Overview

General.We provide software-based computer enabled detection, or CED, products and solutions that use advanced signal processing software algorithms to detect and monitor objects in a designated field of view. Our technology analyzes the signal from a sophisticated sensor and passes the information along to management systems, controllers or directly to users. Our core products, the Autoscope® Video Vehicle Detection System and the RTMS® Radar Detection System, operate using our proprietary software in conjunction with video cameras or radar and commonly available electronic components. Each of these systems is used by traffic managers primarily to improve the flow of vehicle traffic and to enhance safety at intersections, main thoroughfares, freeways and tunnels.

Autoscope systems are sold to distributors and end users of traffic management products in North America, the Caribbean and Latin America by Econolite Control Products, Inc., or Econolite, our exclusive licensee in these regions. We sell RTMS systems to distributors and end users in North America. We also sell both Autoscope and RTMS to distributors and end users in Europe and Asia through our European and Hong Kong subsidiaries, respectively. End users of our products throughout the world are generally funded by government agencies responsible for traffic management or traffic law enforcement.

EIS Asset Purchase.On December 6, 2007, we purchased certain assets from EIS Electronic Integrated Systems Inc., or EIS, including its principal product line, the RTMS system. In its fiscal year ended September 30, 2007, EIS had revenue of $8.7 million, substantially all of which related to RTMS sales. Our consolidated financial statements include revenue and expenses related to the operations of the EIS asset purchase from December 7, 2007 forward.

Trends and Challenges in Our Business.

We believe recent growth in our business can be attributed primarily to the following global trends:

• worsening traffic caused by increased numbers of vehicles in metropolitan areas without corresponding expansions of roadway infrastructure, which has increased demand for our products;

• advances in information technology, which have made our products easier to market and implement;

• the continuing rise in funding allocations in large cities for centralized traffic management services, which has increased the ability of our primary end users to implement our products; and

• general increases in the cost-effectiveness of electronics, which make our products more affordable for end users.

We believe our continued growth primarily depends upon:

• continued adoption and governmental funding of intelligent transportation systems, or ITS, for traffic control in developed countries;

• countries in the developing world adopting above-ground detection technology, such as video or radar, instead of in-pavement loop technology to manage traffic;

• use of CED to provide solutions to security/surveillance and environmental issues associated with increasing automobile use in metropolitan areas; and

• our ability to develop new products, such as hybrid CED devices incorporating, for example, radar and video technologies, that provide increasingly accurate information and enhance the end users' ability to cost-effectively manage traffic, security/surveillance and environmental issues.

Because our principal end users are governmental entities, we are faced with challenges related to potential delays in purchase decisions by those entities and unforeseen changes in budgetary constraints. These contingencies could result in significant and unforeseen fluctuations in our revenue between periods.

Key Financial Terms and Metrics.

Seasonality. Our quarterly revenues and operating results have varied significantly in the past due to the seasonality of our business. Our first quarter generally is the weakest due to weather conditions that make roadway construction more difficult in North America, Europe and northern Asia. We expect such seasonality to continue for the foreseeable future. Additionally, our international revenues have a significant large project component, resulting in a varying revenue stream. Accordingly, we believe that quarter-to-quarter comparisons of our financial results should not be relied upon as an indication of our future performance. No assurance can be given that we will be able to achieve or maintain profitability on a quarterly or annual basis in the future.

Revenue. Revenue historically has been derived from two sources: (1) royalties received from Econolite for sales of the Autoscope system in North America, the Caribbean and Latin America and (2) revenue received from direct sales of Autoscope systems in Europe and Asia. Royalties from Econolite historically have provided the majority of our revenue. We calculate the royalties using a profit sharing model where we split evenly the gross profit on sales of Autoscope product made through Econolite. This royalty arrangement has the benefit of decreasing our cost of revenues and our selling, marketing and product support expenses because these costs and expenses are borne primarily by Econolite. Although this royalty model has a positive impact on our gross margin, it also negatively impacts our total revenue, which would be higher if all the sales made by Econolite were made directly by us. The royalty arrangement is exclusive under a long-term agreement. Our acquisition of the RTMS product line, which we assemble, gives us an additional source of revenue that we expect will significantly increase our overall revenue and lessen fluctuations in our revenue from period to period due to our ownership of more than one product line and the higher volumes it brings, notwithstanding normal seasonality.

Cost of Revenue.There is no cost of revenue related to royalties, as virtually all manufacturing, warranty and related costs are incurred by Econolite. Cost of revenue related to direct product sales consists primarily of the amount charged by our third party contractors to manufacture the Autoscope and RTMS hardware platforms, which is influenced mainly by the cost of electronic components. The cost of revenue also includes logistics costs and estimated expenses for product warranties and inventory reserves. The key metric that we follow is achieving certain gross margin percentages by geographic region.

Operating Expenses.Our operating expenses fall into three categories: (1) selling, marketing and product support; (2) general and administrative; and (3) research and development. Selling, marketing and product support expenses consist of various costs related to sales and support of our products, including salaries, benefits and commissions paid to our personnel, commissions paid to third parties, travel, trade show and advertising costs, second-tier technical support for Econolite, and general product support, where applicable. General and administrative expenses consist of certain corporate and administrative functions that support the development and sales of our products and provide an infrastructure to support future growth. General and administrative expenses reflect management, supervisory and staff salaries and benefits, legal and auditing fees, travel, rent and costs associated with being a public company, such as board of director fees, Sarbanes-Oxley compliance, listing fees and annual reporting expenses. Research and development expenses consist mainly of salaries and benefits for our engineers and third party costs for consulting and prototyping. We measure all operating expenses against our annually approved budget, which is developed with achieving a certain operating margin as a key focus. Also included in operating expenses is non-cash expense for intangible asset amortization.

History. We were incorporated in the state of Minnesota in December 1984 and began operations by pioneering the commercial application of wide-area video vehicle detection for traffic management. The technology underlying our products was initially developed at the University of Minnesota. In 1989, the University was awarded a patent for that technology, which it exclusively licensed to us. In 1991, we sub-licensed this technology to Econolite, a leading manufacturer and seller of traffic control products in North America and the Caribbean, to manufacture and distribute products incorporating the technology.

Segments. We currently operate in two reportable segments: Autoscope and RTMS. Autoscope is our machine-vision product line, and revenue consists of royalties (all of which are received from Econolite), as well as a portion of international sales. RTMS is our radar product line acquired in the EIS asset purchase in December 2007 (see Note C), and revenue consists of all North American sales and a portion of international sales. All segment revenues are derived from external customers (see Note G).

Results of Operations

The following table sets forth, for the periods indicated, (1) certain
statements of income data as a percent of total revenue, (2) gross profit on
product sales and royalties as a percentage of product sales and royalties,
respectively, and (3) period-to-period changes of items in the consolidated
statements of income from 2008 to 2007:


                                                      Three-Month Periods
                                                      Ended September 30,         Quarter Over
                                                                                     Quarter
                                                      2008            2007           Change

International sales                                       23.3 %         27.3 %            24.3 %
North American sales                                      15.1              -               n/m
Royalties                                                 61.6           72.7              23.1

Total revenue                                            100.0          100.0              45.4
Gross profit - international sales                        72.0           53.1              68.5
Gross profit - North American sales                       49.8              -               n/m
Gross profit - royalties                                 100.0          100.0              23.1
Selling, marketing and product support expenses           27.9           17.9             126.3
General and administrative expenses                       16.1           17.0              38.0
Research and development expenses                         11.5           13.2              26.8
Amortization of intangible assets                          3.2              -               n/m
Income from operations                                    27.2           39.1               1.1
Other income (expense), net                               (0.1 )          3.6               n/m
Income taxes                                               8.0           11.7              (0.4 )
Net income                                                19.1           31.0             (10.4 )


                                                       Nine-Month Periods
                                                      Ended September 30,          Period Over
                                                                                     Period
                                                      2008            2007           Change

International sales                                       22.6 %         22.6 %            89.1 %
North American sales                                      23.9              -               n/m
Royalties                                                 53.5           77.4              31.1

Total revenue                                            100.0          100.0              89.5
Gross profit - international sales                        61.2           57.4             101.6
Gross profit - North American sales                       59.0              -               n/m
Gross profit - royalties                                 100.0          100.0              31.1
Selling, marketing and product support expenses           25.1           23.4             102.9
General and administrative expenses                       15.4           18.6              57.4
Research and development expenses                         11.6           17.0              28.9
Amortization of intangible assets                          3.1              -               n/m
Income from operations                                    26.3           31.4              58.8
Other income, net                                          0.3            4.3             (86.5 )
Income taxes                                               8.2            9.8              59.0
Net income                                                18.4           25.9              34.4

Total revenue increased to $6.1 million, or 45.4%, in the third quarter of 2008, from $4.2 million in the third quarter of 2007 and to $18.7 million, or 89.5%, in the first nine months of 2008 from $9.9 million in the comparable period of 2007. Royalties for the third quarter of 2008 increased to $3.7 million, or 61.6% of revenue, from $3.0 million, or 72.7% of revenue, in 2007, and for the first nine months of 2008 increased to $10.0 million, or 53.5% of revenue, from $7.6 million, or 77.4% of revenue, in 2007. The increase in royalties in 2008 resulted primarily from a similar increase in sales volume of Autoscope products by Econolite. International sales for the third quarter of 2008 increased to $1.4 million, or 23.3% of revenue, from $1.1 million, or 27.3% of revenue, in 2007, and for the first nine months of 2008 increased to $4.2 million, or 22.6% of revenue, from $2.2 million, or 22.6% of revenue, in 2007. The 89.1% increase in international sales for the first nine months of 2008 was due primarily to increasing acceptance of Autoscope Terra products in European and Asian markets, as well as the sales of the newly added RTMS product line. North American sales were 15.1% and 23.9% of revenue in the third quarter and first nine months of 2008, respectively, and reflect the addition of the RTMS product line. In the first quarter of 2008, we began reporting two segments: Autoscope and RTMS. Revenue in the third quarter and first nine months of 2008 for the Autoscope segment was $4.9 million and $13.3 million, respectively, compared to $4.2 million and $9.9 million in the comparable periods of 2007. The increase in Autoscope segment revenues for these periods resulted from increased sales volumes worldwide, including increasing acceptance of Autoscope Terra products in European and Asian markets. Revenue in the third quarter and first nine months of 2008 for the RTMS segment was $1.2 million and $5.4 million, respectively. There is no comparable period information for 2007 because the RTMS product line was acquired in December 2007.

Gross profit margins on international sales for the third quarter of 2008 were 72.0%, up from 53.1% in the comparable quarter of 2007, and 61.2% in the first nine months of 2008, up from 57.4% in the comparable quarter of 2007. The third quarter margin, and to a lesser extent the nine months margin, was positively impacted by a reversal of manufacturing build cost accruals that subsequently were not incurred. Gross profit margins on North American sales for the third quarter and first nine months of 2008 were 49.7% and 59.0%, respectively. Margins in the third quarter were negatively impacted by inventory reserves established to reflect the transition from the third generation RTMS product line to the fourth generation.

Operating expenses increased to $3.6 million for the third quarter of 2008 from $2.0 million for the comparable period in 2007, and to $10.3 million for the first nine months of 2008 from $5.8 million for the comparable period in 2007, increases of 77.3% and 77.1%, respectively. The primary reason for the increases was the addition of operating expenses from the EIS asset purchase in December 2007, which currently has a run rate of approximately $700,000 per quarter, before variable selling expense, including research and development expense for the next-generation RTMS system. Additionally, increases were in selling, marketing and general product support expenses, which was attributable to headcount additions for sales and product support and in general and administrative, which included increased stock option and compensation expense and higher fees for professional services. In the third quarter of 2008, we recognized a $221,000 charge for costs incurred in conjunction with our withdrawn stock offering. The expense is recognized in the general and administrative line on the statements of income. We also began incurring amortization expense on intangible assets purchased as part of the EIS asset purchase. We expect the level of expenses in each of the selling, marketing and product support and research and development operating expense categories to increase in absolute dollars in the fourth quarter of 2008 as opposed to the third quarter, while general and administrative and amortization of intangible assets are expected to remain stable.

Income from operations in the third quarter of 2008 was $1.7 million, or 27.2% of revenue, compared to $1.6 million, or 39.1% of revenue, in the comparable quarter in 2007, an increase of 1.1%. Income from operations in the first nine months of 2008 was $4.9 million, or 26.2% of revenue, compared to $3.1 million, or 31.4% of revenue, in the comparable quarter in 2007, an increase of 58.8%. The increase resulted primarily from growth in all revenue categories, which was offset in part by increased operating expenses as described above.

Other income (expense), net, decreased to ($6,000) in the third quarter of 2008 from $149,000 in the comparable quarter of 2007 and to $58,000 in the first nine months of 2008 from $429,000 in the comparable period of 2007 as a result of lower cash balances and interest expense incurred on bank debt.

Income tax expense was $486,000, or 28.7% of pretax income, in the third quarter of 2008, compared to $488,000, or 27.3% of pretax income in the comparable quarter of 2007. Income tax expense was $1.5 million, or 30.7% of pretax income, in the first nine months of 2008, compared to $968,000, or 27.5% of pretax income, in the comparable period of 2007. The increase in the nine months effective rate was due primarily to there being no tax-exempt interest income in 2008 versus significant amounts in 2007 and recognition of the federal research and development credit in 2007 versus none in 2008. The research and development credit has been reinstated as of our fourth quarter and will reduce the annual provision accordingly. With this change, we anticipate that the effective tax rate for 2008 will decrease to approximately 30%.

Net income was $1.2 million in the third quarter of 2008, a 10.4% decrease, compared to $1.3 million in the comparable quarter of 2007 and $3.4 million in the first nine months of 2008, a 34.4% increase, compared to $2.6 million in the comparable period of 2007 due to the factors described above.

Liquidity and Capital Resources

At September 30, 2008, we had $7.7 million in cash and cash equivalents and $5.0 million in restricted long-term investments, compared to $5.6 million in cash and cash equivalents, $5.3 million in restricted cash and $-0- in investments at December 31, 2007. As discussed below, our investments are auction rate securities and are not currently liquid.

Net cash provided by operating activities was $3.3 million in the first nine months of 2008, compared to $650,000 in 2007. The primary reasons for the change were the incremental net income increase in 2008 and significant increases in depreciation and amortization in 2008 over 2007. We purchased $5.4 million in investments, net of redemptions, in 2008 as opposed to selling $2.1 million in investments, net of purchases, in 2007. We also repaid $1.0 million in debt in 2008.

At September 30, 2008, we held $5.4 million (par value) of investments comprised of auction rate securities, or ARS, with maturity dates ranging from 2031 to 2047, which were purchased from UBS ($4.0 million) and Credit Suisse ($1.4 million). All our ARS held are AAA/Aaa rated, with substantially all collateralized by student loans guaranteed by the U.S. government under the Federal Family Education Loan Program. Until February 2008, the auction rate securities market was highly liquid. Since mid-February 2008, a substantial number of auctions have failed. The immediate effect of a failed auction is that holders cannot sell the securities at auction. In the case of a failed auction, with respect to the ARS held by us, the ARS are deemed not currently liquid. In the case of funds invested by us in ARS which are the subject of a failed auction, we may not be able to access the funds in the near term without a loss of principal unless a future auction on these investments is successful or the issuer calls the security pursuant to a mandatory tender or redemption prior to maturity.

In the third quarter of 2008, both UBS and Credit Suisse announced settlement offers with governmental authorities in which the banks agreed to repurchase the ARS from their clients at par. Based on the information made available from the banks, we believe that the repurchases of our ARS will be completed by the end of January 2009. While we believe that the repurchases are highly probable to occur, we have determined the proper accounting for these investments is to continue to consider them long-term and temporarily impaired until such repurchases are completed.

At September 30, 2008, there was insufficient observable ARS market information available to determine the fair value of our investments. Therefore, we estimated fair value by using broker quotes. Based on this analysis, we recorded an unrealized loss of $449,000 in other comprehensive income ($297,000 net of tax) related to our ARS investments. The ARS investments are pledged as collateral as described below.

Credit Suisse purchased the $1.4 million of ARS held in our account at par in November 2008.

In May 2008, we entered into a financing arrangement with Associated Bank, National Association, or Associated Bank, which replaced our loan agreements with Wells Fargo Bank, N.A., including fully repaying those loans. Under the arrangement with Associated Bank, we entered into a revolving line of credit and a term loan. The revolving line of credit provides for up to $5.0 million at an annual interest rate equal to the greater of 4.5% or LIBOR plus 2.75%, as reset from time to time by Associated Bank. Advances on the line of credit cannot exceed a borrowing base determined under a formula which is a percentage of the amounts of ARS and receivables. The line of credit currently has $2.0 million in borrowings outstanding and matures on May 1, 2011. The term loan is for $3.0 million and has a fixed annual interest rate of 6.75%. Repayment on the term loan is in equal monthly principal installments over a 36-month period. As collateral, Associated Bank has a first priority security interest in all of our assets, and we have pledged $5.4 million in ARS. As a result of the new financing arrangement with Associated Bank, our restricted cash is no longer restricted; however, our ARS investments are now restricted as pledged to Associated Bank.

We believe that cash and cash equivalents on hand at September 30, 2008, along with our $5.0 million revolving line of credit and cash provided by operating activities will satisfy our projected working capital needs, investing activities and other cash requirements for the foreseeable future.

In conjunction with our EIS asset purchase, the sellers have an earn-out arrangement over approximately three years. The earn-out is based on earnings from RTMS sales less related cost of revenue and operating expenses, depreciation and amortization, and it is calculated annually. If the earnings are at target levels, the sellers would receive $2.0 million annually, or $6.0 million in total. Earn-out payments generally are due within three months of the end of an earn-out period. The first earn-out period runs from December 6, 2007 to December 31, 2008. Thus, if any earn-out payment is due for this period, it would be paid by March 31, 2009. If we are acquired or sell substantially all of our assets before December 6, 2010, we must pay EIS $6.0 million less earn-out amounts previously paid as an acceleration of potential earn-out payments under the EIS asset purchase agreement.

Critical Accounting Policies

Our significant accounting policies are described in Note 1 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2007. The accounting policies used in preparing our interim 2008 consolidated financial statements are the same as those described in our Annual Report.

New and Recently Adopted Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurement but does not require any new fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. However, on February 12, 2008, the FASB issued proposed FSP FAS 157-2 which delayed the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). This FSP partially defers the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. Effective for 2008, we have adopted SFAS No. 157 except as it applies to those nonfinancial assets and nonfinancial liabilities as noted in proposed FSP FAS 157-2. The partial adoption of SFAS No. 157 impacted our disclosures surrounding our restricted long-term investments.

On February 15, 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115. This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. The fair value option established by SFAS No. 159 permits all entities to choose to measure eligible items at fair value at specified election dates. SFAS No. 159 is effective for the Company as of January 1, 2008. The impact of adopting this pronouncement had no effect on our consolidated financial statements because we did not elect the fair value option for any financial assets or liabilities.

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations. SFAS No. 141(R) will significantly change the accounting for business combinations. Under SFAS No. 141(R), an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS No. 141(R) will change the accounting treatment for certain specific items. SFAS No. 141(R) also includes a substantial number of new disclosure requirements. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. SFAS No. 141(R) will impact us if we complete an acquisition after the effective . . .