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 June 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 August 10, 2006, the registrant had 29,133,339 shares of common stock outstanding

 

 

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

Table of Contents

PART I.		FINANCIAL INFORMATION
ITEM 1.		FINANCIAL STATEMENTS
		UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS AT JUNE 30, 2006 AND MARCH 31, 2006
		UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2006 AND 2005
		UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED JUNE 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)

		June 30, 2006			March 31, 2006
		(unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	225		$	131
Trade accounts receivable, net of allowance for doubtful accounts of $482 and $429 at June 30, 2006 and March 31, 2006, respectively		10,512			11,426
Costs and estimated earnings in excess of billings on uncompleted contracts		3,585			2,693
Inventories, net of reserve for inventory obsolescence of $618 and $592 at June 30, 2006 and March 31, 2006, respectively		2,989			2,814
Deferred income taxes		886			790
Prepaid expenses and other current assets		953			368
Total current assets		19,150			18,222
Property and equipment, net		1,795			1,783
Deferred income taxes		1,178			818
Intangible assets, net of accumulated amortization of $297 and $261 at June 30, 2006 and March 31, 2006, respectively		515			551
Goodwill		27,774			27,774
Other assets		417			485
Total assets		$	50,829		$	49,633
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Trade accounts payable		$	3,446		$	3,620
Accrued payroll and related expenses		3,352			3,481
Accrued liabilities		2,788			2,304
Billings in excess of costs and estimated earnings on uncompleted contracts		655			893
Revolving line of credit		3,509			2,662
Current portion of long-term debt		2,271			1,969
Total current liabilities		16,021			14,929
Non-current liabilities		288			12
Deferred compensation plan liability		754			820
Deferred gain on sale of building		378			449
Long-term debt		1,536			2,171
Convertible debentures, net		9,255			9,203
Total liabilities		28,232			27,584
Commitments and contingencies
Redeemable common stock, 1,219 shares issued and outstanding at June 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 June 30, 2006 and March 31, 2006		—			—
Common stock, $0.10 par value, 50,000 shares authorized, 27,571 and 27,432 shares issued and outstanding at June 30, 2006 and March 31, 2006, respectively		2,757			2,743
Additional paid-in capital		126,914			126,664
Common stock held in trust, 311 shares at June 30, 2006 and March 31, 2006		(374		)	(374		)
Notes receivable from employees		(45		)	(49		)
Accumulated deficit		(110,077		)	(110,356		)
Accumulated other comprehensive income		8			7
Total stockholders’ equity		19,183			18,635
Total liabilities and stockholders’ equity		$	50,829		$	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 June 30,
		2006			2005
Net sales and contract revenues:
Net sales		$	8,600		$	7,525
Contract revenues		5,216			4,554
Total net sales and contract revenues		13,816			12,079
Costs and expenses:
Cost of net sales (a)		4,758			3,755
Cost of contract revenues (a)		3,339			2,969
Gross profit		5,719			5,355
Operating expenses:
Selling, general and administrative (a)		4,001			3,828
Research and development (a)		1,003			1,746
Deferred compensation plan		(66		)	62
Amortization of intangible assets		36			37
Total operating expenses		4,974			5,673
Operating income (loss)		745			(318		)
Other income (expense):
Other expense, net		(690		)	(48		)
Interest expense, net		(386		)	(352		)
Total other income (expense), net		(1,076		)	(400		)
Loss before income taxes		(331		)	(718		)
Income tax benefit (expense)		610			(8		)
Net income (loss)		$	279		$	(726	)
Earnings (loss) per common share:
Basic		$	0.01		$	(0.03	)
Diluted		$	0.01		$	(0.03	)
Weighted average common shares outstanding:
Basic		28,393			28,062
Diluted		32,368			28,062
(a)  Includes stock-based compensation expense as follows:
Cost of net sales		5			9
Cost of contract revenues		29			70
Selling, general and administrative expense		54			139
Research and development expense		12			47

 

See accompanying notes to unaudited condensed consolidated financial statements.

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ITERIS, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

		Three Months Ended June 30,
		2006			2005
Cash flows from operating activities
Net income (loss)		$	279		$	(726	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Change in deferred tax assets		(456		)	─
Depreciation and amortization of property and equipment		130			162
Stock-based compensation		100			265
Amortization of deferred gain on sale—leaseback transaction		(71		)	(71		)
Amortization of debt discount		52			52
Amortization of intangible assets		36			37
Amortization of deferred financing costs		34			35
Changes in operating assets and liabilities:
Accounts receivable		914			(831		)
Net costs and estimated earnings in excess of billings		(1,130		)	(419		)
Inventories		(175		)	496
Prepaid expenses and other assets		(551		)	(168		)
Accounts payable and accrued liabilities		239			(695		)
Net cash used in operating activities		(599		)	(1,863		)
Cash flows from investing activities
Purchases of property and equipment		(142		)	(212		)
Cash flows from financing activities
Proceeds from borrowings on line of credit, net		847			1,353
Payments on long-term debt		(333		)	(333		)
Change in checks drawn in excess of available bank balances		153			885
Proceeds from stock option and warrant exercises		168			124
Net cash provided by financing activities		835			2,029
Increase (decrease) in cash		94			(46		)
Cash at beginning of period		131			46
Cash at end of period		$	225		$	─
Supplemental cash flow information:
Cash paid (received) during the period:
Interest		$	301		$	254
Income taxes		40			44
Supplemental schedule of non-cash investing and financing activities:
Fair value of warrants issued in settlement of liabilities		—			28

 

See accompanying notes to unaudited condensed consolidated financial statements.

5

 

ITERIS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 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 June 30, 2006, the consolidated results of operations for the three months ended June 30, 2006 and 2005, and the consolidated cash flows for the three months ended June 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 months ended June 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.

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.

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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 $2.9 million and $3.2 million at June 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 $80,000, with no impact on earnings per share, for the three months ended June 30, 2006.

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 fair value of reporting units is generally determined 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.

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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.

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 5, 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 will adopt this Interpretation in the first quarter of its fiscal year ending March 31, 2008.

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2.   Supplemental Financial Information

Inventories

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

 

		June 30, 2006			March 31, 2006
		(In thousands)
Materials and supplies		$	2,512		$	2,258
Work in process		182			217
Finished goods		295			339
		$	2,989		$	2,814

 

Goodwill and Identifiable Intangible Assets

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

 

		June 30, 2006						March 31, 2006
		Gross Carrying Amount			Accumulated Amortization			Gross Carrying Amount			Accumulated Amortization
		(In thousands)
Developed technology		$	495		$	(204	)	$	495		$	(179	)
Patents		317			(93		)	317			(82		)
Total		$	812		$	(297	)	$	812		$	(261	)

 

Amortization expense for intangible assets subject to amortization was $36,000 and $37,000 for the three month periods ended June 30, 2006 and June 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 June 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:

 

		Three Months Ended June 30,
		2006			2005
		(In thousands)
Balance at beginning of period		$	519		$	326
Additions charged to cost of sales		135			75
Warranty claims		(64		)	(59		)
Balance at end of period		$	590		$	342

 

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Earnings (Loss) Per Share

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

		Three Months Ended June 30,
		2006			2005
		(In thousands, except per share amounts)
Numerator:
Net income (loss)		$	279		$	(726	)
Denominator:
Weighted average common shares used in basic computation		28,393			28,062
Dilutive stock options		3,417			—
Dilutive warrants		558			—
Weighted average common shares used in dilutive computation		32,368			28,062
Basic and diluted earnings (loss) per share		$	0.01		$	(0.03	)

 

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

 

		Three Months Ended June 30,
		2006		2005
		(In thousands)
Stock options		525		7,323
Warrants		1,380		3,624
Convertible debentures		2,729		2,729

 

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 effective August 1, 2005, which provided for borrowings of up to $5.0 million.  This line of credit agreement expired on July 31, 2006 but was extended until August 31, 2006.  The Company is currently in negotiations with its bank to replace this line of credit, but cannot assure that a new credit line will be obtained in a timely manner, on acceptable terms or at all.

Under this line of credit, the Company may borrow against its eligible accounts receivable and the value of its eligible inventory, as defined in the credit agreement. Interest on borrowed amounts is payable monthly at the current stated prime rate plus 3.0%.  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.

There are no monthly collateral management fees and no pre-payment or early termination fees. On June 30, 2006, the available credit under this line of credit agreement was $4.1 million, of which $600,000 was unused.

Long-Term Debt

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

 

		June 30, 2006			March 31, 2006
		(In thousands)
Convertible debentures, net		$	9,255		$	9,203
Bank term note		2,396			2,708
Promissory note to landlord		1,292			1,292
Other		119			140
		13,062			13,343
Less current portion		(2,271		)	(1,969		)
		$	10,791		$	11,374

 

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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 June 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 June 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 June 30, 2006).

Both the bank term note and the 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 its landlord.  Under the terms of the note agreement, interest is payable quarterly and accrues at a rate of prime plus 2.0% (10.25% at June 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.

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

 

 

4.  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 preliminary settlement in connection with this matter.  In full settlement of this dispute, the Company agreed to pay $125,000 on or before October 20, 2006, plus an additional $350,000 to be paid in equal monthly installments of $9,700 over three years beginning in November 2006.  Additionally, the Company agreed to issue shares of its common stock valued at $213,000 in August 2006, based on the closing sales price of the Company’s common stock on the date of issuance.  In connection with this settlement, the Company has recorded $688,000 to other expense in the accompanying condensed consolidated statement of operations for the three months ended June 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,

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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.

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 June 30, 2006, including the lease for the Company’s Anaheim facilities were as follows:

 

 

Inventory Purchase Commitments

At June 30, 2006, the Company had firm commitments to purchase inventory in the amount of $1.9 million during the second and third quarters of its fiscal year ending March 31, 2007.

5.  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 Black-Scholes-Merton (“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 as if the Company had continued to account for stock-based compensation under APB 25:

 

		Three Months Ended June 30, 2006
		SFAS 123R			APB 25
		(In thousands, except per share amounts)
Loss before income taxes		$	(331	)	$	(276	)
Net income (loss)		$	279		$	334
Basic and diluted earnings per common share		$	0.01		$	0.01

 

 

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The following table illustrates the effect on net loss and net loss per share for the three months ended June 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 June 30, 2005
		(In thousands, except per share amounts)
Net loss — as reported		$	(726	)
Add: Stock-based employee compensation expense included in net loss — as reported		265
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards		(371		)
Net loss — pro forma		$	(832	)
Basic and diluted loss per share — as reported		$	(0.03	)
Basic and diluted loss per share — pro forma		$	(0.03	)

 

The Company has one stock option plan, the 1997 Stock Incentive Plan (the “Plan”), which 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.

In connection with the merger of the Company and the Iteris Subsidiary (Note 1), the Company assumed all of the outstanding options under the 1998 Stock Incentive Plan of the Iteris Subsidiary (the “1998 Plan”).  As of June 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.

Both the Plan and the 1998 Plan (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 changes in the Plans for the three months ended June 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		105		$	2.21		N/A
Exercised		(140	)	$	1.14		N/A
Forfeited		(17	)	$	2.74		N/A
Expired		(22	)	$	2.36		N/A
Options outstanding at June 30, 2006		6,903		$	1.43		3.80		$	8,252
Vested and expected to vest at June 30, 2006		6,766		$	1.41		3.70		$	8,202
Options exercisable at June 30, 2006		6,370		$	1.37		3.44		$	7,954
Options exercisable pursuant to a change in control at June 30, 2006		6,903		$	1.43		3.80		$	8,252

 

At June 30, 2006, there were 168,000 shares of common stock available for grant under the Plan.

For the three month periods ended June 30, 2006 and 2005, the Company received $168,000 and $87,000, respectively, in cash from the exercise of stock options.  Total stock-based compensation expense for the three month period ended June 30, 2006 was $100,000.  No income tax benefit was realized from activity in the Plans during the three month periods ended June 30, 2006 and 2005.

At June 30, 2006, there was $788,000 of total unrecognized compensation expense related to unvested stock options.  This expense is expected to be recognized over a weighted-average period of approximately 1.6 years.

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The fair value of each stock-based award is estimated on the grant date using the BSM option-pricing formula. Expected volatilities are 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 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 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:

 

 

6.  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 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.

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

 

 

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

 

		Three Months Ended June 30,
		2006			2005
					(In thousands)
Total income for reportable segments		$	1,519		$	581
Unallocated amounts:
Corporate expenses		(774		)	(899		)
Other expense, net		(690		)	(48		)
Interest expense, net		(386		)	(352		)
Loss before income taxes		$	(331	)	$	(718	)

 

 

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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 more efficient allocation of 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 Mercedes, MAN, Freightliner and International trucks.  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 negotiations to provide our LDW system to other passenger car OEMs; however, we cannot assure you that such negotiations 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 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

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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.

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 have recorded 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.

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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 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 the recording of valuation allowances 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 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.  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. 

 

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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 June 30,
		2006		2005
Net sales and contract revenues:
Net sales		62.2	%	62.3	%
Contract revenues		37.8		37.7
Total net sales and contract revenues		100.0		100.0
Costs and expenses:
Cost of net sales		34.4		31.1
Cost of contract revenues		24.2		24.6
Gross profit		41.4		44.3
Operating expenses:
Selling, general and administrative		29.0		31.7
Research and development		7.3		14.5
Deferred compensation plan		(0.5	)	0.5
Amortization of intangible assets		0.2		0.3
Total operating expenses		36.0		47.0
Operating income (loss)		5.4		(2.6	)
Other income (expense):
Other expense, net		(5.0	)	(0.4	)
Interest expense, net		(2.8	)	(2.9	)
Total other income (expense), net		(7.8	)	(3.3	)
Loss before income taxes		(2.4	)	(5.9	)
Income tax benefit (expense)		4.4		(0.1	)
Net income (loss)		2.0	%	(6.0	)%

 

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 10.7% of total net sales and contract revenues in the three months ended June 30, 2006.

Total net sales and contract revenues increased 14.4% to $13.8 million for the three months ended June 30, 2006, compared to $12.1 million in the corresponding period in the prior fiscal year. This increase was primarily due to increased Roadway Sensors net sales and Transportation Systems contract revenues offset in part by decreased Automotive Sensors net sales, as discussed below.

Net sales increased 14.3% to $8.6 million for the three months ended June 30, 2006 as compared to $7.5 million in the corresponding period of the prior fiscal year.  This increase was driven by a 21.9% increase in Roadway Sensors net sales in the three months ended June 30, 2006 over the corresponding period 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.  The increase in Roadway Sensors net sales was partially offset by a decrease of 4.3% in Automotive Sensors net sales, which was primarily a result of reduced sales to our largest AutoVue customer.  The higher level of sales in the prior fiscal year occurred largely as a result of our largest AutoVue 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 months ended June 30, 2006, and are not expected to occur for at least

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the remainder of this current fiscal year.  Additionally, our largest customer benefited from volume pricing discount which were effective January 1, 2006, also contributing to the decline in our net sales for Automotive Sensors.  The reduced level of sales to our largest AutoVue customer was somewhat offset by a 150% increase in sales of aftermarket LDW systems in North America.  While we have enjoyed recent success in signing new customers in the truck market, for the reasons previously noted, we have experienced a decline in sales from our largest Automotive Sensors hardware customers.  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 14.5% to $5.2 million for the three months ended June 30, 2006 as compared to $4.6 million in the corresponding period of the prior fiscal year.  This increase is 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 9% in the three months ended June 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 three months ended June 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.

Gross Profit.  Total gross profit increased 6.8% to $5.7 million for the three months ended June 30, 2006 as compared to $5.4 million in the corresponding period of the prior fiscal year.  Total gross profit as a percent of net sales and contract revenues decreased to 41.4% for the three months ended June 30, 2006 as compared to 44.3% for the corresponding period of the prior fiscal year.

Gross profit as a percent of net sales was 44.7% for the three months ended June 30, 2006 compared to 50.1% in the corresponding period of the prior fiscal year.  This decrease was primarily due to volume discounts given to our largest Automotive Sensors hardware customer, increased product support activities in our Roadway Sensors business, an increased level of lower margin non-recurring engineering services sold to our strategic partner Valeo in the current year period and the mix of products sold in the current quarter. Gross profit as a percent of net sales generally fluctuates in any specific quarter based on customer mix.

Gross profit as a percent of contract revenues increased to 36.0% for the three months ended June 30, 2006 compared to 34.8% in the corresponding period of the prior fiscal year.  The increase in gross profit as a percent of contract revenues was primarily due to a continued focus on higher margin contracts and a favorable contract mix.

Selling, General and Administrative Expense.  Selling, general and administrative expense increased 4.5% to $4.0 million (or 29.0% of total net sales and contract revenues) in the three months ended June 30, 2006 compared to $3.8 million (or 31.7% of total net sales and contract revenues) in the corresponding period of the prior fiscal year.  The increase in selling, general and administrative expenses was largely due to increased sales and marketing costs to support sales growth in Roadway Sensors and Transportation Systems, consisting primarily of higher commissions on higher sales, and higher personnel costs and related expenses due to the additional sales and support staff hired during the current quarter.  While we recently reached a preliminary settlement in the Delta litigation, we anticipate we will incur additional legal fees in the next quarter related to the finalization of the settlement.

Research and Development Expense.  Research and development expense decreased 42.6% to $1.0 million (or 7.3% of total net sales and contract revenues) in the three months ended June 30, 2006 compared to $1.7 million (or 14.5% of total net sales and contract revenues) in the corresponding period of the prior fiscal year.  The decrease in research and development expense was largely a result of higher than anticipated costs in the prior year period in Automotive Sensors as we expended significant development resources in qualifying the next generation LDW system with our largest customer.  Additionally, in the current year there has been a slight shift in engineering resources from research and development activities to product support activities as a result of the introduction of new products.

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

Deferred Compensation Plan Expense.  During the three month period ended June 30, 2006, we recorded a non-cash benefit of $66,000 related to the depreciation in value of 310,510 shares of our common stock held in trust by our deferred compensation savings plan.  This compares to a non-cash expense of $62,000 recorded in the three month period ended June 30, 2005.  We expect to continue to experience non-cash expense or benefit in future periods as the value of the assets held in our deferred compensation savings plan fluctuates.

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

 

Other expense, net for the three months ended June 30, 2006 primarily reflects $688,000 of expense recorded in connection with the settlement of litigation described in Note 4 to the accompanying condensed consolidated financial statements.

Interest expense, net reflects the following:

 

 

Interest expense increased 9.7% for the three month period ended June 30, 2006 compared to the corresponding period in the prior fiscal year primarily as a result of a higher level of borrowings on our line of credit in the current year.

Income Taxes.  During the three months ended June 30, 2006, we recognized an income tax benefit of $610,000, as compared to income tax expense of $8,000 in the three months ended June 30, 2005.  The tax benefit recorded in the three months ended June 30, 2006 reflects a tax benefit of $154,000 based on an estimated annual effective tax rate of 47.3% applied to the pre-tax losses for the three months ended June 30, 2006, as well as a $456,000 reduction in the valuation allowance recorded against our deferred tax assets as a result of changes in estimates of the future realizability of these assets.  As a result, total deferred tax assets on our consolidated balance sheet increased from $1.6 million at March 31, 2006 to $2.1 million at June 30, 2006.  In the future, we may continue to record similar adjustments to our deferred tax asset valuation allowance as our estimates are updated.  We anticipate this will cause our future effective tax rate in any given period to fluctuate from prior effective tax rates, estimated effective tax rates and statutory tax rates.

Liquidity and Capital Resources

Cash Flows

We have historically financed our operations with a combination of cash flows from operations, borrowings under credit facilities and the sale of equity securities. We currently rely on cash flows from operations and borrowings on a line of credit facility to fund our operations.  At June 30, 2006, we had $3.1 million in working capital, which included borrowings of $3.5 million on our revolving line of credit and $225,000 in cash and cash equivalents. This compares to working capital of $3.3 million at March 31, 2006, which included borrowings of $2.7 million on our revolving line of credit and $131,000 in cash and cash equivalents. Our operations used $599,000 of cash during the three months ended June 30, 2006, primarily as a result of increases in prepayments, accounts payable and accrued expenses due to the timing of payments.  Additionally, inventory levels increased slightly to support sales growth.  During the three months ended June 30, 2005, we used $1.9 million in cash, primarily as a result of a higher level of open accounts receivable driven by sales growth and increased accounts payable and accrued expenses due to the timing of payments, partially offset by planned decreases in inventory levels.

Our investing activities for the three months ended June 30, 2006 and 2005 consisted entirely of purchases of property and equipment, which aggregated $142,000 and $212,000, respectively.

Cash provided by financing activities was $835,000 in the three months ended June 30, 2006, which was the result of net borrowings of $667,000 and cash inflows of $168,000 from the exercise of outstanding stock options to purchase our common stock. During the three months ended June 30, 2005, financing activities provided $2.0 million of cash, which was comprised of net borrowings of $1.9 million and cash inflows of $124,000 from the exercise of outstanding stock options and warrants to purchase our common stock.

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Borrowings

The following table summarizes our borrowings and long-term debt:

 

 

We renewed our credit agreement with our bank effective August 1, 2005.  This credit agreement expired on July 31, 2006, but was extended until August 31, 2006, and provides for borrowings of up to $5.0 million subject to a borrowing formula based upon qualified accounts receivable and inventories as defined in the credit agreement.  At June 30, 2006, we had $4.1 million available under the revolving line of credit, of which $600,000 was unused.  We are in the process of renegotiating with our bank for a new line of credit but cannot assure you that we will be successful in securing a new line on a timely basis, on favorable terms, or at all.  If our line of credit is renewed, we believe that the cash generated from our operations, together with our line of credit, will be sufficient to fund our operations for at least the next twelve months. However, should a shortfall occur, we believe we could obtain additional funds through additional borrowings or the sale of equity securities.

Contractual Obligations

Our contractual obligations are as follows at June 30, 2006:

 

		Payments Due by Period
		2007			2008			2009			2010			2011			Total
		(In thousands)
Lines of credit		$	3,509		$	—		$	—		$	—		$	—		$	3,509
Notes payable		1,636			1,940			231			—			—			3,807
Convertible debentures		—			—			—			9,850			—			9,850
Operating leases		1,112			932			127			85			43			2,299
Total		$	6,257		$	2,872		$	358		$	9,935		$	43		$	19,465

 

At June 30, 2006, we had firm commitments to purchase inventory in the amount of $1.9 million during the second and third quarters of the fiscal year ending March 31, 2007.

Off Balance Sheet Arrangements

In May 2004 we issued subordinated convertible debentures in an aggregate original principal amount of $10.1 million. These debentures are due in full on May 19, 2009 and are convertible into shares of our common stock at a conversion price of $3.61 per share. At June 30, 2006, $9.9 million of these convertible debentures remained outstanding. Because these debentures are conventionally convertible, we have not separately accounted for the conversion feature and, accordingly, no separate amounts are presented in our condensed consolidated financial statements in connection with this conversion feature.

At June 30, 2006, outstanding warrants to purchase 1,250,000 shares of our common stock at an exercise price of $1.64 per share and outstanding warrants to purchase an aggregate of 62,500 shares of common stock at an exercise price of $1.95 per share are callable by us if the closing sales price of our common stock for 20 consecutive days is equal to or greater than two times the exercise price of the warrants. Outstanding warrants to purchase an aggregate of 75,000 shares of our common stock at an exercise price of $5.00 per share are callable by us if the price of our common stock for 20 consecutive days is equal to or greater than one and a half times the exercise price of the warrants.

In connection with the issuance of warrants to purchase 1,250,000 shares of our common stock at $1.64 per share, we are a party to certain registration rights agreements that contain provisions under which we could be subjected to liquidated damages should we fail to maintain effective registration statements for the underlying shares of common stock.  These warrants have been accounted for within equity in our condensed consolidated balance sheets 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 the date of this filing, no liquidated damages are payable under the provisions of the registration rights agreements associated with these warrants.

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Recent Accounting Pronouncements

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 No. 109, Accounting for Income Taxes.  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.  We are currently evaluating the impact of FIN 48 and will adopt this Interpretation in the first quarter of our fiscal year ending March 31, 2008.

 

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