UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

x                              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

OR

o                                 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to              

Commission file number:  001-08762

ITERIS, INC.

(Exact name of registrant as specified in its charter)

 

(714) 774-5000

(Registrant’s telephone number, including area code)

 

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

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

Yes  x    No  o

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

Large accelerated filer  o

Accelerated filer  o

Non-accelerated filer  x

 

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

Yes  o    No  x

As of November 10, 2006, the registrant had 30,685,110 shares of common stock outstanding

 

ITERIS, INC.
Quarterly Report on Form 10-Q
For the Three Months and Six Months Ended September 30, 2006

Table of Contents

PART I.		FINANCIAL INFORMATION
ITEM 1.		FINANCIAL STATEMENTS
		UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS AT SEPTEMBER 30, 2006 AND MARCH 31, 2006
		UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
		UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
		NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4.		CONTROLS AND PROCEDURES
PART II.		OTHER INFORMATION
ITEM 1.		LEGAL PROCEEDINGS
ITEM 1A.		RISK FACTORS
ITEM 2.		UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
ITEM 3.		DEFAULTS UPON SENIOR SECURITIES
ITEM 4.		SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5.		OTHER INFORMATION
ITEM 6.		EXHIBITS

 

Unless otherwise indicated in this report, the “Company,” “we,” “us” and “our” collectively refer to Iteris, Inc., formerly known as Iteris Holdings, Inc. and Odetics, Inc., and its former subsidiary, Meyer, Mohaddes Associates, Inc., which was dissolved effective April 2006.

AutoVue®, Iteris®, Vantage® and eAccess™ are among the trademarks of Iteris, Inc. Any other trademarks or trade names mentioned herein are the property of their respective owners.

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PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

ITERIS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)

 

		September 30, 2006			March 31, 2006
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	19		$	131
Trade accounts receivable, net of allowance for doubtful accounts of $555 and $429 at September 30, 2006 and March 31, 2006, respectively		12,462			11,426
Costs and estimated earnings in excess of billings on uncompleted contracts		3,033			2,693
Inventories, net of reserve for inventory obsolescence of $721 and $592 at September 30, 2006 and March 31, 2006, respectively		4,792			2,814
Deferred income taxes		761			790
Prepaid expenses and other current assets		504			368
Total current assets		21,571			18,222
Property and equipment, net		1,745			1,783
Deferred income taxes		1,475			818
Intangible assets, net of accumulated amortization of $334 and $261 at September 30, 2006 and March 31, 2006, respectively		478			551
Goodwill		27,774			27,774
Other assets		438			485
Total assets		$	53,481		$	49,633
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable		$	6,161		$	3,620
Accrued payroll and related expenses		2,924			3,481
Accrued liabilities		2,749			2,304
Billings in excess of costs and estimated earnings on uncompleted contracts		845			893
Revolving line of credit		577			2,662
Current portion of long-term debt		2,261			1,969
Total current liabilities		15,517			14,929
Non-current accrued liabilities		216			12
Deferred compensation plan liability		788			820
Deferred gain on sale of building		307			449
Long-term debt		1,213			2,171
Convertible debentures, net		9,307			9,203
Total liabilities		27,348			27,584
Commitments and contingencies
Redeemable common stock, 1,219 shares issued and outstanding at September 30, 2006 and March 31, 2006		3,414			3,414
Stockholders’ equity:
Preferred stock, $1.00 par value, 2,000 shares authorized, none issued and outstanding at September 30, 2006 and March 31, 2006		—			—
Common stock, $0.10 par value, 50,000 shares authorized, 29,363 and 27,432 shares issued and outstanding at September 30, 2006 and March 31, 2006, respectively		2.936			2,743
Additional paid-in capital		129,538			126,664
Common stock held in trust, 311 shares at September 30, 2006 and March 31, 2006		(374		)	(374		)
Notes receivable from employees		(45		)	(49		)
Accumulated deficit		(109,345		)	(110,356		)
Accumulated other comprehensive income		9			7
Total stockholders’ equity		22,719			18,635
Total liabilities and stockholders’ equity		$	53,481		$	49,633

 

See accompanying notes to unaudited condensed consolidated financial statements.

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ITERIS, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)

 

		Three Months Ended September 30,						Six Months Ended September 30,
		2006			2005			2006			2005
Net sales and contract revenues:
Net sales		$	9,323		$	7,975		$	17,923		$	15,500
Contract revenues		5,143			4,740			10,359			9,294
Total net sales and contract revenues		14,466			12,715			28,282			24,794
Costs and expenses:
Cost of net sales(a)		5,296			4,236			10,054			7,991
Cost of contract revenues(a)		3,213			3,037			6,552			6,006
Gross profit		5,957			5,442			11,676			10,797
Operating expenses:
Selling, general and administrative(a)		3,985			4,086			7,986			7,914
Research and development(a)		771			1,370			1,774			3,116
Deferred compensation plan		34			16			(32		)	78
Amortization of intangible assets		37			36			73			73
Total operating expenses		4,827			5,508			9,801			11,181
Operating income (loss)		1,130			(66		)	1,875			(384		)
Non-operating income (expense):
Other income (expense), net		45			86			(645		)	38
Interest expense, net		(424		)	(358		)	(810		)	(710		)
Income (loss) before income taxes		751			(338		)	420			(1,056		)
Income tax benefit (provision)		(19		)	183			591			175
Net income (loss)		$	732		$	(155	)	$	1,011		$	(881	)
Earnings (loss) per share:
Basic		$	0.03		$	(0.01	)	$	0.04		$	(0.03	)
Diluted		$	0.02		$	(0.01	)	$	0.03		$	(0.03	)
Weighted average shares outstanding:
Basic		28,882			28,106			28,637			28,084
Diluted		33,020			28,106			32,694			28,084
(a) Includes stock-based compensation expense as follows:
Cost of net sales		$	4		$	9		$	9		$	18
Cost of contract revenues		$	19		$	67		$	48		$	137
Selling, general and administrative expense		$	5		$	136		$	59		$	275
Research and development expense		$	46		$	46		$	58		$	93

 

See accompanying notes to unaudited condensed consolidated financial statements.

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ITERIS, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

		Six Months Ended September 30,
		2006			2005
Cash flows from operating activities
Net income (loss)		$	1,011		$	(881	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Change in deferred tax assets		(628		)	(189		)
Depreciation and amortization of property and equipment		278			335
Stock-based compensation expense		174			523
Issuance of warrants for services		21			—
Amortization of deferred gain on sale—leaseback transaction		(142		)	(142		)
Amortization of debt discount		104			104
Amortization of intangible assets		73			73
Amortization of deferred financing costs		69			69
Changes in operating assets and liabilities:
Accounts receivable		(1,036		)	(17		)
Net costs and estimated earnings in excess of billings		(388		)	(435		)
Inventories		(1,978		)	1,341
Prepaid expenses and other assets		(158		)	(177		)
Accounts payable and accrued liabilities		2,735			(563		)
Net cash provided by operating activities		135			41
Cash flows from investing activities
Purchases of property and equipment		(240		)	(386		)
Cash flows from financing activities
Proceeds (payments) from borrowings on line of credit, net		(2,085		)	766
Payments on long-term debt		(666		)	(657		)
Change in checks drawn in excess of available bank balances		81			—
Proceeds from stock option and warrant exercises		2,663			190
Net cash (used in) provided by financing activities		(7		)	299
Decrease in cash		(112		)	(46		)
Cash at beginning of period		131			46
Cash at end of period		$	19		$	—
Supplemental cash flow information:
Cash paid during the period:
Interest		$	637		$	528
Income taxes		—			44
Supplemental schedule of non-cash investing and financing activities:
Fair value of common stock issued in settlement of liabilities		$	213		$	—
Fair value of warrants issued in settlement of liabilities		—			28

 

See accompanying notes to unaudited condensed consolidated financial statements.

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ITERIS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2006

1.  Description of Business and Summary of Significant Accounting Policies

Description of Business

Iteris, Inc., formerly known as Iteris Holdings, Inc. and Odetics, Inc. (“Iteris” or the “Company”), is a leading provider of outdoor machine vision systems and sensors that optimize the flow of traffic and enhance driver safety. Using proprietary software and Intelligent Transportation Systems (“ITS”) industry expertise, the Company provides video sensor systems, transportation management and traveler information systems and other engineering consulting services to the ITS industry. The ITS industry is comprised of companies applying a variety of technologies to enable the safe and efficient movement of people and goods. The Company uses its outdoor image recognition software expertise to develop proprietary algorithms for video sensor systems that improve vehicle safety and the flow of traffic. Using its knowledge of the ITS industry, the Company designs and implements transportation management systems that help public agencies reduce traffic congestion and provide greater access to traveler information.  The Company was originally incorporated in Delaware in 1987 as Odetics, Inc. and in September 2003 changed its name to Iteris Holdings, Inc. to reflect its focus on the ITS industry and its capital structure at that time.  On October 22, 2004, the Company completed a merger with its majority-owned subsidiary, Iteris, Inc. (the “Iteris Subsidiary”), and officially changed its corporate name from Iteris Holdings, Inc. to Iteris, Inc.

Basis of Presentation

The unaudited condensed consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Securities and Exchange Commission (“SEC”) Form 10-Q and Article 10 of SEC Regulation S-X. In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring adjustments, necessary to present fairly the consolidated financial position of the Company as of September 30, 2006, the consolidated results of operations for the three and six months ended September 30, 2006 and 2005, and the consolidated cash flows for the six months ended September 30, 2006 and 2005. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) have been condensed or omitted pursuant to the rules and regulations of the SEC. The results of operations for the three and six months ended September 30, 2006, are not necessarily indicative of those to be expected for the entire year. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended March 31, 2006, which was filed with the SEC on June 29, 2006.

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Significant estimates made in the preparation of the consolidated financial statements 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 and estimates of future cash flows used to assess the recoverability of long-lived assets, the valuation of debt and equity instruments and the realization of goodwill.

Revenue Recognition

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

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Contract revenues are derived primarily from long-term contracts with governmental agencies.  Contract revenues include costs incurred plus a portion of estimated fees or profits determined on the percentage of completion method of accounting based on the relationship of costs incurred to date to total estimated costs.  Any anticipated losses on contracts are charged to earnings when identified.  Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to costs and revenues and are recognized in the period in which the revisions are determined.  Profit incentives are included in revenue when their realization is reasonably assured.

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

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

Concentration of Credit Risk

Accounts receivable are primarily derived from revenues earned from customers located throughout North America and Europe.  The Company generally does not require collateral or other security from customers. Collectibility of receivable balances is estimated through review of invoices outstanding greater than a certain period of time and ongoing credit evaluations of customers’ financial condition.  Reserves are maintained for potential credit losses, and such losses have historically been within management’s expectations.

Fair Values of Financial Instruments

The fair values of cash and cash equivalents, receivables, inventories, accounts payable and accrued expenses approximate carrying value because of the short period of time to maturity. The fair values of line of credit agreements and long-term debt approximate carrying value because the related rates of interest approximate current market rates.  The fair value of convertible debentures approximates carrying value because the effective interest rate, taking into account recorded debt discounts, approximates current market rates.  The estimated fair value of redeemable common stock was $3.0 million and $3.2 million at September 30, 2006 and March 31, 2006, respectively, based on the closing price of the Company’s common stock on those dates.

Inventories

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

Property and Equipment

Property and equipment are recorded at cost and are depreciated over the estimated useful life ranging from three to eight years.  Leasehold improvements are depreciated over the term of the related lease or the estimated useful life of the improvement, whichever is shorter.  Beginning April 1, 2006, the Company began depreciating property and equipment using the straight-line method of depreciation.  Prior to this date, the Company used the double declining balance method of depreciation.  As a result of this change in estimate, depreciation expense declined by $114,000 and $194,000 for the three and six months ended September 30, 2006, respectively, resulting in no impact on earnings per share for the three months ended September 30, 2006, and a $0.01 per share impact on earnings per share for the six months ended September 30, 2006.

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Goodwill and Long-Lived Assets

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Intangible Assets, goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment)  on an annual basis in the Company’s fourth fiscal quarter or more frequently if indicators of impairment exist, of which none have been identified.  The performance of the test involves a two-step process.  The first step of the impairment test involves comparing the fair value of the Company’s reporting units with each respective reporting unit’s carrying amount, including goodwill.  The Company determines the fair value of reporting units using the income approach.  If the carrying amount of a reporting unit exceeds the reporting unit’s fair value, the second step of the goodwill impairment test is performed to determine the amount of any impairment loss.  The second step of the goodwill impairment test involves comparing the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill.

The Company evaluates long-lived assets for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which requires impairment evaluation on long-lived assets used in operations when indicators of impairment are present.  Reviews are performed to determine whether the carrying value of assets is impaired, based on a comparison to undiscounted expected future cash flows.  If this comparison indicates that there is impairment, the impaired asset is written down to fair value, which is typically calculated using discounted expected future cash flows and a discount rate based upon the Company’s weighted average cost of capital adjusted for risks associated with the related operations.  Impairment is based on the excess of the carrying amount over the fair value of those assets.

Income Taxes

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

Research and Development Expenditures

Research and development expenditures are charged to expense in the period incurred.

Shipping and Handling Costs

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

Warranty

The Company generally provides a one to three year warranty from the original invoice date on all products, materials and workmanship.  Products sold to certain original equipment manufacturer (“OEM”) customers sometimes carry longer warranties. Defective products will be either repaired or replaced, generally at the Company’s option, upon meeting certain criteria. The Company accrues a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized.  The accrued warranty provision is included within accrued expenses on the accompanying condensed consolidated balance sheets.

Repair and Maintenance Costs

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

Reclassifications

Certain amounts in the prior period financial statements have been reclassified to conform with current year presentation.

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Other Comprehensive Income

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

Recent Accounting Pronouncements

On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS 123R”), which replaces SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), supersedes Accounting Principles Board Opinion No. 25 (“APB 25”), and amends SFAS No. 95, Statement of Cash Flows.  Generally, the approach in SFAS 123R is similar to the approach described in SFAS 123.  However, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values (i.e., pro forma disclosure is no longer an alternative to financial statement recognition).  As further discussed in Note 6, the Company adopted SFAS 123R effective April 1, 2006 using the modified prospective method.

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”).  FIN 48 clarifies the accounting and reporting for income taxes recognized in accordance with SFAS 109.  This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns.  The Company is currently evaluating the impact of FIN 48 and expects to adopt this Interpretation in 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 fair value, establishes a framework for measuring fair value, and expands disclosure about fair value measurements. SFAS 157 does not require any new fair value measurements; rather it specifies valuation methods to be applied when fair value measurements are required under existing or future accounting pronouncements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early application of the statement is encouraged. Generally, this statement will be applied prospectively. The Company is currently evaluating the impact of SFAS 157 and expects to adopt SFAS 157 in the first quarter of its fiscal year ending March 31, 2009. 

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”).  SAB 108 provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment.  The Company is currently evaluating the impact of SAB 108 and expects to adopt SAB 108 in the first quarter of its fiscal year ending March 31, 2008.

In June 2006, the FASB ratified Emerging Issues Task Force Issue No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation) (“EITF 06-3”).  The task force reached a conclusion that either method is acceptable; however, if taxes are reported on a gross basis (included as sales) a company should disclose those amounts if significant.  EITF 06-3 is effective for the first interim reporting period beginning after December 15, 2006.  The Company is currently evaluating the impact of EITF 06-3 and expects to adopt EITF 06-3 in the fourth quarter of the current fiscal year.

2.  Supplemental Financial Information

Inventories

The following table presents details of the Company’s inventories:

		September 30, 2006			March 31, 2006
		(In thousands)
Materials and supplies		$	3,750		$	2,258
Work in process		200			217
Finished goods		842			339
		$	4,792		$	2,814

 

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Goodwill and Intangible Assets

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

		September 30, 2006						March 31, 2006
		Gross Carrying Amount			Accumulated Amortization			Gross Carrying Amount			Accumulated Amortization
		(In thousands)
Developed technology		$	495		$	(230	)	$	495		$	(179	)
Patents		317			(104		)	317			(82		)
Total		$	812		$	(334	)	$	812		$	(261	)

 

Amortization expense for intangible assets subject to amortization was $37,000 and $73,000 for the three and six months ended September 30, 2006, respectively, and $36,000 and $73,000 for the three and six months ended September 30, 2005, respectively.  Future estimated amortization expense for the remainder of the current fiscal year, the next four fiscal years and thereafter is as follows:

 

At September 30, 2006, goodwill of $27.8 million was comprised of $18.0 million associated with the October 2004 merger between the Company and its Iteris Subsidiary; $9.6 million associated with the acquisitions of the Rockwell International Transportation Systems Group, Meyer Mohaddes Associates, Inc. and the Viggen Systems Consulting Group; and $200,000 associated with the purchase of the assets of Mil-Lektron, a complementary product to the Company’s Vantage video detection business.

Warranty Reserve Activity

The following table presents activity in accrued warranty obligations:

 

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Earnings (Loss) Per Share

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

 

The following shares were excluded from the computation of diluted earnings (loss) per share as their effect would have been antidilutive:

 

3.  Revolving Line of Credit and Long-Term Debt

Revolving Line of Credit

The Company renewed its line of credit agreement with its primary bank in August 2005, which provided for borrowings of up to $5.0 million.  This line of credit agreement was scheduled to expire on July 31, 2006 but was extended until October 31, 2006. 

Subsequent to September 30, 2006, the Company replaced its current facility and entered into a new two year credit facility with a different bank.  The new facility provides for combined line of credit and bank term note borrowings of up to $8.0 million.  Under the new credit facility, the Company may borrow against its eligible accounts receivable and eligible inventory, as defined in the credit agreement.  Line of credit interest on borrowed amounts is payable monthly at the current stated prime rate plus 1.25%.  Additionally, the Company is obligated to pay an unused line fee of 0.25% per annum applied to the amount by which the maximum credit amount exceeds the average daily principal balance during the preceding month. The new credit facility requires $2,000 in monthly collateral management fees and includes an early termination fee equal to 2% of the total facility during the first year of the agreement and 1% of the total facility in the second year of the agreement.  Additionally, the Company paid a commitment fee of $40,000 in October 2006 and is obligated to pay an additional $40,000 on the one year anniversary of the facility. The new credit facility is secured by substantially all of the assets of the Company. 

On September 30, 2006, the available credit under the prior line of credit agreement was $4.4 million, of which $3.8 million was unused.

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Long-Term Debt

The Company’s long-term debt consists of the following:

		September 30, 2006			March 31, 2006
		(In thousands)
Convertible debentures, net		$	9,307		$	9,203
Bank term note		2,084			2,708
Promissory note to landlord		1,292			1,292
Other		98			140
		12,781			13,343
Less current portion		(2,261		)	(1,969		)
		$	10,520		$	11,374

 

Convertible Debentures, Net.  In May 2004, the Company sold and issued subordinated convertible debentures in the aggregate original principal amount of $10.1 million.  In connection with the issuance of the debentures, the Company issued warrants to purchase an aggregate of 639,847 shares of its common stock, the value of which was recorded as a debt discount against the face amount of the debentures on the date of issuance and is being amortized to interest expense over the term of the convertible debentures.

The debentures are due in full on May 19, 2009, provide for 6.0% annual interest, payable quarterly, and are convertible into the 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 redeemed by the Company, at its option, at 120% of the principal amount; and from May 19, 2008, until the maturity date, the Company may redeem the debentures at 110% of the principal amount.  As of September 30, 2006, $250,000 of convertible debentures had been converted into  69,252 shares of common stock leaving $9.9 million of the originally issued convertible debentures outstanding at September 30, 2006.

Bank Term Note.  In October 2004, the Company entered into a $5.0 million term note payable with a bank.  The note is due on May 27, 2008, and provides for monthly principal payments of approximately $104,000.  Interest accrues at the current stated prime rate plus 0.25% (8.50% at September 30, 2006). Subsequent to September 30, 2006 the term note was assumed by the Company’s new bank as part of the Company’s new $8.0 million credit facility. The new term note is also due on May 27, 2008 and provides for monthly principal payments of approximately $104,000.  Interest accrues under the new term note at the current stated prime rate plus 1.25%.  Amounts due under the term note reduce the Company’s ability to borrow against its eligible assets on its line of credit.

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

Promissory Note to Landlord.  The Company has a $1.3 million unsecured promissory 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 September 30, 2006).  Beginning on October 1, 2006, the Company is required to make four equal quarterly payments of principal and accrued interest.  All outstanding accrued interest and principal becomes payable in full on July 1, 2007. The first principal payment of approximately $323,000 was made on October 5, 2006.

Scheduled aggregate maturities of long-term debt principal as of September 30, 2006 were as follows:

Fiscal Year Ending March 31,
(In thousands)
Remainder of 2007		$	1,292
2008		1,939
2009		243
2010		9,850
		$	13,324
Less: unamortized debt discount		(543		)
		$	12,781

 

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4.  Common Stock Warrants

On September 27, 2006, the Company issued warrants to purchase an aggregate 246,250 shares of common stock at an exercise price of $3.25 with a five year life to an existing shareholder in exchange for the early exercise of 1,250,000 outstanding warrants with an exercise price of $1.61.  The new warrants are immediately exercisable and are callable by the Company if the market price of the Company’s common stock trades for 20 consecutive days at a price greater than or equal to two times the exercise price of the warrants.  The fair value of the new warrants was $320,000 calculated using the Black-Scholes-Merton (“BSM”) option-pricing formula.  The warrants were considered a cost of raising capital and were recorded in equity. 

In connection with the issuance of the new warrants, the Company is party to a registration rights agreement that contains provisions under which the Company could be subjected to liquidated damages should it fail to maintain effective registration statements for the underlying shares of common stock.  These warrants have been accounted for within equity in the condensed consolidated balance sheet in accordance with EITF 00-19 Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and, accordingly, no liabilities have been recorded in connection therewith.  As of September 30, 2006, no liquidated damages were payable under the provisions of the registration rights agreement associated with these warrants. 

5.  Commitments and Contingencies

Litigation and Other Contingencies

On June 29, 2004, a supplier to Mariner Networks, Inc., a former subsidiary of the Company that was discontinued in the fiscal year ended March 31, 2002, filed a complaint in Orange County Superior Court against the Company alleging various breaches of written contract claims arising out of alleged purchase orders. 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 in connection with this matter.  The dispute was settled in full for $688,000 payable as follows:  (i) the Company issued 88,912 shares of the Company’s common stock on August 18, 2006 valued at $213,000 based on the closing 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) the Company is obligated to pay $350,000 in cash in equal monthly installments of $9,700 over the next three years beginning in November 2006.  In connection with this settlement, the Company has recorded a charge of $636,000, representing the fair value of the settlement, within other expense in the accompanying condensed consolidated statement of operations for the six months ended September 30, 2006. 

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

Furthermore, from time to time, the Company has experienced unforeseen developments in contingencies related to its former subsidiaries.  For example, the Company has been the subject of a number of routine tax audits for time periods and jurisdictions related to the businesses of its former subsidiaries, some of which are still in process.  Although the development and ultimate outcome of these and other unforeseen matters cannot be predicted with any certainty, management does not believe that the Company is presently involved in any matters related to its former subsidiaries that would have a material adverse effect on the Company’s consolidated results of operations, financial position or cash flows.

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Operating Lease Commitments

The Company has lease commitments for facilities in various locations throughout the United States. Future commitments under these non-cancelable operating leases at September 30, 2006 were as follows:

 

Inventory Purchase Commitments

At September 30, 2006, the Company had firm commitments to purchase inventory in the amount of $1.5 million during the third and fourth quarters of its fiscal year ending March 31, 2007.

6.  Stock-Based Compensation

The Company adopted SFAS 123R effective April 1, 2006.  Prior to April 1, 2006, the Company followed the 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-based compensation plans using the intrinsic value method under APB 25 and related interpretations.

SFAS 123R requires all stock-based payments, including grants of employee stock options, to be recognized in the statement of operations as an expense, based on their grant date fair values with such fair values amortized over the requisite service period.  The Company elected to utilize the modified prospective method for the transition to SFAS 123R. Under the modified prospective method, SFAS 123R applies to all awards granted or modified after the date of adoption. In addition, under the modified prospective method, compensation expense will be recognized for all stock-based compensation awards granted prior to but not yet vested as of April 1, 2006, based on grant-date fair values estimated in accordance with the original provisions of SFAS 123.  Accordingly, prior period amounts presented herein have not been restated to reflect the adoption of SFAS 123R.

The fair value concepts were not changed significantly as a result of implementing SFAS 123R; however, in adopting SFAS 123R, companies must choose among alternative valuation models and amortization assumptions. After assessing alternative valuation models and amortization assumptions, the Company continues to use both the BSM option-pricing formula and straight-line amortization of compensation expense over the requisite service period of stock option grants.  The Company will reconsider use of this model if additional information becomes available in the future that indicates another model would be more appropriate, or if grants issued in future periods have characteristics that cannot be reasonably estimated using this model.  SFAS 123 did not require the estimation of forfeitures in the calculation of stock compensation expense; however, SFAS 123R does require such estimation and upon adoption of SFAS 123R, the Company changed its methodology to include an estimate of forfeitures. The adoption of SFAS 123R had no effect on cash flows from operating activities because no tax benefits are realized from stock option exercises. The adoption of SFAS 123R also had no effect on cash flows from financing activities.

The following table illustrates the impact of adopting SFAS 123R:

		Three Months Ended September 30, 2006			Six Months Ended September 30, 2006
		(In thousands, except per share amounts)
Income before income taxes		$	(39	)	$	(94	)
Net income		$	(39	)	$	(94	)
Basic and diluted earnings per share		$	0.00		$	0.00

 

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The following table illustrates the effect on net loss and net loss per share for the three and six months ended September 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to options granted under the Company’s stock option plans.  For purposes of this pro forma disclosure, the fair value of the options was estimated using the BSM option-pricing formula and amortized on a straight-line basis to expense over the options’ vesting period:

		Three Months Ended September 30, 2005			Six Months Ended September 30, 2005
		(In thousands, except per share amounts)
Net loss — as reported		$	(155	)	$	(881	)
Add: Stock-based compensation expense included in net loss — as reported		258			523
Deduct: Total stock-based compensation expense determined under fair value based method for all awards		(364		)	(735		)
Net loss — pro forma		$	(261	)	$	(1,093	)
Basic and diluted loss per share — as reported		$	(0.01	)	$	(0.03	)
Basic and diluted loss per share — pro forma		$	(0.01	)	$	(0.04	)

 

The Company’s 1997 Stock Incentive Plan (the “Plan”) provides that options to purchase shares of the Company’s unissued common stock may be granted to directors, associates and consultants to the Company at exercise prices which are equal to or greater than the fair market value of the Company’s common stock on the date of grant.  Options expire ten years after the date of grant or 90 days after termination of employment and generally vest ratably at the rate of 25% on each of the first four anniversaries of the grant date.  New shares are issued to satisfy stock option exercises under the Plan.  As of September 30, 2006, options to purchase 1.5 million shares of the Company’s common stock were outstanding under the Plan. 

In connection with the merger of the Company and the Iteris Subsidiary (Note 1), the Company assumed the 1998 Stock Incentive Plan of the Iteris Subsidiary (the “1998 Plan”) and all outstanding options granted thereunder.  As of September 30, 2006, options to purchase 5.4 million shares of the Company’s common stock were outstanding under the 1998 Plan.  No further options may be granted under the 1998 Plan.

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

A summary of activity in the Plans for the six months ended September 30, 2006 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		3.97
Granted		169		$	2.33		N/A
Exercised		(191	)	$	1.16		N/A
Forfeited		(18	)	$	2.64		N/A
Expired		(24	)	$	2.50		N/A
Options outstanding at September 30, 2006		6,913		$	1.44		3.62		$	8,890
Vested and expected to vest at September 30, 2006		6,839		$	1.43		3.56		$	8,874
Options exercisable at September 30, 2006		6,462		$	1.38		3.26		$	8,716
Options exercisable at September 30, 2006 pursuant to a change-in-control		6,913		$	1.44		3.62		$	8,890

 

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At September 30, 2006, there were 106,000 shares of common stock available for grant under the Plan.

For the six month periods ended September 30, 2006 and 2005, the Company received $224,000 and $153,000, respectively, in cash from the exercise of stock options.  Total stock-based compensation expense for the three and six months ended September 30, 2006 was $74,000 and $174,000, respectively.  No income tax benefit was realized from activity in the Plans during the six months ended September 30, 2006 and 2005.

At September 30, 2006, there was $780,000 of total unrecognized compensation expense related to unvested stock options.  This expense is expected to be recognized over a weighted-average period of approximately 2.9 years.

The fair value of each stock-based award is estimated on the grant date using the BSM option-pricing formula. Expected volatility is based on the historical volatility of the Company’s stock price. The expected life of options granted subsequent to the adoption of SFAS 123R is derived based on the historical life of the Company’s options.  The risk-free interest rate for periods within the expected life of the option is based on the U.S. Treasury interest rates in effect at the time of grant. The grant date fair value of options granted was estimated using the following weighted-average assumptions:

 

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

 

7.  Business Segment Information

The Company currently operates in three reportable segments: Roadway Sensors, Automotive Sensors and Transportation Systems.  The Roadway Sensors segment includes the Company’s Vantage vehicle detection systems for traffic intersection control, incident detection and certain highway traffic data collection applications.  The Automotive Sensors segment includes AutoVue and is comprised of all activities related to lane departure warning systems for vehicle safety.  The Transportation Systems segment includes transportation engineering and consulting services and the development of transportation management and traveler information systems for the ITS industry. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies except that certain expenses, such as interest, amortization of certain intangibles and certain corporate expenses are not allocated to the segments. In addition, certain assets, including cash and cash equivalents, deferred taxes and certain long-lived and intangible assets, are not allocated to the segments.  The reportable segments are each managed separately because they manufacture and distribute distinct products or provide services with different processes.  All segment revenues are derived from external customers.

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The following table sets forth selected unaudited financial information for the Company’s reportable segments for the three and six months ended September 30, 2006 and 2005:

 

The following table reconciles segment income to consolidated income (loss) before income taxes:

		Three Months Ended September 30,						Six Months Ended September 30,
		2006			2005			2006			2005
		(In thousands)
Total income for reportable segments		$	1,781		$	870		$	3,306		$	1,451
Unallocated amounts:
Corporate expenses		(651		)	(936		)	(1,431		)	(1,835		)
Other income (expense), net		45			86			(645		)	38
Interest expense, net		(424		)	(358		)	(810		)	(710		)
Income (loss) before income taxes		$	751		$	(338	)	$	420		$	(1,056	)

 

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

This report, including the following discussion and analysis, contains forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) that are based on our current expectations, estimates and projections about our business and our industry, and reflect management’s beliefs and certain assumptions made by us based upon information available to us as of the date of this report. When used in this report and the information incorporated herein by reference, the words “expect(s),” “feel(s),” “believe(s),” “should,” “will,” “may,” “anticipate(s),” “estimate(s)” and similar expressions or variations of these words are intended to identify forward-looking statements. These forward-looking statements include but are not limited to statements regarding our anticipated sales, revenue, expenses, profits, capital needs, competition, development plans, backlog and manufacturing capabilities, the applications for and acceptance of our products and services, the status of our facilities and product development, and the impact of pending litigation. These statements are not guarantees of future performance and are subject to certain risks and uncertainties which could cause actual results to differ materially from those projected. You should not place undue reliance on these forward-looking statements that speak only as of the date hereof. We undertake no obligation to republish revised forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. We encourage you to carefully review and consider the various disclosures made by us which describe certain factors which could affect our business, including in “Risk Factors” set forth in Part II, Item 1A of this report, before deciding to invest in our company or to maintain or increase your investment. We undertake no obligation to revise or update publicly any forward-looking statement for any reason.

Overview

We are a leading provider of outdoor machine vision systems and sensors that optimize the flow of traffic and enhance driver safety. Using our proprietary software and ITS industry expertise, we provide video sensor systems, transportation management and traveler information systems and other engineering and consulting services to the ITS industry. We use our outdoor image recognition software expertise to develop proprietary algorithms for video sensor systems that improve vehicle safety and the flow of traffic. Using our knowledge of the ITS industry, we design and implement transportation management systems that help public agencies reduce traffic congestion and provide greater access to traveler information.

Our Vantage product is a video vehicle detection system that detects the presence of vehicles on roadways.  Vantage systems are used at signalized intersections to enable a traffic controller to more efficiently allocate green signal time and are also used for incident detection and highway traffic data collection applications. We sell and distribute our Vantage products primarily to commercial customers and municipal agencies.

Our AutoVue Lane Departure Warning (“LDW”) systems consist of a small windshield mounted sensor that uses proprietary software to detect and warn drivers of unintended lane departures. Approximately 25,000 production AutoVue units have been sold for truck platforms in the North American and European markets.  Our AutoVue LDW systems are currently offered as an option on certain trucks, including Mercedes, MAN, Iveco, DAF, Scania, Freightliner and International.  In North America our LDW systems are sold primarily to truck fleets, and to date, 36 U.S. heavy truck fleets have selected our LDW systems, representing an estimated 19,000 vehicles.  In September 2003, we entered into an agreement with Valeo Schalter and Sensuren GmbH (“Valeo”), pursuant to which we granted Valeo the exclusive right to sell and manufacture our AutoVue LDW systems to the worldwide passenger car market in exchange for royalty payments for each AutoVue LDW unit sold.  To date, royalty payments from Valeo have not been significant.  Pursuant to this agreement, we also provide specific contract engineering services, technical marketing and sales support to Valeo to enable the launch of our LDW technology on three Infiniti platforms, the FX, M and Q, where the device is offered as part of the technology option package.  Valeo is currently in discussions to provide our LDW system to other passenger car OEMs; however, we cannot assure you that such discussions will be successful.  We plan to continue to provide technical marketing and sales support to Valeo in our efforts to win new OEM customers for the passenger car market as well as contract engineering services related to the possible launch of new Infiniti platforms that include our LDW system.  We believe that AutoVue is a broad sensor platform that, through additional software development, may be expanded to incorporate additional safety and convenience features.

Our transportation management systems business includes transportation engineering and consulting services focused on the planning, design, development and implementation of software-based systems that integrate sensors, video surveillance, computers and advanced communications equipment to enable public agencies to monitor, control and direct

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traffic flow, assist in the quick dispatch of emergency crews and distribute real-time information about traffic conditions.  Our services include planning and other engineering for the implementation of transportation infrastructure and related communications systems, analysis and study related to goods movement and commercial vehicle operations, and parking systems designs.  These services and systems are sold to local, state and national transportation agencies in the United States.  Our transportation management systems business is largely dependent upon governmental funding and budgetary issues.  The Federal Highway Bill was passed in August 2005, which provides for a significant increase in transportation funding over the next six years.  Our Transportation management systems business is expanding partly due to the passage of the Federal Highway Bill combined with expansion of transportation funds at state and local agencies throughout the country.

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

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our unaudited condensed consolidated financial statements included herein, which have been prepared in accordance with U.S generally accepted accounting principles. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an ongoing basis, we evaluate these estimates and assumptions, including those related to the collectibility of accounts receivable, the valuation of inventories, the recoverability of long-lived assets and goodwill, accounting for stock-based compensation related to SFAS 123R, and other contingencies. We base these estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. These estimates and assumptions by their nature involve risks and uncertainties, and may prove to be inaccurate. In the event that any of our estimates or assumptions are inaccurate in any material respect, it could have a material adverse effect on our reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.

The following critical accounting policies affect our more significant judgments and estimates used in the preparation of our unaudited condensed consolidated financial statements.

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

Contract revenues are derived primarily from long-term contracts with governmental agencies.  Contract revenues include costs incurred plus a portion of estimated fees or profits determined using the percentage of completion method of accounting based on the relationship of costs incurred to total estimated costs.  Any anticipated losses on contracts are charged to earnings when identified.  Changes in job performance and estimated profitability, including those arising from contract penalty provisions and final contract settlements, may result in revisions to recognized costs and revenues and are recognized in the period in which the revisions are determined.  Profit incentives are included in revenue when their realization is reasonably assured.

In addition to product and contract revenues, we derive revenue from technology access fees, the provision of specific non-recurring contract engineering services related to our AutoVue LDW systems, and royalties related to unit sales of our AutoVue LDW systems by our strategic partner Valeo to the passenger car market. Technology access fee revenues are recognized evenly over the period in which they are earned.  Non-recurring contract engineering revenues are recognized in the period in which the related services are performed.  Royalty revenues are recorded based on unit sales of our products by Valeo and are recognized in the period in which such sales occur.  Technology access fee revenues, contract engineering revenues and royalty revenues are included in net sales.

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

Accounts Receivable.  We estimate the collectibility of customer receivables on an ongoing basis by periodically reviewing invoices outstanding greater than a certain period of time.  We record reserves for receivables deemed to be at risk for collection as well as a general reserve based on our historical collections experience.  A considerable amount of judgment is required in assessing the ultimate realization of trade receivables, including the current credit-worthiness of each customer.  If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make required payments, additional allowances may be required that could adversely affect our operating results.

Inventory. Inventories consist of finished goods, work-in-process and raw materials and are stated at the lower of cost or market.  We provide reserves for potentially excess and obsolete inventory. In assessing the ultimate realization of inventories, we make judgments as to future demand requirements and compare that with the current or committed inventory levels.  Reserves are established for inventory levels that exceed anticipated future demand.  It is possible that reserves over and above those already established may be required in the future if market conditions for our products deteriorate.

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

Warranty.  We generally provide a one to three year warranty from the original invoice date on all products, materials and workmanship.  Defective products are either repaired or replaced, at our option, upon meeting certain criteria.  We accrue a provision for the estimated costs that may be incurred for product warranties relating to a product as a component of cost of sales at the time revenue for that product is recognized.  The accrued warranty provision is included within accrued expenses on the accompanying condensed consolidated balance sheets.  Should our actual experience of warranty returns be higher than anticipated, additional warranty reserves may be required, which may adversely affect our operating results.

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

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

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

SFAS 123R requires all stock-based payments, including grants of employee stock options, to be recognized in the

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

In implementing SFAS 123R, we have used the Black-Scholes-Merton (“BSM”) option-pricing formula to estimate the fair value of stock-based awards granted subsequent to April 1, 2006.  Our assumptions under the BSM formula include the following:  expected volatilities are based on the historical volatility of our stock price, the expected life of options is derived based on the historical life of our options, and the risk-free rate for periods within the expected life of the option is based on the U.S. Treasury interest rates in effect at the time of grant.  Additionally, SFAS 123 did not require the estimation of forfeitures in the calculation of stock compensation expense; however, SFAS 123R does require such estimation and upon adoption of SFAS 123R, we changed our methodology to include an estimate of forfeitures.  Future stock-based compensation expense in any particular quarter or year could be affected by changes in our assumptions or changes in market conditions. 

Results of Operations

The following table sets forth certain statement of operations data as a percentage of total net sales and contract revenues for the periods indicated. The following table should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations.

		Three Months Ended September 30,				Six Months Ended September 30,
		2006		2005		2006		2005
Net sales and contract revenues:
Net sales		64.4	%	62.7	%	63.4	%	62.5	%
Contract revenues		35.6		37.3		36.6		37.5
Total net sales and contract revenues		100.0	%	100.0	%	100.0	%	100.0	%
Costs and expenses:
Cost of net sales		36.6		33.3		35.5		32.2
Cost of contract revenues		22.2		23.9		23.2		24.3
Gross profit		41.2		42.8		41.3		43.5
Operating expenses:
Selling, general and administrative		27.5		32.1		28.2		31.9
Research and development		5.3		10.8		6.3		12.6
Deferred compensation plan		0.3		0.1		(0.1	)	0.3
Amortization of intangible assets		0.3		0.3		0.3		0.3
Total operating expenses		33.4		43.3		34.7		45.1
Operating income (loss)		7.8		(0.5	)	6.6		(1.6	)
Non-operating income (expense):
Other income (expense), net		0.3		0.7		(2.3	)	0.2
Interest expense, net		(2.9	)	(2.8	)	(2.8	)	(2.9	)
Income (loss) before income taxes		5.2		(2.6	)	1.5		(4.3	)
Income tax benefit (provision)		(0.1	)	1.4		2.1		0.7
Net income (loss)		5.1	%	(1.2	)%	3.6	%	(3.6	)%

 

Analysis of Quarterly Results of Operations

Net Sales and Contract Revenues.  Net sales are comprised of Roadway Sensor sales, which are derived from sales of our Vantage video detection systems; and Automotive Sensor sales, which are derived from sales of AutoVue LDW systems, technology access fees, contract engineering revenue and royalty revenue generated from AutoVue related activities.  Contract revenues consist entirely of Transportation Systems revenues, which are generated from systems integration and ITS consulting services with federal, state, county and municipal agencies. We currently have a diverse customer base with our largest customer constituting 9.6% and 10.1% of total net sales and contract revenues in the three and six months ended September 30, 2006.

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Total net sales and contract revenues increased 13.8% to $14.5 million and 14.1% to $28.3 million for the three and six months ended September 30, 2006, respectively, compared to $12.7 million and $24.8 million in the corresponding periods in the prior fiscal year.  This increase was driven by increased net sales in both the Roadway Sensors and Automotive Sensors businesses as well as increased contract revenues in the Transportation Systems business, as discussed below.

Net sales increased 16.9% to $9.3 million and 15.6% to $17.9 million for the three and six months ended September 30, 2006, respectively, compared to $8.0 million and $15.5 million in the corresponding periods of the prior fiscal year.  This increase was driven by a 20.1% and a 20.9% increase in Roadway Sensors net sales in the three and six months ended September 30, 2006, respectively, over the corresponding periods in the prior year as we continue to experience positive reaction to recently introduced Vantage product offerings such as eAccess and color cameras, as well as higher governmental spending which we believe is related to the passage of the Federal Highway Bill in August 2005.  In addition to the increase in Roadway Sensors net sales, Automotive Sensors net sales increased 8.5% and 2.1% in the three and six months ended September 30, 2006, respectively, over the corresponding periods in the prior year primarily as a result of an increase in sales of our LDW systems in the North American aftermarket and an increase in revenues generated through engineering activities in the passenger car market. Despite an increase of 14.7% in sales of our LDW systems to the heavy truck market for the three months ended September 30, 2006 compared to the same period in the prior year, sales of our LDW systems to this market have decreased by 4.7% for the six months ended September 30, 2006 compared to the same period in the prior year. The higher level of sales in the prior fiscal year occurred largely as a result of our largest Automotive Sensors customer purchasing approximately $1.0 million of spare LDW systems in the prior year in anticipation of the changeover to the next generation LDW system.  $400,000 of these LDW systems were purchased in the first quarter of the prior fiscal year and resulted in unusually high volumes for this customer in that period.  Such purchases of spare systems did not occur in the three and six months ended September 30, 2006, and are not expected to occur for at least the remainder of this current fiscal year.  Additionally, our largest customer benefited from volume pricing discounts which became effective January 1, 2006 and negatively impacted our net sales for Automotive Sensors.  The reduced level of sales to our largest Automotive Sensors hardware customer was somewhat offset by a 166% increase in sales of aftermarket LDW systems in North America for the six months ended September 30, 2006.  Two of the largest European truck manufacturers also recently announced the launch of our LDW system as an option on heavy duty truck models, which may positively impact our LDW sales in the current fiscal year.  While we have enjoyed recent success in signing new customers in the truck market, we have experienced a decline in sales from our largest Automotive Sensors hardware customer, which we have not been able to overcome through sales to new customers in North America or Europe.  We cannot assure you that this trend will not continue.

Royalty revenues from Valeo for sales of our LDW systems for the passenger car market remained relatively insignificant in the current quarter.  Our LDW systems are now offered as an option on three Infiniti models.  While Valeo is currently in discussions to offer our LDW systems on other passenger car platforms, we cannot assure you that Valeo will be successful in these efforts.

Contract revenues increased 8.5% to $5.1 million and 11.5% to $10.4 million for the three and six months ended September 30, 2006, respectively, as compared to $4.7 million and $9.3 million in the corresponding periods of the prior fiscal year.  This increase was largely due to increased funding at the federal, state and local levels throughout the country.  In response to this growth in funding, we have increased our Transportation Systems staff by 12% in the six months ended September 30, 2006.  We expect to continue to increase our Transportation Systems staff over the next couple quarters, although not at the same rate as in the six months ended September 30, 2006.  We believe the ability of our Transportation Systems business to grow and successfully win and service new contracts will be highly dependent upon our continued success in recruiting and retaining qualified personnel.  All of our contract revenues are derived from work performed in North America under a broad range of fixed price and cost plus fixed fee contracts.  In September 2006 we were awarded a $9.8 million contract from the Federal Highway Administration (“FHWA”), which covers a period of two years beginning April 2007 and contains renewal options extending through 2012.  Although this contract is not expected to substantially affect the trend in contract revenues in our Transportation Systems business and although we cannot assure you that the full face amount of the contract will be spent or that any of the options will be exercised, this contract does help solidify our future FHWA business.

Gross Profit.  Total gross profit increased 9.5% to $6.0 million and 8.1% to $11.7 million for the three and six months ended September 30, 2006, respectively, as compared to $5.4 million and $10.8 million in the corresponding periods of the prior fiscal year.  Total gross profit as a percent of net sales and contract revenues decreased to 41.2% and 41.3% for the three and six months ended September 30, 2006, respectively, as compared to 42.8% and 43.5% in the corresponding periods of the prior fiscal year.

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