2.9 | ) | (2.5 | ) |
| Income (loss) before income taxes and minority interest |       | 2.7                                                 |       | (1.6 | ) | (23.5 | ) |
| Income tax benefit                                      |       | 2.3                                                 |       | 1.8 |   | 0.2 |   |
| Minority interest in earnings of subsidiary             |       | —                                              |       | — |   | (1.1 | ) |
| Net  income (loss)                                      |       | 5.0                                                 | %          | 0.2 | % | (24.4 | )% |

 

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| (a) Includes stock-based  compensation expense as a percent of total net sales and contract revenues as  follows: |   |   |   |   |   |   |   |
|-------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Cost of net sales                                                                                                 |   | 0.0    | %      | 0.1    | %      | 0.6    | %      |
| Cost of contract revenues                                                                                         |   | 0.1    |   | 0.4    |   | 5.2    |   |
| Selling, general and administrative expense                                                                       |   | 0.3    |   | 0.7    |   | 15.2   |   |
| Research and development expense                                                                                  |   | 0.0    |   | 0.3    |   | 4.4    |   |
| Total stock-based compensation expense                                                                            |   | 0.5    | %      | 1.4    | %      | 25.4   | %      |

 

**Years Ended March 31, 2007, 2006and 2005**

*Net Sales and Contract Revenues*.Net sales are comprised of Roadway Sensors sales, which are derived from salesof our Vantage video detection systems, and Automotive Sensors sales, which arederived from sales of AutoVue LDW systems, technology access fees, contractengineering revenue and royalty revenue generated from AutoVue relatedactivities.  Contract revenues consist entirely of Transportation Systemscontract revenues, which are generated from systems integration and ITSconsulting services with federal, state, county and municipal agencies. Wecurrently have a diverse customer base with our 

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largest customer constituting 12.4% of total net salesand contract revenues in Fiscal 2007. Total net sales and contract revenuesincreased 15.5% to $58.3 million in Fiscal 2007 compared to $50.5 million inFiscal 2006, and increased 8.8% in Fiscal 2006 from $46.4 million in Fiscal 2005.

Net sales increased 16.3% to $36.2 million in Fiscal2007 compared to $31.2 million in Fiscal 2006, and increased 7.2% in Fiscal2006 compared to $29.1 million in Fiscal 2005. The increase in net sales ineach of the periods reflected increased unit sales in both Roadway Sensors andAutomotive Sensors.

Roadway Sensors net salescomprised 75.2%, 72.0% and 75.4% of net sales in Fiscal 2007, Fiscal 2006 andFiscal 2005, respectively and increased 21.5% to $27.3 million in Fiscal 2007compared to $22.4 million in Fiscal 2006 and increased 2.4% in Fiscal 2006compared to $21.9 million in Fiscal 2005. The majority of Roadway Sensors net sales were derived from sales withinNorth America.  The Fiscal 2007 increasewas primarily due to higher unit sales of Vantage video detection systems,which reflected broader market acceptance of video-based detection technologiesand positive reaction to new Vantage product offerings such as color camerasand eAccess, as well as higher governmental spending, which we believe wasrelated to the passage of the Federal Highway Bill in August 2005.  The Fiscal 2006 increase was primarily due toincreased market adoption of video-based detection technologies for trafficintersection management and our ability to obtain additional contracts withstate departments of transportation.  InFiscal 2007, we experienced increased lead times in procuring components, atrend that we expect to continue and which could adversely affect our sales inthe future.

Netsales from Automotive Sensors products and services increased 3.2% in Fiscal2007 to $9.0 million compared to $8.7 million in Fiscal 2006 and increased22.0% in Fiscal 2006 compared to $7.1 million in Fiscal 2005.  The increase in Fiscal 2007 net sales ofAutomotive Sensors products and services was primarily related to increasedunit sales of LDW systems in the North American commercial heavy truckmarket.  While overall unit sales of ourAutoVue LDW systems increased in Fiscal 2007, Automotive Sensors net sales werenegatively affected by OEM volume discounts provided to our largest customerand the impact of the transition to our next generation AutoVue LDW systems forthe heavy truck market in the latter part of Fiscal 2006.  The Fiscal 2006 increase in Automotive Sensorsnet sales was largely due to increased LDW unit sales in the European and NorthAmerican commercial heavy truck markets, which increased 35.6% in Fiscal 2006compared to Fiscal 2005.  Although wehave seen increased unit sales of AutoVue LDW systems in recent fiscal years,Automotive Sensors unit sales in Fiscal 2008 could be adversely impacted byslower than expected adoption rates of our LDW system by European and Asian OEM’sand North American heavy truck fleets, as well as potential additional OEMvolume discounts.  Additionally, recentenvironmental regulations in Europe and North America have substantiallyincreased the cost of new commercial trucks, which could impact future trucksales volumes and, ultimately, unit sales of our LDW systems.

Royalty revenues fromValeo for sales of our LDW systems for the passenger car market remainedrelatively insignificant in Fiscal 2007. Our LDW systems are now offered as an option on three Infiniti models.  While Valeo is currently in discussions tooffer our LDW systems on other passenger car platforms, we cannot assure youthat Valeo will be successful in these efforts.

Contract revenues increased 14.1% to $22.0 million inFiscal 2007 compared to $19.3 million in Fiscal 2006, and increased 11.5% inFiscal 2006 compared to $17.3 million in Fiscal 2005. Contract revenues reflecta broad range of fixed price and cost plus fixed fee contracts for engineeringstudy and design, systems integration and system implementation. All of ourcontract revenue is currently derived from work performed in North America.Contract revenues are dependent upon the continued availability of funding atboth the state and federal levels from the various departments oftransportation.  We believe the increasein Fiscal 2007 contract revenues compared to Fiscal 2006 and Fiscal 2006compared to Fiscal 2005 was largely the result of the passage of the FederalHighway Bill in August 2005, as well as increased spending at the stateand local levels. The increase in contract revenues in Fiscal 2007 was also dueto continued growth in the California market and stronger sales in the EasternU.S. market.  In response to the growthin our Transportation Systems segment, we have increased our TransportationSystems staff by 16% in Fiscal 2007.  Weexpect to continue to increase our Transportation Systems staff over the nextfiscal year.  We believe the ability ofour Transportation Systems business to grow and successfully win and servicenew contracts will be highly dependent upon our continued success in recruitingand retaining qualified personnel.

*Gross Profit*.Total gross profit increased 12.2% to $24.0 million in Fiscal 2007 compared to$21.4 million in Fiscal 2006, and increased 28.2% in Fiscal 2006 compared to$16.7 million in Fiscal 2005.  Totalgross profit as a percent of net sales and contract revenues decreased to 41.2%in Fiscal 2007 compared to 42.4% in Fiscal 2006 and increased in Fiscal 2006from 36.0% in Fiscal 2005.

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Gross profit as a percentage of net sales was 45.3% inFiscal 2007 compared to 47.1% in Fiscal 2006 and 45.2% in Fiscal 2005.  The 180 basis point decrease in gross profitin Fiscal 2007 compared to Fiscal 2006 was primarily due to volume discountsgiven to our largest Automotive Sensors hardware customer as well as an overalldecline in unit volumes to this customer. Fiscal 2007 gross profit as a percentage of net sales in our RoadwaySensors division were relatively consistent with Fiscal 2006 gross profit as apercentage of net sales. We limit quantitative discussion of gross profit forour Roadway Sensors and Automotive Sensors segments for competitivereasons.  Gross profit as a percentage ofnet sales can fluctuate in any specific quarter or year based on customer mix andvolume discounts given, as well as possible shifts of engineering resourcesfrom development activities to sustaining activities which we record as cost ofgoods sold.  Gross profit as a percent ofnet sales has fluctuated over the last five years from a high of 51.0% inFiscal 2003 to a low of 45.2% in Fiscal 2005.

The 190 basis point increase in gross profit in Fiscal2006 compared to Fiscal 2005 was primarily a result of increased margins onRoadway Sensors products due to product improvements aimed at reducing the costof goods sold, production efficiencies as a result of higher unit sales and achange in our Roadway Sensors business model in California to a direct salesmodel. Additionally, Fiscal 2005 cost of net sales included $280,000 of stockbased compensation compared to $27,000 in Fiscal 2006.

Gross profit as a percentage of contract revenuesdecreased to 34.4% in Fiscal 2007 compared to 34.8% in Fiscal 2006 andincreased from 20.5% in Fiscal 2005. We recognize contract revenues and relatedgross profit using percentage of completion contract accounting and theunderlying mix of contract activity affects the related gross profit recognizedin any given period.  The decrease ingross profit as a percent of contract revenues in Fiscal 2007 compared toFiscal 2006 reflects a contract mix weighted more toward lower margin contractsin the period.  The increase in Fiscal2006 from Fiscal 2005 was largely a result of the inclusion of $2.4 million ofstock-based compensation in the cost of contract revenues in Fiscal 2005compared to $205,000 in Fiscal 2006.  Bycomparison, $60,000 of stock-based compensation was included in Fiscal 2007cost of contract revenues.

*Selling, General and AdministrativeExpense*. Selling, general and administrative expenseincreased 4.8% to $16.1 million (or 27.6% of total net sales and contractrevenues) in Fiscal 2007 compared to $15.4 million (or 30.4% of total net salesand contract revenues) in Fiscal 2006, and decreased 26.9% in Fiscal 2006compared to $21.0 million (or 45.3% of total net sales and contract revenues)in Fiscal 2005. The increase in selling, general and administrative expense inFiscal 2007 compared to Fiscal 2006 was mainly a result of higher commissionsassociated with increased Roadway Sensors net sales and increased sales andmarketing activities in our Transportation Systems segment.  Additionally, selling, general andadministrative expense included legal expenses associated with the settlementof litigation described in Note 7 to the accompanying consolidated financialstatements, a severance accrual of approximately $300,000 associated with thedeparture of our former Chief Executive Officer in March 2007 and $180,000related to the write-off of past-due accounts receivable related to rent andother services provided to our former subsidiary, MAXxess.  No further expense is expected to be incurredin connection with the aforementioned lawsuit or the severance arrangement withour former Chief Executive Officer. Severance payments to our former Chief Executive Officer will be madeover a one year period.  We have writtenoff all balances receivable from MAXxess based on our accounts receivableaccounting policy and will continue to work with MAXxess to collect amounts dueto us.  Certain members of our Board of Directorsare part of MAXxess management and ownership. In the coming quarters, weanticipate increased selling, general and administrative expense related to ourefforts to comply with the internal control attestation requirements of theSarbanes-Oxley Act, with which we must begin to comply in April 2007.

The decrease in selling, general and administrativeexpense in Fiscal 2006 compared to Fiscal 2005 was largely a result of a $7.1million charge for stock-based compensation incurred in Fiscal 2005, comparedto stock-based compensation expense of $364,000 in Fiscal 2006; additionalaccounting and legal fees incurred in the first and second quarter of Fiscal2006 related to a change in audit firms; costs incurred in anticipation ofcompliance with the Sarbanes-Oxley Act of 2002; additional common area chargesincurred in connection with our Anaheim headquarters; and increased outsidesales commissions in our Roadway Sensors business.

*Research and Development Expense*.Research and development expense decreased 22.8% to $4.0 million (or 6.9% oftotal net sales and contract revenues) in Fiscal 2007 compared to $5.2 million(or 10.3% of total net sales and contract revenues) in Fiscal 2006, anddecreased 16.3% in Fiscal 2006 compared to $6.2 million (or 13.4% of total netsales and contract revenues) in Fiscal 2005. The decrease in research anddevelopment expense in Fiscal 2007 compared to Fiscal 2006 was largely a resultof higher than anticipated costs in the prior year period in Automotive Sensorsas we expended significant development resources in qualifying the nextgeneration LDW system with our largest customer, as well as several other heavy

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truck OEMs.  Additionally, in Fiscal 2007, there was ashift in engineering resources from research and development activities toproduct support activities as a result of new product introductions andimprovements in Roadway Sensors.  Costsassociated with product support activities are included in cost of net salesrather than research and development expense. We plan to introduce several key products in our Roadway Sensorsdivision in Fiscal 2008 and expect research and development expenses toincrease slightly from Fiscal 2007 levels.

The decrease in research and development expense inFiscal 2006 compared to Fiscal 2005 was mainly a result of $2.0 million ofstock-based compensation charged to research and development expense in Fiscal2005 compared to stock-based compensation of $129,000 in Fiscal 2006.  This effect was offset by increased spendingin Fiscal 2006 for both our Vantage video detection products and our AutoVueLDW system for the heavy truck market. Additional development funds were allocated to the Roadway Sensorsbusiness in Fiscal 2006 to complete the development of new products that wereintroduced in Fiscal 2007, refresh the existing product line and enhance costreduction activities.  Additional fundsallocated to the Automotive Sensors business were primarily used to develop andqualify the next generation AutoVue LDW system for the heavy truck market inEurope and North America.

For competitive reasons, we closely guard theconfidentiality of specific development projects.

*DeferredCompensation Expense (Benefit).* Deferred compensation expense(benefit) represents changes in the fair value of assets, primarily shares ofour common stock, held by our deferred compensation savings plan under whichcertain senior executives may defer compensation. Prior to the merger of theIteris Subsidiary into us in Fiscal 2005, the plan held shares of IterisSubsidiary common stock.  In connectionwith the Fiscal 2005 merger of the Iteris Subsidiary into us, shares of IterisSubsidiary common stock held by the plan were exchanged for shares of ourcommon stock. Changes in the value of common stock held by the plan resulted ina benefit of $91,000 in Fiscal 2007, expense of $48,000 in Fiscal 2006 and abenefit of $484,000 in Fiscal 2005.  Nocompensation was deferred into the plan in Fiscal 2007, Fiscal 2006 and Fiscal2005.

*Other Income (Expense), Net*.Other income (expense), net reflects the following:
|                              | ** ** | **Year Ended March 31,** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|
| ** **                   | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                   | ** ** | **(In thousands)**                 | ** ** |
| Settlement of lawsuits       |       | $                                       | (635       | ) | $ | — |   | $ | 949 |   |
| Other                        |       | (18                                     | )          | 35 |   | 105 |   |
| Other income (expense),  net |       | $                                       | (653       | ) | $ | 35 |   | $ | 1,054 |   |

**Otherincome (expense), net in Fiscal 2007 primarily reflects $635,000 of expenserecorded in connection with the settlement of litigation in July 2006.  Other income (expense), net in Fiscal 2005primarily reflects a $949,000 gain recognized on the settlement of litigationin which we were a beneficiary of, but not a party to, litigation betweenRockwell International and the Michigan Department of Transportation.  Refer to Note 7 to the accompanyingconsolidated financial statements for further discussion of these settlements.**

*Interest Expense, Net*.Interest expense, net reflects the net of interest expense and interest incomeas follows:
|                       | ** ** | **Year Ended March 31,** | ** ** |
|-----------------------|------------|-----------------------------------------|------------|
| ** **            | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **            | ** ** | **(In thousands)**                 | ** ** |
| Interest expense      |       | $                                       | (1,601     | ) | $ | (1,461 | ) | $ | (1,180 | ) |
| Interest income       |       | 1                                       |       | 2 |   | 2 |   |
| Interest expense, net |       | $                                       | (1,600     | ) | $ | (1,459 | ) | $ | (1,178 | ) |

 

**Interestexpense, net increased 9.7% in Fiscal 2007 compared to Fiscal 2006 andincreased 23.9% in Fiscal 2006 compared to Fiscal 2005.  The increase in interest expense in Fiscal2007 compared to Fiscal 2006 was mainly related to the October 2006 bankingchange, in which we refinanced our existing term note and line of credit with anew bank. In connection with this refinancing, we also increased our creditfacility by $3.0 million from $5.0 million to $8.0 million, which resulted inslightly higher interest costs in Fiscal 2007 as compared to Fiscal 2006.  The increase in interest expense, net inFiscal 2006 as compared to Fiscal 2005 was mainly related to an increase in theinterest rate on our line of credit and term note as well as increased averageborrowings on our line of credit.**

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*Income Taxes*.During Fiscal 2007, we recognized an income tax benefit of $1.3 million and atMarch 31, 2007, our consolidated balance sheet included net deferred taxassets of $3.0 million. The ability to record the deferred tax asset was basedon the more likely than not criteria of Statement of Financial AccountingStandards (“SFAS”) No. 109, *Accounting for IncomeTaxes*.  During Fiscal 2006, werecognized an income tax benefit of $885,000, and at March 31, 2006, ourconsolidated balance sheet included net deferred tax assets of $1.6 million.

At March 31, 2007, we had $49.3 million offederal net operating loss carryforwards and $22.4 million of state netoperating loss carryforwards that begin to expire in 2019 and 2008,respectively. Due to changes in stock ownership, our federal net operating losscarryforwards are subject to a Section 382 limitation estimated atapproximately $2.9 million annually which can be utilized to offset federalconsolidated taxable income.

Although the impact cannot be precisely determined, webelieve that our net operating loss carryforwards and the valuation allowancewe have recorded against our net deferred tax assets in our consolidatedbalance sheets will cause us to have future income tax payments and income taxexpense that are substantially lower than the income tax liability and incometax expense calculated using statutory tax rates.

*Minority Interest in Earnings ofSubsidiary*. Minority interest in earnings of subsidiaryrepresents the minority stockholders’ share of the Iteris Subsidiary’s netincome (loss) combined with the accretion of the redemption preference of theIteris Subsidiary’s Series A preferred stock. On October 22, 2004, wecompleted the merger of the Iteris Subsidiary into us. As a result of thecompletion of the merger in October 2004, we did not incur any charge forminority interest subsequent to that date. No future charges for minority interest are anticipated.

*Stock-Based Compensation Expense*.  In Fiscal 2007, we adopted SFAS 123R usingthe modified prospective approach.  Stock-based compensation expense was $288,000in Fiscal 2007.  See Notes 1 and 10 tothe accompanying consolidated financial statements for additional discussionregarding our implementation of SFAS 123R.

As discussed above and in the Overview to Management’sDiscussion and Analysis of Financial Condition and Results of Operations and inNote 3 to the accompanying consolidated financial statements, onOctober 22, 2004, we completed the merger of the Iteris Subsidiary intous.  Upon completion of the merger, werecorded $11.3 million of stock-based compensation expense related to theassumption and exchange of vested stock options assumed in the merger.  Additionally, stock-based compensationexpense was recorded subsequent to the merger date based on the vestingschedule of stock options that were not yet vested on the merger date.  This resulted in stock-based compensationexpense of $725,000 and $11.8 million in Fiscal 2006 and Fiscal 2005,respectively.  No additional stock-basedcompensation expense is expected to be recognized in connection with stockoptions assumed in the merger.

**Liquidityand Capital Resources**

*CashFlows*

We havehistorically financed our operations with a combination of cash flows fromoperations, borrowings under credit facilities and the sale of equitysecurities. We currently rely on cash flows from operations and borrowings on aline of credit facility to fund our operations, which we believe to besufficient to fund our operations for at least the next twelve months. However,should a shortfall occur, we believe we could obtain additional funds throughadditional borrowings or the sale of equity securities. At March 31, 2007,we had $7.0 million in working capital, which included borrowings of $4.0million on our revolving line of credit and $35,000 in cash and cashequivalents. This compares to working capital of $3.0 million at March 31,2006, which included borrowings of $2.7 million on our revolving line of creditand $131,000 in cash and cash equivalents. Our operations used $2.0 million ofcash during Fiscal 2007, primarily as a result of investments in inventory dueto sales growth and longer lead times in procuring certain compenents, and anincreased level of net costs and estimated earnings in excess of billings dueto sales growth and the timing of invoicing on contracts in our TransportationSystems segment.  These were partiallyoffset by net income of $2.9 million. During Fiscal 2006, our operations provided $218,000 of cash, primarilyas a result of planned decreases in inventory and the timing of payments onaccrued expenses and payables, which 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.  We generated $590,000 in cash from operationsin Fiscal 2005, primarily due to the receipt of $949,000 related to a legalsettlement between Rockwell International and the Michigan Department ofTransportation, to which we were a third party beneficiary.

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Investingactivities for Fiscal 2007, Fiscal 2006 and Fiscal 2005 consisted primarily ofpurchases of property and equipment, which aggregated $488,000, $1.3 millionand $670,000, respectively.  In Fiscal2006, capital expenditures increased significantly primarily due to hardware,software and related labor costs to implement a new enterprise resourcemanagement system, which was put into use at the beginning of Fiscal 2007.

Cash provided byfinancing activities was $2.4 million in Fiscal 2007, which was the netresult of net payments on borrowings of $1.2 million offset by cash inflows of$3.6 million from the exercise of outstanding stock options and warrants topurchase our common stock. As discussed in Note 9 to the accompanyingconsolidated financial statements, approximately $2.0 million of the $3.6million in proceeds from the exercise of stock options and warrants was raisedthrough the exercise of outstanding warrants to purchase an aggregate of1,250,000 shares of our common stock. During Fiscal 2006, financing activities provided $1.1 million of cashas a result of net borrowings of $792,000 and cash inflows of $333,000 from theexercise of outstanding stock options and warrants to purchase our commonstock.  During Fiscal 2005, financingactivities used $2.5 million of cash, which was comprised of net cash outflowsof approximately $3.1 million related to the merger activities described morefully above in the Overview to Management’s Discussion and Analysis ofFinancial Condition and Results of Operations and in Note 3 to the accompanyingconsolidated financial statements, partially offset by $501,000 in proceedsfrom the exercise of stock options and warrants to purchase our common stock.

*Borrowings*

The following table summarizes our borrowings andlong-term debt:
|                              | ** ** | **At March 31, 2007** | ** ** |
|------------------------------|------------|--------------------------------------|------------|
| ** **                   | ** ** | **(In thousands)**              | ** ** |
| Revolving line of  credit    |       | $                                    | 4,015      |   |
| Convertible debentures,  net |       | 9,410                                |       |
| Bank term note               |       | 1,573                                |       |
| Promissory note to  landlord |       | 646                                  |       |
| Other long-term debt         |       | 78                                   |       |
|                         |       | $                                    | 15,722     |   |

 

In October 2006,we refinanced our existing line of credit and entered into a new two-yearcredit facility with our new bank.  Thefacility provides for combined line of credit and term note borrowings of up to$8.0 million.  Under the new creditfacility, we may borrow against our eligible accounts receivable and eligibleinventory, as defined in the credit agreement. Interest on borrowed amounts is payable monthly at the current statedprime rate plus 1.25%.  Additionally, weare obligated to pay an unused line fee of 0.25% per annum applied to theamount by which the maximum credit amount exceeds the average daily principalbalance during the preceding month. The new credit facility requires $2,000 inmonthly collateral management fees and includes an early termination fee equalto 2% of the total facility during the first year of the agreement and 1% ofthe total facility in the second year of the agreement. Additionally, we paid acommitment fee of $40,000 in October 2006 and are obligated to pay anadditional $40,000 on the one year anniversary of the facility. The new creditfacility is secured by substantially all of our assets.  At March 31, 2007, we had $8.0 millionavailable under our credit facility, of which $2.4 million was unused.

We believe thatthe cash generated from our operations, together with our new credit facility,will be sufficient to fund our operations for at least the next twelve months.However, should a shortfall occur, we may need to raise additional fundsthrough other debt financings or the sale of equity securities.

**ContractualObligations**

Our contractual obligations are as follows atMarch 31, 2007:
| ** **             | ** ** | **Payments Due by Period** | ** ** |
|------------------------|------------|-------------------------------------------|------------|
| ** **             | ** ** | **2008**                                  | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| ** **             | ** ** | **(In thousands)**                   | ** ** |
| Lines of credit        |       | $                                         | 4,015      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 4,015 |   |
| Notes payable          |       | 1,947                                     |       | 350 |   | — |   | — |   | — |   | — |   | 2,297 |   |
| Convertible debentures |       | —                                    |       | — |   | 9,850 |   | — |   | — |   | — |   | 9,850 |   |
| Operating leases       |       | 1,277                                     |       | 1,398 |   | 1,391 |   | 1,348 |   | 1,332 |   | 3,823 |   | 10,569 |   |
| Total                  |       | $                                         | 7,239      |   | $ | 1,748 |   | $ | 11,241 |   | $ | 1,348 |   | $ | 1,332 |   | $ | 3,823 |   | $ | 26,731 |   |

 

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At March 31, 2007, we had firm commitments topurchase inventory in the amount of $2.6 million during the first and secondquarters of Fiscal 2008.

**Off Balance Sheet Arrangements**

Inconnection with the restructuring and merger activities described in the Overviewto Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Notes 3, 5and 9 to the accompanying consolidated financial statements, in May 2004 weissued subordinated convertible debentures in an aggregate original principalamount of $10.1 million. These debentures are due in full on May 19, 2009and are convertible into shares of our common stock at a conversion price of$3.61 per share. At March 31, 2007, $9.9 million of these convertibledebentures remained outstanding. Because these debentures are conventionallyconvertible, we have not separately accounted for the conversion feature and,accordingly, no separate amounts are presented in our consolidated financialstatements in connection with this conversion feature.

AtMarch 31, 2007, outstanding warrants to purchase 62,500 shares of our commonstock at an exercise price of $1.95 per share and outstanding warrants topurchase an aggregate of 246,250 shares of common stock at an exerciseprice of $3.25 per share are callable by us if the market price of our commonstock trades for 20 consecutive days at a price equal to or greater than twotimes the exercise price of the warrants. Outstanding warrants topurchase an aggregate of 75,000 shares of our common stock at an exerciseprice of $5.00 per share are callable by us if the market price of our commonstock trades for 20 consecutive days at a price equal to or greater thanone and a half times the exercise price of the warrants.

In connection with the issuance of warrants topurchase 246,250 shares of our common stock at $3.25 per share, we are a partyto a registration rights agreement that contains provisions under which wecould be subjected to liquidated damages should we fail to maintain effectiveregistration statements for the shares of common stock issuable upon exerciseof certain underlying warrants.  Thesewarrants have been accounted for within equity in our consolidated balancesheet at March 31, 2007 in accordance with EITF 00-19, *Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock*, and, accordingly, no liabilities have beenrecorded in connection therewith.  As ofthe date of this filing, no liquidated damages are payable under the provisionsof the registration rights agreement associated with these warrants.

**Rule10b5-1 Trading Plans**

Two ofour executive officers, Greg McKhann and Francis Memole, have entered intotrading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of1934, as amended, which cover an aggregate of 150,000 shares of our commonstock.  Abbas Mohaddes terminated histrading plan upon his promotion to Chief Executive Officer in March 2007.

**Recent AccountingPronouncements**

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

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”), which defines fairvalue, establishes a framework for measuring fair value, and expands disclosureabout fair value measurements. SFAS 157 does not require any new fair valuemeasurements; rather it specifies valuation methods to be applied when fairvalue measurements are required under existing or future accountingpronouncements. SFAS 157 is effective for fiscal years beginning after November15, 2007, and interim periods within those fiscal years. Early application ofthe statement is encouraged. Generally, this statement will be appliedprospectively.  We are currentlyevaluating the impact of SFAS 157 and expect to adopt SFAS 157 in the firstquarter of our fiscal year ending March 31, 2009.

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities —Including an Amendment of FASB Statement No. 115* (“SFAS 159”). SFAS159 permits entities to choose to measure many financial instruments andcertain other items at fair value. Unrealized gains and losses on items forwhich the fair value option has been elected will be recognized in earnings ateach subsequent reporting date. SFAS 159 is effective for financial statementsissued for fiscal years beginning after November 15, 2007.  We are evaluating the impact that theadoption of SFAS 159 will have on our results of operations and financialcondition and expect to adopt SFAS 159 in our fiscal year ending March 31,2009.  

**Seasonality**

We have historically experienced seasonality,particularly with respect to our Roadway Sensors net sales in the third andfourth fiscal quarters due to a reduction in road construction or repairsduring the winter months due to inclement weather conditions.

**ITEM 7A.****     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

Ourexposure to interest rate risk is limited to our line of credit, bank term noteand a promissory note to our landlord. Our line of credit, bank term note andpromissory note to our landlord bear interest based on the prevailing primerate (8.25%

31

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at March 31,2007).  We do not believe that a 10%increase in the interest rate on our line of credit, bank term note andpromissory note to our landlord (from 9.50% to 10.45% on the line of credit,from 9.50% to 10.45% on the bank term note and from 10.25% to 11.28% on thepromissory note to our landlord) would have a material impact on our financialposition, operating results or cash flows. In addition, we believe that thecarrying value of our outstanding debt approximates fair value.

**ITEM 8.****        FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

The financialstatements and supplementary data required by Regulation S-X are included inPart IV, Item 15 of this report.

**ITEM 9.****        CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

None.

**ITEM 9A.****     CONTROLS AND PROCEDURES**

**Evaluation of Disclosure Controls andProcedures**

As of the end ofthe period 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 has materiallyaffected, or is reasonably likely to materially affect, our internal controlsover financial reporting.

Effective April 1, 2006,we implemented a new enterprise resource planning system that we believe hasnot resulted in any material changes in our internal controls over financialreporting.

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

None.

**PART III**

**ITEM 10.****      DIRECTORS, EXECUTIVE OFFICERS AND CORPORATEGOVERNANCE**

(a)  *Identification of Directors.*Theinformation under the caption “Election of Directors,” appearing in our proxystatement for the 2007 Annual Meeting of Stockholders, is incorporated hereinby reference.

(b)  *Identification of Executive Officers.*Theinformation under the caption “Executive Compensation and Other Information -Executive Officers,” appearing in our proxy statement for the 2007 AnnualMeeting of Stockholders, is incorporated herein by reference.

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(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 2007Annual Meeting of Stockholders is incorporated herein by reference.

(d)  *Corporate Governance*. The informationunder the caption “Corporate Governance,” appearing in our proxy statement forthe 2007 Annual Meeting of Stockholders, is incorporated herein by reference.

(e)  *Audit Committee*. The information under thecaption “Board Meetings and Committees – Audit Committee,” appearing in ourproxy statement for the 2007 Annual Meeting of Stockholders, is incorporatedherein by reference.

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

The informationunder the caption “Executive Compensation and Other Information,” appearing inour proxy statement for the 2007 Annual Meeting of Stockholders, isincorporated herein by reference.

**ITEM 12.**      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERSAND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

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 2007 Annual Meeting of Stockholders, isincorporated herein by reference.

**ITEM 13.**      CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The informationunder the captions “Corporate Governance – Director Independence” and “CertainTransactions,” appearing in our proxy statement for the 2007 Annual Meeting ofStockholders, is incorporated herein by reference.

**ITEM 14.**      PRINCIPALACCOUNTING FEES AND SERVICES

The informationunder the caption “Fees Paid to Independent Registered Public Accounting Firm,”appearing in our proxy statement for the 2007 Annual Meeting of Stockholders,is incorporated herein by reference.

**PART IV**

**ITEM 15.**      EXHIBITSAND FINANCIAL STATEMENT SCHEDULES

(a)     Documentsfiled as part 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 thepages referenced below:
| Report of Independent  Registered Public Accounting Firm                                                                               |   |   |
|----------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Consolidated Balance  Sheets as of March 31, 2007 and 2006                                                                        |   |   |
| Consolidated  Statements of Operations for the years ended March 31, 2007, 2006 and  2005                                         |   |   |
| Consolidated  Statements of Stockholders’ Equity and Comprehensive Income for the years  ended March 31, 2007, 2006 and 2005 |   |   |
| Consolidated  Statements of Cash Flows for the years ended March 31, 2007, 2006 and  2005                                         |   |   |
| Notes to  Consolidated Financial Statements                                                                                            |   |   |

 

2.                 *Financial Statement Schedules*.
| Schedule II — Valuation  and Qualifying Accounts |   |   |
|------------------------------------------------------------|--------|--------|

 

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

33

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3.             *Exhibits*.

The following exhibitsare filed herewith or incorporated by reference to the location indicatedbelow:
| 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*                                          |
|            |       |                                                                                                                                                             | * *   | * *                                                                                                                                                                                                    |
| 3.4             |       | Certificate of Amendment to Bylaws of registrant  dated September 9, 2004                                                                                        | * *   | *Exhibit 3.1 to the registrant’s Quarterly Report  on Form 10-Q for the quarter ended September 30, 2004 as filed with the SEC  on November 15, 2004*                                                  |
|            |       |                                                                                                                                                             | * *   | * *                                                                                                                                                                                                    |
| 3.5             |       | Certificate of Amendment to Bylaws of registrant  effective September 16, 2005                                                                                   | * *   | *Filed Herewith*                                                                                                                                                                                            |
|            |       |                                                                                                                                                             | * *   | * *                                                                                                                                                                                                    |
| 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             |       | Amended and Restated Rights Agreement, dated as of  May 10, 2004, by and between the registrant and U.S. Stock Transfer  Corporation, including exhibits thereto | * *   | *Exhibit 99.1 to the registrant’s Registration  Statement on Form 8-A/A as field with the SEC on June 18, 2004*                                                                                        |
|            |       |                                                                                                                                                             | * *   | * *                                                                                                                                                                                                    |
| 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*                      |
| ** **      | ** ** | ** **                                                                                                                                                       | ** ** | ** **                                                                                                                                                                                                  |
| 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                                                                                                                     | * *   | *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*                                            |

 

34

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| Exhibit  Number | ** ** | **Description**                                                                                                                                                               | ** ** | **Where Located**                                                                                                                                                                 |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                          | * *   | * *                                                                                                                                                                          |
| 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                                                                                                    | * *   | *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                                                                                                     | * *   | *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*                 |
|            |       |                                                                                                                                                                          | * *   | * *                                                                                                                                                                          |
| 10.16           |       | 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*                                                         |

 

35

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| 10.17* |   | 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* |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.18* |   | 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*          |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.19* |   | 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*       |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.20* |   | 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*             |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.21* |   | 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*             |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.22* |   | 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*             |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.23* |   | 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*       |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.24+ |   | 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* |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.25  |   | Warrant Exercise  Agreement dated September 27, 2006 by and among the registrant and Special  Situations Fund III QP, L.P., Special Situations Fund III, L.P., Special  Situations Cayman Fund, L.P. and Special Situations Private Equity Fund, L.P.                                                                             | * * | *Exhibit  10.1 to the registrants’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2006 as filed with the SEC on November 14, 2006.*            |
|   |   |                                                                                                                                                                                                                                                                                                                              | * * | * *                                                                                                                                                                 |
| 10.26  |   | Registration  Rights Agreement dated September 28, 2006 by and among the registrant and  Special Situations Fund III QP, L.P., Special Situations Fund III, L.P.,  Special Situations Cayman Fund, L.P. and Special Situations Private Equity  Fund, L.P.                                                                         | * * | *Exhibit  10.2 to the registrants’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2006 as filed with the SEC on November 14, 2006.*            |

 

36

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| 10.27+ |   | National  Intelligent Transportation Systems (ITS) Architecture Evolution and Support  Award/Contract effective as of October 1, 2006 by and between the registrant  and the Federal Highway Administration | * * | *Exhibit  10.3 to the registrants’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2006 as filed with the SEC on November 14, 2006.* |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                        | * * | * *                                                                                                                                                      |
| 10.28  |   | Loan and  Security Agreement effective as of October 16, 2006 by and between the  registrant and Silicon Valley Bank                                                                                        | * * | *Exhibit  10.4 to the registrants’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2006 as filed with the SEC on November 14, 2006.* |

 

37

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| Exhibit  Number | ** ** | **Description**                                                                                                                                                   | ** ** | **Where Located**                                                                                                                                             |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                              | * *   | * *                                                                                                                                                      |
| 10.29           |       | Intellectual Property Security Agreement dated  October 9, 2006 by and between the registrant and Silicon Valley Bank                                             | * *   | *Exhibit 10.5 to the registrants’s Quarterly  Report on Form 10-Q for the quarter ended September 30, 2006 as filed with  the SEC on November 14, 2006.* |
|            |       |                                                                                                                                                              | * *   | * *                                                                                                                                                      |
| 10.30+          |       | Settlement Agreement, effective August 15, 2006, by  and between the registrant and Delta Networks, Inc.                                                          | * *   | *Exhibit 10.1 to the registrant’s Current Report  on Form 8-K as filed with the SEC on August 21, 2006*                                                  |
|            |       |                                                                                                                                                              | * *   | * *                                                                                                                                                      |
| 10.31*          |       | Offer letter effective February 28, 2007 by and  between the registrant and Abbas Mohaddes                                                                        | * *   | *Exhibit 10.1 to the registrant’s Current Report  on Form 8-K as filed with the SEC on March 6, 2007*                                                    |
|            |       |                                                                                                                                                              | * *   | * *                                                                                                                                                      |
| 10.32*          |       | Separation Agreement and Release of Claims dated  March 1, 2007 by and between the registrant and Jack Johnson                                                    | * *   | *Exhibit 10.2 to the registrant’s Current Report  on Form 8-K as filed with the SEC on March 6, 2007*                                                    |
|            |       |                                                                                                                                                              | * *   | * *                                                                                                                                                      |
| 21              |       | Subsidiaries of  the registrant                                                                                                                                   | * *   | *Filed  Herewith*                                                                                                                                             |
|            |       |                                                                                                                                                              | * *   | * *                                                                                                                                                      |
| 23              |       | Consent of  Independent Registered Public Accounting Firm                                                                                                         |       | *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*                                                                                                                                             |

 

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* Indicates amanagement contract or compensatory plan or 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 withRule 24b-2, these confidential portions have been omitted from theexhibit and filed separately with the SEC.

38

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.
|        | ** ** | **ITERIS, INC.** |
|--------|------------|------------------|
|   |       | (Registrant)     |
|   |       |             |   |   |
|   |       | By               |   | /s/ ABBAS MOHADDES |
|   |       |             |   | Abbas Mohaddes |
|   |       |             |   | President and Chief Executive Officer |

 

39

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

We, theundersigned officers and directors of Iteris, Inc., do hereby constituteand appoint James S. Miele and Abbas Mohaddes, 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/ ABBAS MOHADDES     |       | Director, President and Chief Executive Officer |       | June 21, 2007 |
| Abbas Mohaddes         |       | (principal executive officer)                   |       |               |
|                   |       |                                            |       |               |
| /s/ JAMES S. MIELE     |       | Chief Financial Officer                         |       | June 21, 2007 |
| James S. Miele         |       | (principal financial and accounting officer)    |       |               |
|                   |       |                                            |       |               |
| /s/ GREGORY A. MINER   |       | Chairman of the Board                           |       | June 21, 2007 |
| Gregory A. Miner       |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ RICHARD CHAR       |       | Director                                        |       | June 21, 2007 |
| Richard Char           |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ KEVIN C. DALY      |       | Director                                        |       | June 21, 2007 |
| Kevin C. Daly, Ph.D.   |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ GARY HERNANDEZ     |       | Director                                        |       | June 21, 2007 |
| Gary Hernandez         |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ HARTMUT MARWITZ    |       | Director                                        |       | June 21, 2007 |
| Hartmut Marwitz, Ph.D. |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ JOHN SEAZHOLTZ     |       | Director                                        |       | June 21, 2007 |
| John Seazholtz         |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ JOEL SLUTZKY       |       | Director                                        |       | June 21, 2007 |
| Joel Slutzky           |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ THOMAS L. THOMAS   |       | Director                                        |       | June 21, 2007 |
| Thomas L. Thomas       |       |                                            |       |               |
|                   |       |                                            |       |               |
| /s/ PAUL E. WRIGHT     |       | Director                                        |       | June 21, 2007 |
| Paul E. Wright         |       |                                            |       |               |

 

40

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**Iteris, Inc.**

**Index to Consolidated Financial Statements**
| Report of Independent  Registered Public Accounting Firm                                                                                |   |   |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                                                    |   |   |
| Consolidated Balance  Sheets as of March 31, 2007 and 2006                                                                         |   |   |
|                                                                                                                                    |   |   |
| Consolidated  Statements of Operations for the years ended March 31, 2007, 2006, and  2005                                         |   |   |
|                                                                                                                                    |   |   |
| Consolidated  Statements of Stockholders’ Equity and Comprehensive Income for the years  ended March 31, 2007, 2006, and 2005 |   |   |
|                                                                                                                                    |   |   |
| Consolidated  Statements of Cash Flows for the years ended March 31, 2007, 2006, and  2005                                         |   |   |
|                                                                                                                                    |   |   |
| Notes to  Consolidated Financial Statements                                                                                             |   |   |

 

41

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**Reportof Independent Registered Public Accounting Firm**

To the Board ofDirectorsIteris, Inc.Anaheim, California

Wehave audited the consolidated balance sheets of Iteris, Inc. as of March 31,2007 and 2006, and the related consolidated statements of operations,stockholders’ equity and comprehensive income and cash flows for each of thethree years in the period ended March 31, 2007. Our audits also included the financial statement schedules of Iteris,Inc. listed in Item 15(a).  Thesefinancial statements and financial statement schedules are the responsibilityof the Company’s management.  Ourresponsibility is to express an opinion on these financial statements andschedules based on our audits.

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Iteris, Inc. as ofMarch 31, 2007 and 2006, and the results of its operations and its cash flowsfor each of the three years in the period ended March 31, 2007, in conformitywith U.S. generally accepted accounting principles.  Also, in our opinion, the related financialstatement schedules, when considered in relation to the basic consolidatedfinancial statements taken as a whole, present fairly in all material respectsthe information set forth therein.

Asdiscussed in Note 1 to the consolidated financial statements, effective April1, 2006, the Company changed its method of accounting for stock-based compensation.
| /s/ McGladrey & Pullen, LLP |   |   |
|--------------------------------------|--------|--------|
| Irvine, California                   |   |   |
| June 21, 2007                        |   |   |

 

42

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**Iteris, Inc.**

**Consolidated Balance Sheets**

**(In thousands)**
| ** **                                                                                                                          | ** ** | **March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                          | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Assets                                                                                                                              |       |               |       |   |   |
| Current assets:                                                                                                                     |       |               |       |   |   |
| Cash and cash  equivalents                                                                                                          |       | $                  | 35         |   | $ | 131 |   |
| Trade accounts  receivable, net of allowance for doubtful accounts of $664 and $429 at  March 31, 2007 and 2006, respectively. |       | 11,493             |       | 11,426 |   |
| Costs and estimated  earnings in excess of billings on uncompleted contracts                                                        |       | 3,689              |       | 2,693 |   |
| Deferred income taxes                                                                                                               |       | 494                |       | 790 |   |
| Inventories, net of  reserve for inventory obsolescence of $844 and $592 at March 31, 2007  and 2006, respectively             |       | 6,379              |       | 2,814 |   |
| Prepaid expenses and  other current assets                                                                                          |       | 385                |       | 368 |   |
| Total current assets                                                                                                                |       | 22,475             |       | 18,222 |   |
|                                                                                                                                |       |               |       |   |   |
| Property and equipment:                                                                                                             |       |               |       |   |   |
| Leasehold improvements                                                                                                              |       | 112                |       | 112 |   |
| Equipment                                                                                                                           |       | 6,830              |       | 6,638 |   |
| Accumulated  depreciation                                                                                                           |       | (5,230             | )          | (4,967 | ) |
|                                                                                                                                |       | 1,712              |       | 1,783 |   |
|                                                                                                                                |       |               |       |   |   |
| Deferred income taxes                                                                                                               |       | 2,533              |       | 818 |   |
| Intangible assets, net of accumulated amortization of $408 and $261  at March 31, 2007 and 2006, respectively                  |       | 404                |       | 551 |   |
| Goodwill                                                                                                                            |       | 27,774             |       | 27,774 |   |
| Other assets                                                                                                                        |       | 352                |       | 485 |   |
| Total assets                                                                                                                        |       | $                  | 55,250     |   | $ | 49,633 |   |

 

See accompanyingnotes.

43

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**Iteris, Inc.**

**Consolidated Balance Sheets**

**(In thousands, except share and pershare amounts)**
| ** **                                                                                                    | ** ** | **March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                    | ** ** | **2007**           | ** ** | **2006** | ** ** |
| Liabilities and  stockholders’ equity                                                                    |       |               |       |   |   |
| Current liabilities:                                                                                          |       |               |       |   |   |
| Trade accounts payable                                                                                        |       | $                  | 3,542      |   | $ | 3,620 |   |
| Accrued payroll and related expenses                                                                          |       | 3,527              |       | 3,481 |   |
| Accrued liabilities                                                                                           |       | 1,618              |       | 2,588 |   |
| Revolving line of credit                                                                                      |       | 4,015              |       | 2,662 |   |
| Billings in excess of costs and estimated earnings  on uncompleted contracts                                  |       | 847                |       | 893 |   |
| Current portion of long-term debt                                                                             |       | 1,947              |       | 1,969 |   |
| Total current  liabilities                                                                                    |       | 15,496             |       | 15,213 |   |
|                                                                                                          |       |               |       |   |   |
| Non-current  liabilities                                                                                      |       | 163                |       | 177 |   |
|                                                                                                          |       |               |       |   |   |
| Deferred  compensation plan liability                                                                         |       | 730                |       | 820 |   |
|                                                                                                          |       |               |       |   |   |
| Long-term debt                                                                                                |       | 350                |       | 2,171 |   |
|                                                                                                          |       |               |       |   |   |
| Convertible  debentures, net                                                                                  |       | 9,410              |       | 9,203 |   |
|                                                                                                          |       |               |       |   |   |
| Commitments and  contingencies                                                                                |       |               |       |   |   |
|                                                                                                          |       |               |       |   |   |
| Redeemable  common stock                                                                                      |       |               |       |   |   |
| Issued and outstanding shares — 1,219,445 at  March 31, 2007 and 2006                               |       | 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 — 30,600,717 at  March 31, 2007 and 27,431,502 at March 31, 2006 |       | 3,060              |       | 2,743 |   |
| Additional paid-in capital                                                                                    |       | 130,425            |       | 126,664 |   |
| Common stock held in trust — 310,510 shares at  March 31, 2007 and 2006                             |       | (374               | )          | (374 | ) |
| Notes receivable from employees                                                                               |       | (5                 | )          | (49 | ) |
| Accumulated deficit                                                                                           |       | (107,438           | )          | (110,356 | ) |
| Accumulated other comprehensive income                                                                        |       | 19                 |       | 7 |   |
| Total  stockholders’ equity                                                                              |       | 25,687             |       | 18,635 |   |
| Total liabilities and  stockholders’ equity                                                              |       | $                  | 55,250     |   | $ | 49,633 |   |

 

See accompanying notes.

44

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**Iteris, Inc.**

**Consolidated Statements of Operations**

**(In thousands, except per share amounts)**
| ** **                                               | ** ** | **Year Ended March 31,** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                               | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales and  contract revenues:                        |       |                                    |       |   |   |   |   |
| Net sales                                                |       | $                                       | 36,248     |   | $ | 31,156 |   | $ | 29,062 |   |
| Contract revenues                                        |       | 22,049                                  |       | 19,330 |   | 17,335 |   |
| Total net sales  and contract revenues                   |       | 58,297                                  |       | 50,486 |   | 46,397 |   |
|                                                     |       |                                    |       |   |   |   |   |
| Costs of net  sales and contract revenues:               |       |                                    |       |   |   |   |   |
| Cost of net sales (a)                                    |       | 19,829                                  |       | 16,493 |   | 15,925 |   |
| Cost of contract revenues (a)                            |       | 14,460                                  |       | 12,600 |   | 13,789 |   |
| Gross profit                                             |       | 24,008                                  |       | 21,393 |   | 16,683 |   |
| Operating  expenses:                                     |       |                                    |       |   |   |   |   |
| Selling, general and administrative (a)                  |       | 16,094                                  |       | 15,362 |   | 21,027 |   |
| Research and development (a)                             |       | 4,030                                   |       | 5,217 |   | 6,236 |   |
| Amortization of intangible assets                        |       | 147                                     |       | 147 |   | 114 |   |
| Deferred compensation expense (benefit)                  |       | (91                                     | )          | 48 |   | (484 | ) |
| Disposal of fixed assets                                 |       | —                                  |       | — |   | 422 |   |
| Acquired in-process research and development             |       | —                                  |       | — |   | 140 |   |
| Total operating expenses                                 |       | 20,180                                  |       | 20,774 |   | 27,455 |   |
| Operating income  (loss)                                 |       | 3,828                                   |       | 619 |   | (10,772 | ) |
| Non-operating  income (expense):                         |       |                                    |       |   |   |   |   |
| Other income (expense), net                              |       | (653                                    | )          | 35 |   | 1,054 |   |
| Interest expense, net                                    |       | (1,600                                  | )          | (1,459 | ) | (1,178 | ) |
| Income (loss)  before income taxes and minority interest |       | 1,575                                   |       | (805 | ) | (10,896 | ) |
| Income tax  benefit                                      |       | 1,343                                   |       | 885 |   | 94 |   |
| Minority  interest in earnings of subsidiary             |       | —                                  |       | — |   | (526 | ) |
| Net income  (loss)                                       |       | $                                       | 2,918      |   | $ | 80 |   | $ | (11,328 | ) |
|                                                     |       |                                    |       |   |   |   |   |
| Earnings (loss)  per share:                              |       |                                    |       |   |   |   |   |
| Basic                                                    |       | $                                       | 0.10       |   | $ | 0.00 |   | $ | (0.45 | ) |
| Diluted                                                  |       | $                                       | 0.09       |   | $ | 0.00 |   | $ | (0.45 | ) |
|                                                     |       |                                    |       |   |   |   |   |
| Weighted average  shares outstanding:                    |       |                                    |       |   |   |   |   |
| Basic                                                    |       | 29,698                                  |       | 28,182 |   | 25,284 |   |
| Diluted                                                  |       | 33,348                                  |       | 32,737 |   | 25,284 |   |

 

----

(a)             Includes stock-based compensation expense as follows:
| Cost of net  sales                           |   | $   | 13     |   | $      | 27    |   | $ | 280    |   |
|----------------------------------------------|--------|-----|--------|--------|--------|-------|--------|---|--------|--------|
| Cost of contract  revenues                   |   | 60  |   | 205    |   | 2,391 |   |
| Selling, general  and administrative expense |   | 195 |   | 364    |   | 7,063 |   |
| Research and  development expense            |   | 20  |   | 129    |   | 2,043 |   |
| Total  stock-based compensation expense      |   | $   | 288    |   | $      | 725   |   | $ | 11,777 |   |

 

See accompanying notes*.*

45

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**Iteris, Inc.**

**Consolidated Statements of Stockholders’Equity and ComprehensiveIncome**

**(In thousands)**
| ** **                                                               | ** ** | **Common Stock  Shares Outstanding** | ** ** | ** **               | ** ** | ** ** | ** ** | **Common**                       | ** ** | ** **                     | ** ** | **Notes**           | ** ** | ** **                      | ** ** | **Accumulated**          | ** ** | **Total**                        | ** ** | ** **                                | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------|------------|--------------------------|------------|------------|------------|----------------------------------|------------|--------------------------------|------------|---------------------|------------|---------------------------------|------------|--------------------------|------------|----------------------------------|------------|-------------------------------------------|------------|
| ** **                                                               | ** ** | **Class A  Shares**                       | ** ** | **Class B  Shares** | ** ** | **Amount** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Stock  Held in  Trust** | ** ** | **Treasury  Stock** | ** ** | **Receivable  From  Employees** | ** ** | **Accumulated  Deficit** | ** ** | **Other  Comprehensive  Income** | ** ** | **Stockholder’s  Equity  (Deficit)** | ** ** | **Comprehensive  Income  (Loss)** | ** ** |
| Balance at March 31,  2004                                          |       | 20,477                                         |       | 928                      |       | $          | 2,141      |                             | $          | 95,937                         |       | $                   | —     |                            | $          | (1                       | )          | $                                | (45        | )                                         | $          | (99,108 | ) | $ | — |   | $ | (1,076 | ) |   |   |
| 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              |       | —                                         |       | —                   |       | —     |       | 12,383                           |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 12,383                                    |       |   |   |
| Common stock held  in trust                                              |       | 310                                            |       | —                   |       | 31         |       | 343                              |       | (374                           | )          | —              |       | —                          |       | —                   |       | —                           |       | —                                    |       |   |   |
| Stock-based  compensation                                                |       | —                                         |       | —                   |       | —     |       | 508                              |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 508                                       |       |   |   |
| Net loss                                                                 |       | —                                         |       | —                   |       | —     |       | —                           |       | —                         |       | —              |       | —                          |       | (11,328                  | )          | —                           |       | (11,328                                   | )          | $ | (11,328 | ) |
| Balance at  March 31, 2005                                          |       | 27,090                                         |       | —                   |       | 2,709      |       | 125,609                          |       | (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                                        |       |   |   |
| Stock-based  compensation                                                |       | —                                         |       | —                   |       | —     |       | 725                              |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 725                                       |       |   |   |
| Retirement of  treasury stock                                            |       | —                                         |       | —                   |       | —     |       | (1                               | )          | —                         |       | 1                   |       | —                          |       | —                   |       | —                           |       | —                                    |       |   |   |
| Foreign currency  translation                                            |       | —                                         |       | —                   |       | —     |       | —                           |       | —                         |       | —              |       | —                          |       | —                   |       | 7                                |       | 7                                         |       | $ | 7 |   |
| Net income                                                               |       | —                                         |       | —                   |       | —     |       | —                           |       | —                         |       | —              |       | —                          |       | 80                       |       | —                           |       | 80                                        |       | 80 |   |
| Balance at  March 31, 2006                                          |       | 27,432                                         |       | —                   |       | 2,743      |       | 126,664                          |       | (374                           | )          | —              |       | (49                             | )          | (110,356                 | )          | 7                                |       | 18,635                                    |       | $ | 87 |   |
| Warrant exercises                                                        |       | 1,706                                          |       | —                   |       | 170        |       | 2,265                            |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 2,435                                     |       |   |   |
| Stock option  exercises                                                  |       | 1,374                                          |       | —                   |       | 138        |       | 982                              |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 1,120                                     |       |   |   |
| Issuance of  warrants                                                    |       | —                                         |       | —                   |       | —     |       | 22                               |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 22                                        |       |   |   |
| Stock-based  compensation                                                |       | —                                         |       | —                   |       | —     |       | 288                              |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 288                                       |       |   |   |
| Issuance of  common stock in connection with legal settlement            |       | 89                                             |       | —                   |       | 9          |       | 204                              |       | —                         |       | —              |       | —                          |       | —                   |       | —                           |       | 213                                       |       |   |   |
| Repayment of  notes receivable from employees                            |       | —                                         |       | —                   |       | —     |       | —                           |       | —                         |       | —              |       | 44                              |       | —                   |       | —                           |       | 44                                        |       |   |   |
| Foreign currency  translation                                            |       | —                                         |       | —                   |       | —     |       | —                           |       | —                         |       | —              |       | —                          |       | —                   |       | 12                               |       | 12                                        |       | $ | 12 |   |
| Net income                                                               |       | —                                         |       | —                   |       | —     |       | —                           |       | —                         |       | —              |       | —                          |       | 2,918                    |       | —                           |       | 2,918                                     |       | 2,918 |   |
| Balance at  March 31, 2007                                          |       | 30,601                                         |       | —                   |       | $          | 3,060      |                             | $          | 130,425                        |       | $                   | (374       | )                               | $          | —                   |       | $                                | (5         | )                                         | $          | (107,438 | ) | $ | 19 |   | $ | 25,687 |   | $ | 2,930 |   |

 

See accompanying notes.

46

----

**Iteris, Inc.**

**Consolidated Statements of Cash Flows**

**(In thousands)**
| ** **                                                                                           | ** ** | **Year Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                           | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Operating  activities**                                                                            |       |                                    |       |   |   |   |   |
| Net income  (loss)                                                                                   |       | $                                       | 2,918      |   | $ | 80 |   | $ | (11,328 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                                    |       |   |   |   |   |
| Change in deferred tax assets                                                                        |       | (1,419                                  | )          | (948 | ) | (200 | ) |
| Depreciation of property and equipment                                                               |       | 559                                     |       | 684 |   | 787 |   |
| Stock-based compensation                                                                             |       | 288                                     |       | 725 |   | 11,777 |   |
| Amortization of deferred gain on sale-leaseback                                                      |       | (284                                    | )          | (284 | ) | (609 | ) |
| Issuance of common stock in connection with legal settlement                                         |       | 213                                     |       | — |   | — |   |
| Amortization of debt discounts                                                                       |       | 207                                     |       | 207 |   | 184 |   |
| Amortization of intangible assets                                                                    |       | 147                                     |       | 147 |   | 114 |   |
| Amortization of deferred financing costs                                                             |       | 137                                     |       | 138 |   | 121 |   |
| Fair value of warrants issued for services                                                           |       | 22                                      |       | — |   | 26 |   |
| Minority interest in earnings of subsidiary                                                          |       | —                                  |       | — |   | 526 |   |
| Loss on disposal of assets                                                                           |       | —                                  |       | — |   | 422 |   |
| Write-off of acquired in-process research and  development                                           |       | —                                  |       | — |   | 140 |   |
| Changes in operating assets and liabilities:                                                         |       |                                    |       |   |   |   |   |
| Accounts receivable                                                                                  |       | (67                                     | )          | (2,560 | ) | (611 | ) |
| Net costs and estimated earnings in excess of  billings                                              |       | (1,042                                  | )          | (658 | ) | 961 |   |
| Inventories                                                                                          |       | (3,565                                  | )          | 1,530 |   | (746 | ) |
| Prepaid expenses and other assets                                                                    |       | 19                                      |       | 109 |   | 41 |   |
| Accounts payable and accrued expenses                                                                |       | (182                                    | )          | 1,048 |   | (789 | ) |
| Deferred revenue                                                                                     |       | —                                  |       | — |   | (226 | ) |
| Net cash  provided by (used in) operating activities                                                 |       | (2,049                                  | )          | 218 |   | 590 |   |
|                                                                                                 |       |                                    |       |   |   |   |   |
| **Investing  activities**                                                                            |       |                                    |       |   |   |   |   |
| Purchases of  property and equipment                                                                 |       | (488                                    | )          | (1,258 | ) | (670 | ) |
| Notes receivable                                                                                     |       | —                                  |       | — |   | 125 |   |
| Acquisition  costs                                                                                   |       | —                                  |       | — |   | (80 | ) |
| Net cash used in  investing activities                                                               |       | (488                                    | )          | (1,258 | ) | (625 | ) |
|                                                                                                 |       |                                    |       |   |   |   |   |
| **Financing  activities**                                                                            |       |                                    |       |   |   |   |   |
| Proceeds from  borrowings on lines of credit, net                                                    |       | 1,353                                   |       | 1,717 |   | 845 |   |
| Proceeds from  long-term debt                                                                        |       | —                                  |       | — |   | 5,000 |   |
| Payments on  long-term debt                                                                          |       | (1,843                                  | )          | (1,314 | ) | (1,038 | ) |
| Credit facility  commitment fees                                                                     |       | (40                                     | )          | — |   | — |   |
| Checks drawn in  excess of available bank balances                                                   |       | (628                                    | )          | 389 |   | 268 |   |
| Proceeds from  stock option and warrant exercises                                                    |       | 3,555                                   |       | 333 |   | 501 |   |
| Proceeds from  notes receivable from employees                                                       |       | 44                                      |       | — |   | — |   |
| Proceeds from  issuance of convertible debentures                                                    |       | —                                  |       | — |   | 9,436 |   |
| Purchase of  Iteris subsidiary Series A preferred stock                                         |       | —                                  |       | — |   | (17,543 | ) |
| Net cash  provided by (used in) financing activities                                                 |       | 2,441                                   |       | 1,125 |   | (2,531 | ) |
| Increase  (decrease) in cash                                                                         |       | (96                                     | )          | 85 |   | (2,566 | ) |
| Cash and cash  equivalents at beginning of year                                                      |       | 131                                     |       | 46 |   | 2,612 |   |
| Cash and cash  equivalents at end of year                                                            |       | $                                       | 35         |   | $ | 131 |   | $ | 46 |   |
|                                                                                                 |       |                                    |       |   |   |   |   |
| **Supplemental  cash flow information:**                                                             | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid  (received) during the period:                                                             |       |                                    |       |   |   |   |   |
| Interest                                                                                             |       | $                                       | 1,263      |   | $ | 1,095 |   | $ | 747 |   |
| Income taxes                                                                                         |       | 39                                      |       | (2 | ) | 624 |   |
|                                                                                                 |       |                                    |       |   |   |   |   |
| **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 |   |

 

See accompanying notes.

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**Iteris, Inc.Notes to Consolidated Financial StatementsMarch 31,2007**

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

**Description of Business**

Iteris, Inc.,formerly known as Iteris Holdings, Inc. (the “Company”), is a leadingprovider of outdoor machine vision systems and sensors that optimize the flowof traffic and enhance driver safety. Using proprietary software andIntelligent Transportation Systems (“ITS”) industry expertise, the Companyprovides video sensor systems, transportation management and travelerinformation systems and other engineering and consulting services to the ITSindustry. The ITS industry is comprised of companies applying a variety oftechnologies to enable the safe and efficient movement of people and goods. TheCompany uses its outdoor image recognition software expertise to developproprietary algorithms for video sensor systems that improve vehicle safety andthe flow of traffic. Using its knowledge of the ITS industry, the Companydesigns and implements transportation management systems that help publicagencies reduce traffic congestion and provide greater access to travelerinformation. On October 22, 2004, the Company completed the merger withits majority-owned subsidiary, Iteris, Inc. (the “Iteris Subsidiary”), andofficially changed the Company’s corporate name from Iteris Holdings, Inc.to Iteris, Inc. (Note 3). The Company was originally incorporated inDelaware in 1987 as Odetics, Inc. and in September 2003 changed itsname to Iteris Holdings, Inc. to reflect its focus on the ITS industry andits capital structure at that time.

**Basis of Presentation**

Theaccompanying consolidated financial statements include the accounts of theCompany and its subsidiaries. All significant intercompany accounts andtransactions have been eliminated in consolidation.

**Use of Estimates**

Thepreparation of consolidated financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makecertain estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosures of contingent assets and liabilities at thedate of the financial statements, and reported amounts of revenues and expensesduring the reporting period. Actual results could differ from those estimates.Significant estimates made in the preparation of the consolidated financialstatements include the allowance for doubtful accounts, deferred tax assets,inventory and warranty reserves, costs to complete long-term contracts,overhead rates used in cost-plus contracts, contract reserves, the valuation ofequity instruments and estimates of future cash flows used to assess the recoverabilityof long-lived assets and the realization of goodwill.

**Reclassifications**

Certainreclassifications have been made to the prior year financial statements toconform to the current year presentation.

**RevenueRecognition**

Product revenuesand related costs of sales are recognized upon the transfer of title, whichgenerally occurs upon shipment or, if required, upon acceptance by thecustomer, provided that the Company believes collectibility of the net salesamount is reasonably assured. Accordingly, at the date revenue is recognized,the significant uncertainties concerning the sale have been resolved.

Contract revenuesare derived primarily from long-term contracts with governmental agencies.Contract revenues include costs incurred plus a portion of estimated fees orprofits determined on the percentage of completion method of accounting basedon the relationship of costs incurred to total estimated costs. Any anticipatedlosses on contracts are charged to earnings when identified. Changes in job performanceand estimated profitability, including those arising from contract penaltyprovisions and final contract settlements, may result in revisions to costs andrevenues and are recognized in the period in which the revisions aredetermined. Profit incentives are included in revenue when their realization isreasonably assured.

In addition toproduct and contract revenue, the Company derives revenue from technologyaccess fees, the provision of specific non-recurring contract engineeringservices and royalties. Technology access fee revenues are recognized evenlyover the period in which they are earned. Non-recurring contract engineeringrevenues are recognized in the period in which the related services areperformed. Royalty revenues are recorded in the period in which the royalty isearned, based on unit

48

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salesof the Company’s products. Technology access fee revenues, contract engineeringrevenues and royalty revenues are included in net sales in the accompanyingconsolidated statements of operations.

Revenues fromfollow-on service and support, for which the Company charges separately, arerecorded in the period in which the services are performed.

**Concentration of Credit Risk**

Accountsreceivable are derived from revenues earned from customers located throughoutNorth America and Europe. The Company generally does not require collateral orother security from customers. Collectibility of receivable balances isestimated through review of invoices outstanding greater than a certain periodof time and ongoing credit evaluations of customers’ financial condition.Reserves are maintained for potential credit losses, and such losses havehistorically been within management’s expectations.

At March 31,2007 and 2006, accounts receivable from governmental agencies and primegovernment contractors were approximately $5.2 million and $4.4 million,respectively. No customer or government agency had a receivable balance atMarch 31, 2007 or 2006 greater than 10% of our total net sales and contractrevenues for the years ended March 31, 2007 and 2006.

**Fair Values of Financial Instruments**

Thefair value of cash and cash equivalents, receivables, inventories, accountspayable and accrued expenses approximate carrying value because of the shortperiod of time to maturity. The fair value of line of credit agreements andlong-term debt approximate carrying value because the related rates of interestapproximate current market rates. The fair value of convertible debenturesapproximates carrying value because the effective interest rate, taking intoaccount recorded debt discounts, approximates current market rates. AtMarch 31, 2005, the fair value of redeemable common stock approximatedcarrying value since these shares were not tradable in any public equity markets.At March 31, 2007 and 2006, the estimated fair value of the redeemableshares was $2.8 million and $3.2 million, respectively, based on the closingprice of the Company’s common stock on that date.

**Cash and Cash Equivalents**

Cash and cashequivalents consist of cash and short-term investments with initial maturitiesof ninety days or less.

**Inventories**

Inventoriesare stated at the lower of cost or market. Cost is determined using thefirst-in, first-out method.

**Property and Equipment**

Property and equipment are recorded at cost and aredepreciated over the estimated useful life ranging from three to eightyears.  Leasehold improvements aredepreciated over the term of the related lease or the estimated useful life ofthe improvement, whichever is shorter. Beginning April 1, 2006, the Company began depreciating property andequipment using the straight-line method of depreciation, which the Companybelieves more closely approximates the usage of the underlying assets, whichgenerally provide value evenly througout the estimated life.  Prior to this date, the Company used thedouble declining balance method of depreciation.  As a result of this change in estimate,depreciation expense declined by $455,000 for the year ended March 31, 2007,resulting in a $0.02 per share impact on basic and diluted earnings per share.

**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 on an annualbasis in the Company’s fourth fiscal quarter or more frequently if indicatorsof impairment exist, of which none have been identified.  The performance of the test involves atwo-step process.  The first step of theimpairment test involves comparing the fair value of the Company’s reportingunits with each respective reporting unit’s carrying amount, includinggoodwill.  The Company determines thefair value of reporting units using the income approach.  If the carrying amount of a reporting unitexceeds the reporting unit’s fair value, the second step of the goodwillimpairment test is performed to determine the amount of any impairmentloss.  The second step of the goodwill 

49

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impairmenttest involves comparing the implied fair value of the reporting unit’s goodwillwith the carrying amount of that 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 areperformed to determine whether the carrying value of assets is impaired, basedon a comparison to undiscounted expected future cash flows.  If this comparison indicates that there isimpairment, the impaired asset is written down to fair value, which is typicallycalculated using discounted expected future cash flows and a discount ratebased upon the Company’s weighted average cost of capital adjusted for risksassociated with the related operations. Impairment is based on the excess of the carrying amount over the fairvalue 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 theliability method, deferred taxes are determined based on the temporarydifferences between the financial statement and tax bases of assets andliabilities using enacted tax rates.  Avaluation allowance is recorded when it is more likely than not that all or aportion of the deferred tax assets will not be realized. See Note 6.

## **Stock-BasedCompensation**

EffectiveApril 1, 2006, the Company adopted SFAS No. 123 (revised 2004), *Share-Based Payment* (“SFAS 123R”), which replaced SFAS No.123, *Accounting for Stock-Based Compensation*(“SFAS 123”), superceded Accounting Principles Board Opinion No. 25 (“APB 25”),and amended SFAS No. 95, *Statement of Cash Flows*.  Prior to April 1, 2006, the Company followedthe disclosure-only provisions of SFAS 123, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation – Transition and Disclosure*,**and, accordingly, accounted for its stock-basedcompensation plans using the intrinsic value method under APB 25 and relatedinterpretations.

SFAS123R requires all stock-based payments, including grants of employee stock options,to be recognized in the statement of operations as an expense, based on theirgrant date fair values with such fair values amortized over the requisiteservice period.  The Company elected touse the modified prospective transition method for transition to SFAS123R.  Under the modified prospectivemethod, SFAS 123R applies to all awards granted or modified after the date ofadoption.  In addition, under themodified prospective method, compensation expense will be recognized for allstock-based compensation awards granted prior to but not yet vested as of April1, 2006, based on grant-date fair values estimated in accordance with theoriginal provisions of SFAS 123. Accordingly, prior period amounts presented herein have not beenrestated to reflect the adoption of SFAS 123R.

The fair valueconcepts were not changed significantly as a result of implementing SFAS 123R;however, in adopting SFAS 123R, companies must choose among alternativevaluation models and amortization assumptions. After assessing alternativevaluation models and amortization assumptions, the Company continued to useboth the Black-Scholes-Merton (“BSM”) option-pricing formula and straight-lineamortization of compensation expense over the requisite service period of stockoption grants.  The Company willreconsider use of this model if additional information becomes available in thefuture that indicates another model would be more appropriate, or if grantsissued in future periods have characteristics that cannot be reasonably estimatedusing this model.  SFAS 123 did notrequire the estimation of forfeitures in the calculation of stock compensationexpense; however, SFAS 123R does require such estimation and upon adoption ofSFAS 123R, the Company changed its methodology to include an estimate offorfeitures.

In addition, in accordance with SFAS 123R,SFAS 109 and EITF Topic D-32, *IntraperiodTax Allocation of the Tax Effect of Pretax Income from Continuing Operations*,the Company has elected to recognize excess income tax benefits from stockoption exercises in additional paid-in capital only if an incremental incometax benefit would be realized after considering all other tax attributespresently available to the Company. The Company measures the tax benefitassociated with excess tax deductions related to stock-based compensationexpense by multiplying the excess tax deductions by the statutory tax rates.

As a result ofimplementing SFAS 123R, the Company recognized incremental stock-basedcompensation expense of $208,000 for the year ended March 31, 2007, whichreduced income before taxes and net income by $208,000, and reduced basic and dilutedearnings per share by $0.01 for the year ended March 31, 2007.  The adoption of SFAS 123R had no effect oncash flows from operating activities because no tax benefits are realized 

50

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fromstock option exercises. The adoption of SFAS 123R also had no effect on cashflows from financing activities because the Company did not realize any excesstax benefits from stock option exercises.

The followingtable illustrates the effect on net income (loss) and earnings (loss) per sharefor the years ended March 31, 2006 and 2005 as if the Company had applied thefair value recognition provisions of SFAS 123R to options granted under theCompany’s stock option plans.  Forpurposes of this pro forma disclosure, the fair value of the options wasestimated using the BSM option-pricing formula and amortized on a straight-linebasis to expense over the options’ vesting period:
| ** **                                                                                              | ** ** | **Year Ended March 31,**                               | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2006**                                                              | ** ** | **2005** | ** ** |
| ** **                                                                                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Net income (loss) — as reported                                                                    |       | $                                                                     | 80         |   | $ | (11,328 | ) |
| Add: Stock-based compensation expense included in  net income (loss) — as reported                 |       | 725                                                                   |       | 11,777 |   |
| Deduct: Total stock-based compensation expense  determined under fair value based method for all awards |       | (1,108                                                                | )          | (12,806 | ) |
| Net income (loss) — pro forma                                                                      |       | $                                                                     | (303       | ) | $ | (12,357 | ) |
|                                                                                                    |       |                                                                  |       |   |   |
| Basic and diluted earnings (loss) per share — as  reported                                         |       | $                                                                     | 0.00       |   | $ | (0.45 | ) |
| Basic and  diluted loss per share — pro forma                                                      |       | $                                                                     | (0.01      | ) | $ | (0.49 | ) |

 

**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.

**Sales Taxes**

Sales taxes are presented on a net basis (excludedfrom net sales and contract revenues) in the consolidated statements ofoperations.

**AdvertisingExpenses**

Advertisingcosts are expensed in the period incurred and totaled $152,000, $185,000 and$112,000 in the years ended March 31, 2007, 2006 and 2005, respectively.

**Warranty**

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

**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.

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**RecentAccounting Pronouncements**

In July 2006, the Financial Accounting Standards Board(the “FASB”) issued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”).  FIN 48 clarifies the accounting and reportingfor income taxes recognized in accordance with SFAS 109.  This Interpretation prescribes acomprehensive model for the financial statement recognition, measurement,presentation and disclosure of uncertain tax positions taken or expected to betaken in income tax returns.  The Companyis currently evaluating the impact of FIN 48 and will adopt this Interpretationin the first quarter of its fiscal year ending March 31, 2008.

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements* (“SFAS 157”), which defines fairvalue, establishes a framework for measuring fair value, and expands disclosureabout fair value measurements. SFAS 157 does not require any new fair valuemeasurements; rather it specifies valuation methods to be applied when fairvalue measurements are required under existing or future accountingpronouncements. SFAS 157 is effective for fiscal years beginning after November15, 2007, and interim periods within those fiscal years. Early application ofthe statement is encouraged. Generally, this statement will be appliedprospectively. The Company is currently evaluating the impact of SFAS 157 andexpects to adopt SFAS 157 in the first quarter of its fiscal year ending March31, 2009.

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities —Including an Amendment of FASB Statement No. 115* (“SFAS 159”). SFAS159 permits entities to choose to measure many financial instruments andcertain other items at fair value. Unrealized gains and losses on items forwhich the fair value option has been elected will be recognized in earnings ateach subsequent reporting date. SFAS 159 is effective for financial statementsissued for fiscal years beginning after November 15, 2007.  The Company is evaluating the impact that theadoption of SFAS 159 will have on its results of operations and financialcondition and expects to adopt SFAS 159 in its fiscal year ending March 31,2009.

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

**Inventories**

Thefollowing table presents details regarding the Company’s inventories:
|                         | ** ** | **March 31,**      | ** ** |
|-------------------------|------------|-------------------------|------------|
| ** **              | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **              | ** ** | **(In thousands)** | ** ** |
| Materials and  supplies |       | $                       | 4,705      |   | $ | 2,258 |   |
| Work in process         |       | 366                     |       | 217 |   |
| Finished goods          |       | 1,308                   |       | 339 |   |
|                    |       | $                       | 6,379      |   | $ | 2,814 |   |

 

**Goodwill and Intangible Assets**
|                                             | ** ** | **March 31, 2007** | ** ** | **March 31, 2006**  | ** ** |
|---------------------------------------------|------------|------------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **Gross  Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** |
| ** **                                  | ** ** | **(In thousands)**      | ** ** |
| Intangible  assets subject to amortization: |       |                         |       |                          |       |   |   |   |   |
| Developed Technology                        |       | $                            | 495        |                          | $          | (280 | ) | $ | 495 |   | $ | (179 | ) |
| Patents                                     |       | 317                          |       | (128                          | )          | 317 |   | (82 | ) |
| Total                                       |       | $                            | 812        |                          | $          | (408 | ) | $ | 812 |   | $ | (261 | ) |

 

Amortization expense forintangible assets subject to amortization was $147,000 for the years endedMarch 31, 2007 and 2006 and $114,000 for the year ended March 31, 2005.Future estimated amortization expense for the next five years is as follows:
| Year Ending March 31: | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
| **(In thousands)**              | ** ** | ** ** | ** ** |
| 2008                                 |       | $          | 147        |   |
| 2009                                 |       | 147        |       |
| 2010                                 |       | 58         |       |
| 2011                                 |       | 46         |       |
| 2012                                 |       | 6          |       |
|                                 |       | $          | 404        |   |

 

At March 31, 2007,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 complementaryproduct to the Company’s Vantage video detection business.

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**Warranty Reserve Activity**

The following table presentsactivity in accrued warranty obligations:
|                                    | ** ** | **Year  Ended March 31,** | ** ** |
|------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2007**                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | **(In thousands)**             | ** ** |
| Balance at  beginning of year      |       | $                                   | 519        |   | $ | 326 |   | $ | 192 |   |
| Additions charged to cost of sales |       | 630                                 |       | 517 |   | 614 |   |
| Warranty claims                    |       | (629                                | )          | (324 | ) | (480 | ) |
|                               |       |                                |       |   |   |   |   |
| Balance at end of year             |       | $                                   | 520        |   | $ | 519 |   | $ | 326 |   |

 

**Earnings (Loss) Per Share**

Thefollowing table sets forth the computation of basic and diluted income (loss)per share:
| ** **                                                   | ** ** | **Year Ended March 31,**                               | ** ** |
|--------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                   | ** ** | **2007**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                   | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Numerator:                                                   |       |                                                                  |       |   |   |   |   |
| Net income (loss)                                            |       | $                                                                     | 2,918      |   | $ | 80 |   | $ | (11,328 | ) |
|                                                         |       |                                                                  |       |   |   |   |   |
| Denominator:                                                 |       |                                                                  |       |   |   |   |   |
| Weighted average common shares used in basic  computation    |       | 29,698                                                                |       | 28,182 |   | 25,284 |   |
| Dilutive stock options                                       |       | 3,346                                                                 |       | 3,818 |   | — |   |
| Dilutive warrants                                            |       | 304                                                                   |       | 737 |   | — |   |
| Weighted average common shares used in dilutive  computation |       | 33,348                                                                |       | 32,737 |   | 25,284 |   |
|                                                         |       |                                                                  |       |   |   |   |   |
| Earnings (loss)  per share:                                  |       |                                                                  |       |   |   |   |   |
| Basic                                                        |       | $                                                                     | 0.10       |   | $ | 0.00 |   | $ | (0.45 | ) |
| Diluted                                                      |       | $                                                                     | 0.09       |   | $ | 0.00 |   | $ | (0.45 | ) |

 

The following shares wereexcluded from the computation of diluted earnings (loss) per share as theireffect would have been anti-dilutive:
|                        | ** ** | **Year Ended March 31,** | ** ** |
|------------------------|------------|-----------------------------------------|------------|
| ** **             | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **             | ** ** | **(In thousands)**                 | ** ** |
| ** **             | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options          |       | 582                                     |       | 470 |   | 4,560 |   |
| Warrants               |       | 1,240                                   |       | 1,265 |   | 1,095 |   |
| Convertible debentures |       | 2,729                                   |       | 2,729 |   | 2,729 |   |

 

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**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 theSeries A preferred stock of the Iteris Subsidiary (the “Series Apreferred stock”), which were held by DaimlerChrysler Ventures GmbH (“DCV”) andHockenheim Investment Pte. Ltd. (“Hockenheim”), in exchange for approximately$17.5 million in cash. In addition, the Company acquired all of the 547,893shares of common stock of the Iteris Subsidiary held by DCV in exchange for theissuance of 1,219,445 shares of the Company’s Class A common stock (nowknown as the Company’s common stock) which was valued at $3.4 million at thedate of issuance. 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 theOTC Bulletin Board averaged over a five-day period. The purchase and exchangeof the shares were made pursuant to a Stock Purchase and Exchange Agreementdated March 31, 2004, by and among the Company, the Iteris Subsidiary, DCVand Hockenheim (the “Purchase and 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.The purchase of the shares was financed primarily with a $10.1 millionconvertible debenture financing completed in May 2004 with a group ofaccredited investors, in addition to a $5.0 million senior credit facilityarranged through a bank and $2.4 million in cash (Note 5).

OnJune 30, 2004, the Company and certain minority stockholders of the IterisSubsidiary (including certain officers and directors) entered into an exchangeagreement whereby an aggregate of 1,319,541 shares of common stock of theIteris Subsidiary were exchanged for 2,639,082 shares of the Company’s newlyissued common stock valued at $8.6 million at the date of issuance. The fairvalue of the Company’s 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. The effect of this exchange was to reduce the residualminority interest in the Iteris Subsidiary to 8.1%.

OnOctober 22, 2004, the Iteris Subsidiary was merged into the Company. Theremaining 8.1% minority interest in the Iteris Subsidiary (consisting of1,228,981 shares of common stock of the Iteris Subsidiary) was converted to2,457,962 shares of the Company’s common stock valued at $7.6 million at themerger date. Immediately following the merger, the Company converted all of itsoutstanding Class B common stock (921,917 shares) into 1,014,108 shares ofits common stock (formerly designated as Class A common stock). Theexchange ratio used in conversion was determined by the Company’s Board ofDirectors. The fair value of the Company’s common stock issued in thetransaction was based on the quoted market price of the Company’s common stockon the OTC Bulletin Board averaged over a five-day period. In October 2004,the Company also amended its certificate of incorporation to (a) changethe voting rights of its common stock from one-tenth to one vote per share,(b) remove the ability to issue any further shares of Class B commonstock, and (c) rename its Class A common stock to common stock. As aresult, the Company currently has only one class 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 be subjectto, the same terms and conditions as were applicable immediately prior to themerger, provided that (A) such option or warrant shall be exercisable forthat number of whole shares of the Company’s common stock equal to the productof the number of shares of the Company’s common stock that were issuable uponexercise of such assumed option or warrant immediately prior to the mergermultiplied by two (2) (the “Exchange Ratio”) rounded down to the nearestwhole number of shares and (B) the per share exercise price for the sharesof the Company’s common stock issuable upon exercise of such assumed option orwarrant is equal to the quotient determined by dividing the exercise price pershare at which such option or warrant was exercisable immediately prior to themerger by the Exchange Ratio (rounded up to the nearest whole cent). As aresult, options and warrants to purchase approximately 3.1 million sharesand 327,000 shares, respectively, of common stock of the Iteris Subsidiaryassumed in the merger became options and warrants to purchase approximately6.1 million and 654,000 shares, respectively, of common stock of theCompany. The weighted-average exercise prices of the assumed options andwarrants were $1.09 and $2.32, respectively. Stock-based compensation expenseof $11.3 million was recorded in connection with the assumption and exchange ofvested Iteris Subsidiary stock options for stock options immediatelyexercisable into the Company’s common stock based on the difference between thefair market value of the Company’s common stock on the October 22, 2004merger date and the exercise price of the modified stock option. Additionally,the Company recorded approximately $1.4 million in deferred compensationrelated to the assumption of

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unvestedstock options to purchase common stock of the Iteris Subsidiary. Deferredcompensation was amortized to stock-based compensation expense as the optionsvested; and all such options were fully vested at March 31, 2007.  The Company also recorded $1.1 million ofgoodwill and additional paid-in-capital in connection with the 654,000 vestedwarrants assumed in the merger and acquisition of the Iteris Subsidiary. The$1.1 million value was based on the difference between the fair market value ofthe Company’s common stock on the October 22, 2004 merger date andmodified 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 |

The followingtable summarizes fair values of the assets acquired and liabilities assumed andthe allocation 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                                                      |   | $      | 317    |   |
| 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)                   |   | 17,968 |   |
| Total purchase price  allocation                             |   | $      | 37,354 |   |

 

OnOctober 22, 2004, in connection with the Company’s merger with the IterisSubsidiary, the Chief Executive Officer of the Iteris Subsidiary was promotedto President and Chief Executive Officer of the Company, replacingMr. Gregory Miner. This merger triggered certain obligations under theCompany’s change-in-control agreement with Mr. Miner. Accordingly, theCompany recorded approximately $807,000 in severance expense, which included$57,000 for related payroll taxes, as a charge to operations for the year endedMarch 31, 2005. The severance amount was paid to Mr. Miner inbi-weekly installments over 30 months, and the final payment was made in April2007.

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**4.****                                     Costsand Estimated Earnings on Uncompleted Contracts**

Costs incurred, estimatedearnings and billings on uncompleted long-term contracts are as follows:
| ** **                                                                   | ** ** | **March 31,**      | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                   | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                                                                   | ** ** | **(In thousands)** | ** ** |
| Total estimated  contract value                                              |       | $                       | 74,794     |   | $ | 74,990 |   |
|                                                                         |       |                    |       |   |   |
| Costs incurred  on uncompleted contracts                                     |       | $                       | 20,688     |   | $ | 18,233 |   |
| Estimated earnings                                                           |       | 2,069                   |       | 1,823 |   |
|                                                                         |       | 22,757                  |       | 20,056 |   |
| Less billings to date                                                        |       | (19,915                 | )          | (18,256 | ) |
|                                                                         |       | $                       | 2,842      |   | $ | 1,800 |   |
|                                                                         |       |                    |       |   |   |
| Included in  accompanying consolidated balance sheets:                       |       |                    |       |   |   |
| Costs and estimated earnings in excess of billings  on uncompleted contracts |       | $                       | 3,689      |   | $ | 2,693 |   |
| Billings in excess of costs and estimated earnings  on uncompleted contracts |       | (847                    | )          | (893 | ) |
|                                                                         |       | $                       | 2,842      |   | $ | 1,800 |   |

 

Costsand estimated earnings in excess of billings at March 31, 2007 and 2006include $786,000 and $806,000, respectively, that were not billable as certainmilestone objectives specified in the contracts had not been attained.Substantially all costs and estimated earnings in excess of billings atMarch 31, 2007 are expected to be billed and collected during the yearending March 31, 2008.

**5.****                                     RevolvingLine of Credit and Long-Term Debt**

**Revolving Line of Credit**

OnMay 28, 2004, the Iteris Subsidiary entered into a line of creditagreement with its former bank, which provided for a maximum available creditline of $5.0 million. This line of credit was assumed by the Company inOctober 2004 and expired on October 31, 2006.

In October 2006,the Company replaced its former credit facility and entered into a new two-yearcredit facility with a different bank. The new facility provides for combined line of credit and term noteborrowings of up to $8.0 million.  Underthe new credit facility, the Company may borrow against its eligible accountsreceivable and eligible inventory, as defined in the credit agreement.  Line of credit interest on borrowed amountsis payable monthly at the current stated prime rate plus 1.25%.  Additionally, the Company is obligated to payan unused line fee of 0.25% per annum applied to the amount by which themaximum credit amount exceeds the average daily principal balance during thepreceding month. The new credit facility requires $2,000 in monthly collateralmanagement fees and includes an early termination fee equal to 2% of the totalfacility during the first year of the agreement and 1% of the total facility inthe second year of the agreement. Additionally, the Company paid a commitment fee of $40,000 in October2006 and is obligated to pay an additional $40,000 on the one-year anniversaryof the facility. The new credit facility is secured by substantially all of theassets of the Company.

On March 31, 2007,the available credit under the credit facility was $8.0 million, of which $2.4million was unused.

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**Long-Term Debt**

Long-term debt consists of the following:
|                              | ** ** | **March 31,**      | ** ** |
|------------------------------|------------|-------------------------|------------|
| ** **                   | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                   | ** ** | **(In thousands)** | ** ** |
| Convertible  debentures, net |       | $                       | 9,410      |   | $ | 9,203 |   |
| Bank term note               |       | 1,573                   |       | 2,708 |   |
| Promissory note  to landlord |       | 646                     |       | 1,292 |   |
| Other                        |       | 78                      |       | 140 |   |
|                         |       | 11,707                  |       | 13,343 |   |
| Less current  portion        |       | (1,947                  | )          | (1,969 | ) |
|                         |       | $                       | 9,760      |   | $ | 11,374 |   |

 

*ConvertibleDebentures, Net.*In order to finance the purchase of theIteris Subsidiary Series A preferred stock (Note 3), the Company enteredinto a Debenture and Warrant Purchase Agreement dated May 19, 2004 (the “Debentureand Warrant Purchase Agreement”), with a group of accredited investors, whichincluded certain officers of the Company, pursuant to which the Company soldand issued subordinated convertible debentures in the aggregate originalprincipal amount of $10.1 million. In connection with the issuance of theconvertible debentures, the Company issued detachable warrants to purchase anaggregate of 639,847 shares of its common stock (Note 9), the value of whichwas recorded as a debt discount against the face amount of the debentures onthe date of issuance and is being amortized to interest expense over the termof the convertible debentures.

Thedebentures are due in full on May 19, 2009, provide for 6.0% annualinterest, payable quarterly, and are convertible at the holder’s option intothe Company’s common stock at an initial conversion price of $3.61 per share,subject to certain adjustments, including adjustments for dilutive issuances.From May 19, 2007, until May 18, 2008, the debentures may be redeemedby the Company, at its option, at 120% of the principal amount being redeemed;and from May 19, 2008, until the maturity date, the debentures may beredeemed at 110% of the principal amount being redeemed. During the year endedMarch 31, 2005, $250,000 of convertible debentures were converted into69,252 shares of common stock leaving $9.9 million of the originally issuedconvertible debentures outstanding at March 31, 2007 and 2006.

*Bank TermNote.*Concurrent with the Company’s issuance of theconvertible debentures, the Iteris Subsidiary entered into a $5.0 million termnote with a bank. This note was assumed by the Company in October 2004.The proceeds from the note were used to purchase the Series A preferredstock of the Iteris Subsidiary (Note 3). The note was due on May 27, 2008,and provided for monthly principal payments of approximately $104,000.  Interest accrued at the current stated primerate plus 0.25%.  In October 2006, theterm note was transferred to the Company’s new bank as part of the Company’snew $8.0 million credit facility. The new term note is also due on May 27, 2008and provides for monthly principal payments of approximately $104,000.  Interest accrues under the new term note atthe current stated prime rate plus 1.25%. Amounts due under the term note reduce the Company’s ability to borrowagainst its eligible assets on its line of credit.

Both the new bankterm note and the new line of credit are held by one bank under the same creditagreement and are secured by substantially all of the assets of the Company.

*PromissoryNote to Landlord.*The Company has a $1.3 million unsecuredpromissory note payable to the landlord of its Anaheim headquarters.  Under the terms of the note agreement,interest is payable quarterly and accrues at a rate of prime plus 2.0% (10.25%at March 31, 2007).  In October 2006, January2007 and April 2007, the Company made the first three of four required equalquarterly principal payments of $323,000. All outstanding accrued interest and principal are payable in full onJuly 1, 2007.

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Scheduled aggregate maturities of long-term debtprincipal as of March 31, 2007 were as follows:
| Year Ending March 31, | ** ** | ** ** | ** ** |
|--------------------------------------|------------|------------|------------|
| **(In thousands)**              | ** ** | ** ** | ** ** |
| 2008                                 |       | $          | 1,947      |   |
| 2009                                 |       | 350        |       |
| 2010                                 |       | 9,850      |       |
|                                 |       | 12,147     |       |
| Less:  unamortized debt discount     |       | (440       | )          |
|                                 |       | $          | 11,707     |   |

 

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

The reconciliation of the Company’s income tax benefitto taxes computed at U.S. federal statutory rates is as follows:
|                                                                            | ** ** | **Year Ended March 31,** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                 | ** ** | **(In thousands)**                 | ** ** |
| Income tax  (benefit) provision at statutory rates                         |       | $                                       | 536        |   | $ | (284 | ) | $ | (3,705 | ) |
| State income  taxes net of federal benefit                                 |       | (147                                    | )          | (85 | ) | (72 | ) |
| Change in  valuation allowance associated with federal deferred tax assets |       | (1,895                                  | )          | (892 | ) | (755 | ) |
| Compensation  charges                                                      |       | —                                  |       | 222 |   | 3,692 |   |
| Adjustment to  prior year deferred taxes                                   |       | —                                  |       | — |   | 229 |   |
| Expiration of  unused credits                                              |       | —                                  |       | — |   | 266 |   |
| AMT and foreign  taxes                                                     |       | 24                                      |       | 46 |   | — |   |
| Other permanent  differences                                               |       | 139                                     |       | 108 |   | 251 |   |
| Income tax benefit                                                         |       | $                                       | (1,343     | ) | $ | (885 | ) | $ | (94 | ) |

 

The components of deferred tax assets and liabilitiesare as follows:
|                                          | ** ** | **March 31,**      | ** ** |
|------------------------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **2007**                | ** ** | **2006** | ** ** |
| ** **                               | ** ** | **(In thousands)** | ** ** |
| Deferred tax  assets:                    |       |                    |       |   |   |
| Net operating losses                     |       | $                       | 18,806     |   | $ | 18,061 |   |
| Property and equipment                   |       | —                  |       | 623 |   |
| Credit carry forwards                    |       | 1,401                   |       | 1,356 |   |
| Deferred compensation and payroll        |       | 2,032                   |       | 1,770 |   |
| Bad debt allowances and other reserves   |       | 524                     |       | 410 |   |
| Acquired intangibles                     |       | 67                      |       | — |   |
| Other, net                               |       | —                  |       | 124 |   |
| Total deferred  tax assets               |       | 22,830                  |       | 22,344 |   |
| Valuation  allowance                     |       | (19,543                 | )          | (20,516 | ) |
| Net deferred tax  assets                 |       | 3,287                   |       | 1,828 |   |
|                                     |       |                    |       |   |   |
| Deferred tax  liabilities:               |       |                    |       |   |   |
| Other, Net                               |       | (135                    | )          | — |   |
| Property and equipment                   |       | (125                    | )          | — |   |
| Acquired intangibles                     |       | —                  |       | (220 | ) |
| Total deferred  tax liabilities          |       | (260                    | )          | (220 | ) |
| Net deferred tax  assets                 |       | $                       | 3,027      |   | $ | 1,608 |   |
|                                     |       |                    |       |   |   |
| Current portion  of net deferred taxes   |       | 494                     |       | 790 |   |
| Long-term  portion of net deferred taxes |       | 2,533                   |       | 818 |   |
| Net deferred tax assets                  |       | $                       | 3,027      |   | $ | 1,608 |   |

 

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The components of current and deferred federal andstate income tax benefits and provisions are as follows:
|                               | ** ** | **Year Ended March 31,** | ** ** |
|-------------------------------|------------|-----------------------------------------|------------|
| ** **                    | ** ** | **2007**                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                    | ** ** | **(In thousands)**                 | ** ** |
| Current income  tax provision |       |                                    |       |   |   |   |   |
| Federal                       |       | $                                       | 25         |   | $ | 9 |   | $ | 91 |   |
| State                         |       | 32                                      |       | 3 |   | 14 |   |
| Foreign                       |       | 24                                      |       | 46 |   | — |   |
| Deferred income  tax benefit  |       |                                    |       |   |   |   |   |
| Federal                       |       | (1,170                                  | )          | (812 | ) | (75 | ) |
| State                         |       | (254                                    | )          | (131 | ) | (124 | ) |
| Net income tax benefit        |       | $                                       | (1,343     | ) | $ | (885 | ) | $ | (94 | ) |

 

AtMarch 31, 2007, the Company had approximately $583,000 in federal generalbusiness credit carryforwards that begin to expire in 2008 and $818,000 instate general business credit carryforwards that can be carried forwardindefinitely. The Company had $49.3 million of federal net operating losscarryforwards at March 31, 2007, that begin to expire in 2019 and $22.4million of state net operating loss carryforwards that begin to expire in 2008.

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 offederal net operating loss carryforwards and other federal tax attributes ofthe Company are subject to a Section 382 limitation estimated atapproximately $2.9 million annually which can be utilized to offset federalconsolidated taxable income. To the extent such limitation is not exceeded in aparticular year, the excess limitation accumulates and adds to subsequent years’limitations. 

AtMarch 31, 2007, the Company recorded a valuation allowance against its netdeferred tax assets of approximately $19 million for that portion of deferredtax assets 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.

Unremittedearnings of the Company’s foreign subsidiary have been included in theconsolidated financial statements without giving effect to the United Statestaxes that may be payable on distribution to the United States because it isnot anticipated that such earnings will be remitted to the United States.  If remitted, the additional United Statestaxes would not be material.  

**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 sought monetary damages aggregating approximately$850,000 plus attorney fees and related costs. On July 20, 2006, the Company entered into a settlement agreement inconnection with this matter.  The disputewas settled in full for $688,000 payable as follows:  (i) the Company issued 88,912 shares of theCompany’s common stock on August 18, 2006 valued at $213,000 based on theclosing sales price of the Company’s common stock on the date of issuance; (ii)the Company made a cash payment of $125,000 on October 20, 2006; and (iii) theCompany is obligated to pay $350,000 in cash in equal monthly installments of$9,700 over three years beginning in November 2006.  In connection with this settlement, theCompany recorded a charge of $635,000, representing the fair value of thesettlement, within other expense in the accompanying consolidated statement ofoperations for the year ended March 31, 2007.

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.

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Fromtime to time, the Company has been involved in litigation relating to claimsarising out of its operations in the normal course of business. The Companycurrently is not a party to any legal proceedings, the adverse outcome ofwhich, in management’s opinion, individually or in the aggregate, would have amaterial 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.  Forexample, the Company has been the subject of a number of routine tax audits fortime periods and jurisdictions related to the businesses of its formersubsidiaries, some of which are still in process.  Although the development and ultimate outcomeof these and other unforeseen matters cannot be predicted with any certainty,management does not believe that the Company is presently involved in anymatters related to its former subsidiaries that would have a material adverseeffect on the Company’s consolidated results of operations, financial positionor cash flows.

**OperatingLeases**

TheCompany has lease commitments for facilities in various locations throughoutthe United States.  Future minimum rentalpayments under these noncancelable operating leases at March 31, 2007 were asfollows:
| **Fiscal Year Ending March 31,** | ** ** | ** ** | ** ** |
|------------------------------------------------------|------------|------------|------------|
| **(In thousands)**                              | ** ** | ** ** | ** ** |
| 2008                                                 | ** ** | $          | 1,277      | ** ** |
| 2009                                                 | ** ** | 1,398      | ** ** |
| 2010                                                 | ** ** | 1,391      | ** ** |
| 2011                                                 | ** ** | 1,348      | ** ** |
| 2012                                                 | ** ** | 1,332      | ** ** |
| Thereafter                                           | ** ** | 3,823      | ** ** |
| Total                                                | ** ** | $          | 10,569     | ** ** |

 

Rent expense totaled $2.2million, $1.9 million and $1.7 million, respectively, for the years ended March 31,2007, 2006 and 2005.

TheCompany has recorded on its consolidated balance sheet a deferred gain relatedto the May 2002 sale and leaseback of its headquarters in Anaheim,California.  The deferred gain is beingamortized over the term of the underlying lease, which terminates in September2007, and resulted in a realized gain of $284,000 in the fiscal years endedMarch 31, 2007 and 2006, and $609,000 in the fiscal year ended March 31,2005.  The remaining deferred gain was$165,000 at March 31, 2007.

TheCompany subleases 10,000 square feet of space in its 94,000 square foot Anaheim,California facility at a monthly rate of $10,000 to MAXxess Systems, Inc.(“MAXxess”), a former subisidiary of the Company that was sold in September2003 and is currently owned by an investor group that includes one of theCompany’s directors.  During the fiscalyear ended March 31, 2007, the Company wrote off amounts receivable fromMAXxess aggregating $180,000 related primarily to this sublease due to MAXxess’inability to pay this balance.  As aresult of this write-off, the Company does not expect to recognize any futuresublease income related to this sublease, which terminates in September 2007.

On May 25, 2007, the Company entered into an agreement to leaseapproximately 50,000 square feet of space in Santa Ana, California for a termof 88 months, beginning in September 2007. This location will be the new location of the Company’s headquarters andprincipal operations. The monthly lease rate will be $102,000 during the firstyear of the lease, and will increase each year thereafter, up to a maximum of$120,000 during the last year of the lease. The lease may be extended for a period of five years, at the option ofthe Company, at a lease rate to be based on the market lease rate forcomparable property determined as of the commencement date of the extensionperiod.   Future lease commitments underthis lease are included in the above table of lease commitments.

**InventoryPurchase Commitments**

AtMarch 31, 2007, the Company had firm commitments to purchase inventory inthe amount of $2.6 million during the first and second quarters of its fiscalyear ending March 31, 2008.

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**DeferredCompensation Plan**

In 1986, theCompany adopted the Executive Deferral Plan (the “1986 Plan”) under whichcertain executives were able to defer a portion of their annual compensationinto the 1986 Plan. All deferred amounts earned interest, generally with noguaranteed rate of return.

During the yearended March 31, 2003, the Iteris Subsidiary adopted the DeferredCompensation Plan for the sole purpose of transferring Iteris Subsidiary commonstock and cash out of the 1986 Plan. All assets of the 1986 Plan weredistributed prior to March 31, 2003. Certain of these assets, consistingof 133,333 shares of the Iteris Subsidiary’s common stock and $14,000 in cash,were transferred to the Deferred Compensation Plan during the year endedMarch 31, 2003. No compensation withholdings were deferred under the 1986Plan or the Deferred Compensation Plan in the years ended March 31, 2007,2006 and 2005.

During the yearended March 31, 2005, the Company assumed the Deferred Compensation Planas part of the October 2004 merger and acquisition of the IterisSubsidiary. In accordance with the merger (Note 3) the Company exchanged theoriginal 133,333 shares of Iteris Subsidiary common stock held in the DeferredCompensation Plan and an additional 21,922 shares of the Iteris Subsidiary’scommon stock subsequently purchased with deferred wages for 310,510 shares of theCompany’s common stock. All shares of Iteris Subsidiary stock held in the planwere purchased with funds earned by the executives and deferred to the plan atthe estimated fair value and the same price that was paid by outside investorsat that time, or approximately $374,000.

AtMarch 31, 2007, the Deferred Compensation Plan held 310,510 shares of theCompany’s common stock and $15,000 in cash, which the Company has presented asan aggregated $730,000 deferred compensation plan liability in the accompanyingconsolidated balance sheet. Changes in the value of Company common stock heldby the Deferred Compensation Plan are determined based on changes in the quotedmarket price of the Company’s common stock at the close of each reportingperiod and presented within operating expenses in the accompanying consolidatedstatements of operations. The original $374,000 cost basis of shares of Companycommon stock held in the Deferred Compensation Plan has been recorded as acontra-equity account in the accompanying consolidated financialstatements.  In May 2007, the Company’sformer Chief Executive Officer, who departed in March 2007, elected to receivea distribution of fifty percent of his deferred compensation plan balance,representing 143,333 shares of the Company’s common stock and $8,000 in cash,on or before June 30, 2007, and his remaining deferred compensation planbalance of 143,333 shares of the Company’s common stock and $7,000 in cash onthe one year anniversary of this election.

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

Asdiscussed in Note 3, the Company issued 1,219,445 shares of its Class Acommon stock (now known as common stock) (“Exchange Shares”) in connection withthe merger of the Iteris Subsidiary into the Company. Beginning onNovember 28, 2005, DCV may require the Company to repurchase up to 50% ofthe Exchange Shares at a purchase price of $1.438 per share; and beginning onMay 28, 2007, DCV may require the Company to repurchase up to 100% of theExchange Shares at a purchase price of $1.438 per share. All such rights torequire the repurchase of the Exchange Shares expire on September 28,2007. Because this right is outside the control of the Company, the Company hasclassified the $3.4 million value of the 1,219,445 shares as redeemable commonstock on the accompanying March 31, 2007 and 2006 consolidated balancesheets. On February 1, 2005, DCV announced that its investment portfolio,which included its ownership in Iteris, Inc., was sold to European-basedCipio Partners for an undisclosed sum. All repurchase rights associated withthe DCV shares inured to the benefit of Cipio Partners.

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

**PreferredStock**

TheCompany’s certificate of incorporation provides for the issuance of up to2,000,000 shares of preferred stock. As of March 31, 2007 and 2006, therewere no outstanding shares of preferred stock, and the Company does not haveany plans to issue any shares of preferred stock. The Company’s Board ofDirectors is authorized to issue from time to time such authorized but unissuedshares of preferred stock in one or more series and to fix or alter thedesignations, preferences, rights and any qualifications, limitations orrestrictions of the shares of each such series, including the dividend,conversion, voting, redemption and liquidation rights.

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**CommonStock and Common Stock Warrants**

On September 28,2006, the Company issued warrants to purchase an aggregate 246,250 shares ofcommon stock at an exercise price of $3.25 with a five-year life to an existingshareholder in exchange for the early exercise of 1,250,000 outstandingwarrants with an exercise price of $1.61. The new warrants were immediately exercisable and are callable by theCompany if the market price of the Company’s common stock trades for 20consecutive days at a price greater than or equal to two times the exerciseprice of the warrants.  The fair value ofthe new warrants was $320,000 calculated using the Black-Scholes-Merton (“BSM”)option-pricing formula.  The warrantswere considered a cost of raising capital and were recorded in equity.

In connection with theissuance of the new warrants, the Company is party to a registration rightsagreement that contains provisions under which the Company could be subjectedto liquidated damages should it fail to maintain effective registrationstatements for the shares of common stock issuable upon exercise of thewarrants.  These warrants have beenaccounted for within equity in the consolidated balance sheet as of March 31,2007 in accordance with EITF 00-19 *Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock*, and, accordingly, no liabilities have been recorded inconnection therewith.  As of March 31,2007, no liquidated damages were payable under the provisions of the registrationrights agreement associated with these warrants.

As discussed in Note 3, on October 22, 2004, the Iteris Subsidiarywas merged into the Company. Also in October 2004, the Company amended itscertificate of incorporation to (a) change the voting rights of itsClass 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) rename its Class A common stock to common stock. As a result, theCompany currently has only one class of common stock outstanding, the commonstock. Previously, the Company had two classes of common stock outstanding —the Class A common stock and the Class B common stock.

Subject to the rightsspecifically granted to holders of any then outstanding shares of the Company’spreferred stock, the Company’s common stockholders are entitled to anydividends that may be declared by the Board of Directors. Upon dissolution,liquidation or winding up, holders of common stock are entitled to shareratably in net assets after payment or provision for all liabilities and anypreferential liquidation rights of preferred stock then outstanding. Commonstockholders generally do not have preemptive or redemption rights, except forthe Exchange Shares issued to DCV in exchange for shares of the IterisSubsidiary (Notes 3 and 8). The rights, preferences and privileges of holdersof common stock will be subject to those of the holders of any shares of commonstock and preferred stock the Company may 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.The exercise prices are subject to certain adjustments, including adjustmentsfor dilutive 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 $440,000 and $647,000 at March 31, 2007 and 2006, respectively,and is classified within convertible debentures, net on the accompanyingconsolidated balance sheets.

Also in connection withthe Debenture and Warrant Purchase Agreement, the Company issued warrants tothe investment bankers, as a commission, to purchase 34,036 shares of itscommon stock at an exercise price of $3.86 per share. The warrants wereimmediately exercisable and expire on May 18, 2009. The estimated fairvalue of these warrants of $40,000 was recorded as a deferred financing costand is being amortized to interest expense over the five-year life of thedebentures. Additionally, the Company incurred $621,000 in transaction costsassociated with the debenture offering, which have also been capitalized asdeferred financing costs and are being amortized to interest expense over thefive-year term of the debentures. Unamortized deferred financing costsaggregated $293,000 and $430,000 at March 31, 2007 and 2006, respectively,and are classified within other assets on the accompanying consolidated balancesheets.

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The following table summarizes information regardingoutstanding warrants to purchase the Company’s common stock as ofMarch 31, 2007:
| Range of Exercise Prices | ** ** | **Warrants Outstanding  at March 31, 2007**       | ** ** | **Weighted Avg.  Remaining  Contractual Life** | ** ** | **Weighted Avg.  Exercise Price** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
| $1.42 to $1.95                |       | 127                                                                   |       | 1.12                                                     |       | $                                           | 1.78       |   |
| $2.45 to $3.25                |       | 286                                                                   |       | 3.70                                                     |       | $                                           | 3.14       |   |
| $3.61 to $4.03                |       | 674                                                                   |       | 2.13                                                     |       | $                                           | 3.93       |   |
| $5.00 to $5.26                |       | 230                                                                   |       | 2.66                                                     |       | $                                           | 5.18       |   |
|                                    |       | 1,317                                                                 |       | 2.47                                                     |       | $                                           | 3.77       |   |

 

Allof the warrants were exercisable at March 31, 2007.  Warrants to purchase an aggregate of 62,500shares of common stock at an exercise price of $1.95 per share and warrants topurchase an aggregate of 246,260 shares of common stock at an exerciseprice of $3.25 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 the Company’scommon stock trades for 20 consecutive days at a price equal to or greaterthan one and a half times the exercise price of the warrants.

Commonstock reserved for future issuance at March 31, 2007:
|                                         | ** ** | **(In thousands)** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| Issuable under  stock options plans     |       | 5,827                   |       |
| Issuable upon  the exercise of warrants |       | 1,317                   |       |
|                                    |       | 7,144                   |       |

**10.****                              AssociateBenefit Plans**

**StockOption Plan**

The Company’s 1997Stock Incentive Plan (the “Plan”) provides that options to purchase shares ofthe Company’s unissued common stock may be granted to directors, associates andconsultants to the Company at exercise prices which are equal to or greaterthan the fair market value of the Company’s common stock on the date ofgrant.  Options expire ten years afterthe date of grant or 90 days after termination of employment and generally vestratably at the rate of 25% on each of the first four anniversaries of the grantdate.  New shares are issued to satisfystock option exercises under the Plan. As of March 31, 2007, options to purchase 1.6 million shares of theCompany’s common stock were outstanding under the Plan.

In connection withthe merger of the Company and the Iteris Subsidiary (Note 3), the Companyassumed the 1998 Stock Incentive Plan of the Iteris Subsidiary (the “1998 Plan”)and all outstanding options granted thereunder. As of March 31, 2007, options to purchase 3.6 million shares of theCompany’s common stock were outstanding under the 1998 Plan.  No further options may be granted under the1998 Plan.

Certain optionsgranted under the Plan and the 1998 Plan (collectively, the “Plans”) providefor accelerated vesting of unvested options in the event of a change in controlunder certain circumstances.  Thesechange-in-control provisions meet the criteria of a performance condition underSFAS 123R.

As of March 31,2007, the Company had 711,000 outstanding stock options that were originallygranted outside of the Plans and that were assumed by the Plan in connectionwith the merger of the Company and the Iteris Subsidiary (Note 3).

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A summary ofactivity in the Plans for the year ended March 31, 2007 is as follows:
| ** **                                                             | ** ** | **Options**                                                           | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Life (In Years)** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------|------------|-------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                             | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Options outstanding at March 31, 2006                                  |       | 6,977                                                                 |       | $                                      | 1.42       |                                                        | 4.0        |                                |       |   |
| Granted                                                                |       | 272                                                                   |       | $                                      | 2.41       |                                                        | N/A        |                                |       |   |
| Exercised                                                              |       | (1,374                                                                | )          | $                                      | 0.81       |                                                        | N/A        |                                |       |   |
| Forfeited                                                              |       | (23                                                                   | )          | $                                      | 2.86       |                                                        | N/A        |                                |       |   |
| Expired                                                                |       | (34                                                                   | )          | $                                      | 2.13       |                                                        | N/A        |                                |       |   |
| Options outstanding at March 31, 2007                                  |       | 5,818                                                                 |       | $                                      | 1.60       |                                                        | 3.4        |                                | $          | 6,115 |   |
| Vested and expected to vest at March 31, 2007                          |       | 5,730                                                                 |       | $                                      | 1.59       |                                                        | 3.4        |                                | $          | 6,106 |   |
| Options exercisable at March 31, 2007                                  |       | 5,324                                                                 |       | $                                      | 1.52       |                                                        | 3.0        |                                | $          | 6,001 |   |
| Options  exercisable at March 31, 2007 pursuant to a change-in-control |       | 5,818                                                                 |       | $                                      | 1.60       |                                                        | 3.4        |                                | $          | 6,115 |   |

 

At March 31, 2007, there were 9,000 options available for grant underthe Plan.

For the years ended March 31, 2007, 2006 and 2005, the Company received$1.1 million, $296,000 and $118,000, respectively, in cash from the exercise ofstock options.

**Stock-Based Compensation Expense**

Total stock-based compensation expense for the yearsended March 31, 2007, 2006 and 2005 was $288,000, $725,000 and $11.8 million,respectively.  No income tax benefit wasrealized from activity in the Plans during the years ended March 31, 2007, 2006and 2005.

The fair value of each stock-based award is estimatedon the grant date using the BSM option-pricing formula.

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Expected volatility is based on the historicalvolatility of the Company’s stock price. The expected life of options grantedsubsequent to the adoption of SFAS 123R is derived based on the historical lifeof the Company’s options.  The risk-freeinterest rate for periods within the expected life of the option is based onthe U.S. Treasury interest rates in effect at the time of grant. The grant datefair value of options granted was estimated using the followingweighted-average assumptions:
|                                      | ** ** | **Years Ended March 31,** | ** ** |
|--------------------------------------|------------|------------------------------------------|------------|
| ** **                           | ** ** | **2007**                                 | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                 |       |                                     |       |   |   |   |   |
| Dividend yield                       |       | 0.0                                      | %          | 0.0 | % | 0.0 | % |
| Expected life —  years          |       | 7.0                                      |       | 7.0 |   | 7.0 |   |
| Risk-free  interest rate             |       | 4.7                                      | %          | 5.5 | % | 4.5 | % |
| Expected volatility of  common stock |       | 0.9                                      |       | 0.5 |   | 0.5 |   |

 

A summary of the grant date fair value and intrinsic value informationis as follows:
|                                                                      | ** ** | **Years Ended March 31,**                              | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2007**                                                              | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                           | ** ** | **(In thousands, except per share amounts)** | ** ** |
| Weighted average  grant date fair value per share of options granted |       | $                                                                     | 1.92       |   | $ | 1.77 |   | $ | 1.83 |   |
| Intrinsic value  of options exercised                                |       | $                                                                     | 2,288      |   | $ | 295 |   | $ | 20 |   |
| Total fair value of  options vested during the period                |       | $                                                                     | 638        |   | $ | 1,541 |   | $ | 1,206 |   |

 

At March 31, 2007, there was $855,000 of total unrecognizedcompensation expense related to unvested stock options.  This expense is expected to be recognizedover a weighted-average period of approximately 3.2 years.

**Associate Incentive Programs**

Under the terms of a Profit Sharing Plan, the Companycontributes to a trust fund such amounts as are determined annually by theBoard of Directors. No contributions were made during the years endedMarch 31, 2007, 2006 and 2005.

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 the401(k) Plan, eligible associates voluntarily contribute to the plan up to15% of their salary through payroll deductions. The Company matches 50% ofcontributions up to a stated limit. Under the provisions of the401(k) Plan, associates have thirteen investment choices, one of which isthe purchase of Iteris, Inc. common stock at market price. Company matchingcontributions were approximately $480,000, $317,000, and $409,000 and for theyears ended March 31, 2007, 2006, and 2005, respectively.

**11.****                              Disposalof Fixed Assets**

After the merger of the Iteris Subsidiary into theCompany on October 2004, the Company reviewed and determined certaincorporate property and equipment would not provide value to its on-goingoperations. These assets primarily consisted of furniture and fixtures andcomputer equipment. Accordingly, the Company recorded a $422,000 loss on disposalof fixed assets in the year ended March 31, 2005.

**12.****                              BusinessSegment and Geographic Information**

The Company currently operates in three reportablesegments: Roadway Sensors, Automotive Sensors and Transportation Systems. TheRoadway Sensors segment includes 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 certainintangibles and certain corporate expenses are not allocated to the segments.In addition, certain assets including cash and cash equivalents, deferred taxesand certain long-lived and intangible assets are not allocated to the segments.The reportable segments are each managed

65

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separately because theymanufacture and distribute distinct products or provide services with differentprocesses. All segment revenues are derived from external customers.

Selected financial information for the Company’sreportable segments as of and for the years ended March 31, 2007, 2006 and2005 is as follows:
| ** **                                         | ** ** | **Roadway  Sensors**    | ** ** | **Automotive  Sensors** | ** ** | **Transportation  Systems** | ** ** | **Total**  | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------|------------|------------|------------|
| ** **                                         | ** ** | **(In thousands)** | ** ** |
| **Year  Ended March 31, 2007**                | ** ** | ** **              | ** ** | ** **              | ** ** | ** **                  | ** ** | ** ** | ** ** |
| Product revenue  from external customers           |       | $                       | 27,261     |                    | $          | 6,408                       |       | $          | —     |   | $ | 33,669 |   |
| Service and  other revenue from external customers |       | —                  |       | 2,579                   |       | 22,049                      |       | 24,628     |       |
| Stock-based  compensation                          |       | 37                      |       | 54                      |       | 78                          |       | 169        |       |
| Depreciation                                       |       | 82                      |       | 138                     |       | 126                         |       | 346        |       |
| Allocated  goodwill                                |       | 8,197                   |       | 4,671                   |       | 14,906                      |       | 27,774     |       |
| Segment income  (loss)                             |       | 6,035                   |       | (2,625                  | )          | 2,551                       |       | 5,961      |       |
|                                               |       |                    |       |                    |       |                        |       |       |       |
| **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     |       |
| Stock-based  compensation                          |       | 177                     |       | 101                     |       | 342                         |       | 620        |       |
| Depreciation                                       |       | 132                     |       | 189                     |       | 266                         |       | 587        |       |
| Allocated  goodwill                                |       | 8,197                   |       | 4,671                   |       | 14,906                      |       | 27,774     |       |
| Segment income  (loss)                             |       | 3,420                   |       | (2,476                  | )          | 1,842                       |       | 2,786      |       |
|                                               |       |                    |       |                    |       |                        |       |       |       |
| **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     |       |
| Stock-based  compensation                          |       | 2,492                   |       | 1,505                   |       | 3,971                       |       | 7,968      |       |
| Depreciation                                       |       | 117                     |       | 116                     |       | 415                         |       | 648        |       |
| Allocated  goodwill                                |       | 8,197                   |       | 4,671                   |       | 14,906                      |       | 27,774     |       |
| Segment income (loss)                              |       | 1,140                   |       | (3,109                  | )          | (2,440                      | )          | (4,409     | )          |

 

The Roadway Sensors segment had one customer withrevenue representing 26.5% of total segment revenue for the year ended March31, 2007; one customer with revenue representing 25.9% of total segment revenuefor the year ended March 31, 2006; and two customers with combined revenuerepresenting 38.0% of total segment revenue for the year ended March 31,2005. The Automotive Sensors segment had three customers with combined revenuerepresenting 64.2% of total segment revenue for the year ended March 31, 2007;two customers with combined revenue representing 70.7% of total segment revenuefor the year ended March 31, 2006; and two customers with combined revenuerepresenting 85.2% of total segment revenue for the year ended March 31,2005. The Transportation Systems segment had one customer with revenue representing13.3% of total segment revenue for the year ended March 31, 2007; and onecustomer with revenue representing 14.9% of total segment revenue for the yearended March 31, 2005.

In connection with the October 2004 merger of theIteris Subsidiary into the Company (Note 3), goodwill of $8.0 million, $4.7million and $5.3 million was allocated to the Roadway Sensors, AutomotiveSensors and Transportation Systems segments, respectively. This allocation wasdetermined based on the respective fair value of each segment as calculatedusing the income approach.

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The following reconciles segment income toconsolidated income (loss) before income taxes and minority interest andsegment assets to consolidated assets:
| ** **                                                    | ** ** | **March 31,**      | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                    | ** ** | **2007**                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                    | ** ** | **(In thousands)** | ** ** |
| Segment income  (loss)                                        |       |                    |       |   |   |   |   |
| Total income  (loss) for reportable segments                  |       | $                       | 5,961      |   | $ | 2,786 |   | $ | (4,409 | ) |
| Unallocated  amounts:                                         |       |                    |       |   |   |   |   |
| Corporate and other expenses                                  |       | (2,077                  | )          | (1,972 | ) | (6,171 | ) |
| Amortization of intangible assets                             |       | (147                    | )          | (147 | ) | (114 | ) |
| Deferred compensation (expense) benefit                       |       | 91                      |       | (48 | ) | 484 |   |
| Disposal of fixed assets                                      |       | —                  |       | — |   | (422 | ) |
| Acquired in-process research and development                  |       | —                  |       | — |   | (140 | ) |
| Other income (expense), net                                   |       | (653                    | )          | 35 |   | 1,054 |   |
| Interest expense, net                                         |       | (1,600                  | )          | (1,459 | ) | (1,178 | ) |
| Income (loss) before income taxes and  minority interest |       | $                       | 1,575      |   | $ | (805 | ) | $ | (10,896 | ) |
|                                                          |       |                    |       |   |   |   |   |
| Assets                                                        |       |                    |       |   |   |   |   |
| Total assets for  reportable segments                         |       | $                       | 51,490     |   | $ | 47,520 |   | $ | 44,833 |   |
| Unallocated  assets                                           |       | 3,760                   |       | 2,113 |   | 1,823 |   |
| Total assets                                                  |       | $                       | 55,250     |   | $ | 49,633 |   | $ | 46,656 |   |

 

The Company’srevenues are generated and the Company’s assets are held substantially in theUnited States.

**13.**                              QuarterlyFinancial Data (Unaudited)
|                          | ** ** | **Net  Sales**                                                        | ** ** | **Gross  Profit** | ** ** | **Net  Income (Loss)** | ** ** | **Basic  Earnings  (Loss)  per Share** | ** ** | **Diluted  Earnings  (Loss)  per Share** | ** ** |
|--------------------------|------------|-----------------------------------------------------------------------|------------|-------------------|------------|-----------------------------|------------|---------------------------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **(In thousands, except per share amounts)** | ** ** |
| June 30,  2006      |       | $                                                                     | 13,816     |              | $          | 5,719                       |       | $                                           | 279        |                                          | $          | 0.01 |   | $ | 0.01 |   |
| September 30,  2006 |       | 14,466                                                                |       | 5,957             |       | 732                         |       | 0.03                                        |       | 0.02                                          |       |
| December 31,  2006  |       | 14,488                                                                |       | 5,676             |       | 310                         |       | 0.01                                        |       | 0.01                                          |       |
| March 31,  2007     |       | 15,527                                                                |       | 6,656             |       | 1,597                       |       | 0.05                                        |       | 0.05                                          |       |
|                     |       | $                                                                     | 58,297     |              | $          | 24,008                      |       | $                                           | 2,918      |                                          | $          | 0.10 | * | $ | 0.09 | * |
|                     |       |                                                                  |       |              |       |                        |       |                                        |       |                                          |       |
| June 30,  2005      |       | $                                                                     | 12,079     |              | $          | 5,355                       |       | $                                           | (726       | )                                             | $          | (0.03 | ) | $ | (0.03 | ) |
| September 30,  2005 |       | 12,715                                                                |       | 5,442             |       | (155                        | )          | (0.01                                       | )          | (0.01                                         | )          |
| December 31,  2005  |       | 12,183                                                                |       | 4,981             |       | 136                         |       | 0.00                                        |       | 0.00                                          |       |
| March 31,  2006     |       | 13,509                                                                |       | 5,615             |       | 825                         |       | 0.03                                        |       | 0.03                                          |       |
|                     |       | $                                                                     | 50,486     |              | $          | 21,393                      |       | $                                           | 80         |                                          | $          | 0.00 | * | $ | 0.00 | * |

 

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

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**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, 2007** | ** ** | ** **                                     | ** ** | ** **                                    | ** ** | ** **                    | ** ** | ** **                                   | ** ** |
| Deducted from asset accounts:       |       |                                           |       |                                          |       |                          |       |                                         |       |
| Allowance for doubtful accounts     |       | $                                              | 429        |                                          | $          | 220                           |       | $                                            | 15         |   | $ | 664 |   |
| Reserve for inventory obsolescence  |       | 592                                            |       | 420                                           |       | (168                          | )          | 844                                          |       |
| **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                                          |       |

 

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