UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the transition period from            to

Commission file number:  001-08762

ITERIS, INC.

(Exact name of registrant as specified in its charter)

Iteris Holdings, Inc.

(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  ý   No  o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  o   No  ý

As of February 11, 2005, the registrant had 28,304,107 shares of common stock outstanding.

ITERIS, INC.

Quarterly Report on Form 10-Q

For the three and nine month periods ended December 31, 2004

Table of Contents

Unless otherwise indicated in this Report, the “Company,” “we,” “us” and “our” collectively refer to Iteris, Inc. (formally known as Iteris Holdings, Inc. and Odetics, Inc.) and its subsidiary, Meyer, Mohaddes Associates.

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PART I. FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

ITERIS, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

3

ITERIS, INC.

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS (continued)

(in thousands, except share amounts)

See accompanying notes to unaudited condensed consolidated financial statements.

4

ITERIS, INC.

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)

See accompanying notes to unaudited condensed consolidated financial statements.

5

ITERIS, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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ITERIS, INC.

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1—Summary of Significant Accounting Policies

The Company

Iteris, Inc. formerly known as Iteris Holdings, Inc. (“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 and transportation management and traveler information systems 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. On October 22, 2004, the Company completed the merger with its majority-owned subsidiary, Iteris, Inc. (the “Iteris Subsidiary”), and officially changed the Company’s name from Iteris Holdings, Inc. to Iteris, Inc. (Note 4). 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.

Basis of Presentation

The condensed consolidated financial statements of the Company have been prepared in accordance with principals 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 December 31, 2004, and the consolidated results of operations for the three and nine month periods ended December 31, 2004, and 2003, and cash flows for the nine month periods ended December 31, 2004 and 2003. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) have been condensed or omitted pursuant to the rules and regulations of the SEC. The results of operations for the three and nine month periods ended December 31, 2004, are not necessarily indicative of those to be expected for the entire year. The accompanying 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, 2004, which was filed with the SEC on June 29, 2004.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of the Company and its current and former subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.  The statements of operations for the three and nine month periods ended December 31, 2003, and statement of cash flows for the nine month period ended December 31, 2003, have been restated to reflect the discontinuation of all operations except those of the Company and it’s remaining subsidiary, Meyer, Mohaddes Associates.

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 and disclosures of contingent assets and liabilities at the date of the financial statements, and 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, contract reserves and estimates of future cash flows used to assess the recoverability of long-lived assets, the valuation of equity instruments and the realization of goodwill.

Reclassifications

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

Revenue Recognition

Product revenues and related cost 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 reasonably assured.  Accordingly, at the date revenue is recognized, significant uncertainties concerning the sale have been resolved.

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Contract revenues are derived primarily from long-term contracts with governmental agencies.  Contract revenues include costs incurred plus a portion of estimated fees or profits determined 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 realization is reasonably assured.

In addition to product and contract revenue, the Company derives revenue from technology access fees and the provision of specific non-recurring contract engineering services related to the Company’s AutoVue^TM lane departure warning system. Combined technology access fees and contract engineering revenues are recognized on the percentage of completion method of accounting based on the relationship of hours incurred to total estimated hours.  Technology access fee revenues and contract engineering revenues are included in net sales on the accompanying statements of operations. The Company also derives royalty revenue based on unit sales of AutoVue^TM systems through the Company’s strategic partner Valeo Schalter und Sensoren Gmbh (“Valeo”).

Revenues from follow-on service and support, for which the Company charges separately, are recorded in the period in which the services are performed and are included in net sales or contract revenues.

Concentration of Credit Risk

The Company maintains reserves for potential credit losses, estimating the collectibility of customer receivables on an ongoing basis by periodically reviewing invoices outstanding greater than a certain period of time. The Company has recorded reserves for receivables deemed to be at risk for collection. A considerable amount of judgment is required in assessing the ultimate realization of trade receivables deemed to be at risk for collection including the current credit-worthiness of each customer. Such losses have historically been minimal and within management’s estimates. Receivables from customers are generally unsecured.

Fair Values of Financial Instruments

Fair values of cash, receivables, inventories, accounts payable and accrued expenses approximate carrying values due to the short period of time to maturity. The fair values of line of credit agreements, long-term debt and convertible debentures, approximate carrying value since the related effective rates of interest approximate current market rates.

Inventories

Inventories consist of finished goods, work-in-process and raw materials and are stated at the lower of cost or market. Cost is determined using the first-in, first-out method.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost. Equipment is depreciated primarily using the declining balance method over its estimated useful life, which ranges from four to eight years.

Long-Lived Assets

Long-lived assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company believes there were no indicators of impairment of the carrying value of its long-lived assets at December 31, 2004. The Company performs an annual impairment review of its long-lived assets in the fourth quarter of each fiscal year.

Loss Per Share

Basic loss per share is computed by dividing net loss available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted loss per share is computed by dividing net loss available to common stockholders by the weighted average number of common and common equivalent shares outstanding for the period, which includes any additional dilution related to conversion of stock options and warrants as computed under the treasury stock method.

For the three and nine month periods ended December 31, 2004, and December 31, 2003, the Company incurred a net loss and therefore, all stock options and warrants were anti-dilutive and not included in the calculation of diluted loss per share. 4,680,332  and 852,151 stock options and warrants were excluded from the dilutive computation for the three month period ended December 31, 2004. Stock options and warrants excluded from the dilutive computation for the nine month period ended December 31, 2004 were 4,662,273 and 843,939, respectively. 355,218 stock options were excluded from the dilutive computation for the three month period ended December 31, 2003. Stock options excluded from the dilutive computation for the nine month period ended December 31, 2003 were 43,226.  There were no dilutive warrants in the three or nine month periods ended December 31, 2003.

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Research and Development Expenditures

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

Warranty

Unless otherwise stated, the Company provides a one to two year warranty from the original invoice date on all products, materials, and workmanship. Subsequent to December 31, 2004, the Company extended its warranty for certain Vantage^TM products to three years. 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.

The activity in accrued warranty obligations is as follows (in thousands):

Stock-Based Compensation

The Company accounts for stock-based employee compensation arrangements in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”) and related interpretations, and complies with the disclosure provisions of Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”). Under APB No. 25, compensation cost is recognized based on the difference, if any, on the date of the grant between the fair value of the Company’s stock and the amount the employee must pay to acquire the stock.

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure (“SFAS 148”) providing alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The accompanying condensed consolidated financial statements reflect all of the disclosures required by SFAS 148.

In calculating pro forma information regarding net loss and loss per share, as required by SFAS 123, the fair value of outstanding stock options was estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions:

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For purposes of pro forma disclosures, the estimated fair value of stock options is amortized to expense over the vesting period of the options. The Company’s pro forma information follows (in thousands, except per share amounts):

Shipping and Handling Costs

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

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.

Discontinued Operations

In May 2003, the Company completed the sale of substantially all of the assets of its Zyfer, Inc. subsidiary (“Zyfer”) for $2.3 million in cash plus the assumption of certain liabilities. The asset purchase agreement provided for future incentive payments of up to $1.0 million in each of the twelve month periods ending April 30, 2004 and 2005, based on the achievement of certain revenue goals related to the sale of Zyfer products or the licensing of its technologies.  Based on the terms of the sale agreement, Zyfer has 60 days after the end of each twelve month period to provide the Company with support for the incentive payments. Incentive payments of $135,000 for the twelve month period ended April 30, 2004 were received and recognized as other income by the Company in October 2004. The Company currently estimates that approximately the same amount will be earned for the twelve month period ending April 30, 2005.

In September 2003, the Company sold substantially all of the assets of its MAXxess Systems, Inc. Subsidiary (“MAXxess”) to an investor group that included certain members of the MAXxess management group. The consideration received for the assets consisted of the assumption of $2.7 million of liabilities, resulting in a net gain of $2.4 million from the sale.

The results of operations and related asset write-downs and accrued costs of Zyfer and MAXxess for all periods presented have been reclassified and presented as discontinued operations in the accompanying condensed consolidated statements of operations. Interest expense was not reclassified to discontinued operations because the discontinuances did not eliminate any of the Company’s debt.

No assets or liabilities of discontinued operations were included in the Company’s condensed consolidated balance sheets at December 31, 2004, or March 31, 2004.

Commitments

The Company has lease commitments for facilities in various locations throughout the United States. The annual commitment under these non-cancelable operating leases at December 31, 2004, including the lease for the Company’s Anaheim facilities is as follows (in thousands):

Recent Accounting Pronouncements

In November 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 151, Inventory Costs, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material.  SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  We do not believe the adoption of SFAS No. 151 will have a material impact on our financial statements.

On December 16, 2004, the FASB issued SFAS No.123 (revised 2004), “Share-Based Payment” (SFAS 123R) which replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, supersedes Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” 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).  SFAS 123R is effective for the Company beginning on July 1, 2005.  The Company is currently assessing the impact of SFAS 123R.  As of the date of this filing, no decisions have been made as to whether the Company will apply the modified prospective or retrospective transition method of application.

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Note 2—Income Taxes

Income taxes for the three and nine month periods ended December 31, 2004, and 2003, have been provided at the estimated annualized effective tax rates (“ETR”) based on the estimated income tax liability or assets and change in deferred taxes for each respective fiscal years. Deferred taxes result primarily from temporary differences in the reporting of income for financial statement and income tax purposes.

The Company recorded $51,000 and $(24,000) of income tax benefit (expense) for the three and nine months ended December 31, 2004, respectively.  Income tax expense was $293,000 and $744,000 for the three and nine months ended December 31, 2003, respectively.  The decrease in the effective tax rate was due to the release of valuation allowance on net operating loss carryforwards as a result of transactions that occurred during the first quarter of the current fiscal year (Note 4).

On May 28, 2004, the Company acquired a greater than 80% ownership interest in its former operating subsidiary, Iteris, Inc.  (the “Iteris Subsidiary”). From this date forward, income taxes are provided for on a consolidated basis for federal income tax purposes.  Due to this consolidation, federal net operating loss carryforwards and other federal tax attributes of the Company (subject to IRC Section 382 limitations) can be utilized to offset federal consolidated taxable income, which includes income from the Iteris Subsidiary.  Prior to this date, the Iteris Subsidiary was required to file a separate federal income tax return.

Note 3—Business Segment Information

The Company currently operates in two reportable segments: Sensors and Systems. 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 intangible assets 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 assets are not allocated to the segments.

The Sensors segment includes Vantage^TM vehicle detection systems for traffic intersection control and certain highway traffic data collection applications and AutoVue^TM lane departure warning systems for vehicle safety. The Systems segment includes transportation engineering and consulting services and the development of transportation management information systems for the ITS industry.

The reportable segments are each managed separately because they manufacture and distribute distinct products or provide services using different processes.

The following table sets forth selected financial information for the Company’s reportable segments as of and for the three and nine month periods ended December 31, 2004, and 2003 (in thousands):

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The following reconciles segment income to consolidated income from continuing operations before income taxes and (in thousands):

The Company’s income (loss) from continuing operations are generated and the Company’s assets are held substantially in the United States.

Note 4— Mergers and Acquisitions

On May 28, 2004 (the “Closing Date”), in order to simplify the Company’s capital structure and facilitate the merger of the Iteris Subsidiary into the Company, the Company completed the purchase of all of the outstanding shares of the Series A preferred stock of the Iteris Subsidiary (the “Series A preferred stock”), which were held by DaimlerChrysler Ventures GmbH (“DCV”) and Hockenheim Investment Pte. Ltd. (“Hockenheim”), in exchange for approximately $17.5 million in cash.  In addition, the Company acquired all of the 547,893 shares of common stock of the Iteris Subsidiary held by DCV in exchange for the issuance of 1,219,445 shares (the “Exchange Shares”) of the Company’s Class A common stock (now known as the Company’s common stock) which was valued at $3.4 million at the date of issuance. The fair value of the Company’s common stock issued in the transaction was based on the quoted market price of the Company’s stock on the OTC Bulletin Board averaged over a five-day period. The purchase and exchange of the shares were made pursuant to a Stock Purchase and Exchange Agreement dated March 31, 2004, by and among the Company, the Iteris Subsidiary, DCV and Hockenheim (the “Purchase and Exchange Agreement”).

Pursuant to the Purchase and Exchange Agreement, the Company purchased 3,124,913 shares of the Series A preferred stock of the Iteris Subsidiary from DCV and Hockenheim for a purchase price of $5.61 per share.  The purchase price represented the stated redemption value of the Series A preferred stock.  The purchase of the shares was financed primarily with a $10.1 million convertible debenture financing completed in May 2004 (Note 5) with a group of accredited investors, in addition to a $5.0 million senior credit facility arranged through a bank and $2.4 million in cash (Note 6).

Subject to certain exceptions, DCV has agreed not to sell or otherwise transfer the Exchange Shares during the year following the Closing Date.  However, beginning on November 28, 2005, DCV may require the Company to repurchase up to 50% of the Exchange Shares at a purchase price of $1.438 per share; and beginning on May 28, 2007, DCV may require the Company to repurchase up to 100% of the Exchange Shares at a purchase price of $1.438 per share.  All such rights to require the repurchase of the Exchange Shares expire on September 28, 2007. Because this right is outside the control of the Company, the Company has classified the $3.4 million value of the 1,219,445 shares as redeemable common stock on the accompanying December 31, 2004, condensed consolidated balance sheet. In addition, beginning on May 28, 2005, DCV will have the right to request registration of all 1,219,445 shares of the Company’s common stock held as part of this exchange.  In the event the Company decides not to file a registration statement to register all such shares, DCV may require the Company to repurchase any or all of its shares of the Company’s common stock at a purchase price of $1.438 per share.  On February 1, 2005, DCV announced that its investment portfolio, which included its ownership in Iteris, Inc., was sold to European-based Cipio Partners for an undisclosed sum.  All repurchase and registration rights associated with the DCV shares may have inured to the benefit of Cipio Partners.

On June 30, 2004, the Company and certain minority stockholders of the Iteris Subsidiary (including officers and directors) entered into an exchange agreement whereby an aggregate of 1,319,541 shares of common stock of the Iteris Subsidiary were exchanged for 2,639,082 shares of the Company’s newly issued common stock valued at $8.6 million at the date of issuance. The fair value of the Company’s stock issued in the transaction was based on the quoted market price of the Company’s common stock on the OTC Bulletin Board averaged over a five-day period. The effect of this exchange was to reduce the residual minority interest in the Iteris Subsidiary to 8.1%.

On October 22, 2004, the Iteris Subsidiary was merged into the Company. The remaining 8.1% minority interest in the Iteris Subsidiary (consisting of 1,228,981 shares of common stock of the Iteris Subsidary) was converted to 2,457,962 shares of the Company’s common stock valued at $7.6 million at the merger date. Immediately following the merger, the Company converted all of its outstanding Class B common stock (921,917 shares) into 1,014,108 shares of its common stock (formerly designated as Class A common stock). The fair value of the Company’s common stock issued in the transaction was based on the quoted market price of the Company’s common stock on the OTC Bulletin Board averaged over a five-day period. In October 2004, the Company also amended its certificate of incorporation to (a) change the voting rights of its common stock from one-tenth to one vote per share, (b) remove the ability to issue any further shares of Class B common stock, and (c) rename its Class A common stock to common stock. As a result, the Company currently has only one class of common stock outstanding, the common stock.

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In connection with the merger, the Company assumed all outstanding options and warrants to purchase shares of common stock of the Iteris Subsidiary, which were outstanding immediately prior to the merger, whether vested or unvested, together with the Iteris Subsidiary’s 1998 Stock Incentive Plan (the “Option Plan”). Each such option and warrant assumed by the Company shall continue to have, and be subject to, the same terms and conditions as were applicable immediately prior to the merger, provided that (A) such option or warrant shall be exercisable for that number of whole shares of the Company’s common stock equal to the product of the number of shares of the Company’s common stock that were issuable upon exercise of such assumed option or warrant immediately prior to the merger multiplied by two (2) (the “Exchange Ratio”) rounded down to the nearest whole number of shares and (B) the per share exercise price for the shares of the Company’s common stock issuable upon exercise of such assumed option or warrant is equal to the quotient determined by dividing the exercise price per share at which such option or warrant was exercisable immediately prior to the merger by the Exchange Ratio (rounded up to the nearest whole cent).  As a result, options and warrants to purchase approximately 3.1 million shares and 327,000 shares, respectively, of common stock of the Iteris Subsidiary assumed in the merger became options and warrants to purchase 6.2 million and 654,000 shares of common stock respectively. The weighted-average exercise prices of the assumed options and warrants are $1.09 and $2.32, respectively. $11.5 million in stock-based compensation expense was recorded in connection with the assumption and exchange of vested Iteris Subsidiary stock options for stock options immediately exercisable into the Company’s common stock based on the difference between the fair market value of the Company’s common stock on the October 22, 2004, merger date and the exercise price of the modified stock option. Additionally, the Company incurred approximately $1.2 million in deferred compensation related to the assumption of unvested stock options to purchase common stock of the Iteris Subsidiary. Deferred compensation is expected to be amortized to stock-based compensation expense as the options vest.  The Company also recorded $1.1 million of goodwill and additional paid-in-capital in connection with the 654,0000 vested warrants assumed in the merger and acquisition of the Iteris Subsidiary.  The $1.1 million value was based on the difference between the fair market value of the Company’s common stock on the October 22, 2004 merger date and modified exercise price of the assumed warrant awards.

The excess of the purchase price over the proportionate amount of minority interest acquired has been allocated to the acquired intangible assets based on the estimated fair values with the residual allocated to goodwill. Accordingly, the Company recorded goodwill of $19.1 million, which represents the excess of the purchase price over the fair value of the proportionate identifiable net assets acquired. The estimated fair value of the intangible assets was determined using the income method and discounting future expected returns. The estimated useful lives for each of the acquired intangible assets is provided below:

The following table summarizes the proportionate estimated fair values of the assets acquired and liabilities assumed and the preliminary allocation of the purchase price at the date of acquisition (in thousands):

Amounts allocated to patents, developed technology and goodwill have not yet been attributed to the Company’s segments.  This allocation will be completed within a year from the acquisition date.

The value of the acquired intangible assets is being amortized using the straight-line method over the estimated useful life of the asset. The Company will record approximately $46,000 of amortization expense per fiscal year over the next seven years in connection with the acquired patents and $101,000 per fiscal year over the next five years in connection with the acquired developed technology. For the three and nine month periods ended December 31, 2004, the Company recorded amortization expense of $44,000 and $78,000 related to both the patents and the developed technology.

On October 22, 2004, in connection with the Company’s merger with the Iteris Subsidiary, the Chief Executive Officer of the Iteris Subsidiary, Mr. Jack Johnson, was promoted to President and Chief Executive Officer of the Company, replacing Mr. Gregory Miner. This merger triggered certain obligations under the Company’s change-in-control agreement with Mr. Miner. Accordingly the Company recorded approximately $807,000 in severance expense, which included $57,000 for related payroll taxes, in the third quarter ended December 31, 2004, as a charge to operations.  The severance amount will be paid to Mr. Miner in bi-weekly installments over the next 30 months. Mr. Miner is not required to render any services to the Company in connection with this agreement.

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Note 5—Convertible Debentures and Warrants

In order to finance the purchase of the Iteris Subsidiary Series A preferred stock (Note 4), the Company entered into a Debenture and Warrant Purchase Agreement dated May 19, 2004 (the “Debenture and Warrant Purchase Agreement”), with a group of accredited investors, which included certain officers of the Company, pursuant to which the Company sold and issued subordinated convertible debentures in the aggregate original principal amount of $10.1 million and issued detachable warrants to purchase an aggregate of 639,847 shares of its common stock.

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 being redeemed; and from May 19, 2008, until the maturity date of May 18, 2009, the debentures may be redeemed at 110% of the principal amount being redeemed.

Pursuant to the Debenture and Warrant Purchase Agreement, each individual investor also received two warrants to purchase shares of the Company’s common stock.  For every dollar of debenture purchased, each investor received one warrant to purchase approximately 0.03235 shares of the Company’s common stock at an exercise price of $3.86 per share and a second warrant to purchase approximately 0.03100 shares of the Company’s common stock at an exercise price of $4.03 per share.  The exercise prices are subject to certain adjustments, including adjustments for dilutive issuances.  The warrants to purchase 639,347 shares of common stock were immediately exercisable and expire on May 18, 2009. Debt discount costs related to the fair value of the warrants issued in connection with the convertible debentures, were calculated based on the fair value of the warrants determined using the Black-Scholes valuation model, and were approximately $905,000 at December 31, 2004. These costs have been netted against the $10.1 million convertible debentures on the accompanying condensed consolidated balance sheet and are being amortized to interest expense over the five-year term of the debentures.

In connection with the Debenture and Warrant Purchase Agreement, the Company issued warrants valued at $40,000 to the investment bankers, as a commission, to purchase 34,036 shares of its common stock at an exercise price of $3.86 per share. The warrants were immediately exercisable and expire on May 18, 2009. The value of these warrants has been recorded as a deferred financing cost in other assets on the accompanying condensed consolidated balance sheet and are being amortized to interest expense over the five-year life of the debentures. The Company incurred $621,000 in transaction costs associated with the debenture offering, which have also been capitalized as deferred financing costs in other assets on the accompanying condensed consolidated balance sheet and are being amortized to interest expense over the five-year term of the debentures.

Significant valuation estimates included in the determination of the value of the warrants include an expected life of five years, no dividends, a risk-free interest rate of 4.5% and a stock volatility factor of 0.5.

Note 6—Debt

Concurrent with the issuance of the convertible debentures, the Iteris Subsidiary entered into a $5.0 million term note payable with a bank. The proceeds from the note were used to purchase the Series A preferred stock of the Iteris Subsidiary (Note 4). The note is due on May 27, 2008, and provides for monthly principal payments of approximately $104,167. Interest accrues at the current stated prime rate plus 0.25%.

Also on May 28, 2004, the Iteris Subsidiary renegotiated its existing line of credit agreement and entered into a new line of credit agreement with the same bank. The new agreement has a one year term, expires on August 1, 2005, and provides for a maximum available credit line of $5.0 million. Under the terms of the new agreement, the Iteris Subsidiary 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.  Additionally, the Iteris Subsidiary 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 associated with the new line of credit and no pre-payment or early termination fees. On December 31, 2004, the available credit under this line of credit agreement was $4.0 million, of which $3.5 million was unused. As of December 31, 2004, the Company failed to met a debt covenant requiring year-to-date net income after taxes to be at least greater than $1.00. On February 10, 2004, the bank waived its right of default regarding this breach of covenant for the quarter ended December 31, 2004 only.

In connection with the October 22, 2004 merger (Note 4), the Company assumed the $5.0 million note payable and the $5.0 million line of credit with the bank under the same terms and conditions previously negotiated.

Both the term note payable and the line of credit are secured by substantially all of the assets of the Company.

On November 1, 2004, the Company amended its existing lease for the Anaheim facility and increased the $860,000 note payable to the landlord by $432,000 resulting in a total payable of $1.3 million. The $432,000 was recorded as a reduction of the deferred gain on the sale of the building, which is being amortized to operations over the remaining life of the lease. This increase was negotiated as a settlement to release the Company from its obligations under the existing lease related to the separation of buildings located at 1515 and 1585 S. Manchester Avenue, Anaheim California 92802, and other facility improvements to be made at the Anaheim location.

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Long-term debt consisted of the following (in thousands):

Note 7— Disposal of Fixed Assets

After the October 22, 2004 merger of the Iteris Subsidiary into the Company, the Company reviewed and determined certain corporate property and equipment would not provide value to its on-going operations.  These assets primarily consist of furniture and fixtures and computer equipment. Accordingly, the Company recorded a $422,000 loss on disposal of fixed assets in the three months ended December 31, 2004.

Note 8—Litigation

On June 29, 2004, a supplier to the Company’s former subsidiary, Mariner Networks, Inc., filed a complaint against the Company alleging various breaches of written contract claims arising out of alleged purchase orders.  The Plaintiff in this lawsuit seeks monetary damages plus attorney fees and related costs.  The Company has not yet answered or responded to the complaint. Settlement discussions are currently pending at this time, but there can be no assurance that this lawsuit will be settled in a timely manner or for a reasonable amount.  The Company believes that the ultimate resolution of this claim will not have a material impact on the Company’s financial position, results of operations or cash flows and accordingly has not recorded any amounts in the accompanying condensed consolidated financial statements in connection with this matter.

Additionally during the three months ended June 30, 2004, the Company received $949,000 as part of a settlement between Rockwell International and the Michigan Department of Transportation, pursuant to which the Company was a third party beneficiary.  This amount was recorded in other income in the accompanying condensed consolidated statements of operations.

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

Cautionary Statement

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, backlog and manufacturing capabilities, the practical market applications and acceptance of our products and services, and the status of our facilities and product development. 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 below, 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

Iteris, Inc. is 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 Intelligent Transportation Systems (“ITS”) industry expertise, we provide video sensor systems and transportation management and traveler information systems for 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. 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.

We currently operate in two reportable segments: Sensors and Systems. The Sensors segment includes Vantage^TM vehicle detection systems for traffic intersection control and certain highway traffic data collection applications and AutoVue^TM lane departure warning systems for vehicle safety. The Systems segment includes transportation engineering and consulting services and the development of transportation management information systems for the ITS industry.

Vantage^TM is a video vehicle sensing system that detects the presence of vehicles at signalized intersections enabling a more efficient allocation of green signal time and has certain highway traffic data collection applications. The Company sells and distributes its Vantage^TM products primarily to commercial customers and municipal agencies. In the past, the Vantage^TM business has experienced decreased revenues in winter months as severe weather conditions can exacerbate performance issues and delay the deployment of our systems due to construction schedules. We anticipate our Vantage^TM sales in the three months ended March 31, 2005 will be negatively impacted by such conditions.

Our AutoVue^TM lane departure warning systems consist of a small windshield mounted sensor that uses proprietary software to detect and warn drivers of unintended lane departures. Approximately 11,000 production AutoVue^TM units have been sold for truck platforms in the North American and European market and are currently offered as an option on certain Mercedes, MAN, Freightliner and International trucks.

In September of 2003, the Company entered into an agreement with Valeo Schalter und Sensoren Gmbh (“Valeo”) which granted Valeo the exclusive right sell and manufacture our AutoVue^TM lane departure warning product to the worldwide passenger car market in exchange for royalty payments for each AutoVue^TM unit sold. We provided specific contract engineering services, technical marketing and sales support to Valeo to enable the launch of our lane departure warning technology on the Infiniti FX45 platform in October 2004. As a result, we believe we will derive modest royalty revenues from shipments of our product from Valeo to Infiniti in our fourth quarter ending March 31, 2005. We plan 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 for the expected launch of the Infiniti M35 and M45 platforms in the spring of 2005.  We believe that AutoVue^TM 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 transposition engineering and consulting services focused on the 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 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.

During the past two fiscal years, we divested all of our remaining subsidiaries other than our Iteris Subsidiary (the “Iteris Subsidiary”) to focus on our core business, ITS Sensors and Systems. In May 2004, we repurchased all of the outstanding

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shares of Series A preferred stock of the Iteris Subsidiary for an aggregate purchase price of approximately $17.5 million in cash and we purchased 547,893 shares of the Iteris Subsidiary common stock from DCV in consideration for the issuance of 1,219,445 shares of our common stock. We financed the purchase price for the Iteris Subsidiary Series A preferred stock through the issuance of convertible debentures in the original principal amount of $10.1 million and a $5.0 million term note payable to our bank and $2.4 million in cash.

In June on 2004, we entered into an exchange agreement with certain minority shareholders of the Iteris Subsidiary and issued an aggregate of 2,639,082 shares of our common stock to the stockholders in exchange for their 1,319,541 shares of common stock of the Iteris Subsidiary.

On October 22, 2004, we completed the merger with our Iteris Subsidiary. Our statements of operations for the three and nine month periods ended December 31, 2003 and statement of cash flows for the nine months ended December 31, 2003 have been restated to reflect the discontinuation of all operations except those of the Iteris Subsidiary.

Critical Accounting Policies And Estimates

Management’s Discussion and Analysis of Financial Conditions 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 and the recoverability of long-lived assets and goodwill. 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 cost 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 revenue is derived primarily from long-term contracts with governmental agencies. Contract revenue includes 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 revenue, we derive revenue from technology access fees and the provision of specific non-recurring contract engineering services related to our AutoVue^TM lane departure warning system. Combined technology access fees and contract engineering revenues are recognized on the percentage of completion method of accounting based on the relationship of hours incurred to total estimated hours. Technology access fee revenues and contract engineering revenues are included in net sales in the accompanying statements of operations. We also derive royalty revenue based on unit sales of our AutoVue^TM systems by our strategic partner Valeo. While we have not recognized any royalty revenue to date, the first Valeo unit sales of our product occurred in the quarter ended December 31, 2004. We plan to recognize royalty revenue for all unit sales beginning in our fourth ending March 31, 2005.

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 which could adversely affect our operating results.

Inventory. Inventories consist of finished goods, work-in-process and raw materials and are stated at the lower of cost or market. We provide reserves for potentially excess and obsolete inventory. In assessing the ultimate realization of inventories, we make judgments as to future demand requirements and compare that with the current or committed inventory levels. Reserves are established for inventory levels that exceed 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.

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Goodwill and Purchased Intangible Assets.  The purchase method of accounting for acquisitions requires extensive use of accounting estimates and judgments to allocate the purchase price to the fair value of the net tangible and intangible assets acquired. Goodwill and intangible assets deemed to have indefinite lives are subject to annual impairment tests. We believe there were no indicators of impairment of the carrying value of long-lived assets at December 31, 2004. We perform the annual impairment review in the fourth quarter of each fiscal year. The amounts and useful lives assigned to other intangible assets impact future amortization. If the assumptions and estimates used to allocate the purchase price are not correct or if business conditions change, purchase price adjustments or future asset impairment charges could be required.

Warranty.  Unless otherwise stated, we 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.

Results of Operations

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