UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

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

		For the quarterly period ended September 30, 2006

		OR

o		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: 0-12965

NESTOR, INC.

(Exact name of registrant as specified in its charter)

Delaware		13-3163744
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

42 Oriental Street; Providence, RI		02908
(Address of principal executive offices)		(Zip Code)

401-274-5658

(Registrant’s telephone number, including area code)

[None]

(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 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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer:¨

Accelerated filer: ¨

Non-accelerated filer:x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange 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 on November 7, 2006
[Common Stock, $.01 par value per share]		20,386,816 shares

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INDEX

NESTOR, INC.

FORM 10Q

For the Quarterly Period Ended September 30, 2006

INDEX

		Page Number

Part I	FINANCIAL INFORMATION

Item 1	Financial Statements:

	Condensed Consolidated Balance Sheets	4
	September 30, 2006 (Unaudited ) and December 31, 2005

	Condensed Consolidated Statements of Operations (Unaudited)	5
	Quarter and Nine months ended September 30, 2006 and 2005 (as restated)

	Condensed Consolidated Statements of Cash Flows (Unaudited)	6
	Nine months ended September 30, 2006 and 2005 (as restated)

	Notes to Condensed Consolidated Financial Statements	7


Item 2	Management’s Discussion and Analysis of
	Financial Condition and Results of Operations	19


Item 3	Quantitative and Qualitative Disclosure of Market Risk	30


Item 4	Controls and Procedures	30


Part II	OTHER INFORMATION

Item 1	Legal Proceedings	31

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	36

Item 3	Defaults Upon Senior Securities	36

Item 4	Submission of Matters to a Vote of Security Holders	36

Item 5	Other Information	36

Item 6	Exhibit Index	36

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INDEX

PART I

Item 1

Restatement of Consolidated Financial Statements

As previously reported in our Annual Report on Form 10-K filed with the Securities and Exchange Commission on April 14, 2006, we have restated our consolidated financial statements for fiscal 2003 and fiscal 2004 as well as the first three interim periods of fiscal 2005. In this Quarterly Report on Form 10-Q, we have restated our condensed consolidated statements of operations, statements of cash flows and related disclosures for the three months and nine months ended September 30, 2005.

As previously reported in our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 5, 2005, the Company had extensive discussions with the Staff of the Securities and Exchange Commission concerning the proper accounting treatment of certain of its convertible debt, product sales, and unbilled revenue in previously reported financial results. The Company settled its accounting treatment of product sales and unbilled revenue without any financial restatement necessary. However, as a result of these discussions, the Company’s financial statements were restated to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities.

Refer to Note 3 in our Condensed Consolidated Financial Statements for additional information.

Our Annual Reports on Form 10-K for the years ended 2004 and 2003 and our Quarterly Reports on Form 10-Q for fiscal 2004 through the third quarter of fiscal 2005 have not been revised to reflect the restatement and the financial statements contained in those reports should not be relied upon. Instead, the restated financial statements for fiscal 2004 and fiscal 2003 included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 should be relied upon.

The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005.

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INDEX

NESTOR, INC.

Condensed Consolidated Balance Sheets

In Thousands, Except Share And Per Share Information


	September 30, 2006				December 31, 2005
		(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents	$	9,024		$	1,224
Cash and cash equivalents - restricted		3,859			---
Marketable securities		58			56
Accounts receivable, net		1,571			1,949
Inventory, net		2,121			1,671
Other current assets		159			391
Total current assets		16,792			5,291
Noncurrent assets
Capitalized system costs, net		7,244			5,379
Property and equipment, net		765			925
Goodwill		5,581			5,581
Patent development costs, net		136			146
Other long term assets		3,779			1,893
Total Assets	$	34,297		$	19,215

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Current portion of notes payable	$	2,098		$	4,136
Accounts payable		725			1,071
Accrued liabilities		1,818			1,471
Accrued employee compensation		502			478
Deferred revenue		422			103
Asset retirement obligation		148			129
Total current liabilities		5,713			7,388
Noncurrent Liabilities:
Long term convertible notes payable		721			1,650
Long term notes payable		8,391			3,286
Derivative financial instruments - debt and warrants		11,800			1,419
Long term asset retirement obligation		139			65
Total liabilities		26,764			13,808

Commitments and contingencies		---			---

Stockholders’ Equity:
Preferred stock, $1.00 par value, authorized 10,000 shares;
issued and outstanding: Series B - 180,000 shares at
September 30, 2006 and December 31, 2005		180			180
Common stock, $0.01 par value, authorized 30,000,000
shares issued and outstanding: 20,386,816 shares at
September 30, 2006 and 19,127,065 shares at December 31, 2005		204			191
Warrants		---			9
Additional paid-in capital		72,985			66,015
Accumulated deficit		(65,836	)		(60,988	)
Total stockholders’ equity		7,533			5,407
Total Liabilities and Stockholders’ Equity	$	34,297		$	19,215


*The Unaudited Notes to the Condensed Consolidated Financial Statements are an integral part of this statement.*

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INDEX

NESTOR, INC.

Condensed Consolidated Statements of Operations

In Thousands, Except Share And Per Share Information

(Unaudited)

	Quarter Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
					(As Restated)						(As Restated)
Revenues:
Lease and service fees	$	1,979		$	1,596		$	5,733		$	4,407
Product sales		---			318			---			1,758
Product royalties		3			---			4			15

Total revenue		1,982			1,914			5,737			6,180

Cost of sales:
Lease and service fees		1,659			1,225			4,715			3,264
Product sales		---			292			---			1,386
Product royalties		---			---			---			---

Total cost of sales		1,659			1,517			4,715			4,650


Gross profit:
Lease and service fees		320			371			1,018			1,143
Product sales		---			26			---			372
Product royalties		3			---			4			15

Total gross profit		323			397			1,022			1,530


Operating expenses:
Engineering and operations		861			1,078			3,162			2,780
Research and development		365			382			1,137			1,037
Selling and marketing		549			672			1,598			1,602
General and administrative		1,316			792			4,044			2,775

Total operating expenses		3,091			2,924			9,941			8,194

Loss from operations		(2,768	)		(2,527	)		(8,919	)		(6,664	)

Derivative instrument income (expense)		7,145			1,235			10,112			3,249
Debt discount expense		(1,167	)		(660	)		(4,681	)		(1,716	)
Other (expense) income, net		(562	)		(265	)		(1,360	)		(363	)

Net income (loss)	$	2,648		$	(2,217	)	$	(4,848	)	$	(5,494	)


Income (loss) per share:

Income (loss) per share, basic and diluted	$	0.13		$	(0.12	)	$	(0.24	)	$	(0.29	)

Shares used in computing loss per share:
Basic		20,378,648			18,879,464			20,241,421			18,815,952
Diluted		20,385,970			18,879,464			20,241,421			18,815,952

The Unaudited Notes to the Condensed Consolidated Financial Statements are an integral part of this statement.

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INDEX

NESTOR, INC.

Condensed Consolidated Statements of Cash Flows

In Thousands, Except Share And Per Share Information

(Unaudited)

	Nine Months Ended September 30,
		2006			2005
					(As Restated)
Cash flows from operating activities:
Net income (loss)	$	(4,848	)	$	(5,494	)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
Depreciation and amortization		2,165			1,807
Asset impairment charge		175			---
Write off of deferred financing fees		406			---
Stock based compensation		1,940			---
Derivative instrument (income) expense		(10,112	)		(3,249	)
Debt discount expense		4,681			1,716
Unrealized loss on marketable securities		(1	)		(5	)
Dividend income reinvested		---			(10	)
Expenses charged to operations relating to options, warrants and capital transactions		---			428
Provision for doubtful accounts		63			86
Provision for inventory reserve		83			421
Increase (decrease) in cash arising from
changes in assets and liabilities:
Accounts receivable		316			(650	)
Unbilled contract revenue		---			(162	)
Inventory		(533	)		(1,430	)
Other assets		231			(134	)
Accounts payable and accrued expenses		119			1,532
Deferred revenue		319			(31	)

Net cash used in operating activities		(4,996	)		(5,175	)

Cash flows from investing activities:
Sale of (investment in) marketable securities		---			522
Purchase of Transol Assets		---			(1,760	)
Investment in capitalized systems		(3,538	)		(2,211	)
Purchase of property and equipment		(172	)		(581	)
Investment in patent development costs		(7	)		(3	)

Net cash used in investing activities		(3,717	)		(4,033	)

Cash flows from financing activities:
Repayment of obligations under capital leases		---			(33	)
Repayment of notes payable		(10,850	)		(181	)
Proceeds from notes payable, net		26,397			7,250
Cash restricted by notes payable		(3,859	)		---
Proceeds from private stock placement		4,822			---
Proceeds from issuance of common stock, net		3			195

Net cash provided by financing activities		16,513			7,231

Net change in cash and cash equivalents		7,800			(1,977	)
Cash and cash equivalents - beginning of period		1,224			5,850

Cash and cash equivalents - end of period	$	9,024		$	3,873

Supplemental cash flows information:
Interest paid	$	891		$	381

Income taxes paid	$	---		$	---

*The Unaudited Notes to the Condensed Consolidated Financial Statements are an integral part of this statement.*

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INDEX

Nestor, Inc.

Notes to Condensed Consolidated Financial Statements

In Thousands, Except Share And Per Share Information

(Unaudited)

Note 1 - Nature of Operations:

A.	Organization

Nestor, Inc. was organized on March 21, 1983 in Delaware to develop and succeed to certain patent rights and know-how, which was acquired from its predecessor, Nestor Associates, a limited partnership. Two wholly-owned subsidiaries, Nestor Traffic Systems, Inc. (“NTS”) and Nestor Interactive, Inc. (“Interactive”), were formed effective January 1, 1997. Effective November 7, 1998, Nestor, Inc. ceased further investment in the Interactive subsidiary. CrossingGuard, Inc., a wholly owned subsidiary of NTS, was formed July 18, 2003 in connection with a financing. The condensed consolidated financials statements include the accounts of Nestor, Inc. and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated. The Company’s principal offices are located in Providence, RI and Los Angeles, CA.

The Company is a provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States. The Company provides a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. The Company’s principal product, CrossingGuard, incorporates our patented image processing technology into a solution that predicts and records the occurrence of a red light violation. The Company’s speed enforcement product, Poliscan^speed, or Poliscan, utilizes technology developed by Vitronic GmbH. We have exclusive distribution rights to market in North America. By coupling CrossingGuard or Poliscan equipment with the Company’s Citation Composer citation preparation and processing software, we are able to provide fully integrated speed enforcement solutions to municipalities.

B.	Liquidity and management’s plans

The Company has incurred significant losses to date and at September 30, 2006, we have an accumulated deficit of $65,836. Management believes that the significant financing obtained in 2006, liquidity at September 30, 2006, and current contracts with municipalities will enable us to sustain operations through the foreseeable future. However, should the Company's 7% Senior Secured Convertible noteholders exercise their right to put up to 20% of their notes back to the Company by December 29, 2006 and the Company's financial performance not sufficiently improve, the Company may be required to raise additional capital in the near term. There can be no assurance, however, that our operations will be sustained or be profitable in the future, that the Company’s product development and marketing efforts will be successful, or that if we have to raise additional funds to expand and sustain our operations, such funds will be available on terms acceptable to us, if at all.

Note 2 - Basis of Presentation:

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of financial results have been included. Operating results for the quarter ending September 30, 2006 are not necessarily indicative of the results that may be expected for the year ended December 31, 2006. There were no material unusual charges or credits to operations during the recently completed fiscal quarter.

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The balance sheet at December 31, 2005 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

For further information, refer to the audited consolidated financial statements and footnotes thereto included in our annual report on Form 10-K for the year ended December 31, 2005.

Certain prior period balances have been reclassified to conform to the current year presentation. The reclassifications had no net effect on the net loss previously reported.

Cash equivalents - the Company considers all highly liquid debt instruments purchased with an original maturity of 90 days or less to be cash equivalents.

Marketable securities - our marketable securities consist of an investment in a closed-end insured municipal bond fund. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other income (expense).

Inventory - inventory is valued at the lower of cost or market, with cost determined by the first-in, first-out basis, and consists mostly of component equipment considered to be finished goods and which is to be installed as roadside capitalized systems or speed enforcement units.

Fixed assets - material and labor costs incurred to build and install our equipment are capitalized and depreciated over the life of our conracts. The Company's CrossingGuard red light enforcement business requires us to install our technology in the communities that we serve. To do this, the Company deploys internal resources to design, help install, and configure its software and equipment in those communities (i.e. buildout). Buildout costs are defined as directly related payroll, fringe, and travel and entertainment expense. Those buildout costs are capitalizable as part of the cost of the system deployed under contract in a community we serve and depreciated over the life of the contract. The Company accumulates the amount of those internal buildout costs incurred on a quarterly basis and capitalizes them. Internal buildout costs capitalized in 2006 and 2005 were approximately $336 and zero, respectfully.

Intangible assets - costs of acquiring customer contracts are being amortized on a straight line basis over the life of the respective contracts, unless events or circumstances warrant a reduction to the remaining period of amortization.

Goodwill - goodwill represents the excess of cost over the fair value of net assets acquired. Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” requires that goodwill be tested for impairment at least annually and whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Goodwill is reviewed for impairment using the Company’s quoted stock price as a measurement of the Company’s fair value of assets, including goodwill, and liabilities. Any resulting goodwill impairment will be charged to operations.

Deferred revenue - certain customer contracts allow us to bill and/or collect payment prior to the performance of services, resulting in deferred revenue.

Derivative Instruments - in connection with the sale of debt or equity instruments, the Company may sell options or warrants to purchase our common stock. In certain circumstances, these options or warrants may be classified as derivative liabilities, rather than as equity. Additionally, the debt or equity instruments may contain embedded derivative instruments, such as variable conversion options, which in certain circumstances may be required to be bifurcated from the host instrument and accounted for separately as a derivative instrument liability.

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INDEX

The identification of, and accounting for, derivative instruments is complex. Derivative instrument liabilities are re-valued at the end of each reporting period, with changes in fair value of the derivative liability recorded as charges or credits to income in the period in which the changes occur. For options, warrants and bifurcated conversion options that are accounted for as derivative instrument liabilities, we determine the fair value of these instruments using the Black-Scholes option pricing model, binomial stock price probability trees, or other valuation techniques, sometimes with the assistance of a certified valuation expert. These models require assumptions related to the remaining term of the instruments and risk-free rates of return, our current common stock price and expected dividend yield, and the expected volatility of our common stock price based on not only the history of our stock price but also the experience of other entities considered comparable to us. The identification of, and accounting for, derivative instruments and the assumptions used to value them can significantly affect our financial statements.

Income/loss per share - Income/loss per share is computed using the weighted average number of shares of stock outstanding during the period. Diluted per share computations, which would include shares from the effect of common stock equivalents and other dilutive securities are presented for the third quarter of 2006.

Note 3 - Restatement of Consolidated Financial Statements:

The Company has restated its Consolidated Financial Statements for fiscal 2003 and 2004 as well as the first three interim periods of fiscal 2005 in order to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities. The following provides a more detailed discussion of the restatement along with a comparison of the amounts previously reported in the Condensed Statement of Operations for the three and nine months ended September 30, 2006.

As previously reported in our Current Report on Form 8-K filed with the Securities and Exchange Commission on December 5, 2005, the Company had discussions with the Staff of the Securities and Exchange Commission concerning the proper accounting treatment regarding certain of its convertible debt in current and previously reported financial results. As a result of these discussions, the Company’s 2005 quarterly and 2004 and 2003 fiscal year financial statements were restated to bifurcate embedded derivative instruments within the Company’s debt and account for them separately as derivative instrument liabilities.

More specifically, the Securities and Exchange Commission ("SEC") raised questions with regard to our convertible term notes suggesting that we consider EITF 00-19 "Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock" to evaluate whether there were any embedded derivative instruments and if so, whether they should be accounted for as an equity or liability classification.

As a result, the Company reviewed its initial accounting for its (1) First Laurus Convertible Note dated July 31, 2003, (2) Second Laurus Convertible Note dated January 14, 2004, (3) Third Laurus Convertible Note dated May 16, 2005, and (4) Senior Convertible Notes dated November 5, 2004. During the review, the Company identified that EITF 00-19 should be applied to evaluate whether any embedded derivative instruments qualify as equity instruments or as liabilities. As a result, certain embedded derivatives were identified that met the conditions set forth under paragraph 12 of SFAS No. 133. These embedded derivative instruments were evaluated using EITF 00-19 paragraphs 12 to 32 and determined that these instruments, with the exception of the detached Warrants issued with these Notes, would not be classified as components of stockholders equity. The instruments have been deemed liabilities, and as such, subject to SFAS 133 and recorded at fair value.

Features within the debt noted above that have been evaluated and determined to require such treatment include:

·	The principal conversion options.

·	The monthly payment conversion options.

·	The interest rate adjustment provisions.

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INDEX

Management believes the scope and process of its internal review of previously reported financial information was sufficient to identify issues of a material nature that could affect our Consolidated Financial Statements and the September 30, 2005 quarterly period has been restated to fairly present the results of our operations.

Impact of the Financial Statement Adjustments on the Condensed Consolidated Statements of Operations

The following table presents the impact of the financial statement adjustments on the Company’s previously reported consolidated statements of operations for the fiscal quarter and nine months ended September 30, 2005:

	Quarter Ended September 30, 2005						Nine Months Ended September 30, 2005
		(As restated)			(As reported)			(As restated)			(As reported)

Loss from operations	$	(2,527	)	$	(2,527	)	$	(6,664	)	$	(6,664	)
Other (expense) income, net		(265	)		(265	)		(363	)		(363	)
Derivative instrument income (expense)		1,235			---			3,249			---
Debt discount expense		(660	)		---			(1,716	)		---
Net loss	$	(2,217	)	$	(2,792	)	$	(5,494	)	$	(7,027	)

Basic and diluted net loss per share:	$	(0.12	)	$	(0.15	)	$	(0.29	)	$	(0.37	)
Shares used in computing net loss per share:
Basic and Diluted:		18,879,464			18,879,464			18,815,952			18,815,952

Note 4 - Master Lease Agreement:

The State of Delaware Department of Transportation (DelDOT) executed a Master Lease Agreement with NTS in February 2004 whereby lease financing for equipment installed under this CrossingGuard contract would be financed under lease terms offered by GE Capital Public Finance, Inc. (“GE”). Under this sales-type lease agreement, NTS received $240 in April 2004, $240 in September 2004, $560 in March 2005, $880 in June 2005, and $160 in September 2005 from GE on behalf of DelDOT pursuant to DelDOT’s Assignment and Security Agreement with GE. NTS retains a first priority interest in the equipment and assigned its interest in the DelDOT lease and right to receive rental payments thereunder to GE.

Note 5 - Stock Based Compensation:

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R) (“SFAS 123(R)”), “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS 123(R), share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant). Prior to January 1, 2006, the Company accounted for share-based compensation to employees in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. The Company also followed the disclosure requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-based Compensation (“SFAS 123”). The Company elected to adopt the modified prospective transition method as provided by SFAS 123(R) and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have not been restated to reflect the fair value method of expensing share-based compensation. Under this application, we are required to record compensation cost for all share-based payments granted after the date of adoption based on the grant date fair value estimated in accordance with the provisions of SFAS 123R and for the unvested portion of all share-based payments previously granted that remain outstanding which were based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. The majority of our share-based compensation arrangements vest over either a four or five year graded vesting schedule. The Company expenses its share-based compensation under the ratable method, which treats each vesting tranche as if it were an individual grant.

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INDEX

The following table presents share-based compensation expenses for continuing operations included in the Company’s unaudited condensed consolidated statements of operations:

	Three Months Ended		Nine Months Ended
	September 30, 2006		September 30, 2006

Cost of sales	$	5	$	22
Engineering and operations		43		180
Research and development		43		106
Selling and marketing		3		81
General and administrative		479		1,505
Share-based compensation expense before tax	$	573	$	1,894
Provision for income tax		---		---
Net share-based compensation expense	$	573	$	1,894

The Company estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of the Company’s stock over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. The Company believes that the valuation technique and the approach utilized to develop the underlying assumptions are appropriate in calculating the fair values of the Company’s stock options granted in the nine months ended September 30, 2006. Estimates of fair value are not intended to predict actual future events of the value ultimately realized by persons who receive equity awards.

The fair value of each option grant was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions:

	Three Months Ended		Nine Months Ended
	September 30, 2006		September 30, 2006
Expected option term ⁽¹⁾	6.25	years	5.25 to 6.25	years
Expected volatility factor ⁽²⁾	165	%	165 to 168	%
Risk-free interest rate ⁽³⁾	4.7	%	4.5 to 5.0	%
Expected annual dividend yield ⁽⁴⁾	0	%	0	%

⁽¹⁾	The option life was determined using the simplified method for estimating expected option life, which qualify as “plain-vanilla” options.

⁽²⁾	The stock volatility for each grant is determined based on the review of the experience of the weighted average of historical weekly price changes of the Company’s common stock over the expected option term.

⁽³⁾	The risk-free interest rate for periods equal to the expected term of the share option is based on the U. S. Treasury yield curve in effect at the time of grant.

⁽⁴⁾	The Company has not paid a dividend historically nor plans to declare a dividend in the near future.

The Company did not recognize compensation expense for employee stock option grants for the three and nine months ended September 30, 2005, when the exercise price of the Company’s employee stock options equaled the market price of the underlying stock on the date of grant.

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INDEX

The Company had previously adopted the provisions of SFAS 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure” through disclosure only. The following table illustrates the effects on net income and earnings per share for the three and nine months ended September 30, 2005 as if the Company had applied the fair value recognition provisions of SFAS 123 to share-based employee awards:

	Three Months Ended			Nine Months Ended
	September 30, 2005			September 30, 2005
	(As Restated)			(As Restated)

Net loss, as restated	$	(2,217	)		(5,494	)
Less: Total employee compensation
expenses for options determined
under the net fair value method		(996	)		(3,655	)
Pro forma net loss		(3,213	)		(9,149	)

Pro forma net loss per share:
- as restated	$	(0.12	)	$	(0.29	)
- pro forma	$	(0.17	)	$	(0.49	)

The fair value of each option grant was estimated on the grant date using the Black-Scholes option pricing model with the following assumptions:

	Three Months Ended			Nine Months Ended
	September 30, 2005			September 30, 2005

Expected term		8	years	8	years
Volatility		108	%	109	%
Risk-free interest rate		3.4	%	3.3	%
Dividend yield		0	%	0	%

Stock incentive plans

On May 6, 1997, the Company adopted the 1997 Stock Option Plan under which the Board of Directors granted incentive or non-qualified stock options to employees, directors and consultants to purchase shares of the Company’s common stock at a price equal to the market price of the stock at the date of grant. In June 2001, the 1997 Stock Option Plan was amended to increase the aggregate number of options authorized to 500,000 shares (post-reverse split) of the Company’s common stock. Options vest over four years and are exercisable for up to ten years from the date of grant, although most options currently outstanding expire eight years from the date of grant. The options are not transferable except by will or domestic relations order. No further grants may be made under this Plan pursuant to the adoption of the 2004 Stock Incentive Plan.

On June 24, 2004, the Company adopted the 2004 Stock Incentive Plan, which provides for the grant of awards to employees, officers and directors. Subject to adjustments for changes in the Company’s common stock and other events, the stock plan is authorized to grant up to 4,500,000 shares, either in the form of options to purchase Nestor common stock or as restricted stock awards. The Board of Directors will determine the award amount, price usually equal to the market price of the stock on the date of the grant, vesting provisions and expiration period (not to exceed ten years) in each applicable agreement. The awards are not transferable except by will or domestic relations order.

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The following table presents the activity of the Company’s Stock Option Plans from December 31, 2005 through September 30, 2006.

	Shares			Weighted Average Exercise Price		Weighted Average Remaining Contractual Life (Years)
Outstanding at December 31, 2005		2,866,027		$	4.87		7.3
Granted		257,500			4.18		---
Exercised		(1,940	)		1.80		---
Canceled		(400,734	)		4.98		---
Outstanding at September 30, 2006		2,720,853			4.80		6.7

Options exercisable at September 30, 2006		1,534,753		$	4.76

The following table presents weighted average price and life information about significant option groups outstanding at September 30, 2006:

Options Outstanding						Options Exercisable
Range of Ex. Price			Number of Outstanding at Sept. 30, 2006	Weighted Average Remaining Contractual Life (Years)	Weighted Average Exercise Price	Number Exercisable at Sept. 30, 2006	Weighted Averaged Exercisable Price
$1.00	-	2.99	62,150	6.5	2.50	18,050	1.76
3.00	-	3.99	230,900	5.8	3.60	144,800	3.69
4.00	-	4.99	2,113,975	6.9	4.90	1,256,075	4.85
5.00	-	5.99	307,163	5.8	5.70	114,163	5.61
6.00	-	8.00	6,665	7.0	6.20	1,665	6.04
			2,720,853	6.7	4.80	1,534,753	4.76

During the nine months ended September 30, 2006, there were $6 intrinsic value of options exercised (i.e. the difference between the market price and the price paid by the employee to exercise the options) and $3 of cash was received from the exercise of options.

The total grant date fair value of stock options that vested during the nine months ended September 30, 2006 was approximately $787 with a weighted average remaining contractual term of 6.4 years.

As of September 30, 2006, there was $3,539 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Company’s stock option plans. That cost is expected to be recognized over a weighted-average period of 1.4 years. The Company amortizes stock-based compensation on the straight-line method.

The Company did not realize any actual tax benefit for tax deductions from option exercise of the share-based payment arrangements for the six months ended September 30, 2006.

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Warrants

The Company, at the discretion of the Board of Directors, has granted warrants from time to time, generally in conjunction with the sale of equities. The Company issued 60,000 warrants in connection with the private placement in November 2004, 100,000 warrants in connection with the private placement in May 2005, 371,339 warrants in connection with the private stock placement in January 2006, and 2,394,262 warrants in connection with the 7% Senior Secured Notes placement in May 2006.

The following table presents warrants outstanding:

	September 30, 2006

Eligible, end of quarter for exercise		2,925,601

Warrants issued in the quarter		---

Low exercise price	$	3.60
High exercise price	$	8.44

The warrants outstanding as of September 30, 2006 are currently exercisable and expire at various dates through May, 2011. The outstanding warrants entitle the owner to purchase one share of common stock for each warrant, at prices ranging from $3.60 to $8.44 per share.

Note 6 - Long Term Financial Obligations

The Company considers its long term convertible notes payable, long term notes payable, and derivative financial instruments, to be its long-term financial obligations.

Long-term financial obligations consisted of the following.

	September 30 2006			December 31, 2005

5% Senior Convertible Notes
Principal	$	2,850		$	5,200
Debt discount		(2,129	)		(3,550	)
FMV of embedded derivatives		594			1,419

7% Senior Secured Convertible Notes
Principal		28,550			---
Debt discount		(18,061	)		---
FMV of embedded derivatives, including warrants		11,206			---

Foundation Partners Secured Promissory Note		---			1,250
Heil Secured Promissory Note		---			1,250

Fourth Laurus Note
Principal		---			6,000
Debt discount		---			(1,078	)
	$	23,010		$	10,491
Less current portion		2,098			4,136
Total	$	20,912		$	6,355

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The current portion of long term debt for September 30, 2006 represents $5,710 of principal and $3,612 of related debt discounts.

Aggregate maturities of long-term obligations for the years ending following September 30, 2006 are as follows:

	2006		2009		2011		Total

7% Senior Secured Convertible Notes	$	5,710	$	---	$	22,840	$	28,550
5% Senior Convertible Notes		---		2,850		---		2,850
Total:	$	5,710	$	2,850	$	22,840	$	31,400

The $5,710 shown as current above is in accordance with the noteholder option to require a 20% redemption through December 31, 2006, as explained below.

On May 24, 2006, Nestor, Inc. (the “Company”) entered into a Securities Purchase Agreement (the “Agreement”) with several institutional and accredited investors to sell $28.55 million of Units consisting of five-year, 7% senior secured convertible promissory notes (the “Secured Notes”), convertible into shares of the Company’s common stock (the “common stock”), and five-year warrants to purchase 1,982,639 shares of common stock (the “Warrants”), in a private placement pursuant to Regulation D under the Securities Act of 1933 (the “Transaction”). The Transaction was closed on May 25, 2006.

The Secured Notes, which rank pari passu with the Company’s existing, 5% Senior Convertible Notes (the “5% Notes”), are secured by a first priority security interest in all corporate assets, except contracts entered into by the Company after October 1, 2006 and all assets related thereto and all proceeds thereof. Interest is payable quarterly in arrears, and an amount equal to two years’ interest on the Secured Notes is secured by an irrevocable letter of credit. In order to obtain the irrevocable letter of credit from a bank, the Company needed to establish a restricted cash account as collateral. The letter of credit expires once drawn down, but no later than May 25, 2008; and the bank fee is one and one-quarter percent on the open balance, annually. The interest rate is subject to adjustment for certain changes in the Company’s consolidated EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R, “Share-Based Payment”), as follows: (a) if consolidated EBITDA as reported on the Company’s Quarterly Report on Form 10-Q (“Form 10-Q”) for the fiscal quarter ending June 30, 2007 is less than $1.25 million, the interest rate will increase to 9%, effective July 1, 2007; (b) if consolidated EBITDA as reported on the Form 10-Q for the fiscal quarter ending June 30, 2007 is greater than $2.5 million, the interest rate will decrease to 5%, effective July 1, 2007; and (c) if consolidated EBITDA for the year ended December 31, 2008 as reported on the Company’s Annual Report on Form 10-K (the “Form 10-K”) for that period is greater than $14.0 million, the interest rate currently in effect at that time will decrease by 2%, effective January 1, 2009. In no event will the interest rate be less than 5%. In the event of default on the Secured Notes, the interest rate will be 13.5% during the period of default.

All outstanding principal and interest on the Secured Notes is due on May 25, 2011. The principal of the Secured Notes is convertible into the Company’s common stock at a conversion price of $3.60 per share. The conversion price is subject to full ratchet anti-dilution protection for any equity issuances within three years and standard weighted-average anti-dilution protection thereafter in addition to other customary adjustment events.

The Secured Notes contain restrictive covenants which, among other things, restrict the Company’s ability to incur additional indebtedness, repay indebtedness including the secured notes before maturity, grant security interests on its assets or make distributions on or repurchase its common stock.

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The holders of the Secured Notes have the right to require the Company to redeem up to 20% of the outstanding principal by written notice to the Company at least five trading days prior to December 29, 2006. In addition, the holders have the right to require the Company to redeem all or any portion of the outstanding balance of the Secured Notes on May 25, 2009, provided that this right will be forfeited if, among other things, the Company’s consolidated EBITDA for the twelve-month period ended December 31, 2008 as reported on the Form 10-K exceeds $14.0 million. The Secured Note holders also have the right to redeem some or all of their Secured Notes in the event of a change of control of the Company or an event of default under the Notes.

If, prior to May 25, 2009, a holder elects to convert its Secured Notes into shares of the Company’s common stock, or in the event of a “Mandatory Conversion” (defined below) by the Company, such Secured Note holder will receive a “make-whole” payment in cash equal to 21% of the face value of the Secured Notes so converted, less any interest paid. Beginning on May 25, 2008, if the average closing bid price of the common stock exceeds 165% of the conversion price for any 20 trading days during a 30 consecutive trading day period, the Company can force conversion of the Secured Notes (a “Mandatory Conversion”), subject to certain notice and other requirements. The number of shares of common stock issuable to all Secured Note holders in such Mandatory Conversion cannot exceed the total daily trading volume of the common stock for the 20 consecutive trading days immediately preceding the conversion date. Furthermore, the Company can require a Mandatory Conversion only once in any 60 consecutive trading-day period.

Under the Agreement, the Company has agreed that until 180 days following the effective date of the Registration Statement covering the shares issuable upon conversion of the Secured Notes and exercise of the Warrants, it will not, directly or indirectly, offer, sell grant any option to purchase, or otherwise dispose of (or announce any offer, sale, grant or any option to purchase or other disposition of) any of its or its subsidiaries' equity or equity equivalent securities, including any debt, preferred stock or other instrument or security that is convertible into or exchangeable or exercisable for shares of its common stock without the prior written approval of the holders of at least 75% of the aggregate principal amount of the Secured Notes. In addition, until the first anniversary of the effective date of such Registration Statement, and provided that at least 30% of the principal face amount of the Secured Notes remain outstanding, holders of the Secured Note have the right to purchase up to 30% of any equity or equity-linked financings, subject to certain conditions. Furthermore, if at any time the Company grants, issues or sells any options, convertible securities or rights to purchase stock, warrants, securities or other property pro rata to the record holders of any class of its common stock, each holder will be entitled to acquire, upon the terms applicable to such purchase rights, the aggregate purchase rights a holder could have acquired if the holder had held the number of shares of common stock acquirable upon complete conversion of such holder’s Secured Note.

The Warrants are exercisable at $4.35, subject to standard weighted average anti-dilution protection for the life of the Warrants, and expire on May 25, 2011. In the event of a change of control, unless the closing sale price of the common stock on the first trading day immediately following the public announcement of the change of control exceeds $6.00 per share, the Warrant holder may require the Company to purchase all or any portion of a Warrant (the “redeemed portion”) for cash at a price equal to the value of the redeemed portion of the Warrant determined using the Black-Scholes option pricing model. The Warrants also contain a “cashless exercise” provision.

The Company used the net proceeds from the sale of the Units (after expenses and placement agent fees) to repay the outstanding principal and interest, totaling $5.67 million, of a non-convertible promissory note dated December 28, 2005 issued to Laurus Master Fund, Ltd., the outstanding principal and interest, totaling $1.27 million, of a secured promissory note dated August 30, 2005 issued to Foundation Partners I, LLC, and $2.42 million was used to repurchase approximately $2.35 million principal amount of the Company’s 5% Notes at a price of 102.5% of face amount plus accrued interest. The remaining funds will be used for capital expenditures, including the installation of automated traffic enforcement systems pursuant to existing contracts, for general corporate purposes and working capital.

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In connection with the Transaction, the Company and the holders of the 5% Notes entered into a Written Consent and Waiver and Amendment to Note Agreement (the “5% Noteholder Agreement”) pursuant to which the holders of the 5% Notes consented to the Company granting a security interest in its assets to the holders of the Secured Notes and waiving their right to redeem the balance of their 5% Notes. In addition, the 5% Note holders agreed to extend the maturity of the $2.85 million remaining 5% Notes from October 31, 2007 to May 25, 2009, and received warrants to purchase an aggregate 163,793 shares of common stock at an exercise price of $4.35 (the “5% Warrants”). The 5% Warrants expire on May 25, 2009. The 5% Notes contain full-ratchet anti-dilution protection. As a result of the Transaction, the remaining 5% Notes are now convertible into shares of common stock at a conversion price of $3.60 per share.

In connection with the Transaction, we entered into a registration rights agreement with the holders of the Secured Notes, pursuant to which the Company agreed to file a Registration Statement on Form S-3 registering for resale a number of common shares sufficient to allow for full conversion of the Secured Notes and exercise of the Warrants. The Registration Statement was filed on July 14, 2006. Penalties are imposed on the Company if the registration statement is not declared effective by the SEC within 60 days of filing (or 90 days if subject to SEC review) up to a maximum of 10% of the purchase price of the Secured Notes. In addition, the Company is obligated to register for resale shares of common stock issuable upon exercise of the 5% Warrants issued to the 5% Note holders. The Registration Statement was declared effective by the SEC on September 14, 2006.

The Company was required by the terms of the Transaction documents to seek stockholder approval of the Transaction (as required by NASDAQ Rule 4350(i)) and stockholder approval of an amendment to its certificate of incorporation increasing the number of shares of authorized common stock sufficient to allow for conversion in full of the Secured Notes and exercise in full of the Warrants. No conversions or exercises into common stock was effected by the Company to the extent that such issuance would exceed 19.99% of the currently outstanding common stock, until such approvals were obtained. The Company obtained such approval on July 6, 2006, the date of the Annual Meeting of Stockholders. In connection with the Transaction, the Company entered into Voting Agreements with stockholders who hold, in the aggregate, 10,351,048 shares, or 50.83%, of the outstanding common stock of the Company, pursuant to which they have agreed to vote in favor of the Transaction and the increase in the number of shares of authorized common stock.

Cowen & Co. LLC (“Cowen”) acted as exclusive placement agent for the offering and is entitled to receive a placement agent fee of $1,855,750 (6.5% of the gross proceeds from the offering), of which $1,484,600 was paid at closing. In addition, the Company reimbursed Cowen for its out-of-pocket expenses and issued Cowen Warrants to purchase 198,264 shares of common stock at an exercise price of $3.60 and 49,566 shares of common stock at an exercise price of $4.35, which Warrants generally have the same terms as the Warrants issued to the Secured Note holders in the Transaction.

Note 7 Common and Preferred Stock:

Private Stock Placement:

On January 31, 2006, the Company sold 1,237,811 shares of its common stock to fifteen accredited investors at $4.42 per share raising $4,822, net of expenses and issued warrants to purchase 371,339 shares of its common stock exercisable at $4.91 per share expiring on January 31, 2009. The Company used $1,250 of the proceeds to immediately retire the Heil Secured Promissory Note. Among the purchasers was Silver Star Partners, an affiliate of the Company, which purchased 220,589 shares and a warrant to purchase an additional 66,176 shares.

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INDEX

Preferred Stock:

Series B Convertible Preferred Stock is convertible into Common Stock of the Company at any time on a share-for-share basis. Series B Convertible Preferred Stock has the same rights with respect to voting and dividends as the Common Stock, except that each share of Series B Convertible Preferred Stock has the right to receive $1.00 in liquidation before any distribution is made to holders of the Common Stock. The liquidation value of Series B Preferred was $180 at September 30, 2006.

Note 8 - Litigation:

Two suits have been filed against us and the City of Akron seeking to enjoin the City of Akron speed program and damages. These cases have been consolidated in the U.S. District Court for the Northern District of Ohio. These cases are:

Mendenhall v. The City of Akron, et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiff filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against City of Akron and all of its City Council members in their official capacity and us alleging federal and state constitutional violations. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006. The plaintiff amended her complaint on August 8, 2006 to include equal protection violations among her federal constitutional claims. We filed an answer to that amended complaint on August 18, 2006. Dispositive motions in the case are due by November 22, 2006.

Sipe, et al. v. Nestor Traffic Systems, Inc., et al., United States District Court, Northern District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiffs filed a complaint and class action for declaratory judgment, injunctive relief and for a money judgment in an unspecified amount against us, various past and present employees of ours and the City of Akron and alleging fraud, civil conspiracy, common plan to commit fraud, violations of the Consumer Sales Practices Act, nuisance, conversion, invasion of privacy, negligence, and federal constitutional violation. The action was filed in the Summit County Court of Common Pleas and was removed to federal court. On February 17, 2006, we and the other defendants filed a joint motion for judgment on the pleadings. Plaintiff filed an opposition to that motion on March 24, 2006. On May 19, 2006, the court ruled that the Akron ordinance permitting photo enforcement of speeding laws was a proper exercise of municipal power under the Ohio Constitution, but deferred ruling on the alleged due process violations pending an opportunity for discovery by the plaintiff, which was completed on October 20, 2006. Dispositive motions in the case are due by November 22, 2006.

In addition, from time to time, we are involved in legal proceedings arising in the ordinary course of business. We do not currently have any pending litigation other than that described above.

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ITEM 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward Looking Statements

The following discussion includes “forward-looking statements” within the meaning of Section 21E of the Securities and Exchange Act of 1934, and is subject to the safe harbor created by that section. Forward-looking statements give our current expectations or forecasts of future events. All statements, other than statements of historical facts, included or incorporated in this report regarding our strategy, future operations, financial position, future revenues, projected costs, prospects, plans and objectives of management are forward-looking statements. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We cannot guarantee that we actually will achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements we make. Factors that could cause results to differ materially from those projected in the forward-looking statements are set forth in this section, in Part II - Item 1A, “Risk Factors” of this Report and in Part I - Item 1A, “Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2005. The following discussion should also be read in conjunction with the Condensed Consolidated Financial Statements and accompanying Notes thereto.

Readers are cautioned not to place undue reliance on these prospective statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Our forward-looking statements do not reflect the potential impact of any future acquisitions, mergers, dispositions, joint ventures or investments we may make. Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission.

The following discussion and analysis gives effect to the restatement described in Note 3 in the Notes to the Condensed Consolidated Financial Statements. For this reason, the data in this section may not be comparable to discussions and data in our previously filed annual and quarterly reports.

Executive Summary

We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States. We are the only provider of both a fully video-based automated red light enforcement system and a multi-lane, bi-directional scanning light detection and ranging, or LiDAR, speed enforcement system. CrossingGuard, our red light enforcement product, uses our patented video image processing technology to predict and record the occurrence of a red light violation. Our first speed enforcement product, uses Poliscan^speedLiDAR technology developed by Vitronic. We have exclusive marketing rights to Poliscan in North America through February 2010, subject to meeting certain purchase minimums. By coupling CrossingGuard and Poliscan equipment with Citation Composer, our proprietary citation preparation and processing software, we provide fully integrated, turnkey red light and speed enforcement solutions.

Nestor recently announced a new product, ViDAR™ Video Detection and Ranging technology, that can help communities enforce posted speed limits. ViDAR uses distance over time calculations, as in traditional VASCAR, in combination with video technology to measure and record evidence of speeding vehicles. NTS’s ViDAR™ technology tracks multiple vehicles bi-directionally in multiple lanes and is accurate to within 1 mph. ViDAR incorporates current digital camera technology and secures evidence of violations in real-time with a time-stamp accurate within 1/100 of a second. Also, because the system is based on video tracking, it is undetectable by radar/laser detectors.

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We generate recurring revenue through contracts that provide for equipment leasing and hosting and processing services on a fixed and/or per citation fee basis. Essentially all of our revenue prior to September 30, 2005 was generated through contracts for our CrossingGuard system as explained below. Beginning in the fourth quarter of 2005, we started generating our first revenue from PoliScan systems. The economics of the CrossingGuard product are tied to the number of operating systems in the field and, to an increasingly lesser extent, the number of violations processed by such systems. Throughout 2003 and 2004, there was a trend by customers towards a fixed monthly fee as opposed to variable per ticket fee pricing structures for CrossingGuard systems. Because fixed fees are based upon the expected level of violations over the contract term, the shift to monthly fixed fee contracts should result in a more stable revenue stream for these installations. Many of our initial CrossingGuard contracts, however, compensate us on a per ticket paid or issued basis in return for both equipment lease and maintenance and citation processing and customer support services. Depending on the terms of each contract, we realize from $11 to $99 per citation issued or paid and/or fixed monthly fees ranging from $2,000 to $12,000 per approach for our equipment and services.

State statutes or local ordinances providing for automated red light enforcement may impose liability on either the driver or the registered owner of a vehicle for a violation. Driver liability statutes require that the driver be identified, from the photographic evidence, and that the citation be issued and sent to the driver. Registered owner statutes require that the vehicle’s owner be identified, through registration records, and that the citation be issued and sent to the registered owner. Because only the license plate is required for identification under a registered owner statute, program operating efficiencies are much higher, resulting in lower per citation costs for CrossingGuard systems installed in these jurisdictions. Of the twenty-four jurisdictions that currently allow for automated red light enforcement programs, five require that a driver be identified; the other states limit identification to the vehicle license plate and impose liability on the registered owner. Driver identification states are generally in the western part of the US, and include California, Arizona, Oregon, Utah, and Colorado.

Almost all of our contracts provide for the lease of equipment and the services as a bundled, turnkey program over three to five years. The equipment leases are generally classified as operating leases under FAS 13 “Accounting for Leases” and the revenues are realized along with service revenues as services are delivered to a customer over the life of the contract. One contract with Delaware DOT provided for a monthly lease of the roadside equipment, and we transferred this lease to GE Municipal Services for the face value of the roadside equipment, or $80,000 per approach. In accordance with FAS 13, this lease qualified as a sales-type financing lease and we recognized the value received from the leased equipment, and expensed the associated costs of the system in the same period. We delivered 11 and 20 systems to Delaware DOT in 2004 and 2005, respectively, and have completed delivery of units under the current contract terms.

Our existing CrossingGuard contracts with government entities typically authorize the installation of systems at a specified number of approaches. As of September 30, 2006, our existing active contracts authorized the installation of our CrossingGuard product at up to an additional 225 approaches. Management believes the majority of the authorized red light approaches or speed units under existing active contracts will be installed or deployed, but no assurances can be given that all approaches or units under contract will ultimately be installed or deployed due to factors including locating qualifying intersections, budget or personnel considerations, etc.

The following table provides summary information regarding our active CrossingGuard contracts.

	Quarter Ended September 30,
Number of Approaches and Units:	2006	2005

Installed, operational and revenue-generating
CrossingGuard red light approaches	202	164
Poliscan^speed Units	10	0
Additional Authorized Approaches and Units:
CrossingGuard red light approaches	225	123
Poliscan^speed Units	10	10
Total	447	297

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On October 26, 2005, we deployed the first of four approved Poliscan systems in the City of Akron, Ohio. We receive fees from $19 per ticket paid to 40% of the ticket fine paid under the existing speed agreements with our customers. We expect that a majority of any future speed enforcement contracts will compensate us on a per ticket paid basis in return for both equipment lease and citation processing and customer support services. We anticipate that we will generally receive fees from $10 to $25 per ticket under any future speed enforcement contracts depending on factors including number of units ordered, length of contract, service levels provided, state statutes, and competition.

Some of the cities in which the Company has active contracts include:

Alpharetta, GA		Long Beach, CA
Baltimore, MD		Los Angeles, CA
Berkeley, CA		Marble Falls, TX
Bonney Lake, WA		Montclair, CA
Cerritos, CA		Murietta, CA
Costa Mesa, CA		Northglenn, CO
Davenport, IA		Pasadena, CA
Davis, CA		Rancho Cucamonga, CA
East Cleveland		Rhome, TX
State of Delaware		Roseville, CA
Frederick, MD		San Bernardino, CA
Fresno, CA		Santa Fe Springs, CA
Fullerton, CA		Saskatoon, Canada
Germantown, TN		Whittier, CA

The management team focus is to expand our market share in the emerging traffic safety market. We plan to expand that market share by:

Continuing to aggressively market automated speed and red light enforcement systems and services to states and municipalities

Participating in efforts to increase the public’s acceptance of, and state’s authorization of, automated traffic safety systems

Participating in industry standards setting bodies

Enhancing and seeking patents for our automated enforcement technology to maintain or improve our position and competitive advantages in the industry

Our quarterly operating results have fluctuated in the past and may fluctuate significantly in the future. We may incur significant expenses in anticipation of revenue, which may not materialize and we may not be able to reduce spending quickly if our revenue is lower than expected. In addition, our ability to forecast revenue, particularly with respect to our new speed products, is limited. As a result, our operating results are volatile and difficult to predict and you should not rely on the results of one quarter as an indication of future performance. Factors that may cause our operating results to fluctuate include costs related to customization of our products and services; announcements or introductions of new products and services by our competitors; the failure of additional states to adopt or maintain legislation enabling the use of automated traffic enforcement systems; determinations by state and local government bodies to utilize our equipment without the additional processing services we provide; equipment defects and other product quality problems; a shift towards fixed rate, as opposed to per ticket, compensation arrangements for our speed products, which could adversely affect revenues; the discretionary nature of our customers’ internal evaluation, approval and order processes; the varying size, timing and contractual terms of orders for our products and services; and the mix of revenue from our products and services.

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On August 31, 2005, we acquired certain assets of Transol USA, one of our competitors, in a foreclosure sale. The assets included contracts to provide automated red light enforcement services in six U.S. cities at an aggregate of 39 red light approaches, as well as related equipment, intellectual property, inventory, work in process, accounts receivable and unbilled contract revenue related to Transol’s red light enforcement services. We paid $1.8 million for the acquired assets. We funded the acquisition of the acquired assets with internal working capital.

The following is a summary of key financial measurements monitored by management:

	Quarter Ended September 30						Nine Months Ended September 30,
	2006			2005			2006			2005
				(As restated)						(As restated)
Financial
Revenue	$	1,982,000		$	1,914,000		$	5,737,000		$	6,180,000
Loss from operations		(2,768,000	)		(2,527,000	)		(8,919,000	)		(6,664,000	)
Net income (loss)		2,648,000			(2,217,000	)		(4,848,000	)		(5,494,000	)
Modified EBITDA		(1,501,000	)		(1,945,000	)		(4,685,000	)		(4,857,000	)
Cash and marketable securities		12,941,000			3,938,000
Investment in capitalized systems		1,924,000			1,308,000
Working capital		11,079,000			1,508,000

We are a capital-intensive business, so in addition to focusing on GAAP measures, we focus on modified EBITDA to measure our results. We calculate this number by first calculating EBITDA, which we define as net income before interest expense, debt restructuring or debt extinguishment costs (if any during the relevant measurement period), provision for income taxes, and depreciation and amortization. Then we exclude derivative instrument income or expense, debt discount expense, share-based compensation expense, and asset impairment charges These measures eliminate the effect of financing transactions that we enter into on an irregular basis based on capital needs and market opportunities, and these measures provide us with a means to track internally generated cash from which we can fund our interest expense and our growth. In comparing modified EBITDA from year to year, we also ignore the effect of what we consider non-recurring events not related to our core business operations to arrive at what we define as modified EBITDA. Because modified EBITDA is a non-GAAP financial measure, we include in the tables below reconciliations of modified EBITDA to the most directly comparable financial measures calculated and presented in accordance with accounting principles generally accepted in the United States.

We present modified EBITDA because we believe it provides useful information regarding our ability to meet our future debt payment requirements, capital expenditures and working capital requirements, and that it provides an overall evaluation of our financial condition. In addition, modified EBITDA is defined in certain financial covenants under our 7% Senior Secured Convertible Notes and may be used to adjust the interest rate on those notes at July 1, 2007 and January 1, 2009 and determine whether the holders of those notes have a redemption right at May 25, 2009.

Modified EBITDA has certain limitations as an analytical tool and should not be used as a substitute for net income, cash flows or other consolidated income or cash flow data prepared in accordance with generally accepted accounting principles in the United States or as a measure of our profitability or our liquidity.

When evaluating modified EBITDA as a performance measure, and excluding the above-noted items, all of which have material limitations, investors should consider, among other factors, the following:

	•		increasing or decreasing trends in modified EBITDA;

	•		how modified EBITDA compares to levels of debt and interest expense.

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Because modified EBITDA, as defined, excludes some but not all items that affect our net income, modified EBITDA may not be comparable to a similarly titled performance measure presented by other companies.

The table below is a reconciliation of modified EBITDA to net loss for the three and nine month periods ended September 30:

	Three Months Ended Sept. 30,						Nine Months Ended Sept. 30,
	2006			2005			2006			2005
GAAP net income (loss)	$	2,648,000		$	(2,217,000	)	$	(4,848,000	)	$	(5,494,000	)
Interest expense, net of interest income		562,000			265,000			1,360,000			363,000
Income tax expense		---			---			---			---
Depreciation and amortization		694,000			582,000			2,165,000			1,807,000
EBITDA	$	3,904,000		$	(1,370,000	)	$	(1,323,000	)	$	(3,324,000	)
Derivative instrument (income) expense		(7,145,000	)		(1,235,000	)		(10,112,000	)		(3,249,000	)
Debt discount expense		1,167,000			660,000			4,681,000			1,716,000
Stock-based compensation expense		573,000			---			1,894,000			---
Asset impairment charge		---			---			175,000			---
Modified EBITDA	$	(1,501,000	)	$	(1,945,000	)	$	(4,685,000	)	$	(4,857,000	)

Critical Accounting Policies and Estimates

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which require us to make estimates and assumptions. For more information, see Note 2 to the condensed consolidated financial statements included elsewhere in this report. We believe that of our significant accounting policies, the following may involve a higher degree of judgment and complexity.

Revenue Recognition

In accordance with Staff Accounting Bulletin 104 - Revenue Recognition in Financial Statements (“SAB 104”), revenue is generally recognized and earned when all of the following criteria are satisfied: (a) persuasive evidence of sales arrangements exist, (b) delivery has occurred, (c) the sales price is fixed or determinable, and (d) collectability is reasonably assured. In those cases where all four criteria are not met, we defer recognition of revenue until the period these criteria are satisfied.

The majority of our revenue is derived from three types of customer arrangements:

We provide hardware and equipment, and related third party embedded software (“roadside systems”). The third party embedded software is considered incidental to the system as a whole. In these arrangements, we typically sell or lease the system as a stand alone roadside system and account for it either as a direct sale, in one instance as a sales type lease, as it met the criteria of a sales type lease in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (FAS) No. 13 - Accounting for Leases, or in most other cases as an operating lease accounted for on a monthly basis. For each arrangement, usually upon delivery for the sales type lease or monthly for operating type leases, revenue is recognized as there exists evidence that an arrangement exists, the system is delivered, the price is fixed or determinable, and collectability is reasonably assured in accordance with SAB 104;

We provide services, which typically include citation processing, back office and hosting services. Software is more than incidental to the services as a whole, but 1) is used by us to capture and internally process the violations and 2) customers do not have the right to and do not take possession of our detection and tracking, or our citation processing and back office software. For these services, we typically recognize revenue on a fixed monthly fee or a per citation fee basis. Revenue usually commences for these service arrangements, upon the first month after inception of operations, as there exists evidence that an arrangement exists, services have been rendered or delivered (citations and other services are delivered), the price is fixed or determinable, and collectability is reasonably assured; and

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For two current customers who want to process their own citations, we lease them our detection and tracking and citation processing and back office software and provide monthly customer support on the software. For this arrangement, we recognize revenue in accordance with Statement of Position 97-2 Software Revenue Recognition. Although all software deliverables are complete in the initial month of operations, and the monthly customer support is the only undelivered element, we recognize revenue on a monthly basis as the citations are issued or paid.

Some contracts include penalty provisions relating to timely performance and delivery of systems and services by us. Penalties are charged to operations in the period the penalty is determinable, if incurred.

Unbilled contract revenue

Unbilled contract revenue represents revenue earned by us in advance of being billable under customer contract terms. Under the terms of some current contracts, we cannot bill the municipality until the court has collected the citation fine. Through September 30, 2005, management recorded unbilled contract revenue in these situations at a net amount, based upon a historical pattern of collections by the courts for the municipalities. The pattern of collections on these citations was periodically reviewed and updated by management.

Based upon review of this policy, management decided to defer recognition of income on these contracts until the municipality has collected the applicable citation. Management implemented this change in the fourth quarter of 2005 and recorded a cumulative adjustment to reflect the change including a reduction of lease and service revenue and unbilled contract revenues of $149,000.

Allowance for Doubtful Accounts

The allowance for doubtful accounts is evaluated on a regular basis and adjusted based on management’s best estimate of probable losses inherent in receivables, based on historical experience. Receivables are considered to be past due if they have not been paid by the payment due dates. Debts are written off against the allowance when deemed to be uncollectible. Subsequent recoveries, if any, are credited to the allowance when received.

Inventory Obsolescence

We evaluate our inventory for excess and obsolescence on a quarterly basis. In preparing our evaluation, we look at the expected demand for our products for the next three to twelve months in order to determine whether or not such equipment to be installed requires a change in the inventory reserve in order to record the inventory at net realizable value. After discussions with the senior management team, a reserve is established so that inventory is appropriately stated at the lower of cost or net realizable value.

Capitalization of Internal Buildout Costs

The Company's CrossingGuard red light enforcement business requires us to install our technology in the communities that we serve. To do this, the Company deploys internal resources to design, help install, and configure its software and equipment in those communities (i.e. buildout). Buildout costs are defined as directly related payroll, fringe, and travel and entertainment expense. Those buildout costs are capitalizable as part of the cost of the system deployed under contract in a community we serve and depreciated over the life of the contract. The Company accumulates the amount of those internal buildout costs incurred on a quarterly basis and capitalizes them. Internal buildout costs capitalized in 2006 and 2005 were approximately $336,000 and zero, respectively.

Share-Based Compensation

In the first quarter of 2006, we adopted Statement of Financial Accounting Standards No. 123(R) "Share-Based Payments" ("SFAS 123(R)"), which required all share-based payments to employees to be recognized in our financial statements at their fair value. We have continued to use the Black-Scholes option pricing model to determine fair value of options under SFAS 123(R) and have elected to use the modified-prospective transition method, in which prior period financial statements will not be restated but disclosure of the pro forma net loss calculation will be included in the footnotes to the financial statements for periods prior to fiscal 2006 and the adoption of SFAS123(R).

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The calculation of stock-based compensation requires the use of a valuation model and related assumptions. The use of the Black-Scholes option pricing model requires the use of subjective assumptions including an estimate of the volatility of our stock, the expected life of our share-based instruments, the expected forfeitures of share-based instruments, the expected dividend rate on our common stock, and the risk free interest rates that can materially affect our fair value estimate of our share-based instruments. Changes in these estimates and assumptions could materially impact the calculation of stock-based compensation.

Derivative Instruments

In connection with the sale of debt or equity instruments, we may sell options or warrants to purchase our common stock. In certain circumstances, these options or warrants may be classified as derivative liabilities, rather than as equity. Additionally, the debt or equity instruments may contain embedded derivative instruments, such as variable conversion options, which in certain circumstances may be required to be bifurcated from the host instrument and accounted for separately as a derivative instrument liability.

Long-Term Asset Impairment

In assessing the recoverability of our long-term assets, management must make assumptions regarding estimated future cash flows, contract renewal options and other factors to determine its fair value. If these estimates change in the future, we may be required to record impairment charges that were not previously recorded. During the quarter ended June 30, 2006, the Company recorded impairment charges of $175,000 related to two red light contracts.

Concentrations of credit risk

Our financial instruments that are exposed to concentrations of credit risk consist primarily of cash and cash equivalents, marketable equity securities and trade accounts receivable. We place our cash and temporary cash investments with high credit quality financial institutions. At times such investments may be in excess of the FDIC limit. However, senior management continually reviews the financial stability of these financial institutions. We routinely assess the financial strength of our customers, most of which are municipalities, and, as a result, believe that our trade accounts receivable credit risk exposure is limited. We do not require collateral from our customers.

Liquidity and Capital Resources

Cash Position and Working Capital

We had unrestricted cash and cash equivalents totaling $9,024,000 at September 30, 2006 compared with $1,224,000 at December 31, 2005. At September 30, 2006, we had positive working capital of $11,079,000 compared with $2,097,000 of negative working capital at December 31, 2005. Our net worth at September 30, 2006 was $7,533,000 compared with $5,407,000 at December 31, 2005.

The increase in cash, and improvement in working capital is primarily due to: (i) proceeds of $26,397,000, net of expenses received from our placement of $28,550,000 in 7% Senior Secured Convertible Notes on May 25, 2006, offset by the repayment of existing debt of $10,850,000 and $4,015,000 of cash placed in a restricted cash account for future payment of interest, and (ii) our private stock placement on January 31, 2006 that raised $4,822,000, net of expenses, offset by (iii) cash used in our operations in the nine months of 2006 of $4,994,000 and (iv) investments in capitalized systems of $3,538,000 which are expected to generate revenue in future quarters.

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On May 24, 2006, the Company entered into a Securities Purchase Agreement with several institutional and accredited investors to sell $28,550,000 of units consisting of five-year, 7% senior secured convertible promissory notes, convertible into shares of the Company’s common stock, and five-year warrants to purchase 1,982,639 shares of common stock, in a private placement pursuant to Regulation D under the Securities Act of 1933. The transaction was closed on May 25, 2006.

On January 31, 2006, the Company sold 1,237,811 shares of its common stock to fifteen accredited investors at $4.42 per share raising $4,822,000, net of expenses and issued warrants to purchase 371,339 shares of its common stock exercisable at $4.91 per share expiring on January 31, 2009. The Company used $1,250,000 of the proceeds to immediately retire the Heil Secured Promissory Note. Among the purchasers was Silver Star Partners, an affiliate of the Company, which purchased 220,589 shares and a warrant to purchase an additional 66,176 shares.

We continue to seek additional sources of equity and debt financing to fund system installations and to position ourselves to capitalize on new market and growth opportunities; however, there can be no assurance that the funds will be available on terms acceptable to us, if at all.

Commitments, Contractual Obligations and Off-Balance Sheet Arrangements

The following table summarizes the Company’s contractual obligations at September 30, 2006, and the effect such obligations are expected to have on its liquidity and cash flow in future periods:

Payments due in:	Operating Leases ⁽¹⁾		5 % Senior Convertible Notes		7 % Senior SecuredConvertible Notes		Debt Interest		Total

Remainder of 2006	$	110,000	$		$	5,710,000	$	536,000	$	6,356,000
2007		398,000		---		---		2,141,000		2,539,000
2008		367,000		---		---		2,141,000		2,508,000
2009		367,000		2,850,000		---		2,047,000		5,264,000
2010 &		320,000		---		---		1,999,000		2,319,000
Thereafter		113,000		---		22,840,000		799,000		23,752,000
	$	1,675,000	$	2,850,000	$	28,550,000	$	9,663,000	$	42,738,000

⁽¹⁾ Primarily facility lease obligations in Providence, RI and Los Angeles, CA.

As of September 30, 2006, we have no off balance sheet arrangements.

For the nine months ended September 30, 2006, we invested $3,538,000 in capitalized systems and no system costs were expensed under a sales-type lease for Delaware approaches compared to $2,211,000 invested in capitalized systems and $1,235,000 Delaware system costs expensed in the same period last year. Management expects that NTS will make substantial future commitments for systems related to our CrossingGuard contracts.

Results of Operations

Revenues

Total revenues for the third quarter of 2006 were $1,982,000 as compared to $1,914,000 for the third quarter of 2005.

Lease and service fee revenues totaled $1,979,000 for the third quarter of 2006 as compared to $1,596,000 for the third quarter of 2005, an increase of $383,000 or 24%, primarily due to additional revenue generating CrossingGuard red light approaches and PoliScan^speed Units. During the third quarter of 2006 we had 212 revenue generating CrossingGuard approaches and PoliScan^speed Units as compared to 164 revenue generating CrossingGuard approaches in the third quarter of 2005. This increase in revenue generating approaches is partially offset by a decline in average monthly revenue generated from older approaches which typically occurs due to modified driver behavior.

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There were no direct product sales or product sales recognized from sales-type leases for CrossingGuard roadside systems in the third quarter of 2006 as compared to $318,000 for the third quarter of 2005. Prior year direct product sales were with one customer and product sales recognized from sales-type leases were attributable to two Delaware approaches being completed and funded (under sales-type leasing) during the third quarter of 2005. These product sales are unique and are one-time, non-recurring in nature.

Total revenues for the nine months ended September 30, 2006 were $5,737,000 as compared to $6,180,000 in 2005.

Lease and service fee revenue grew 30% in the nine months as our base of revenue-generating CrossingGuard red light approaches and Poliscan Speed Units increased. As there were no one-time, non-recurring, product sales in the first nine months of 2006, total revenues declined when compared to the prior year quarter.

Lease and service fee revenues totaled $5,733,000 for the first nine months of 2006 as compared to $4,407,000 for the first nine months of 2005, an increase of $1,326,000 or 30%, primarily due to additional revenue generating CrossingGuard red light approaches and PoliScan^speed Units. This increase in revenue generating approaches is partially offset by a decline in average monthly revenue generated from older approaches which typically occurs due to modified driver behavior.

There were no direct product sales or product sales recognized from sales-type leases for CrossingGuard roadside systems in the first nine months of 2006 as compared to $1,758,000 for the first nine months of 2005. Prior year direct product sales were with one customer and product sales recognized from sales-type leases were primarily attributable to twenty Delaware approaches being completed and funded (under sales-type leasing) during the first nine months of 2005. These product sales are unique and are one-time, non-recurring in nature.

Cost of sales

Cost of sales for the third quarter of 2006 totaled $1,659,000 as compared to $1,517,000 for the third quarter of 2005, an increase of $142,000 or 9%. The increase in cost of sales is primarily due to increased amortization of capitalized systems and associated direct processing and support costs for more revenue-generating red-light approaches. The third quarter of 2006 also includes higher costs related to our Transol contracts which we acquired in September 2005 as well as direct and indirect costs for our Poliscan speed business which is not yet profitable. Offsetting these increases was a reduction in inventory obsolescence charges.

For the nine months ended September 30, 2006, cost of sales totaled $4,715,000, an increase of $65,000, or 1%, compared to $4,650,000 in the prior year nine month period. The increase in cost of sales is primarily due to increased amortization of capitalized systems and associated direct processing and support costs for more revenue-generating red-light approaches. The nine months of 2006 also includes higher costs related to our Transol contracts which we acquired in September 2005 as well as direct and indirect costs for our Poliscan speed business which is not yet profitable. These increases in costs are partially offset by the decline in product cost of sales as a result of no one-time, nonrecurring sales in the first half of 2006. Included in the second quarter of 2006 was a $150,000 book to physical inventory charge and a $175,000 impairment charge relating to two of our red-light contracts in assessing the recoverability of our long-term assets. Offsetting these increases was a reduction in inventory obsolescence charges.

Gross Profit

Gross Profit for the third quarter of 2006 totaled $323,000 as compared to $397,000 for the third quarter of 2005, a decline of $74,000. The decline in gross profit is primarily attributable to the above-mentioned lower margins on our Transol and Poliscan speed contracts in the quarter, offset by lower inventory obsolescence charges. To the degree we are permitted to upgrade or expand the Transol contracts and as more Poliscan contracts are signed, we expect Transol and Poliscan contract margins to improve substantially.

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For the nine months ended September 30, 2006, gross profit decreased $508,000, to $1,022,000 from $1,530,000 in the prior year nine month period. Gross margin decreased by seven points to 18% for the nine months ended September 30, 2006 from 25% for prior year nine month period, due to an impairment charge taken in the second quarter and lower margins on our Transol and Poliscan contracts, offset by lower inventory obsolescence charges.

Operating Expenses

Total operating expenses for the third quarter of 2006 totaled $3,091,000 as compared to $2,924,000 for the third quarter of 2005, an increase of $167,000, or 6%. The Company adopted FAS123R in 2006 and recorded a $573,000 non-cash stock compensation expense, which was charged to operating expenses. Excluding this expense, operating expenses decreased in the quarter. In March 2006, the Company initiated steps to reduce costs including the reduction in salaries to most employees by 10% including management under employment contract, and terminated nine employees. The severance cost of this action was $102,000 and is primarily included in operating expense for the first quarter of 2006.

Engineering and operations expenses for the third quarter of 2006 totaled $861,000 as compared to $1,078,000 in the third quarter of 2005, a decrease of $217,000, or 20%. These costs include the salaries and related costs of field and office personnel, as well as, operating expenses related to the maintenance and service of our installed base. The decline was primarily attributable to the above mentioned cost reductions and the elimination of the use of consultants from the prior year.

Research and development expenses for the third quarter of 2006 totaled $365,000 as compared to $382,000 in the third quarter of 2005, a decrease of $17,000, or 4%. The decrease in research and development expenses is primarily due to a shift in engineering time to implementation efforts and away from time on major projects to advance our CrossingGuard product technology and development of our PoliScan mobile speed enforcement technology, offset by a $43,000 stock compensation expense recorded in the second quarter of 2006.

Selling and marketing expenses for the third quarter of 2006 totaled $549,000 as compared to $672,000 in the third quarter of 2005, a decline of $123,000, or 18%. The decline is primarily attributable to a decline in commissions and consultant expenses used in targeted areas to achieve our sales strategy.

General and administrative expenses for the third quarter of 2006 totaled $1,316,000 as compared to $792,000, an increase of $524,000, or 66%. The increase is primarily attributable to $479,000 stock option expense recorded in the third quarter of 2006.

Total operating expenses for the first nine months of 2006 totaled $9,941,000 as compared to $8,194,000 for the first nine months of 2005, an increase of $1,747,000, or 21%. The increase is primarily attributable to: (1) During the first quarter of 2006, the Company adopted FAS123R and for the first nine months of 2006 recorded a $1,894,000 non-cash stock option expense which was charged to operating expenses, and partially offset by (2) In March 2006, the Company initiated steps to reduce costs including the reduction in salaries to most employees by 10% including management under employment contract, and terminated nine employees. The severance cost of this action was $102,000 and is primarily included in operating expense for the first quarter of 2006.

Engineering and operations expenses totaled $3,162,000 in the nine months ended September 30, 2006, an increase of $382,000, or 14%, compared to $2,780,000 in the corresponding nine month period of the prior year. Excluding $180,000 of stock option expense recorded in 2006, the change in costs relates to additional operating expenses related to product maintenance and service of our increasing installed base partially offset by the impact of the cost reduction program in March 2006.

Research and development expenses totaled $1,137,000 in the nine months ended September 30, 2006, an increase of $100,000, or 10%, compared with $1,037,000 in the prior year period. Excluding $106,000 of stock option expense recorded in 2006, expenses were flat with prior year period.

Selling and marketing expenses totaled $1,598,000 in the nine months ended September 30, 2006, relatively flat as compared with $1,602,000 in the corresponding nine month period of the prior year. Stock option expenses of $81,000 in 2006 was offset by a decline in expenses.

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General and administrative expenses totaled $4,044,000 for the nine months ended September 30, 2006, an increase of $1,269,000, or 46%, compared with $2,775,000 in the corresponding nine month period of the prior year. Excluding $1,505,000 of stock option expense recorded in 2006, general and administrative expenses declined primarily due to the reduction in legal expenses associated with the conclusion of a patent infringement case in June 2005.

Derivative instrument income (expense), net and debt discount expense

Derivative instrument income for the third quarter of 2006 totaled $7,145,000 as compared to income of $1,235,000 for the third quarter of 2005. Derivative instrument income for the nine months ended June 30, 2006 totaled $10,112,000 as compared to income of $3,249,000 for the nine months ended September 30, 2005.

The changes were attributable to changes in the fair market value of embedded derivatives issued with our convertible debt. The fair value of the derivatives will fluctuate based on: our stock price at particular points in time, the debt conversion price, the volatility of our stock price over a period of time, changes in the value of the risk free interest rate, and the remaining time to maturity of the outstanding debt.

The major factors contributing to the change for the third quarter of 2006 and 2005 as well as for the nine month periods ending September 30, 2006 and 2005 were due to the decline in the fair market value of our derivative instrument liabilities relating to our convertible debt due to the passage of time and a decline in our stock price.

Debt discount expense

Debt discount expense for the third quarter of 2006 totaled $1,167,000 as compared to an expense of $660,000 for the third quarter of 2005. Debt discount expense for the nine months ending 2006 and 2005 was $4,681,000 and $1,716,000.

The increase in the current quarter and nine months ending September 30, 2006 is primarily due to higher debt discounts associated with the sale of our 7% Senior Secured Convertible Notes, and higher debt discounts on the extension of our 5% Senior Convertible Notes in May 2006. These debt discounts are established at the time a derivative is bifurcated from the host debt agreement at issuance and amortized over the life of the note.

Other Expense, net

Other expense, net for the third quarter of 2006 totaled $562,000 as compared to $265,000 in the third quarter of 2005. Other expense, net totaled $1,360,000 in the nine months ended September 30, 2006, as compared to $363,000 in the corresponding nine month period of the prior year. The increase is primarily attributable to higher levels of interest expense on the new 7% Senior Secured Convertible Notes.

Net Income/(Loss)

Net income for the third quarter of 2006 was $2,648,000 or $0.13 cents per share as compared to net loss of $2,217,000 or $0.12 cents per share for the third quarter of 2005, an increase in net income of $4,865,000 or $0.25 cents per share. The change in net income between the quarters was primarily attributable to (1) a net increase of $5,910,000 in non-cash derivative instrument income offset by a $507,000 increase in debt amortization, (2) the recording of a $573,000 non-cash stock option expense charge in the third quarter of 2006, and (3) additional interest costs related to our debt arrangements.

During the nine months ended September 30, 2006, we incurred a net loss of $4,848,000, or $0.24 per share, a decline of $646,000, or $0.05 per share, compared with a net loss of $5,494,000, or $0.29 per share, in the corresponding nine month period of the prior year. During the nine months ended September 30, 2006, there were 20,241,421 basic and diluted shares outstanding compared with 18,815,952 basic and diluted shares outstanding during the corresponding nine month period of the previous year. The increase in net loss per share was primarily due to the decline in our net loss, partially offset by the increase in outstanding shares. The change in income between the periods was primarily attributable to (1) a net increase of $6,863,000 in non-cash derivative instrument income offset by a $2,965,000 increase in debt amortization, (2) the recording of a $1,894,000 non-cash stock option expense charge in the nine months ending September 30, 2006, and (3) additional interest costs related to our debt arrangements.

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ITEM 3. Quantitative and Qualitative Disclosure of Market Risk.

The following discussion of our market risk includes forward looking statements that involve risk and uncertainty. Actual results could differ materially from those projected in the forward looking statements. Market risk represents risk of changes in value of a financial instrument caused by fluctuations in interest rates, foreign exchange rates and equity and bond prices.

Interest Rates

Our marketable securities, an insured municipal bond fund, valued at $58,000 at September 30, 2006, are exposed to market risk due to changes in U.S. interest rates. The primary objective of our investment activities is the preservation of principal while maximizing investment income. We have exposure to this market risk in the short-term. During the quarter ended September 30, 2006, we had an unrealized loss of $3,000 on securities held at September 30, 2006. The securities are classified as “trading securities” and accordingly are reported at fair value with unrealized gains and losses included in other expense, net.

We have a senior convertible notes payable with interest fixed at 5% and 7% through their May 2011 maturity. Interest on the 7% senior convertible notes is subject to change based on the financial performance of the Company. Management assesses the exposure to market risk for these obligations as minimal.

ITEM 4. Controls and Procedures.

The management of Nestor, Inc., including the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e) and 15d-15(e) as of September 30, 2006. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of September 30, 2006, our disclosure controls and procedures were effective at the reasonable assurance level to ensure (i) that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (ii) that information required to be disclosed in reports that we file or submit under the Exchange Act is accumulated and communicated to our management including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II: OTHER INFORMATION

Item 1. Legal Proceedings

In addition, from time to time, we are involved in legal proceedings arising in the ordinary course of business. We do not currently have any pending litigation other than that described above.

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ITEM 1A Risk Factors

The Risk Factors included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005 have not materially changed other than as set forth below.

We have substantial indebtedness.

As a result of the May 2006 offering of $28,550,000 of secured notes due May 2011, we have substantial indebtedness and we are highly leveraged. As of September 30, 2006, we have total indebtedness of approximately $31,400,000. Our substantial indebtedness may limit our strategic operating flexibility and our capacity to meet competitive pressures and withstand adverse economic conditions. In addition, our secured notes contain restrictive covenants which, among other things, limit our ability to borrow additional funds, repay indebtedness, including the secured notes, before maturity or grant security interests on our assets. Under the terms of the secured notes, we will be unable to refinance our existing debt on more favorable terms.

Our substantial indebtedness could have significant adverse consequences, including:

requiring us to dedicate a substantial portion of the net proceeds of the debt and any cash flow from operations to the payment of interest, and potentially principal, on our indebtedness, thereby reducing the availability of such proceeds and cash flow to fund working capital, capital expenditures or other general corporate purposes.

increasing our vulnerability to general adverse economic and industry conditions,

limiting our ability to obtain additional financing to fund future working capital, capital expenditures, research and development and other general corporate requirements;

limiting our flexibility in planning for, or reacting to, changes in our business and the industry; and

placing us at a disadvantage compared to our competitors with less debt and competitors that have better access to capital resources.

Furthermore, in order to repay our indebtedness at maturity, including the secured notes, we will need to refinance all or a portion of that indebtedness. There can be no assurance that we will be able to effect any such refinancing on commercially reasonable terms or at all.

Our debt service costs exceed our current operating cash flow.

For the quarter ended September 30, 2006, and each of our prior fiscal years, we had negative operating cash flow, and we expect to continue to incur negative operating cash flow in future periods. Our ability to make scheduled payments of interest or principal, if any, on our indebtedness, including the secured notes, or to fund planned capital expenditures, will depend on our future performance, which, to some extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. There can be no assurance that future revenue growth will be realized or that our business will generate sufficient cash flow from operations to enable us to service our indebtedness or to fund our other liquidity needs.

A substantial portion of our debt is subject to redemption at the holder’s option prior to maturity.

The holders of our secured notes have the right to require us to redeem up to $5,710,000 of notes until December 2006. In addition, the secured note holders have the right to require us to redeem all or any portion of those notes on May 25, 2009, unless our consolidated EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R, “Share-Based Payment”) for 2008 exceeds $14,000,000. The terms of our secured notes do not permit us to refinance those notes or to borrow to redeem the notes prior to maturity. Thus, our ability to redeem the secured notes if tendered will depend upon our operating performance as well as prevailing economic and market conditions and other factors beyond our control. Failure to redeem properly tendered notes would constitute an event of default, which, if not cured or waived, could have a material adverse effect on our financial condition, and thus, the value of our common stock.

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If our financial performance doesn’t improve, our interest costs will increase.

The interest rate on our secured notes is subject to a 2% increase if we fail to achieve EBITDA (defined as earnings before interest, taxes, depreciation and amortization, any derivative instrument gain or loss or any employee stock option expense under SFAS 123R, “Share-Based Payment ) of at least $1,250,000 for our fiscal quarter ending June 30, 2007. For the quarter ended September 30, 2006, EBITDA as so calculated was negative $1,502,000. There is no assurance that we will be able to achieve $1,250,000 of EBITDA by the second quarter of fiscal 2007, which would result in a material increase in our fixed interest expense and could adversely affect our results of operations and financial condition.

We have granted a lien on substantially all of our assets.

Our obligations under the secured notes are secured by substantially all of our assets and substantially all of the assets of our principal subsidiaries, except as to contracts we enter into after October 1, 2006 and all assets related thereto. Upon an event of default under the secured notes, these lenders could elect to declare all amounts outstanding, together with accrued and unpaid interest thereon, to be immediately due and payable. If we were unable to repay those amounts, such lenders will have a first claim on our assets and the assets of our subsidiaries. If these creditors should attempt to foreclose on their collateral, it is unlikely that there would be any assets remaining after repayment in full of such secured indebtedness and our financial condition and, thus, the value of our common stock, would be materially adversely affected.

We may need additional financing, which may be difficult or impossible to obtain and may restrict our operations and dilute stockholder ownership interest.

At September 30, 2006, we had approximately $31,400,000 of outstanding debt, at par value. We may need to raise additional funds in the future to fund our operations, deliver our products, expand or enhance our products and services, finance acquisitions and respond to competitive pressures or perceived opportunities. Because the nature of our operations requires us to bear all the up-front costs of deploying our technology, additional funds may be crucial to our continuing operations. We cannot provide any assurance that additional financing will be available on acceptable terms, or at all. If adequate funds are not available or not available on acceptable terms, our business and results of operations may suffer.

Our outstanding debt contains restrictive covenants that limit our ability to raise additional funds through debt financings. As a result of these restrictions, any additional debt must be for the sole purpose of financing the design, engineering, installation, construction, configuring, maintenance, or operation or improvement of property or equipment at customer sites pursuant to customer contracts entered into after October 1, 2006 and will not be available to fund general overhead expenses. If we raise additional funds through a debt financing, the terms and conditions of the debt financing may result in further restrictions on our operations or require that we grant a security interest in some or all of the assets related to the customer contracts toward which such financing would be applied. Any debt that we incur would increase our leverage and could exacerbate the negative consequences described above under “— We have substantial indebtedness.”

Additionally, we could be required to seek funds through arrangements with collaborative partners or others that may require us to relinquish rights to certain of our technologies, product candidates or products which we would otherwise pursue on our own.

Our outstanding debt consists of convertible notes which contain anti-dilution provisions which would lower the conversion price if we were to issue equity for a price less than the conversion price. We also have outstanding warrants to purchase our common stock which contain anti-dilution provisions which would lower the exercise price and increase the number of shares issuable upon exercise if we were to issue equity for a price less than the exercise price. If we raise additional funds by issuing equity securities, further dilution to our then-existing stockholders will result and the terms of the financing may adversely affect the holdings or the rights of such stockholders.

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Provisions of our secured notes and secured note warrants could delay or prevent a change of control

There are provisions in our secured notes and secured note warrants that may discourage, delay or prevent a merger or acquisition because, upon a change of control (as defined in the notes), the holders of the secured notes have the right to redeem some or all of their secured notes and the holders of the secured note warrants will have the right to effectively accelerate the maturity date and demand payment.

We have a significant number of options, warrants and convertible securities outstanding, which if exercised or converted, will have a dilutive effect upon our stockholders. The anti-dilution provisions of some of these securities could magnify that dilutive effect.

As of November 7, 2006, we have issued and outstanding warrants and options to purchase up to approximately 5,947,954 shares of our common stock, preferred stock convertible into 18,000 shares of our common stock and debt convertible into approximately 8,722,223 shares of our common stock.

Furthermore, the documents governing our convertible debt have anti-dilution provisions, pursuant to which the conversion price is reduced if we sell common stock at a price below the conversion price, which is now $3.60 per share. The secured notes provide “full ratchet” anti-dilution protection until May 25, 2009 and “weighted average” anti-dilution protection thereafter. The holders of our 5% notes also have “full ratchet” anti-dilution protection until maturity of the notes. In addition, some of our warrants contain weighted average anti-dilution provisions that would lower the exercise price and increase the number of shares issuable upon exercise if we sell stock at a price below $4.35.

Unlike ordinary anti-dilution provisions, “full ratchet” anti-dilution provisions have the effect of extending a “lowest price guarantee” to the holders of the secured notes and the 5% notes.

If the holders of these securities convert the notes or exercise the options and warrants, we will issue shares of our common stock and such issuances will be dilutive to our stockholders. Because the conversion price of the notes and the exercise price of the warrants may be adjusted from time to time in accordance with the anti-dilution provisions of the notes and the warrants, the number of shares that could actually be issued may be greater than the amount described above. In addition, if such investors or our other stockholders sell substantial amounts of our common stock in the public market during a short period of time, our stock price may decline significantly.

The price of our common stock may decline because a substantial amount of our common stock is available for trading in the public market.

Availability of shares of our common stock could depress the price of our common stock. A substantial amount of common stock is available for trading in the public market. This amount of stock in the market may cause the price of our common stock to decline. In addition, if our stockholders sell substantial amounts of our common stock in the public markets, the market price of our common stock could fall. These sales might also make it more difficult for us to sell equity or equity-related securities at a time and price that we would deem appropriate. We also have issued options, warrants and convertible securities that can be exercised for, or converted to, shares of common stock, many of which would be freely tradable without restrictions or further registration under the Securities Act.

There were approximately 20,386,816 shares of our common stock outstanding as of November 7, 2006, of which approximately 9,329,390 shares were freely tradable without restrictions or further registration under the Securities Act, unless held by our “affiliates” as that term is used in the Securities Act and the rules and regulations thereunder. Silver Star Partners I, LLC, our principal stockholder, has the right to require us to register under the Securities Act the resale of all 9,836,430 shares of common stock that it owns, as soon as practicable after Silver Star requests that registration, of which 220,589 were registered on our registration statement on Form S-3 filed on June 26, 2006 and declared effective by the SEC on July 14, 2006.

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We do not comply with Nasdaq’s Marketplace rules for continued listing from the Nasdaq Global Market, and have applied to transfer our listing to the Nasdaq Capital Market.

Our stock is listed on the Nasdaq Global Market, which affords us an opportunity for relatively broad exposure to a wide spectrum of prospective investors. As a requirement of continued inclusion in the Nasdaq Global Market, we must comply with Nasdaq’s Marketplace Rules.

On October 16, 2006, we received a notification from the Nasdaq Listings Qualification Department that we failed to comply with the continued listing requirements of the Nasdaq Global Market because the market value of our listed securities has fallen below $50,000,000 for 10 consecutive business days pursuant to Nasdaq Marketplace Rule 4450(b)(1)(A). Additionally, the Company does not comply with the alternative Marketplace Rule 4450(b)(1)(B) which requires total assets and total revenue of $50 million each for the most recently completed fiscal year or two of the last three most recently completed fiscal years.

In accordance with Marketplace Rule 4450(e)(4), the Company was provided with 30 calendar days, or until November 15, 2006, to regain compliance. If at anytime before November 15, 2006, the market value of the Company’s common stock had been $50 million or more for at least ten consecutive business days, Nasdaq’s staff would have determined if the Company complied with the Nasdaq Global Market continued listing standards. The Company will not be able to demonstrate compliance by November 15, 2006.

On November 10, 2006, the Executive Committee of the Board of Directors authorized management to file an application to transfer the listing of the Company’s common stock from the Nasdaq Global Market to the Nasdaq Capital Market. The Company filed the application on November 10, 2006. The Company expects to receive Nasdaq’s approval decision within two weeks and expects to maintain its current Nasdaq Global Market status pending approval of the transfer application. The Company believes it is eligible to transfer to the Nasdaq Capital Market, although there can be no assurance that the transfer will be approved.

Even if we are successful in transferring our listing from the Nasdaq Global Market to the Nasdaq Capital Market, there could be a number of negative implications, including reduced liquidity in our common stock as a result of the loss of market efficiencies associated with the Nasdaq Global Market, the loss of federal preemption of state securities laws, the potential loss of confidence by suppliers, customers and employees, as well as the loss institutional investor interest, fewer business development opportunities and greater difficulty in obtaining financing. In addition, if we are unable to transfer our listing to the Nasdaq Capital Market, we will be in default under our outstanding senior secured convertible notes.

Earnings for future periods may be affected by impairment charges.

Because of the nature of our business, long-lived assets, including intangibles, represent a substantial portion of our assets. The Company evaluates long-lived assets for impairment when events or changes in circumstances indicate, in management’s judgment, that the carrying value of such assets used in operations may not be recoverable. The determination of whether an impairment has occurred is based on management’s estimate of undiscounted future cash flows attributable to the assets as compared to the carrying value of the assets. If an impairment occurs, the amount of the impairment recognized will be determined by estimating the fair value for the assets and we will record a charge against earnings if the carrying value is greater than fair value.

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Item 2:

Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3:

Defaults Upon Senior Securities

None

Item 4:

Submission of Matters to a Vote of Security Holders

None, except as reported in our Quarterly Report on Form 10-Q for the period ended June 30, 2006.

Item 5:

Other Information

On November 10, 2006, we applied to transfer the listing of our common stock from the Nasdaq Global Market to the Nasdaq Capital Market.

On November 10, 2006, the Executive Committee of the Board of Directors authorized management to file an application to transfer the listing of the Company’s common stock from The Nasdaq Global Market to The Nasdaq Capital Market. The Company filed the application on November 10, 2006. The Company expects to receive Nasdaq’s approval decision within two weeks and expects to maintain its current Nasdaq Global Market status pending approval of the transfer application. The Company believes it is eligible to transfer to The Nasdaq Capital Market, although there can be no assurance that the transfer will be approved.

As previously announced, on October 16, 2006, the Company received a Nasdaq Staff Deficiency Letter indicating that the market value of the Company’s common stock had fallen below $50 milion, the minimum level required for the continued listing of its common stock on the Nasdaq Global Market based on Marketplace Rule 4450(b)(1)(A). In accordance with marketplace Rule 4450(e)(4), the Company was provided with 30 calendar days, or until November 15, 206, to regain compliance. If at any time before November 15, 2006, the market value of the Company’s common stock had been $50 million or more for at least ten consecutive business days, Nasdaq’s staff would have determined if the Company complied with the Nasdaq Global Market continued listing standards. The Company will not be able to demonstrate compliance by November 15, 2006.

Item 6: Exhibits

Exhibit Number

Description

10.1

Incentive Stock Option Agreement between Nestor, Inc. and Tadas A. Eikinas dated September 8, 2006

10.2

Form Incentive Stock Option Agreement dated November 1, 2006, incorporated by reference from Current Report on Form 8-K filed November 6, 2006

31.1

Certification of principal executive officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended

31.2

Certification of principal financial officer pursuant to Rule 13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as amended

Statement Pursuant to 18 U.S.C. §1350

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FORM 10-Q

NESTOR, INC.

SIGNATURE

Pursuant to 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.

Date: November 14, 2006	NESTOR, INC.
	(REGISTRANT)




	/s/ Nigel P. Hebborn
	Nigel P. Hebborn
	Treasurer and Chief Financial Officer

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	NESTOR, INC.

Dated: September 7, 2006	By: /s/ Nigel P. Hebborn

Name:	Nigel P. Hebborn
Title:	Executive Vice President, Treasurer and CFO

	PARTICIPANT:

	/s/Tadas A. Eikinas

Name:	Tadas A. Eikinas

Address:	4 Mill River Lane
	Hingham, MA 02043

Date: November 14, 2006

/s/ William B. Danzell
William B. Danzell, President and Chief Executive Officer

Date: November 14, 2006

/s/ Nigel P. Hebborn
Nigel P. Hebborn, Treasurer and Chief Financial Officer

Date: November 14, 2006

/s/ William B. Danzell
William B. Danzell, Chief Executive Officer



Date: November 14, 2006

/s/ Nigel P. Hebborn
Nigel P. Hebborn, Chief Financial Officer