The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the Selected Financial Data and our financial statements and the accompanying notes. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in "Risk Factors" and "Information Regarding Forward-Looking Statements" included elsewhere in this Annual Report.

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 former EIS business from December 7, 2007 through December 31, 2008.

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 road 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 changes in budgetary constraints. These contingencies could result in significant fluctuations in our revenue between periods. The current worldwide recession is further adding to the unpredictability of purchase decisions, creating more delays than usual and decreasing governmental budgets, and it is likely to negatively affect 2009 revenue. We believe we may be a beneficiary of the federal stimulus bill enacted early in 2009, but it is too early to determine the level of impact to our operations.

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 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.

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.

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, and revenue consists of all North American sales and a portion of international sales. All segment revenues are derived from external customers.

The following table sets forth selected financial information for each of the Company's reportable segments for the year ended December 31, 2008 (in thousands):

                                              Autoscope      RTMS      Total
                                             -----------   --------   --------
         Revenue                             $    18,705   $  7,760   $ 26,465
         Depreciation                                242        115        357
         Amortization of intangible assets             -        768        768
         Income before income taxes                5,939      1,232      7,171
         Capital expenditures                        273        112        385
         Total assets                             24,135     11,973     36,108

Results of Operations

The following table sets forth, for the periods indicated, certain statements of income data as a percent of total revenue and gross margin on international sales and royalties as a percentage of international sales and royalties, respectively.

                                                    Year Ended December 31,
                                                 ------------------------------
                                                   2008        2007      2006
                                                 ---------    -------   -------
        International sales                           28.2 %     27.0 %    22.7 %
        North American sales                          21.5        1.8         ?
        Royalties                                     50.3       71.2      77.3
                                                 -- ------    - -----   - -----
        Total revenue                                100.0      100.0     100.0
                                                 -- ------    - -----   - -----
        Gross margin-international sales              62.4       52.4      49.6
        Gross margin-North American sales             63.0       77.7         ?
        Gross margin-royalties                       100.0      100.0      97.8
        Selling, marketing and product support        25.2       23.0      21.7
        General and administrative                    15.4       17.6      18.1
        Research and development                      11.0       15.2      20.1
        Amortization of intangibles                    2.9        0.3         ?
        In process research and development              ?       29.8         ?
        Income from operations                        26.9        0.9      26.9
        Income tax expense (benefit)                   8.3       (1.3 )     7.2
        Net income                                    18.8        5.8      23.7

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007. Total revenue increased to $26.5 million in 2008 from $15.1 million in 2007, an increase of 75.5%. Royalty income increased to $13.3 million in 2008 from $10.8 million in 2007, an increase of 24.0%. The increase in royalty income reflects the continued success of Econolite's distribution of Autoscope in the North American market. North American sales, which are sales of RTMS in North America, were $5.7 million in 2008. International sales, which include both Autoscope and RTMS sales outside of North America, increased to $7.5 million in 2008 from $4.1 million in 2007, an increase of 83.3%. The increase in international sales was mainly due to the addition of RTMS but also reflects market gains for Autoscope. We acquired the RTMS family of products in December 2007.

Selling, marketing and product support expense increased to $6.7 million or 25.2% of total revenue in 2008 from $3.5 million or 23.0% of total revenue in 2007. The change related mostly to the addition of RTMS related expenses and to a lesser extent to headcount additions in sales and product support. We anticipate that selling, marketing and product support expense will increase both in terms of actual expense and as a percentage of revenue in 2009 as compared to 2008 as we invest in market expansion activities in Eastern Europe and Asia and realize the impact of headcount additions made late in 2008.

General and administrative expense increased to $4.1 million or 15.4% of total revenue in 2008, up from $2.7 million or 17.6% of total revenue in 2007. The 2008 increase in costs resulted mainly from the addition of RTMS related expenses and increased professional services expenses, including the costs of our withdrawn follow-on offering. We anticipate that general and administrative expense will be flat in terms of actual expense in 2009 as compared to 2008.

Research and development expense increased to $2.9 million or 11.0% of total revenue in 2008, up from $2.3 million or 15.2% of total revenue in 2007. The increase was directly related to the addition of RTMS related expenses and headcount additions towards the end of the year. We anticipate that research and development expense will increase both in terms of actual expense and as a percentage of revenue in 2009 as compared to 2008 as we invest in video/radar hybrid solutions and tailored international offerings and realize the impact of headcount additions made late in 2008.

Amortization of intangibles expense was $768,000 in 2008 and reflects the amortization of intangible assets acquired in the EIS asset purchase. Assuming there are no changes to our intangible assets, we anticipate amortization expense will be $768,000 in 2009.

Other income decreased to $43,000 in 2008 from $543,000 in 2007. In 2008, other income fell due to lower cash and investment balances, lower interest rates and interest expense on debt incurred for the EIS asset purchase. In 2007, other income was mainly tax-exempt interest income, which was partially offset by interest expense on bank debt incurred in December 2007.

Our income tax effective rate was 30.8% in 2008. Our 2007 income tax effective rate was not meaningful due to the significant in-process research and development expense impact on pre-tax book income coupled with federal tax credits that brought our position to a benefit. We expect the effective rate in 2009 to be in the range of 30% to 35%.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006. Total revenue increased to $15.1 million in 2007 from $13.1 million in 2006, an increase of 15.0%. International sales increased to $4.1 million in 2007 from $3.0 million in 2006, an increase of 36.7%. The increase was a result of growing acceptance of Autoscope products in both Europe and Asia, resulting in new customers. Royalty income increased to $10.7 million in 2007 from $10.1 million in 2006, an increase of 6.0%. The increase in royalty income reflects the continued success of Econolite's distribution of Autoscope in the North American market. North American sales were $269,000 in 2007. North American sales represent sales of RTMS products from the date of the EIS asset purchase.

Gross margins for international sales increased to 52.4% in 2007 from 49.6% in 2006. Gross margins on royalty income increased to 100.0% in 2007 from 97.8% in 2006. International gross margins were positively impacted by a shift in product sales mix to higher margin products in 2007 versus 2006. Royalty gross margins were positively impacted by the patent royalty we owed to the University of Minnesota ending in the third quarter of 2006.

Selling, marketing and product support expense increased to $3.5 million or 23.0% of total revenue in 2007 from $2.9 million or 21.7% of total revenue in 2006. The change related mostly to headcount additions and increased promotional expense for the Autoscope Terra product line launch.

General and administrative expense increased to $2.7 million or 17.6% of total revenue in 2007, up from $2.4 million or 18.1% of total revenue in 2006. The 2007 increase resulted mainly from a combination of headcount additions, higher stock option and bonus expenses and, to a lesser extent, increased audit, tax, legal and consulting fees.

Amortization of intangibles expense was $51,000 in 2007 and reflects the amortization of intangible assets acquired in the EIS asset purchase from December 7, 2007 to December 31, 2007.

In-process research and development expense was $4.5 million in 2007 ($3.0 million net of tax). This expense was a result of a purchase price allocation component related to the EIS asset purchase and is one-time in nature.

Other income increased to $543,000 in 2007 from $523,000 in 2006. In 2007, other income was mainly tax-exempt interest income which was partially offset by interest expense on bank debt incurred in December 2007.

Our income tax effective rate was not meaningful in 2007 due to the significant in-process research and development expense impact on pre-tax book income coupled with federal tax credits that brought our position to a benefit. Our 2006 income tax effective rate was unusually low due to a number of federal and state adjustments.

Liquidity and Capital Resources

At December 31, 2008, we had $10.3 million in cash and cash equivalents and $4.0 million in restricted short-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 held at December 31, 2008 were auction rate securities that were redeemed or sold at par subsequent to year-end.

Net cash provided by operating activities was $5.2 million in 2008, compared to $1.5 million and $4.6 million in 2007 and 2006, respectively. The primary reasons for the 2008 change were the incremental net income increase in 2008, significant increases in depreciation and amortization and stabilization of working capital related to the EIS asset purchase. We purchased $4.0 million in investments, net of redemptions, in 2008 as opposed to selling $4.1 million in investments, net of purchases, in 2007. We also repaid $1.3 million in debt in 2008. We anticipate that average receivable collection days in 2009 will increase over 2008 but that it will not have a material impact on our liquidity. Our planned additions of property and equipment are discretionary, and we do not expect them to exceed historical levels in 2009.

At December 31, 2008, we held $4.0 million (par value) of investments comprised of auction rate securities, or ARS. In January 2009, these ARS were redeemed at par under a rights offering established in November 2008 by the broker/dealer. Also in the fourth quarter of 2008, we sold $1.4 million of ARS at par held through a different broker/dealer. After these two transactions, we no longer hold any ARS.

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 pledged all of our ARS. As a result of the new financing arrangement with Associated Bank, ARS investments were restricted as pledged to Associated Bank.

In February 2009, we fully repaid the term loan and outstanding balances on the revolving line of credit using the proceeds from our ARS redemption. We believe, on an ongoing basis, we have regular availability to draw a minimum of $3 million on our line of credit based on qualifying assets.

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. Superior performance of the assets could lead to an earn-out in excess of $2 million, as the earn-out is not capped. Earn-out payments generally are due within three months of the end of an earn-out period. The first earn-out period ran from December 6, 2007 to December 31, 2008. Based on the 2008 results for RTMS, the sellers of the RTMS business, also known as the EIS assets, are entitled to receive a $1.2 million earnout payment, which is expected be paid in March 2009. The liability has been recorded on our balance sheet as of December 31, 2008, with an offsetting entry to increase goodwill. 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.

We do not participate in transactions or have relationships or other arrangements with an unconsolidated entity, including special purpose and similar entities or other off-balance sheet arrangements.

Beginning in 2009, we entered into a number of currency hedging arrangements. The purpose of the hedging was to lock in what we believe to be favorable rates on certain currencies and to increase our predictability on certain expenses at our foreign subsidiaries. All hedging activity is intended to qualify for hedge accounting under Statement of Financial Accounting Standard (SFAS) No. 133. We believe all contracts will be utilized to provide funds to cover operating expenses.

Goodwill and Intangible Assets. Goodwill is not amortized but is tested for impairment annually or whenever an impairment indicator arises. Our recorded goodwill relates to our Flow Traffic subsidiary and assets purchased from EIS. Goodwill for the EIS asset purchase was recorded in December 2007 and is tested for impairment annually on October 1, beginning in 2008. The Flow Traffic goodwill is tested for impairment on December 31 of each year. We also reconcile the fair value of our business segments to market capitalization on December 31 or during interim periods when our consolidated shareholders' equity is similar to or exceeds our market capitalization. The impairment tests require us to estimate the fair value of our subsidiary and then compare it to the carrying value of the subsidiary (or the fair value of all business segments to shareholders' equity for the entity test). If the carrying value exceeds the fair value, further analysis is performed to determine if there is an impairment loss.

For Flow Traffic, we estimate the fair value by using a combination of the income approach, where fair value is dependent on the present value of future economic benefits to be derived from ownership of Flow Traffic, and the prior transactions in company stock method. The future economic benefits are significantly dependent on sustaining revenue growth in our Autoscope product line. For the EIS assets, we estimate fair value by using a combination of the income approach, where fair value is dependent on the present value of future economic benefits to be derived from the RTMS product line, and the market valuation approach, where the business was compared to guideline public company price-earning multiples with a significant weighting to companies in the traffic detection business. The future economic benefits are mainly dependent on future revenue growth of the RTMS product line. No impairment of goodwill was recorded as of December 31, 2008, 2007 and 2006. If Flow Traffic and/or the EIS assets do not provide the future economic benefits we project, the fair value of these assets may become impaired, and we would need to record an impairment loss.

The fair value of all combined business segments was estimated using a discounted cash flow analysis of future income. The market value was determined by multiplying the sum of common shares outstanding at December 31, 2008 and outstanding "in the money" stock options (as reduced using the treasury stock method), by our average share price in December 2008, in total, our market capitalization, and adding to it a control premium. In most industries, . . .