Autoscope Technologies (AATC) 10-Q 2020 Q1 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x          QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2020

or

¨           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to

Commission file number: 0-26056

Image Sensing Systems, Inc.

(Exact Name of Registrant as Specified in its Charter)

Minnesota	41-1519168
State or Other Jurisdiction of Incorporation or Organization	I.R.S. Employer Identification No.
500 Spruce Tree Centre
1600 University Avenue West
St. Paul, MN	55104
Address of Principal Executive Offices	Zip Code

(651) 603-7700

Registrant’s Telephone Number, Including Area Code

Not Applicable

Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Trading Symbol(s)	Name of each exchange on which registered
Common Stock, $0.01 par value	ISNS	The Nasdaq Capital Market
Preferred Stock Purchase Rights	ISNS	The Nasdaq Capital Market

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 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x     No ¨

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).  Yes x    No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ¨	Accelerated filer ¨
Non-accelerated filer x	Smaller reporting company x
	Emerging growth company ¨

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ¨

1

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes ¨    No x

 Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding at April 30, 2020
Common Stock, $0.01 par value per share	5,331,799 shares

2

IMAGE SENSING SYSTEMS, INC.

TABLE OF CONTENTS 

​​​​​​​​​​​​​​​​​

PART I. FINANCIAL INFORMATION	4
Item 1. Financial Statements (Unaudited)	4
Condensed Consolidated Balance Sheets	4
Condensed Consolidated Statements of Operations	5
Condensed Consolidated Statements of Comprehensive Income (Loss)	6
Condensed Consolidated Statements of Cash Flows	7
Condensed Consolidated Statements of Shareholders' Equity	8
Notes to Condensed Consolidated Financial Statements	9
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations	21
Item 3. Quantitative and Qualitative Disclosures About Market Risk	27
Item 4. Controls and Procedures	27
PART II. OTHER INFORMATION	28
Item 1. Legal Proceedings	28
Item 1A. Risk Factors	28
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	28
Item 3. Defaults Upon Senior Securities	28
Item 4. Mine Safety Disclosures	28
Item 5. Other Information	28
Item 6. Exhibits	29
SIGNATURES	30
EXHIBIT INDEX	31

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PART I. FINANCIAL INFORMATION

Item 1.        Financial Statements

Image Sensing Systems, Inc.

Condensed Consolidated Balance Sheets

(in thousands)

	March 31, 2020			December 31,
	(Unaudited)			2019
ASSETS
Current assets:
Cash and cash equivalents	$	5,425		$	5,118
Accounts receivable, net of allowance for doubtful accounts of $4 and $19 respectively		2,898			3,126
Inventories		686			781
Prepaid expenses and other current assets		571			463
Total current assets		9,580			9,488
Property and equipment:
Furniture and fixtures		147			163
Leasehold improvements		6			6
Equipment		1,413			1,339
		1,566			1,508
Accumulated depreciation		1,122			1,089
		444			419
Operating lease assets, net		115			181
Intangible assets, net		3,722			3,875
Deferred income taxes		5,218			5,220
TOTAL ASSETS	$	19,079		$	19,183
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable	$	570		$	373
Deferred revenue		18			28
Warranty		220			313
Accrued compensation		181			105
Operating lease obligations		102			—
Other current liabilities		200			412
Total current liabilities		1,291			1,231
Operating lease obligations		13			19
TOTAL LIABILITIES		1,304			1,250
Shareholders' equity:
Preferred stock, $0.01 par value; 5,000,000 shares authorized, NaN issued or outstanding		—			—
Common stock, $0.01 par value; 20,000,000 shares authorized, 5,331,799 and 5,322,849
issued and outstanding at March 31, 2020 and December 31, 2019, respectively		53			53
Additional paid-in capital		24,810			24,751
Accumulated other comprehensive loss		(412	)		(306	)
Accumulated deficit		(6,676	)		(6,565	)
Total shareholders' equity		17,775			17,933
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	19,079		$	19,183
See accompanying notes to the condensed consolidated financial statements.

4

Image Sensing Systems, Inc.

Condensed Consolidated Statements of Operations

(Unaudited)

(in thousands, except per share data)

	Three-Month Periods Ended March 31,
	2020			2019
Revenue:
Product sales	$	1,050		$	1,621
Royalties		2,109			1,751
		3,159			3,372
Cost of revenue:
Product sales		531			685
Royalties		92			92
		623			777
Gross profit		2,536			2,595
Operating expenses:
Selling, general and administrative		1,909			1,665
Research and development		902			620
Restructuring charges		—			2
		2,811			2,287
Income (loss) from operations before income taxes		(275	)		308
Income tax benefit		(164	)		—
Net income (loss)	$	(111	)	$	308
Net income (loss) per share:
Basic	$	(0.02	)	$	0.06
Diluted	$	(0.02	)	$	0.06
Weighted average number of common shares outstanding:
Basic		5,267			5,224
Diluted		5,267			5,243
See accompanying notes to the condensed consolidated financial statements.

5

Image Sensing Systems, Inc.

Condensed Consolidated Statements of Comprehensive Income (Loss)

(Unaudited)

(in thousands)

	Three-Month Periods Ended March 31,
	2020			2019
Net income (loss)	$	(111	)	$	308
Other comprehensive income (loss):
Foreign currency translation adjustment		(106	)		30
Comprehensive income (loss)	$	(217	)	$	338
See accompanying notes to the condensed consolidated financial statements.

6

Image Sensing Systems, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(in thousands)

	Three-Month Periods Ended March 31,
	2020			2019
Operating activities:
Net income (loss)	$	(111	)	$	308
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		50			51
Software amortization		174			150
Stock-based compensation		59			50
Changes in operating assets and liabilities:
Accounts receivable, net		228			413
Inventories		95			81
Prepaid expenses and other current assets		(108	)		57
Accounts payable		186			(626	)
Accrued expenses and other current liabilities		(79	)		(300	)
Net cash provided by operating activities		494			184
Investing activities:
Capitalized software development costs		(22	)		(419	)
Purchases of property and equipment		(75	)		(75	)
Net cash used for investing activities		(97	)		(494	)
Financing activities:
Stock for tax withholding		—			(12	)
Proceeds from stock options exercised		—			4
Net cash used for financing activities		—			(8	)
Effect of exchange rate changes on cash		(90	)		30
Change in cash and cash equivalents		307			(288	)
Cash and cash equivalents at beginning of period		5,118			4,236
Cash and cash equivalents at end of period	$	5,425		$	3,948
Non-Cash investing and financing activities:
Purchase of property and equipment in accounts payable	$	25		$	9

See accompanying notes to the condensed consolidated financial statements.

7

IMAGE SENSING SYSTEMS, INC.

Condensed Consolidated Statements of Shareholders' Equity

(in thousands, except share data)

	Three-Month Period Ended March 31, 2019
	Shares Issued		Common Stock		Additional Paid-In Capital			Accumulated Other Comprehensive Loss			Accumulated Deficit			Total
Balance, December 31, 2018	5,278,485		$	52	$	24,550		$	(372	)	$	(13,593	)	$	10,637
Stock-based compensation	16,818			—		50			—			—			50
Stock options exercised	1,000			—		4			—			—			4
Stock for tax withholding	(2,362	)		—		(12	)		—			—			(12	)
Comprehensive income (loss):
Foreign currency translation adjustment	—			—		—			30			—			30
Net income	—			—		—			—			308			308
Cumulative effect from adoption of ASU No. 2016-02	—			—		—			—			33			33
Balance, March 31, 2019	5,293,941		$	52	$	24,592		$	(342	)	$	(13,252	)	$	11,050
	Three-Month Period Ended March 31, 2020
	Shares Issued		Common Stock		Additional Paid-In Capital			Accumulated Other Comprehensive Loss			Accumulated Deficit			Total
Balance, December 31, 2019	5,322,849		$	53	$	24,751		$	(306	)	$	(6,565	)	$	17,933
Stock-based compensation	8,950			—		59			—			—			59
Comprehensive income (loss):
Foreign currency translation adjustment	—			—		—			(106	)		—			(106	)
Net income (loss)	—			—		—			—			(111	)		(111	)
Balance, March 31, 2020	5,331,799		$	53	$	24,810		$	(412	)	$	(6,676	)	$	17,775
See accompanying notes to the condensed consolidated financial statements

8

IMAGE SENSING SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements

(Unaudited) 

March 31, 2020

Note A: Basis of Presentation

Image Sensing Systems, Inc. (referred to in this Quarterly Report on Form 10-Q as "we," "us," "our" and the "Company") develops and markets video and radar processing products for use in applications such as intersection control, highway, bridge and tunnel traffic management and traffic data collection. We sell our products primarily to distributors and also receive royalties under a license agreement with a manufacturer/distributor for certain of our products. Our products are used primarily by governmental entities.

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to the Quarterly Report on Form 10-Q, which require the Company to make estimates and assumptions that affect amounts reported. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (the "SEC"). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. It is the opinion of management that the unaudited condensed consolidated financial statements include all adjustments consisting of normal recurring accruals considered necessary for a fair presentation. All significant intercompany balances and transactions have been eliminated.

Operating results for the three month period ended March 31, 2020 are not necessarily indicative of the results that may be expected for the year ending December 31, 2020. The accompanying condensed consolidated financial statements of the Company should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2019 as filed with the SEC.

Summary of Significant Accounting Policies

The Company believes that of its significant accounting policies, the following are particularly important to the portrayal of the Company's results of operations and financial position and may require the application of a higher level of judgment by the Company's management and, as a result, are subject to an inherent degree of uncertainty.

Revenue Recognition 

On January 1, 2018, we adopted Accounting Standards Update ("ASU") No. 2014-09, "Revenue from Contracts with Customers(Topic 606)," using the full retrospective transition method. The Company's adoption of ASU 2014-09 did not have a material impact on the amount and timing of revenue recognized in its consolidated financial statements.

Under ASU 2014-09, we recognize revenue when control of the promised goods or services is transferred to customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services.

We determine revenue recognition through the following steps:
●	Identification of a contract, or contracts, with a customer;
●	Identification of performance obligations in the contract;
●	Determination of the transaction price;
●	Allocation of the transaction price to the performance obligations in the contract; and
●	Recognition of revenue when, or as, we satisfy a performance obligation.

Revenue disaggregated by revenue source for the three months ended March 31, 2020 and 2019 consists of the following (in thousands); revenue excludes sales and usage-based taxes when or if it has been determined that we are acting as a pass-through agent: 

	Three Months Ended March 31,
	2020		2019
Product sales	$	1,050	$	1,621
Royalties		2,109		1,751
Total revenue	$	3,159	$	3,372

9

Product Sales:

Product revenue is generated primarily from the direct sales of our RTMS radar systems worldwide and our Autoscope video systems in Europe and Asia. Revenue is recognized when control of the promised goods or services is transferred to our customers in an amount that reflects the amount we expect to receive in exchange for those goods or services.

Certain product sales may contain multiple performance obligations for revenue recognition purposes. Multiple performance obligations may include hardware, software, installation services, training, and support.  In arrangements where we have multiple performance obligations, the transaction price is allocated to each performance obligation using the relative stand-alone selling price. We generally determine stand-alone selling prices based on the observable stand-alone prices charged to customers. For performance obligations without observable stand-alone prices charged to customers, we evaluate the adjusted market assessment approach, the expected cost plus margin approach, and stand-alone sales to estimate the stand-alone selling prices.

Revenue for services such as maintenance, repair, and technical support is recognized either as the service is performed or ratably over the defined contractual period for service maintenance contracts. From time to time, our payment terms may vary by the type and location of our customer and the products or services offered. 

We record deferred revenues when cash payments are received or due in advance of our performance, including amounts which are refundable. The term between invoicing and when payment is due is not significant. For certain products or services and customer types, we require payment before the products or services are delivered to the customer.

We record provisions against sales revenue for estimated returns and allowances in the period when the related revenue is recorded based on historical sales returns and changes in end user demand.

Royalties:

Econolite Control Products, Inc. (“Econolite”) is our licensee that sells our Autoscope video system products in the United States, Mexico, Canada and the Caribbean.  The royalty of approximately 50% of the gross profit on licensed products is recognized when the products are shipped or delivered by Econolite to its customers.

Practical Expedients and Exemptions:

We generally expense sales commissions when incurred because the amortization periods would have been one year or less.  These costs are recorded within sales and marketing expense.

We do not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed.

10

Inventories

Inventories are primarily electronic components and finished goods and are valued at the lower of cost or net realizable value determined under the first-in, first-out accounting method.

Income Taxes

We record a tax provision for the anticipated tax consequences of our reported results of operations. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those deferred tax assets and liabilities are expected to be realized or settled. We record a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. We believe it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining net realizable value of our deferred tax assets. If all or part of the net deferred tax assets are determined not to be realizable in the future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on our financial condition and operating results. We recognize penalties and interest expense related to unrecognized tax benefits in income tax expense.

Intangible Assets

We capitalize certain software development costs related to software to be sold, leased, or otherwise marketed. Capitalized software development costs include purchased materials, services, internal labor and other costs associated with the development of new products and services. Software development costs are expensed as incurred until technological feasibility has been established, at which time future costs incurred are capitalized until the product is available for general release to the public. Based on our product development process, technological feasibility is generally established once product and detailed program designs have been completed, uncertainties related to high-risk development issues have been resolved through coding and testing, and we have established that the necessary skills, hardware, and software technology are available for production of the product. Once a software product is available for general release to the public, capitalized development costs associated with that product will begin to be amortized to cost of sales over the product's estimated economic selling life, using the greater of straight-line or a method that results in cost recognition in future periods that is consistent with the anticipated timing of product revenue recognition.

Capitalized software development costs are subject to an ongoing assessment of recoverability, which is impacted by estimates and assumptions of future revenues and expenses for these software products, as well as other factors such as changes in product technologies. Any portion of unamortized capitalized software development costs that are determined to be in excess of net realizable value have been expensed in the period in which such a determination is made. Subsequent to reaching technological feasibility for certain software products, we capitalized approximately $22,000 and $419,000 of software development costs during the quarters ended March 31, 2020 and 2019, respectively.

Intangible assets with finite lives are amortized on a straight-line basis over the expected period to be benefited by future cash flows and reviewed for impairment. At both March 31, 2020 and 2019, we determined there was 0 impairment of intangible assets. At both March 31, 2020 and 2019, there were 0 indefinite-lived intangible assets.

11

Note B: Recent Accounting Pronouncements 

Accounting pronouncements recently adopted

In February 2016, the Financial Accounting Standards Board ("FASB") issued ASU No. 2016-02, "Leases (Topic 842)".  We adopted ASU 2016-02 and its amendments and elected the effective date transition method as of January 1, 2019, which included recognizing a cumulative effect adjustment through opening accumulated deficit as of that date.  Prior year amounts were not recast under the transition approach and, therefore, prior year amounts are excluded from the operating leases footnote. See Note E: Operating Leases for further details.

In June 2018, the FASB issued ASU No. 2018-07, "Compensation-Stock Compensation (Topic 718)". ASU 2018-07 largely aligns the accounting for share-based payment awards issued to employees and nonemployees by expanding the scope of Accounting Standards Codification 718 to apply to nonemployee share-based transactions as long as the transaction is not effectively a form of financing. We adopted ASU No. 2018-07 as of January 1, 2019. There was no impact to the Company's consolidated financial statements.

In August 2018, the SEC adopted the final rule under SEC Release No. 33-10532, "Disclosure Update and Simplification," amending certain disclosure requirements that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements on the analysis of stockholders' equity for interim financial statements. Under the amendments, an analysis of changes in each caption of stockholders' equity presented in the balance sheet must be provided in a note or separate statement. The analysis must present a reconciliation of the beginning balance to the ending balance for each period for which a statement of comprehensive income is required to be filed. We adopted these changes as of January 1, 2019.

In August 2018, the FASB issued ASU No. 2018-13, "Fair Value Measurements (Topic 820)." ASU 2018-13 eliminates, amends and adds disclosure requirements for fair value measurements. The standard is required to be adopted for annual periods beginning after December 15, 2019, including interim periods within that annual period, which is our fiscal year 2020.  We adopted these changes as of January 1, 2020; however, there are no required changes that apply to our fair value measurements disclosures. 

Note C: Fair Value Measurements

The guidance for fair value measurements establishes the authoritative definition of fair value, sets out a framework for measuring fair value and outlines the required disclosures regarding fair value measurements. Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. We use a three-tier fair value hierarchy based upon observable and non-observable inputs as follows:

Level 1:	observable inputs such as quoted prices in active markets;
Level 2:	inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
Level 3:	unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

Nonfinancial Assets Measured at Fair Value on a Nonrecurring Basis

Our intangible assets and other long-lived assets are nonfinancial assets that were acquired either as part of a business combination, individually or with a group of other assets. These nonfinancial assets were initially, and have historically been, measured and recognized at amounts equal to the fair value determined as of the date of acquisition.

Financial Instruments not Measured at Fair Value

Certain of our financial instruments are not measured at fair value and are recorded at carrying amounts approximating fair value, based on their short-term nature or variable interest rate. These financial instruments include cash and cash equivalents, accounts receivable, accounts payable and other current financial assets and liabilities.

12

Note D: Inventories

Inventories consisted of the following (in thousands):

	March 31, 2020		December 31, 2019
Finished goods	$	534	$	551
Components		152		230
Total	$	686	$	781

Note E: Operating Leases

On January 1, 2019, we adopted ASU No. 2016-02, Leases (Topic 842), and its amendments and elected the effective date transition method, which included recognizing a cumulative effect adjustment through opening accumulated deficit as of that date.  We recorded $431,000 of operating lease assets and operating lease obligations as of January 1, 2019.

The Company is subject to various non-cancelable operating leases for office space and IT equipment expiring at various dates through November 2022. These leases do not have significant rent escalation, holidays, concessions, leasehold improvement incentives, or other build-out clauses. Further, the leases do not contain contingent rent provisions.

Most of these leases include an option to renew. The exercise of lease renewal options is typically at our sole discretion; therefore, the majority of renewals to extend the lease terms are not included in our right-of-use ("ROU") assets and lease liabilities because they are not reasonably certain of exercise. We regularly evaluate the renewal options and, when they are reasonably certain of exercise, we include the renewal period in our lease term.

Because most of our leases do not provide an implicit rate, we use our incremental borrowing rate in determining the present value of the lease payments. The incremental borrowing rate represents an estimate of the interest rate we would incur at lease commencement to borrow an amount equal to the lease payments on a collateralized basis over the term of a lease. We used incremental borrowing rates as of January 1, 2019 for operating leases that commenced prior to that date. We have a centrally managed treasury function; therefore, based on the applicable lease terms and the current economic environment, we apply a portfolio approach for determining the incremental borrowing rate.

The cost components of our operating leases were as follows (in thousands): 

	Three-Month Periods Ended March 31,
	2020			2019
Operating lease costs	$	66	$	65
Variable lease cost		76		76
Total	$	142	$	141

Variable lease costs consist primarily of property taxes, insurance, and common area or other maintenance costs for our leased facilities and equipment, which are paid based on actual costs incurred by the lessor.

13

Maturities for our lease liabilities for all operating leases are as follows (in thousands) as of March 31, 2020:

	Total
2020	$	102
2021		8
2022		7
2023 and thereafter		—
Total lease payments		117
Less: Interest		(2	)
Present value of lease liabilities	$	115

The weighted average remaining lease terms and discount rates for all of our operating leases were as follows as of March 31, 2020:

	March 31, 2020
Remaining lease term and discount rate:
Weighted average remaining lease term (years)	0.84
Weighted average discount rate	4.75	%

Cash paid for amounts included in the measurement of operating lease liabilities was $67,000 and $65,000 for the three months ended March 31, 2020 and 2019, respectively, and this amount is included in operating activities in the condensed consolidated statements of cash flows. Separate from the initial recognition of the existing leases, there were no operating lease assets obtained in exchange for new operating lease liabilities for the three months ended March 31, 2020 and 2019.

14

Note F: Intangible Assets

Intangible assets consisted of the following (dollars in thousands):            

	March 31, 2020
								Weighted
	Gross					Net		Average
	Carrying		Accumulated			Carrying		Useful Life
	Amount		Amortization			Value		(in Years)
Developed technology	$	3,900	$	(3,900	)	$	—	—
Vision development costs		2,929		(1,278	)		1,651	8.0
Echo development costs		1,852		(44	)		1,808	7.0
IntellitraffiQ development costs		468		(205	)		263	4.0
Wrong Way development costs		228		(228	)		—	—
Total	$	9,377	$	(5,655	)	$	3,722	7.3

	December 31, 2019
								Weighted
	Gross					Net		Average
	Carrying		Accumulated			Carrying		Useful Life
	Amount		Amortization			Value		(in Years)
Developed technology	$	3,900	$	(3,900	)	$	—	—
Vision development costs		2,929		(1,186	)		1,743	8.0
Software development in process costs		1,830		—			1,830	—
IntellitraffiQ development costs		468		(176	)		292	4.0
Wrong Way development costs		228		(218	)		10	2.0
Total	$	9,355	$	(5,480	)	$	3,875	7.1

Note G: Warranties 

We generally provide a two to three year warranty on product sales. Reserves to honor warranty claims are estimated and recorded at the time of sale based on historical claim information and are analyzed and adjusted periodically based on actual claim trends.

Warranty liability and related activity consisted of the following (in thousands):

	Three-Month Periods Ended March 31,
	2020			2019
Beginning balance	$	313		$	656
Warranty provisions		7			30
Warranty claims		(23	)		(33	)
Adjustments to preexisting warranties		(75	)		(81	)
Currency		(2	)		(1	)
Ending balance	$	220		$	573

15

Note H: Stock-Based Compensation

We compensate officers, directors, key employees and consultants with stock-based compensation under the Image Sensing Systems, Inc. 2014 Stock Option and Incentive Plan (the "2014 Plan"), which was approved by our shareholders and is administered under the supervision of our Board of Directors. The Image Sensing Systems, Inc. 2005 Stock Incentive Plan (the "2005 Plan") expired in 2015, and there are 0 options or other awards outstanding under the 2005 Plan.  Stock option awards are granted at exercise prices equal to the closing price of our stock on the day before the date of grant. Generally, options vest ratably over periods of three to five years from the dates of the grant, beginning one year from the date of grant, and have a contractual term of nine to 10 years.

Compensation expense, net of estimated forfeitures, is recognized ratably over the vesting period. Stock-based compensation expense included in general and administrative expense for the three-month periods ended March 31, 2020 and 2019 was $59,000 and $50,000, respectively. At March 31, 2020, 5,331,799 shares were available for grant under the Company's 2014 Plan.

Stock Options

A summary of the stock option activity for the first three months of 2020 is as follows:

	Number of Shares		Weighted Average Exercise Price per Share		Weighted Average Remaining Contractual Term (in years)		Aggregate Intrinsic Value
Options outstanding at December 31, 2019		16,000	$	4.73		3.97	$	3,505
Granted		—	$	—		—	$	—
Exercised		—	$	—		—	$	—
Expired		—	$	—		—	$	—
Forfeited		—	$	—		—	$	—
Options outstanding at March 31, 2020		16,000	$	4.73		3.72	$	—
Options exercisable at March 31, 2020		16,000	$	4.73		3.72	$	—

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There were 0 stock options exercised during the three-month period ended March 31, 2020 and there were stock options exercised to purchase 1,000 shares in the three-month period ended March 31, 2019. During each of the three-month periods ended March 31, 2020 and 2019, we recognized 0 stock-based compensation expense related to stock options. As of March 31, 2020, there was 0 unrecognized compensation cost related to non-vested stock options.

Restricted Stock Awards and Stock Awards

Restricted stock awards are granted under the 2014 Plan at the discretion of the Compensation Committee of our Board of Directors. We issue restricted stock awards to executive officers and key consultants. These awards may contain certain performance conditions or time-based vesting criteria. The restricted stock awards granted to executive officers vest if the various performance or time-based metrics are met. Stock-based compensation is recognized for the number of awards expected to vest at the end of the period and is expensed beginning on the grant date through the end of the vesting period. At the time of vesting of the restricted stock awards, the recipients of common stock may request to receive a net of the number of shares required for employee withholding taxes, which can be withheld up to the relevant jurisdiction's maximum statutory rate. Compensation expense related to any stock awards issued to employees is determined on the grant date based on the publicly-quoted fair market value of our common stock and is charged to earnings on the grant date.  

We also issue stock awards as a portion of the annual retainer for each director on a quarterly basis. The stock awards are fully vested at the time of issuance. 

The following table summarizes restricted stock award activity for the first three months of 2020:

	Number of Shares			Weighted Average Grant Date Fair Value
Awards outstanding December 31, 2019	58,961		$	4.32
Granted	8,950			3.49
Vested	(26,802	)		3.75
Forfeited	—			—
Awards outstanding at March 31, 2020	41,109		$	4.52

As of March 31, 2020, the total stock-based compensation expense related to non-vested awards not yet recognized was $152,000, which is expected to be recognized over a weighted average period of 1.8 years. During the three-month periods ended March 31, 2020 and March 31, 2019, we recognized $59,000 and $50,000, respectively, of stock-based compensation expense related to restricted stock awards.

Note I: Income (Loss) per Common Share

Net income (loss) per share is computed by dividing net income (loss) by the daily weighted average number of common shares outstanding during the applicable periods. Diluted net income (loss) per share includes the potentially dilutive effect of common shares subject to outstanding stock options and restricted stock awards using the treasury stock method. Under the treasury stock method, shares subject to certain outstanding stock options and restricted stock awards have been excluded from the calculation of the diluted weighted average shares outstanding because the exercise of those options or the vesting of those restricted stock awards would lead to a net reduction in common shares outstanding. As a result, stock options and restricted stock awards to acquire 27,139 and 23,000 weighted common shares have been excluded from the diluted weighted shares outstanding for the three-month periods ended March 31, 2020 and 2019, respectively.

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A reconciliation of net income (loss) per share is as follows (in thousands, except per share data): 

	Three-Month  Periods Ended March 31,
	2020			2019
Numerator:
Net income (loss)	$	(111	)	$	308
Denominator:
Weighted average common shares outstanding		5,267			5,224
Dilutive potential common shares		—			19
Shares used in diluted net income (loss) per common share calculations		5,267			5,243
Basic net income (loss) per common share	$	(0.02	)	$	0.06
Diluted net income (loss) per common share	$	(0.02	)	$	0.06

Note J: Segment Information

The Company's Chief Executive Officer and management regularly review financial information for the Company's discrete operating segments. Based on similarities in the economic characteristics, nature of products and services, production processes, type or class of customer served, method of distribution and regulatory environments, the operating segments have been aggregated for financial statement purposes and categorized into 2 reportable segments:  Intersection and Highway.

Autoscope video 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 product sales. Video products are normally sold in the Intersection segment. RTMS is our radar product line, and revenue consists of international and North American product sales. Radar products are normally sold in the Highway segment. All segment revenues are derived from external customers.   

Operating expenses and total assets are not allocated to the segments for internal reporting purposes. Due to the changes in how we manage our business, we may reevaluate our segment definitions in the future.   

The following table sets forth selected unaudited financial information for each of our reportable segments (in thousands):

	Three Months Ended March 31,
	Intersection				Highway				Total
	2020		2019		2020		2019		2020		2019
Revenue	$	2,250	$	2,072	$	909	$	1,300	$	3,159	$	3,372
Gross profit		2,069		1,792		467		803		2,536		2,595
Amortization of intangible assets		92		92		82		58		174		150
Intangible assets		1,651		2,018		2,071		1,568		3,722		3,586

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Note K: Restructuring and Exit Activities

In the third quarter of 2018, we initiated the closure of our Bucharest, Romania office location, which was a sales office for Image Sensing Systems EMEA Limited, a United Kingdom subsidiary. The Company will continue doing business in the European region utilizing its Barcelona, Spain sales office. We incurred $0 of costs for the closure of our office in Romania in the three-month period ended March 31, 2020 and $2,000 of costs related to the closure of the Romania location in the three-month period ended March 31, 2019. 

In the third quarter of 2016, in order to streamline our operating and cost structure, we initiated the closure of our wholly-owned subsidiaries, Image Sensing Systems HK Limited (ISS HK) in Hong Kong; Image Sensing Systems (Shenzhen) Limited (ISS WOFE) in China; Image Sensing Systems Europe Limited (ISS Europe) in the United Kingdom; Image Sensing Systems Europe Limited SP.Z.O.O (ISS Poland) in Poland; and Image Sensing Systems Germany, GmbH (ISS Germany) in Germany. At December 31, 2018, Image Sensing Systems Europe Limited and Image Sensing Systems Europe Limited SP.Z.O.O were fully closed. At December 31, 2019, Image Sensing Systems Germany, GmbH was fully closed. During the first quarter of 2020, we initiated closure of Image Sensing Systems EMEA Limited (ISS UK) and Image Sensing Systems Holdings Limited (ISS Holdings). We incurred $30,000 and $0, respectively, for these entity closure costs in the three-month periods ended March 31, 2020 and March 31, 2019.

Note L: Commitments and Contingencies

Litigation

We are involved from time to time in various legal proceedings arising in the ordinary course of our business, including primarily commercial, product liability, employment and intellectual property claims. In accordance with GAAP, we record a liability in our Consolidated Financial Statements with respect to any of these matters when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. With respect to any currently pending legal proceedings, we have not established an estimated range of reasonably possible additional losses either because we believe that we have valid defenses to claims asserted against us or the proceeding has not advanced to a stage of discovery that would enable us to establish an estimate. We currently do not expect the outcome of these matters to have a material effect on our consolidated results of operations, financial position or cash flows. Litigation, however, is inherently unpredictable, and it is possible that the ultimate outcome of one or more claims asserted against us could adversely impact our results of operations, financial position or cash flows. We expense legal costs as incurred.

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Note M: Subsequent Events

The ramifications of the coronavirus (“COVID-19”) outbreak reported to have started in December 2019 and spread globally are filled with uncertainty and changing quickly.  In March 2020, the World Health Organization declared COVID-19 a pandemic. 

The Company is considered an essential service and has remained operational.  As of the middle of March 2020, all of the Company’s employees began working from home and did not experience any significant interruptions during this transition.  The Company has worked with key suppliers to ensure there is an adequate supply of components and capacity to manufacture and deliver products.  On April 13, 2020, Econolite informed the Company that Econolite had agreed to temporarily close its manufacturing facility in Tecate, Mexico, under guidance from the local government due to COVID-19. Based on information obtained by the Company, Econolite has made alternative arrangements to manufacture Autoscope and related products that had been manufactured at its Mexican facility. We do not know whether the plant remains closed.

The COVID-19 pandemic began to impact our operations late in the first quarter of 2020 and is likely to continue to adversely affect our business and results of operations, including as a result of government authorities imposing mandatory closures, work-from-home orders and social distancing protocols, or imposing other restrictions. These actions could materially adversely affect our ability to adequately staff and maintain our operations, impair our ability to sustain sufficient financial liquidity, and adversely impact our financial results.

At this time, the Company has not experienced any payment interruptions or requests for special terms.  The Company has taken actions to reduce costs, including reductions in fixed-cost compensation and various austerity measures to curtail discretionary spending in light of the circumstances. Other variable costs, including hourly wages, overtime, sales commissions, temporary labor, performance-based compensation, advertising, and delivery expenses, are expected to moderate consistently with our overall business activity. 

The COVID-19 pandemic has resulted, and is likely to continue to result, in significant economic disruption and has and will likely to continue to adversely affect our business and results of operations. Although these disruptions are expected to be temporary, significant uncertainty exists concerning the magnitude of the impact and duration of the COVID-19 pandemic. As we cannot predict the duration or scope of the COVID-19 pandemic, the anticipated negative financial impact to our results of operations cannot be reasonably estimated but could be material and last for an extended period of time.

Under the Paycheck Protection Program (the “PPP”), the United States Small Business Administration (the “SBA”) approved the application of the Company to receive a loan in the amount of $923,700 (the “PPP Loan”). The PPP was established under the congressionally approved Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) and is administered by the SBA. The PPP Loan to the Company was made through BMO Harris Bank N. A. (the “Lender”).  On April 21, 2020, the Company’s Board of Directors approved the PPP Loan, and the Company signed the promissory note (the “Note”) evidencing the PPP Loan, which is dated as of April 17, 2020.  The Lender disbursed the proceeds of the PPP Loan to the Company on April 22, 2020.

Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of loans made under the PPP after 8 weeks if the recipients use the PPP loan proceeds for eligible purposes, including payroll costs, mortgage interest, rent or utility costs and meet other requirements regarding, among other things, the maintenance of employment and compensation levels. The Company intends to use the entire PPP Loan amount for qualifying expenses and to apply for forgiveness of the loan in accordance with the terms of the CARES Act.  No assurance is provided that the Company will obtain forgiveness of the PPP Loan in whole or in part.  To obtain full or partial forgiveness of the PPP Loan, the Company must request forgiveness and provide satisfactory documentation in accordance with applicable SBA guidelines.  Interest payable on the PPP Loan will be forgiven only if the SBA agrees to pay such interest on the forgiven principal amount of the PPP Loan.

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Item 2.        Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

General.  We are a leading provider of above-ground detection products and solutions for the intelligent transportation systems (“ITS”) industry. Our family of products, which we market as Autoscope® video or video products (“Autoscope”), RTMS® radar or radar products (“RTMS”), and IntellitraffiQ® or iQ products, provides end users with the tools needed to optimize traffic flow and enhance driver safety. Our technology analyzes signals from sophisticated sensors and transmits the information to management systems and controllers or directly to users. Our products provide end users with complete solutions for the intersection and transportation markets.

Our technology is a process in which software, rather than humans, examines outputs from various types of sophisticated sensors to determine what is happening in a field of view. In the ITS industry, this process is a critical component of managing congestion and traffic flow. In many cities, it is not possible to build roads, bridges and highways quickly enough to accommodate the increasing congestion levels. On average, United States commuters lose 97 hours a year in congestion, which costs motorists $87 billion a year in time, which is an average of $1,365 per driver (per INRIX 2018 Global Traffic scorecard). We believe this growing use of vehicles will make our ITS solutions increasingly necessary to complement existing and new roadway infrastructure to manage traffic flow and optimize throughput.

We believe our solutions are technically superior to those of our competitors because they have a higher level of accuracy, limit the occurrence of false detection, are generally easier to install, have lower costs of ownership, work effectively in a multitude of light and weather conditions, and provide end users the ability to manage inputs from a variety of sensors for a number of tasks. It is our view that the technical advantages of our products make our solutions well suited for use in ITS markets.

We believe the strength of our distribution channels positions us to increase the penetration of our technology‑driven solutions in the marketplace. We market our Autoscope video products in the United States, Mexico, Canada and the Caribbean through an exclusive agreement with Econolite Control Products, Inc. ("Econolite"), which we believe is the leading distributor of ITS intersection control products in these markets.

We market the RTMS radar systems to a network of distributors globally.  On a limited basis, we may sell directly to the end user. We market our Autoscope video products outside of the United States, Mexico, Canada and the Caribbean through a combination of distribution and direct sales channels, through our office in Spain. Our end users primarily include governmental agencies and municipalities.

The following discussion of period-to-period changes and trends in financial statement results under "Management's Discussion and Analysis of Financial Condition and Results of Operations" aligns with the financial statement presentation discussed above. 

Trends and Challenges in Our Business

We believe the expected 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 and the need to automate safety, security and access applications for automobiles and trucks, which has increased demand for our products;
• advances in information technology, which have made our products easier to market, implement and integrate;
• the continued funding allocations for centralized traffic management services and automated enforcement schemes, which have 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 ITS and other automated applications for traffic control, safety and enforcement in developed countries;
• a propensity by traffic engineers to implement lower cost technology-based solutions rather than civil engineering solutions such as widening roadways;
• countries in the developing world adopting above-ground detection technology, such as video or radar, instead of in-pavement loop technology to manage traffic; and 

• our ability to develop new products that provide increasingly accurate information and enhance the end users' ability to cost-effectively manage traffic and environmental issues.

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Because the majority of our 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 among periods. The ongoing economic environment in Europe and the United States is further adding to the unpredictability of purchase decisions, creating more delays than usual and decreasing governmental budgets, and it is likely to continue to affect our revenue.

Key Financial Terms and Metrics

Revenue. We derive revenue from two sources: (1) royalties received from Econolite for sales of the Autoscope video systems in the United States, Mexico, Canada and the Caribbean and (2) revenue received from the direct sales of our RTMS radar systems and our Autoscope video systems in Europe and Asia. Autoscope video royalties are calculated using a profit sharing model in which the gross profits on sales of product made through Econolite are shared equally with 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 the long-term Manufacturing, Distributing and Technology Agreement dated as of June 11, 1991, as amended (the “Econolite Agreement”), between the Company and Econolite.

On April 13, 2020, Econolite informed the Company that Econolite had agreed to temporarily close its manufacturing facility in Tecate, Mexico, under guidance from the local government due to COVID-19.  It is the Company’s understanding that Econolite manufactures the Company’s Autoscope products at this facility.  We do not know whether the plant remains closed. By a letter to Econolite dated April 22, 2020, the Company informed Econolite that the Econolite Agreement requires Econolite to maintain sufficient inventory of products governed by the Econolite Agreement to permit Econolite to satisfy demand in the “Territory” (as that term is defined in the Econolite Agreement).  Because it was the Company’s understanding that Econolite had not maintained sufficient quantities of completed Autoscope products to satisfy product demand in the Territory, in its April 22, 2020 letter, the Company informed Econolite that Econolite was in breach of the Econolite Agreement and had 60 days from the date of the Company’s letter to manufacture sufficient levels of the Company’s products, including the Company’s Autoscope products, to satisfy demand in the Territory.  In the letter, the Company stated that if Econolite fails to comply with this provision of the Econolite Agreement within the 60-day cure period, the Company may elect to terminate the Econolite Agreement.

Based on information obtained by the Company, Econolite has made alternative arrangements to manufacture Autoscope and related products that had been manufactured at its Mexican facility.  The Company has not yet suffered any shortages of product due to the temporary closing of Econolite’s facility in Tecate, Mexico.  However, it is uncertain whether Econolite is meeting, and can continue to meet, the demand for the products in the Territory.  If Econolite cannot do so, and if any of the Company’s other third-party suppliers are unable to manufacture sufficient product to meet the demand for products in the Territory, then the Company may be prevented or delayed from effectively operating our business, and the manufacture, supply, and sale of our services and our financial results could be adversely affected.

Cost of Revenue. Software amortization is the sole cost of revenue related to royalties, as virtually all manufacturing, warranty and related costs are incurred by Econolite. Cost of revenue related to product sales consists primarily of the amount charged by our third party contractors to manufacture hardware products, whose costs are influenced mainly by the cost of electronic components. The cost of revenue also includes logistics costs, estimated expenses for product warranties, and inventory obsolescence. The key metric that we follow is achieving certain gross margin percentages on product sales by operating segment.

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. These expenses include 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, 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. We also include any restructuring costs in operating expenses.

Non-GAAP Operating Measure. We provide certain non-GAAP financial information as supplemental information to financial measures calculated and presented in accordance with GAAP (Generally Accepted Accounting Principles in the United States). This non-GAAP information excludes the impact of depreciating fixed assets and amortizing intangible assets, and it may exclude other non-recurring items. Management believes that this presentation facilitates the comparison of our current operating results to historical operating results. Management uses this non-GAAP information to evaluate short-term and long-term operating trends in our core operations. Non-GAAP information is not prepared in accordance with GAAP and should not be considered a substitute for or an alternative to GAAP financial measures and may not be computed the same as similarly titled measures used by other companies.

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Reconciliations of GAAP income from operations to non-GAAP income from operations are as follows (in thousands):  

	Three-Month Periods Ended   March 31,
	2020			2019
Income (loss) from operations	$	(275	)	$	308
Adjustments to reconcile to non-GAAP income
Amortization of intangible assets		174			150
Depreciation		50			51
Restructuring		—			2
Non-GAAP income (loss) from operations	$	(51	)	$	511

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 parts of North America, Europe and northern Asia. We expect such seasonality to continue for the foreseeable future. Additionally, our international revenues regularly contain individually significant sales. This can result in significant variations of revenue between periods. 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: Intersection and Highway. Autoscope video 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 product sales. Video products are normally sold in the Intersection segment. RTMS and IntellitraffiQ are our radar product lines, and revenue consists of sales to external customers. Radar products are normally sold in the Highway segment. As a result of business model changes and modifications in how we manage our business, we may reevaluate our segment definitions in the future.

The following table sets forth selected unaudited financial information for each of our reportable segments (in thousands):   

	Three Months Ended March 31,
	Intersection				Highway				Total
	2020		2019		2020		2019		2020		2019
Revenue	$	2,250	$	2,072	$	909	$	1,300	$	3,159	$	3,372
Gross profit		2,069		1,792		467		803		2,536		2,595
Amortization of intangible assets		92		92		82		58		174		150
Intangible assets		1,651		2,018		2,071		1,568		3,722		3,586

Results of Operations  

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

	Three-Month Periods Ended March 31,
	2020		2019
Product sales	33.2	%	48.1	%
Royalties	66.8		51.9
Total revenue	100.0		100.0
Gross profit - product sales	49.4		57.7
Gross profit - royalties	95.6		94.7
Selling, general and administrative	60.4		49.4
Research and development	28.6		18.4
Income (loss) from operations	(8.7	)	9.1
Income tax benefit	(5.2	)	—
Net income (loss)	(3.5	)	9.1

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Total revenue decreased to $3.2 million in the three-month period ended March 31, 2020 from $3.4 million in the same period in 2019, a decrease of 6.3%. Royalty income increased to $2.1 million in the first quarter of 2020 from $1.8 million in the first quarter of 2019. The increase in royalties in the first three months of 2020 was led by strong sales in the Upper Midwest and Sunbelt. Product sales decreased to $1.1 million in the first quarter of 2020 from $1.6 million in the first quarter of 2019, a decrease of 35.2%. The decrease in product sales in the first three months of 2020 was a result of project timing and COVID-19 related supply chain challenges that prevented the delivery of product late in the quarter.  These challenges have since been resolved and our supply chain is positioned to meet anticipated demand.

Revenue for the Intersection segment increased to $2.3 million in the three-month period ended March 31, 2020 from $2.1 million in the three-month period ended March 31, 2019. The increase in revenue in the Intersection segment in the first three months of 2020 was attributable to the increase in royalties.

Revenue for the Highway segment decreased to $0.9 million in the three-month period ended March 31, 2020 from $1.3 million in the three-month period ended March 31, 2019. The decrease in revenue in the Highway segment in the first three months of 2020 was attributable to the supply chain challenges and project timing as COVID-19 impacted increasing numbers of regions towards the end of the quarter.

Gross margin percent for product sales decreased to 49.4% in the three months ended March 31, 2020 from 57.7% in the three months ended March 31, 2019. The dollar amount of product sales gross profit decreased $417,000, or 45%, in the three months ended March 31, 2020 compared to the prior year period. The decrease in product gross margin percent in the first three months of 2020 was the result of lower sales volumes in combination with increased amortization of intangible assets, increased inventory obsolescence, and decreased warranty adjustments, all of which impact product margins.

Gross margin percent for royalty sales for the three months ended March 31, 2020 increased to 95.6% from 94.7% in the same period in 2019. The dollar amount of gross profit from royalties increased $358,000, or 22%, in the three months ended March 31, 2020 compared to the prior year period. The increase in royalty gross margin percent in the first three months of 2020 was due to higher royalty revenues.

Selling, general and administrative expense was $1.9 million, or 60.4% of total revenue, in the first quarter of 2020 compared to $1.7 million, or 49.4% of total revenue, in the first quarter of 2019. The increase in expense in the first three months of 2020 was primarily a result of increased expenses for legal and outside consulting costs related to the efforts around exploring strategic alternatives to maximize shareholder value.

Research and development expense increased to $902,000, or 28.6% of total revenue, in the three-month period ended March 31, 2020 from $620,000, or 18.4% of total revenue, in the three-month period ended March 31, 2019. The increase was partially due to decreased capitalized software development costs in the three-month period ended March 31, 2020 of $22,000 compared to capitalized software costs of $419,000 for the same period in 2019.  After normalizing for software development costs, overall research and development expenditures decreased in the three-month period ended March 31, 2020 compared to the same period in the prior year. 

There was an income tax benefit of $164,000 recorded in the first three months of 2020 and no income tax expense or benefit recorded in the first three months of 2019.

Consolidated net loss was $(111,000), or $(0.02) per basic share and diluted share, in the three-month period ended March 31, 2020 compared to a net income of $308,000, or $0.06 per basic and diluted share, in the comparable prior year period. The net loss for the quarter ended March 31, 2020 is primarily due to the decrease in product revenues and increased operating expenses.  

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Liquidity and Capital Resources

At March 31, 2020, we had $5.4 million in cash and cash equivalents compared to $5.1 million in cash and cash equivalents at December 31, 2019.

Net cash provided by operating activities was $494,000 in the first three months of 2020 compared to net cash provided by operating activities of $184,000 in the same period in 2019. The increase in net cash provided by operating activities in the first three months of 2020 compared to the prior year period is primarily attributed to the reduction in accounts payable and other accrued liabilities during the first three months of 2019 compared to the current year period.

Net cash used for investing activities was $97,000 for the first three months of 2020 compared to net cash used for investing activities of $494,000 in the same period in 2019. The decrease of the amount of net cash used for investing activities in the first three months of 2020 compared to the prior year period was primarily the result of decreased capitalized internal software development costs compared to the prior year period.

Under the Paycheck Protection Program ("PPP"), the United States Small Business Administration ("SBA") approved the Company's application to receive a loan in the amount of $923,700 (the "PPP Loan").  The PPP was established under the congressionally approved Coronavirus Aid, Relief, and Economic Security Act (the "CARES Act") and is administered by the SBA.  The PPP Loan to the Company was made through BMO Harris Bank N.A. (the "Lender"). On April 21, 2020, the Company's Board of Directors approved the PPP Loan and the Company signed the promissory note (the "Note") evidencing the PPP Loan, which is dated as of April 17, 2020.  The Lender distributed the $923,700 of proceeds of the PPP Loan to the Company on April 22, 2020.

The term of the PPP loan is 24 months after the date of the Note (the "Maturity Date").  The annual interest rate on the PPP Loan is 1.00%.  No payments of principal or interest are due during the six months beginning on the date of the Note (the "Deferred Period").  The Company's obligations under the Note are not secured by a security interest in the Company's assets.  The Note requires the Lender's consent if the Company wants to reorganize, merge, consolidate, or otherwise change its ownership or structure.  The Note contains customary events of default by the Company relating to, among other things, payment defaults and the breach of representations and warranties or other provisions of the Note.  Upon a default by the Company under the Note, the Lender may accelerate the Company's obligations under the Note and pursue its rights against the Company under applicable law, including by filing suit and obtaining a judgment against the Company.

Under the terms of the CARES Act, PPP loan recipients can apply for and be granted forgiveness for all or a portion of loans made under the PPP after eight weeks if the recipients use the PPP loan proceeds for eligible purposes, including payroll costs, mortgage interest, rent or utility costs and meet other requirements regarding, among other things, the maintenance of employment and compensation levels. The Company intends to use the entire PPP Loan amount for qualifying expenses and to apply for forgiveness of the PPP Loan in accordance with the terms of the CARES Act. However, no assurance is provided that the Company will obtain forgiveness of the PPP Loan in whole or in part. To obtain full or partial forgiveness of the PPP Loan, the Company must request forgiveness and provide satisfactory documentation in accordance with applicable SBA guidelines. Interest payable on the PPP Loan will be forgiven only if the SBA agrees to pay such interest on the forgiven principal amount of the PPP Loan.

The Company will be obligated to repay any part of the principal amount due under the Note that is not forgiven, together with accrued interest, until the unforgiven portion is paid in full. Beginning one month after the expiration of the Deferred Period and continuing monthly until the Maturity Date, the Company will be obligated to make monthly payments of principal and interest to the Lender with respect to any unforgiven portion of the PPP Loan in such equal amounts as are required to fully amortize the principal amount outstanding under the Note.The Company may prepay any unforgiven amount due under the Note at any time without premium or penalty.

The foregoing description of the Note does not purport to be complete and is qualified in its entirety by reference to the full text of the Note filed as Exhibit 10.1 with the Company’s Current Report on Form 8-K filed with the SEC on April 23, 2020 and incorporated herein by reference.

We believe that cash and cash equivalents on hand at March 31, 2020, cash provided by operating activities, and the cash provided by the PPP Loan will satisfy our projected working capital needs, investing activities, and other cash requirements for at least one year from the date of these financial statements.

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, 2019. The accounting policies used in preparing our interim Condensed Consolidated Financial Statements as of and for the three months ended March 31, 2020 are set forth elsewhere in this Quarterly Report on Form 10-Q and should be read in conjunction with those described in our Annual Report on Form 10-K and the risk factor set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q.

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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 statements represent our expectations or beliefs concerning future events and can be identified by the use of forward-looking words such as "expects," "believes," "may," "will," "should," "intends," "plans," "estimates," or "anticipates" or other comparable terminology. Forward-looking statements are subject to risks and uncertainties that may cause our actual results to differ materially from the results described in the forward-looking statements. Factors that might cause such differences include, but are not limited to:

• our historical dependence on a single product for most of our revenue;
• budget constraints by governmental entities that purchase our products, including constraints caused by declining tax revenue;
• the continuing ability of Econolite to pay royalties owed;

• the mix of and margin on the products we sell;
• our dependence on third parties for manufacturing and marketing our products;
• our dependence on single-source suppliers to meet manufacturing needs;
• our failure to secure adequate protection for our intellectual property rights;
• our inability to develop new applications and product enhancements;
• the potential disruptive effect on the markets we serve of new and emerging technologies and applications, including vehicle-to-vehicle communications and autonomous vehicles;
• unanticipated delays, costs and expenses inherent in the development and marketing of new products;
• our inability to respond to low-cost local competitors;
• our inability to properly manage any growth in revenue and/or production requirements;
• the influence over our voting stock by affiliates;
• our inability to hire and retain key scientific and technical personnel;
• the effects of legal matters in which we may become involved;
• our inability to achieve and maintain effective internal controls;
• our inability to successfully integrate any acquisitions;
• tariffs and other trade barriers;
• political and economic instability, including continuing volatility in the economic and political environment of the European Union;
• our inability to comply with international regulatory restrictions over hazardous substances and electronic waste; and
• conditions beyond our control such as war, terrorist attacks, health epidemics (including the COVID-19 pandemic caused by the coronavirus) and economic recession.

We caution that the forward-looking statements made in this report or in other announcements made by us are further qualified by the risk factors set forth in Item 1A. of our Annual Report on Form 10-K for the fiscal year ended December 31, 2019 and the risk factor set forth in Part II, Item 1A of this Quarterly Report on Form 10-Q.

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Item 3.        Quantitative and Qualitative Disclosures About Market Risk

Approximately 20% of our revenue has historically been derived from shipments to customers outside the United States, and a large portion of this revenue is denominated in currencies other than the U.S. dollar.  Our international subsidiaries have functional currencies other than our U.S. dollar reporting currency and, occasionally, transact business in currencies other than their functional currencies.  These non-functional currency transactions expose us to market risk on assets, liabilities and cash flows recognized on these transactions.

The strengthening of the U.S. dollar relative to foreign currencies decreases the value of foreign currency-denominated revenue and earnings when translated into U.S. dollars.  Conversely, a weakening of the U.S. dollar increases the value of foreign currency-denominated revenue and earnings.  A 10% adverse change in foreign currency rates could have a material effect on our results of operations or financial position.

Item 4.        Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act")). Based upon that evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of March 31, 2020, our disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

During the fiscal quarter covered by this Quarterly Report on Form 10-Q, there has been no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1.        Legal Proceedings

None.

Item 1A.     Risk Factors

Our results of operations and financial condition are subject to numerous risks and uncertainties described in our Annual Report on Form 10-K for our fiscal year ended December 31 2019, filed on March 12, 2020. You should carefully consider these risk factors in conjunction with the other information contained in this Quarterly Report. Should any of these risks materialize, our business, financial condition and future prospects could be negatively impacted. As of May 14, 2020, there have been no material changes to the disclosures made in the above-referenced Form 10-K, other than as set forth below.

COVID-19 could affect our sales and disrupt our operations and could have a material adverse impact on us.

The COVID-19 that was reported to have surfaced in December 2019 and that has spread worldwide could adversely impact the Company’s operations or those of our third-party suppliers, as well as our sales to customers. The extent to which COVID-19 impacts the Company’s operations, those of our third-party suppliers, or our customers will depend on future developments, which are highly uncertain and cannot be predicted with confidence. If the Company or any of our third-party suppliers encounter any disruptions to our or their respective operations or facilities, or if our customers were to partially or fully close for an extended period of time due to COVID-19 then we or they may be prevented or delayed from effectively operating our or their business, respectively, and the manufacture, supply, and sale of our services and our financial results could be adversely affected.

Item 2.        Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3.        Defaults Upon Senior Securities

None.

Item 4.        Mine Safety Disclosures

None.

Item 5.        Other Information

None.

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Item 6.        Exhibits

The following exhibits are filed as part of this Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2020:

Exhibit Number	Description
10.1	Promissory Note, between BMO Harris Bank N.A. and Image Sensing Systems, Inc., dated as of April 17, 2020, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated April 23, 2020 (File No. 0-26056).
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.1	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.2	Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
101	The following financial information from the Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, formatted in iXBRL (Inline Extensible Business Reporting Language), (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Operations, (iii) the Condensed Consolidated Statements of Cash Flows, and (iv) the Notes to Condensed Consolidated Financial Statements (filed herewith).

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SIGNATURES

In accordance with the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	Image Sensing Systems, Inc.
Dated: May 14, 2020	By:	/s/ Chad A. Stelzig
		Chad A. Stelzig
		President and Chief Executive Officer
		(Principal Executive Officer)
Dated: May 14, 2020	By:	/s/ Frank G. Hallowell
		Frank G. Hallowell
		Chief Financial Officer
		(Principal Financial Officer and Principal Accounting Officer)

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EXHIBIT INDEX

Exhibit No.	Description
10.1	Promissory Note, between BMO Harris Bank N.A. and Image Sensing Systems, Inc., dated as of April 17, 2020, incorporated by reference to Exhibit 10.1 to the Company's Current Report on Form 8-K dated April 23, 2020 (File No. 0-26056).
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.1	Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
32.2	Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith).
101	The following financial information from the Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, formatted in iXBRL (Inline Extensible Business Reporting Language), (i) the Condensed Consolidated Balance Sheets, (ii) the Condensed Consolidated Statements of Operations, (iii) the Condensed Consolidated Statements of Cash Flows, and (iv) the Notes to Condensed Consolidated Financial Statements (filed herewith).

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