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 systems 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. In 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.

Trends and Challenges in Our Business

We believe the historical 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 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 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 future 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;

• the 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 our total 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 or timing of impact to our operations.

Key Financial Terms and Metrics

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 in 2007, which we assemble, gives us an additional source of revenue that has increased our overall revenue and lessened 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.

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 2007, 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 2009 to 2008:



                                                      Three-Month Periods        Quarter Over
                                                         Ended June 30,             Quarter
                                                      2009           2008           Change
International sales                                       18.4 %         21.4 %          (19.8 )%
North American sales                                      27.7           28.5             (9.6 )
Royalties                                                 53.9           50.1              0.3
Total revenue                                            100.0          100.0             (6.9 )
Gross profit - international sales                        71.9           56.2              2.5
Gross profit - North American sales                       66.3           59.8              0.3
Gross profit - royalties                                 100.0          100.0              0.3
Selling, marketing and product support expenses           30.6           24.6             15.7
General and administrative expenses                       12.8           15.1            (20.9 )
Research and development expenses                         13.7           11.3             12.7
Amortization of intangible assets                          3.1            2.8              n/m
Income from operations                                    25.3           25.3             (6.6 )
Other income, net                                          0.3            0.3              n/m
Income taxes                                               7.0            7.6            (13.7 )
Net income                                                18.6           18.0             (3.7 )

                                                       Six-Month Periods         Period Over
                                                        Ended June 30,             Period
                                                      2009           2008          Change
International sales                                       21.1 %        22.2 %          (16.4 )%
North American sales                                      27.6          28.1            (14.0 )
Royalties                                                 51.3          49.7             (9.4 )
Total revenue                                            100.0         100.0            (12.2 )
Gross profit - international sales                        69.2          55.7              3.9
Gross profit - North American sales                       68.6          61.5             (4.1 )
Gross profit - royalties                                 100.0         100.0             (9.4 )
Selling, marketing and product support expenses           32.1          23.7             18.6
General and administrative expenses                       16.1          15.1             (6.6 )
Research and development expenses                         15.1          11.6             14.1
Amortization of intangible assets                          3.5           3.0              n/m
Income from operations                                    18.1          25.8            (38.5 )
Other income, net                                          0.1           0.5            (85.9 )
Income taxes                                               5.3           8.3            (44.5 )
Net income                                                12.9          18.0            (37.0 )

Total revenue decreased to $6.3 million in the three-month period ended June 30, 2009 from $6.7 million in the same period in 2008, a decrease of 6.9%, and to $11.1 million in the first half of 2009 from $12.6 million in the same period in 2008, a decrease of 12.2%. Royalties were $3.4 million in both the second quarter of 2009 and 2008, and they decreased to $5.7 million in the first half of 2009 from $6.3 million in the same period in 2008, a decrease of 9.4%. We attribute the decrease in royalties to the economic recession in North America and its negative impact on state and federal spending. North American sales, which are sales of RTMS in North America, decreased to $1.7 million in the second quarter of 2009 from $1.9 million in the same period in 2008, a decrease of 9.6%, and to $3.1 million in the first half of 2009 from $3.5 million in the same period in 2008, a decrease of 14.0%, also reflecting the difficult economic environment in North America. International sales, which include both Autoscope and RTMS sales outside of North America, decreased to $1.2 million in the second quarter of 2009 from $1.4 million in the second quarter of 2008, a decrease of 19.8%, and to $2.3 million in the first half of 2009 from $2.8 million in the first half of 2008, a decrease of 16.4%. The decrease was due mainly to weakness in the Asian market.

Gross margins for international sales increased to 71.9% in the three months ended June 30, 2009 from 56.2% in the same period in 2008, and to 69.2% in the first half of 2009 from 55.7% in the same period in 2008. Gross margins for North American sales increased to 66.3% in the second quarter of 2009 from 59.8% in the first quarter of 2008 and to 68.6% in the first half of 2009 from 61.5% in the first half of 2008. The increases resulted mainly from a positive revenue mix shift and to a lesser extent from positive currency exchange rates and lower inventory reserves recorded in 2009 as compared to 2008. Gross margins on royalty income remained consistent at 100.0% in each of the periods of 2009 and 2008.

Selling, marketing and product support expense increased to $1.9 million, or 30.6% of total revenue, in the three months ended June 30, 2009 from $1.7 million, or 24.6% of total revenue, in the second quarter of 2008, and to $3.6 million, or 32.1% of total revenue, in the first half of 2009 from $3.0 million, or 23.7% of total revenue, in the first half of 2008. The change related mostly to an investment in market expansion activities in Eastern Europe and Asia and the realization of the impact of headcount additions made late in 2008. We anticipate that for the remainder of 2009, the dollar amount of our quarterly selling, marketing and product support expense will remain at levels similar to or below those of the 2009 first half level.

General and administrative expense decreased to $803,000, or 12.8% of total revenue, in the three months ended June 30, 2009, from $1.0 million, or 15.1% of total revenue, in the same period in 2008, and to $1.8 million, or 16.1% of total revenue, in the first half of 2009, from $1.9 million, or 15.1% of total revenue, in the same period in 2008. The 2009 decrease in costs resulted mainly from lower incentive pay expense which was partially offset by increased professional services expenses. We anticipate that for the remainder of 2009, the dollar amount of our quarterly general and administrative expense will remain at levels similar to that of the second quarter of 2009.

Research and development expense increased to $862,000, or 13.7% of total revenue, in the first quarter of 2009, up from $765,000, or 11.3% of total revenue, in the same period in 2008, and to $1.7 million, or 15.1% of total revenue, in the first half of 2009, up from $1.5 million, or 11.6% of total revenue, in the same period in 2008. The increase was directly related to our investment in video/radar hybrid solutions and tailored international offerings, development projects to reduce manufacturing costs, and the realization of the impact of headcount additions made late in 2008. We anticipate that for the remainder of 2009, the dollar amount of our quarterly research and development expense will remain at levels similar to that of the second quarter of 2009.

Amortization of intangibles expense was $192,000 in the second quarter of 2009 and $384,000 in the first half of 2009, the same as in these periods 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 for all of 2009.

Other income was $9,000 in the first half of 2009 as compared to other income of $64,000 in the same period in 2008. In 2009, interest on bank debt offset most interest income as we moved into securities that had lower yields than in 2008.

Income tax expense was $442,000, or 27.4% of pretax income, in the second quarter of 2009, compared to $512,000, or 29.6% of pretax income, in the comparable quarter of 2008, and was $584,000, or 29.0% of pretax income, in the first half of 2009, compared to $1.1 million, or 31.7% of pretax income, in the comparable period of 2008. We anticipate an effective tax rate of approximately 30% for all of 2009.

Liquidity and Capital Resources

At June 30, 2009, we had $7.6 million in cash and cash equivalents and $4.0 million in short-term investments, compared to $10.3 million in cash and cash equivalents and $4.0 million in short-term investments at December 31, 2008. Our investments held at December 31, 2008 were auction rate securities that were redeemed at par in January 2009.

Net cash provided by operating activities was $2.5 million in the first six months of 2009, compared to $2.2 million in 2008. The increase in 2009 was mainly a result of decreased receivable balances as opposed to an increase in 2008, which more than offset lower net income. We anticipate that average receivable collection days in 2009 will increase over 2008 but that the increase 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. In addition to equipment purchases, in 2009 we paid our 2008 earn-out liability of $1.2 million to the sellers of the EIS assets. We also retired our bank debt in full in February 2009, paying a total of $3.75 million during the quarter ended March 31, 2009.

We have a revolving line of credit agreement with our bank, Associated Bank. 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 the bank. Advances on the line of credit cannot exceed a borrowing base determined under a formula, which is a percentage of the amounts of receivables. The line of credit currently has no borrowings outstanding and matures on May 1, 2011. We believe, on an ongoing basis, we have regular availability to draw a minimum of $3.0 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 from the December 2007 date of purchase. 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 results for RTMS for the first earn-out period, which ended December 31, 2008, the sellers of the EIS assets were entitled to receive a $1.2 million earn-out payment, which was paid in March and April 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.

EIS was named in a U.S. lawsuit in 2006 for infringement of a patent. On October 31, 2007, the court entered judgment that EIS had not infringed on the patent. The plaintiff has appealed the decision, and EIS has continued its defense as provided in the EIS asset purchase agreement. In addition, EIS must indemnify us for all expenses, claims or judgments related to this lawsuit up to the amount of the purchase price, including any earn-out payments. Management believes that the ultimate outcome of this legal action will not have a material adverse effect on our financial statements or liquidity.

We believe that cash and cash equivalents on hand at June 30, 2009, along with the availability of funds under our $5.0 million revolving line of credit and cash provided by operating activities, will satisfy our projected working capital needs, payments under the EIS earn-out, investing activities, and other cash requirements for the foreseeable future.

Off-Balance Sheet Arrangements

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.

Critical Accounting Policies

Our significant accounting policies are described in Note 1 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2008. The accounting policies used in preparing our interim 2009 Condensed Consolidated Financial Statements set forth elsewhere in this Quarterly Report on Form 10-Q are the same as those described in our Annual Report on Form 10-K.

New and Recently Adopted Accounting Pronouncements

In December 2007, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (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 to us prospectively for business combinations beginning in 2009, and its adoption did not have a material impact on our financial statements.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements - An Amendment of ARB No. 51. SFAS No. 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS No. 160 also includes expanded disclosure requirements regarding the interests of the parent and its noncontrolling interest. SFAS No. 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The adoption of SFAS No. 160 did not have a material impact on our financial statements.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles. SFAS No. 162 is effective 60 days following the approval by the Securities and Exchange Commission of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. We do not anticipate that the adoption of SFAS No. 162 will materially impact the Company.

In May 2009, the FASB issued SFAS No. 165, Subsequent Events, to incorporate the accounting and disclosure requirements for subsequent events into U.S. generally accepted accounting principles (GAAP). SFAS No. 165 introduces new terminology, defines a date through which management must evaluate subsequent events, and lists the circumstances under which an entity must recognize and disclose events or transactions occurring after the balance sheet date. It is effective prospectively for interim or annual reporting periods ending after June 15, 2009. We adopted SFAS No. 165 as of the required effective date and have applied its provisions. We do not believe the adoption of SFAS No. 165 will have a material effect on our consolidated financial statements.

In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles - a replacement of FASB Statement 162. The FASB Accounting Standards Codification (Codification) will become the source of authoritative U.S. generally accepted accounting principles (GAAP) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of SFAS No. 168, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the Codification will become nonauthoritative. After the effective date of SFAS No. 168, the Board will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates, which will not be authoritative in their own right, but will serve only to update the Codification. SFAS No. 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. We will adopt SFAS No. 168 as of the required effective date, September 15, 2009, and we will apply its provisions prospectively. We do not believe the adoption of SFAS No. 168 will have a material effect on our consolidated financial statements.

Cautionary Statement:

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange of 1934, as amended. Forward-looking . . .