Form 10-Q (March 31, 2007)

10-Q 1 form10q.htm FORM 10-Q (MARCH 31, 2007) Form 10-Q (March 31, 2007)

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 March 31, 2007

		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

(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 at May 10, 2006
[Common Stock, $.01 par value per share]		20,241,816 shares

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NESTOR, INC.

FORM 10Q

For the Quarterly Period Ended March 31, 2007

INDEX

		Page Number

Part I	FINANCIAL INFORMATION

Item 1	Financial Statements:

	Condensed Consolidated Balance Sheets	3
	March 31, 2007 (Unaudited ) and December 31, 2006

	Condensed Consolidated Statements of Operations (Unaudited)	4
	Three months ended March 31, 2007 and 2006

	Condensed Consolidated Statements of Cash Flows (Unaudited)	5
	Three months ended March 31, 2007 and 2006

	Notes to Condensed Consolidated Financial Statements	6


Item 2	Management’s Discussion and Analysis of Results of Operations and Financial Condition	15


Item 3	Quantitative and Qualitative Disclosure of Market Risk	25


Item 4	Controls and Procedures	25


Part II	OTHER INFORMATION

Item 1	Legal Proceedings	26

Item 1 A	Risk Factors	27

Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	27

Item 3	Defaults Upon Senior Securities	27

Item 4	Submission of Matters to a Vote of Security Holders	27

Item 5	Other Information	27

Item 6	Exhibit Index	28

	Signature Page

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Index

NESTOR, INC.

Condensed Consolidated Balance Sheets

In Thousands, Except Share And Per Share Information

	March 31,			December 31,
	2007			2006
	(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents	$	1,654		$	2,952
Marketable securities		60			58
Accounts receivable, net		2,073			2,343
Inventory, net		1,795			1,950
Other current assets		283			197
Total current assets		5,865			7,500
Noncurrent assets
Capitalized system costs, net		8,682			8,185
Property and equipment, net		684			789
Goodwill		5,581			5,581
Patent development costs, net		136			125
Other long term assets		2,197			2,331
Total Assets	$	23,145		$	24,511

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	1,086		$	1,325
Accrued liabilities		1,377			1,493
Accrued employee compensation		403			351
Deferred revenue		1,169			712
Asset retirement obligation		193			186
Total current liabilities		4,228			4,067
Noncurrent Liabilities:
Long term convertible notes payable		1,120			920
Long term notes payable		9,371			8,563
Derivative financial instruments - debt and warrants		3,642			4,971
Long term asset retirement obligation		652			488
Total liabilities		19,013			19,009

Commitments and contingencies		---			---

Stockholders’ Equity:
Preferred stock, $1.00 par value, authorized 10,000 shares;
issued and outstanding: Series B - 180,000 shares at
March 31, 2007 and December 31, 2006		180			180
Common stock, $0.01 par value, authorized 30,000,000
shares issued and outstanding: 20,421,816 shares at
March 31, 2007 and 20,386,816 shares at December 31, 2006		204			204
Additional paid-in capital		73,736			73,597
Accumulated deficit		(69,988	)		(68,479	)
Total stockholders’ equity		4,132			5,502
Total Liabilities and Stockholders’ Equity	$	23,145		$	24,511

*The 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 March 31,
	2007		2006

Revenue:
Lease and service fees	$	2,381	$	1,752
Total revenue		2,381		1,752

Cost of sales:
Lease and service fees		1,465		1,351
Total cost of sales		1,465		1,351

Gross profit:
Lease and service fees		916		401
Total gross profit		916		401

Operating expenses:
Engineering and operations		1,089		1,198
Research and development		137		482
Selling and marketing		196		514
General and administrative		776		1,444
Total operating expenses		2,198		3,638

Loss from operations		(1,282		(3,237	)

Derivative instrument income		1,329		552

Debt discount expense		(1,008		(484	)

Other expense, net		(548		(323	)


Net loss	$	(1,509	$	(3,492	)


Loss per share:

Loss per share, basic and diluted	$	(0.07	$	(0.17	)

Shares used in computing loss per share:
Basic and diluted		20,410,150		19,979,780


*The accompanying Notes are an integral part of these Condensed Consolidated Financial Statements.*

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Index

NESTOR, INC.

Condensed Consolidated Statements of Cash Flows

In Thousands, Except Share And Per Share Information

(Unaudited)

	Quarter Ended March 31,
	2007			2006

Cash flows from operating activities:
Net loss	$	(1,509	)	$	(3,492	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		705			686
Amortization and writeoff of deferred financing fees		135			89
Stock based compensation		140			740
Derivative instrument (income) expense		(1,329	)		(552	)
Debt discount expense		1,008			484
Unrealized gain on marketable securities		(2	)		(1	)
Expenses charged to operations relating to
options, warrants and capital transactions		---			90
Provision for doubtful accounts		11			19
Provision for inventory reserve		60			83
Increase (decrease) in cash arising from changes in assets and liabilities:
Accounts receivable		260			530
Inventory		95			(246	)
Other assets		(90	)		194
Accounts payable and accrued expenses		(132	)		(301	)
Deferred revenue		457			(10	)

Net cash used in operating activities		(191	)		(1,687	)

Cash flows from investing activities:
Investment in capitalized systems		(1,080	)		(716	)
Purchase of property and equipment		(10	)		(50	)
Investment in patent development costs		(17	)		---

Net cash used in investing activities		(1,107	)		(766	)

Cash flows from financing activities:
Repayment of notes payable		---			(1,250	)
Proceeds from private stock placement		---			4,822

Net cash provided by financing activities		---			3,572

Net change in cash and cash equivalents		(1,298	)		1,119
Cash and cash equivalents - beginning of period		2,952			1,224

Cash and cash equivalents - end of period	$	1,654		$	2,343

Supplemental cash flows information:
Interest paid	$	435		$	250

Income taxes paid	$	---		$	---

*The accompanying Notes are an integral part of these Condensed Consolidated Financial Statements.*

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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 and is now inactive. The condensed consolidated financials statements include the accounts of Nestor, Inc. and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated. Our principal offices are located in Providence, RI and Los Angeles, CA.

We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States and also in Canada. 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. We also offer a newly developed ViDAR™ (Video Detection and Ranging) speed detection and imaging system as complement to our other products or as a stand-alone speed enforcement system. CrossingGuard, our red light enforcement product, uses our patented image processing technology to predict and record the occurrence of a red light violation, and manages the process of issuing and processing a citation. Poliscan, one of our speed enforcement products, uses technology developed by Vitronic GmbH. We have exclusive distribution rights to Poliscan in North America through February 2010, subject to meeting certain purchase minimums. ViDAR™ uses average speed over distance calculations to detect and record evidence of speeding vehicles. Because ViDAR™ was developed by in-house talent, there are no purchase minimums. By combining CrossingGuard, Poliscan and ViDAR™ with Citation Composer, our proprietary citation preparation and processing software, we are able to provide fully integrated, turnkey red light and speed enforcement solutions.

B.	Liquidity and management’s plans

We have incurred significant losses since inception and have an accumulated deficit of $69,988 through March 31, 2007. Although the Company has reduced its losses in the first quarter of 2007 and anticipates to be modified EBITDA positive beginning in the third quarter of 2007, these circumstances raise doubt about our ability to continue as a going concern. The accompanying condensed consolidated financial statements have been prepared assuming we will continue as a going concern, which contemplates continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business. Our condensed consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded assets or the amounts and classification of liabilities that might be necessary in the event we cannot continue in existence.

On March 30, 2007, the Company entered into a Note Purchase Agreement, which became effective on April 1, 2007, pursuant to which accredited investors (some of whom are affiliates of the Company) agreed to purchase $1.5 million of the Company’s Variable Rate Senior Notes due May 25, 2011 (the “Speed Notes”), which Speed Notes are secured by a first priority security interest in all of the Company’s assets which are directly and exclusively used for the implementation and performance of existing (entered into after October 1, 2006) and future contracts for fixed and mobile automated speed enforcement units. See Note 7 for further details.

Management believes that given its liquidity at March 31, 2007, its current levels of cash being used by operations, and capital requirements necessary to deliver on current contracts with municipalities, we will be required to raise additional capital in the near term. Even if we obtain the capital desired, there can be no assurance that our operations will be profitable in the future, that our product development and marketing efforts will be successful, or that the additional capital will be available on terms acceptable to us, if at all.

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Index

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 March 31, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007. There were no material unusual charges or credits to operations during the recently completed fiscal quarter.

The balance sheet at December 31, 2006 derives 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, as amended, for the year ended December 31, 2006.

Certain prior year 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 primarily 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 contracts. 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 related expenses. 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 the first quarter of 2007 and 2006 were approximately $135 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.

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Index

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.

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-Sholes 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.

Loss per share - 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 not presented for the first quarter of 2006 and 2005, since their effect would be antidilutive.

Note 3 - 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
	March 31, 2007		March 31, 2006
Cost of sales	$	6	$	11
Engineering and operations		64		106
Research and development		9		44
Selling and marketing		4		47
General and administrative		18		532
Share-based compensation expense before tax	$	101	$	740
Provision for income tax		---		---
Net share-based compensation expense	$	101	$	740

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 three months ended March 31, 2007 and 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
	March 31, 2007		March 31, 2006
Expected option term ⁽¹⁾	5.25	years	5.25	years
Expected volatility factor ⁽²⁾	163-165	%	165	%
Risk-free interest rate ⁽³⁾	4.5	%	4.5	%
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.

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.

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Index

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 determines 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 Board has authorized the Chief Executive Officer to award options to non-executive employees in an amount not to exceed 10,000 shares per employee and 200,000 in the aggregate. All such grants must be approved by the Compensation Committee and be consistent with the Plan. The awards are not transferable except by will or domestic relations order.

The following table presents the activity of the Company’s Stock Option Plans from December 31, 2006 through March 31, 2007.

	2007
			Weighted
			Average
	Shares		Exercise Price
Outstanding at December 31, 2006		2,953,853	$	4.55
Granted		145,000		1.16
Exercised		---		---
Canceled		260,400		3.96
Outstanding at March 31, 2007		2,838,453		4.43

Options exercisable at March 31, 2007		1,899,028	$	4.78

The following table presents weighted average price and life information about significant option groups outstanding at March 31, 2007:

Options Outstanding									Options Exercisable
Range of Ex. Price				Number of Outstanding at March 31, 2007	Weighted Average Remaining Contractual Life (Years)		Weighted Average Exercise Price		Number Exercisable at March 31, 2007	Weighted Averaged Exercisable Price
$	1.00	-	2.99	357,150		7.7		1.84	38,450		1.96
	3.00	-	3.99	226,700		4.7		3.60	144,800		3.69
	4.00	-	4.99	2,062,025		6.3		4.86	1,576,075		4.87
	5.00	-	5.99	185,913		3.8		5.60	136,788		5.62
	6.00	-	8.00	6,665		5.0		6.20	2,915		6.13
				2,838,453		6.2		4.43	1,899,028		4.78

During the three months ended March 31, 2007, and March 31, 2006, there were no 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 no amount of cash was received from the exercise of options.

The total grant date fair value of stock options that vested during the three months ended March 31, 2007 was approximately $79 with a weighted average remaining contractual term of 6.3 years. The weighted average fair value of options, as determined under SFAS123(R), granted during the three months ended March 31, 2007 and 2006 was $1.10 and $3.82 per share, respectively.

As of March 31, 2007, there was $3,373 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 1.6 years. The Company amortizes stock-based compensation on the straight-line method.

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Index

The Company did not realize any actual tax benefit for tax deductions from option exercise of the share-based payment arrangements for the three months ended March 31, 2007.

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:

	March 31, 2007

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 March 31, 2007 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 4 - 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.

	March 31, 2007			December 31, 2006
5% Senior Convertible Notes
Principal	$	2,850		$	2,850
Debt discount		(1,730	)		(1,930	)
FMV of embedded derivatives		16			164

7% Senior Secured Convertible Notes
Principal		22,840			22,840
Debt discount		(13,469	)		(14,277	)
FMV of embedded derivatives, including warrants		3,626			4,807
	$	14,133		$	14,454
Less current portion		---			---
Total	$	14,133		$	14,454

Aggregate maturities of long-term obligations for the years ending following March 31, 2007 are as follows:

		2009		2011		Total
7% Senior Secured Convertible Notes	$	---	$	22,840	$	22,840
5% Senior Convertible Notes		2,850		---		2,850
Total:	$	2,850	$	22,840	$	25,690

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Index

Note 5 - 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 and Kuekenhof Equity Fund, L.P., an affiliate of the Company, which purchased 56,561 shares and a warrant to purchase an additional 16,968 shares.

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 March 31, 2007.

Note 6 - Income Taxes:

The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” ("FIN No. 48"), on January 1, 2007. FIN No. 48 requires that the impact of tax positions be recognized in the financial statements if they are more likely than not of being sustained upon examination, based on the technical merits of the position. As discussed in the consolidated financial statements in the 2006 Form 10-K, the Company has a valuation allowance against the full amount of its net deferred tax assets. The Company currently provides a valuation allowance against deferred tax assets when it is more likely than not that some portion, or all of its deferred tax assets, will not be realized.

As a result of the implementation of FIN No. 48, the Company reduced its deferred tax assets and the associated valuation allowance for gross unrecognized tax affected benefits of approximately $11,545. There was no adjustment to accumulated deficit as a result of these unrecognized tax benefits, since there was a full valuation allowance against the related deferred tax assets. If these unrecognized tax benefits are ultimately recognized, they would have no impact on the effective tax rate due to the existence of the valuation allowance.

The Company is subject to U.S. federal income tax as well as income tax of certain state jurisdictions. The periods from 1999-2006 remain open to examination by the I.R.S. and state authorities. The Company has not been audited by the I.R.S. or any states in connection with income taxes for this period of time.

We recognize interest accrued related to unrecognized tax benefits in interest expense, if any. Penalties, if incurred, are recognized as a component of income tax expense.

Note 7 - Litigation:

On April 13, 2007, the Company filed suit against Place Motor, Inc. and Clair Ford, Lincoln Mercury, Inc. (Nestor Traffic Systems, Inc. Plaintiff, vs. Place Motor, Inc., et al., Rhode Island Superior Court, C.A. No. PC-07-1963). Place Motor, Inc. and Clair Ford, Lincoln Mercury, Inc. are in possession of title for eight vans for which Nestor has paid in full. Nestor has alleged that it paid for these vans by making payment to the defendants’ agent, Northeast Conversions, LLC. Although Northeast Conversions never forwarded our payment to the defendants, Nestor believes that it satisfied its obligation to pay for the vans when it delivered payment to the defendants’ agent. Accordingly, Nestor seeks declaratory judgment in favor stating that the Defendants’ must take any action necessary to deliver the vans together with valid title certificates to Nestor Traffic Systems. The time for defendants to respond to this complaint has not yet passed.

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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 were 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 were due by November 22, 2006.

With respect to both of the above cases, the Court certified a question to the Ohio Supreme Court:

Whether a municipality has the power under home rule to enact civil penalties for the offense of violating a traffic signal light or for the offense of speeding, both of which are criminal offenses under the Ohio Revised Code.

On February 7, 2007, the Ohio Supreme Court accepted the case for determination of the question presented.

With respect to the underlying actions, discovery was complete at the time the Court certified the question to the Ohio Supreme Court.

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

Note 8 - Subsequent Event:

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Speed Note holders will receive interest payments equal to (a) $5.00 per paid citation issued with the Equipment (for “as issued” contracts), (b) $6.00 per paid citation (for “as paid” contracts) and (c) 17% of amounts collected (for “fixed fee” contracts), subject to a minimum return of 10% per annum, payable quarterly in arrears. Payments will be made based upon citations issued from 16 speed units per $1.5 million in aggregate outstanding principal on all Notes. Once the Company has entered into contracts for the operation of 16 speed units, the Company may, but is not obligated to, sell an additional $1.5 million of Speed Notes.

The Speed Notes will mature on May 25, 2011, at which time the Company will pay all unpaid principal together with all accrued but unpaid interest. The Company may at any time redeem the Speed Notes at 110% of face value plus accumulated but unpaid interest.

The proceeds from the Speed Notes will be used, either prospectively or retrospectively, to fund the purchase price or cost of design, engineering, installation, construction, configuring, maintenance, or operation or improvement of property or equipment used in contracts signed after October 1, 2006 at a customer site, including without limitation, costs of site analysis and preparation.

At the April 11, 2007 Board of Directors Meeting, the Compensation Committee recommended that 25% of certain fully vested options granted to Mr. Danzell should be reduced to an exercise price of $2.00. The Board resolved that the option granted to Mr. Danzell on October 13, 2004 to purchase 500,000 shares (vesting in equal annual installments) of the Company’s Common Stock at a purchase price of $4.95 per share be amended such that 25% of the shares purchasable thereby (125,000) be purchasable at a price of $2.00.

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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 and in Part I - Item 1A, “Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. 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.

Executive Summary

We are a leading provider of innovative, automated traffic enforcement systems and services to state and local governments throughout the United States and Canada. 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. We also offer a newly developed ViDAR™ speed detection and imaging system as complement to our other products or as a stand-alone speed enforcement system. CrossingGuard, our red light enforcement product, uses our patented image processing technology to predict and record the occurrence of a red light violation, and manages the process of issuing and processing a citation. Poliscan, one of our speed enforcement products, uses technology developed by Vitronic GmbH. We have exclusive distribution rights to Poliscan in North America through February 2010, subject to meeting certain purchase minimums. It is doubtful that the Company will be able to meet its minimum purchase requirements, and it is likely that it will lose its exclusive distribution rights with respect to the LiDAR system. The Company is in the process of negotiating an extension of its contract with Vitronic GmbH, but at this time, it has been unsuccessful in reaching an agreement with Vitronic for an extension of its exclusive distribution rights. ViDAR™ uses average speed over distance calculations to detect and record evidence of speeding vehicles. Because ViDAR™ was developed by in-house talent, there are no purchase minimums. By combining CrossingGuard, Poliscan and ViDAR™ with Citation Composer, our proprietary citation preparation and processing software, we are able to provide fully integrated, turnkey red light and speed enforcement solutions.

We generate recurring revenue through contracts that provide for equipment leasing and 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 red light system as explained below. Beginning in the fourth quarter of 2005, we started generating revenue from our PoliScan^speed system. The economics of products and services are tied to the number of operating systems in the field and the number of violations processed by such systems. Customer pricing entails fixed monthly fees, variable per ticket fee pricing structures, or a combination of both. A shift to monthly fixed fee contracts may result in a more stable revenue stream for installations. Many of our initial red light and speed 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 $19 to $99 per citation issued or paid and/or fixed monthly fees ranging from $2,000 to $7,000 per approach for system delivery and processing services.

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State statutes providing for automated 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 and monthly fees 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 deliveries 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 March 31, 2007, our existing active contracts authorized the installation of our CrossingGuard product at up to an additional 235 approaches. Management believes the majority of the authorized approaches under existing active contracts will be installed, but no assurances can be given that all approaches under contract will ultimately be installed 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 March 31,
Number of Approaches and Units:		2007	2006

Installed, operational and revenue-generating
CrossingGuard red light approaches		217	175
Poliscan^speed Units		11	6
Additional Authorized Approaches:
CrossingGuard red light approaches		235	188
Poliscan^speed Units		10	3
Total		473	372

During the first quarter of 2007, the Company added 27 CrossingGuard red light approaches and decommissioned 22 approaches, primarily underperforming, former Transol approaches. Thirteen of the decommissioned approaches were due to contract termination and nine due to program suspension as a result of a court ruling presently under appeal.

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 $19 to $35 per ticket under future speed enforcement contracts depending on factors including number of units ordered, length of contract, service levels provided, state statutes, and competition.

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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 CrossingGuard video-based red light enforcement systems and services to states and municipalities for red light enforcement and safety

Implementing a marketing program for speed enforcement systems and services to states and municipalities for speed enforcement and safety

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 traffic safety technology to maintain or improve our position and competitive advantages in the industry

Vigorously defending our patented technology from competitors’ infringement

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.

During our first 25 years of operations, we developed a number of patented intelligent software solutions for decision and data-mining applications, including financial services, fraud detection and intelligent traffic-management systems. In 2000, we made the strategic decision to concentrate on our traffic management technologies and began to dispose of our other product lines. By 2003, we had exited our financial services, fraud detection and Rail CrossingGuard and TrafficVision business lines, and had refocused our resources on our traffic safety and enforcement systems such as CrossingGuard, our current primary source of revenue. This transition involved a series of licensing arrangements and transfers of our rights. In early 2001, we also entered into two separate source-code licensing agreements for our fraud detection product line appointing Applied Communications, Inc., or ACI, and Retail Decisions, Inc., or ReD, as co-exclusive resellers in the transaction processing industry. Royalty revenues from ACI continued through June 2002 when the royalty stream was assigned to Churchill Lane Associates, or CLA. We do not expect to receive future revenues from this license. Additionally, we transferred to ReD certain of our assets that supported the technology licensed under our license to ReD. No ongoing revenues are expected to be realized from ReD. The licensing, royalty and other payments we received under these licensing arrangements and other transfers of our property and technology financed our operations during 2001 and 2002 and enabled us to develop our traffic enforcement business.

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.

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

	Quarter Ended March 31,
		2007			2006

Financial:
Revenue	$	2,381,000		$	1,752,000
Loss from operations		(1,282,000	)		(3,237,000	)
Net loss		(1,509,000	)		(3,492,000	)
Modified EBITDA		(437,000	)		(1,811,000	)
Cash and marketable securities		1,654,000			2,400,000
Investment in capitalized systems		1,080,000			716,000
Working capital		1,637,000			(527,000	)

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.

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.

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The table below is a reconciliation of modified EBITDA to net loss for the three month period ended March 31:

	Three Months Ended March 31,
	2007				2006
GAAP net income (loss)	$	(1,509,000	)	$	(3,492,000	)
Interest expense, net of interest income		548,000			323,000
Income tax expense		---			---
Depreciation and amortization		705,000			686,000
EBITDA	$	(256,000	)	$	(2,483,000	)
Derivative instrument (income) expense		(1,329,000	)		(552,000	)
Debt discount expense		1,008,000			484,000
Stock-based compensation expense		140,000			740,000
Modified EBITDA	$	(437,000	)	$	(1,811,000	)

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

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.

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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. In the first quarter of 2007 and 2006, four and two customers, respectively, each exceeded ten percent of revenue.

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 the first quarter of 2007 and 2006 were approximately $135,000 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 period prior to fiscal 2006 and the adoption of SFAS123(R).

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.

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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.

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 cash, cash equivalents and marketable securities totaling $1,714,000 at March 31, 2007 compared with $3,010,000 at December 31, 2006. At March 31, 2007, we had working capital of $1,637,000 compared with $3,433,000 at December 31, 2006.

Our net worth at March 31, 2007 was $4,132,000 compared with $5,502,000 at December 31, 2006. The decline in cash, working capital, and net worth is primarily due to our net loss in the first quarter of $1,509,000 and investment in capitalized systems of $1,080,000 which are expected to generate revenue in future quarters.

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We continue to seek additional sources of equity and debt financing to fund operations 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 March 31, 2007, and the effect such obligations are expected to have on its liquidity and cash flow in future periods: ⁽¹⁾

Payments due in:		Operating Leases⁽¹⁾		5% Senior Convertible Notes		7% Senior Secured Convertible Notes		Debt Interest		Total
2007	$	288,000	$	---	$	---	$	1,306,000	$	1,594,000
2008		367,000		---		---		1,741,000		2,108,000
2009		367,000		2,850,000		---		1,647,000		4,864,000
2010		320,000		---		---		1,599,000		1,919,000
2011		113,000		---		22,840,000		640,000		23,593,000
Thereafter		---		---		---		---		---
	$	1,455,000	$	2,850,000	$	22,840,000	$	6,933,000	$	34,078,000

⁽¹⁾

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

The interest rate on our 7% Senior Secured Convertible Notes is subject to adjustment for certain changes in the Company’s consolidated EBITDA. If consolidated EBITDA as reported on the Company’s Quarterly Report on Form 10-Q for the fiscal quarter ending June 30, 2007 is less than $1,250,000, the interest rate will increase to 9% effective July 1, 2007. We expect consolidated EBITDA to be less than $1,250,000 million for the fiscal quarter ending June 30, 2007.

The table above does not yet reflect the potential increase to 9% beginning in the third quarter of 2007. The effect of increasing the interest rate would be an increase in interest expense by $114,000 beginning in the third quarter of 2007.

As of March 31, 2007, we have no off balance sheet arrangements.

For the three months ended March 31, 2007, we invested $1,080,000 in capitalized systems compared to $716,000 invested in capitalized systems costs 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 first quarter of 2007 were $2,381,000 as compared to $1,752,000 for the first quarter of 2006. Lease and service fee revenue grew 36% in the first quarter as our base of revenue-generating CrossingGuard red light approaches and Poliscan Speed Units increased. During the first quarter of 2007 we had 217 revenue generating CrossingGuard approaches and 11 PoliScan^speed Units as compared to 175 revenue generating CrossingGuard approaches and 6 PoliScan^speed Units in the first quarter of 2006. The average per approach/unit revenue also increased in the first quarter of 2007 due to mix. As more speed units are deployed, they generate higher per unit revenues than CrossingGuard approaches. In addition, several underperforming former Transol approaches were shut down in the first quarter of 2007.

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Cost of sales

Cost of sales for the first quarter of 2007 totaled $1,465,000 as compared to $1,351,000 for the first quarter of 2006, an increase of $114,000, or 8%. The increase in cost of sales is primarily due to increased amortization of new capitalized systems and associated direct processing and support costs for more revenue-generating red-light approaches. This was offset by cost reductions in our mature contracts. The first quarter of 2005 also included higher costs related to our Transol contracts, which we acquired in September 2005. Most depreciable Transol assets were written off as part of the impairment charge taken in the fourth quarter of 2006.

Gross Profit

Gross Profit for the first quarter of 2007 totaled $916,000 or 38% as compared to $401,000 or 23% for the first quarter of 2006, an increase of $515,000 or fifteen percentage points. The increase in gross profit is primarily attributable to higher levels of revenue, the reduction in costs on our mature contracts, and the write-off of the depreciable assets related to our Transol contracts in the fourth quarter of 2006.

Operating Expenses

In March 2006, the Company took 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 primarily affected our operating expenses. In November 2006, we instituted additional operational cost reductions in an internal reorganization intended to focus the company's operations on program delivery and support and reduce current operating expense levels. The reorganization resulted in the reduction of 27 employees, or approximately 20% of the workforce, which is expected to result in an annual payroll reduction of over $1.5 million. The cost savings of the actions taken in the fourth quarter of 2006 began to affect our financial results in the first quarter of 2007.

Total operating expenses for the first quarter of 2007 totaled $2,198,000 as compared to $3,638,000 for the first quarter of 2006, a decline of $1,440,000. The decline in operating expenses was due to (1) the above-mentioned cost reduction actions taken by the Company in the first and fourth quarters of 2006, (2) The decline in the Company’s non-cash stock compensation charges from $740,000, of which $729,000 was charged to operating expenses, in the first quarter of 2006 compared to $140,000, of which $134,000 was charged to operating expenses, in the first quarter of 2007. We continue to pursue cost containment going forward.

Engineering and operations expense for the first quarter of 2007 totaled $1,089,000 as compared to $1,198,000 in the first quarter of 2006, a decline of $109,000. These costs include the salaries and related costs of field and office personnel, as well as, operating expenses related to delivery, configuration, maintenance and service of our installed base. The decline is primarily attributable to the cost reduction actions taken in 2006 as mentioned above.

Research and development expenses for the first quarter of 2007 totaled $137,000 as compared to $482,000 in the first quarter of 2006, a decline of $345,000. The decline in research and development expenses is primarily due to the completion of our transition to digital technology in 2006 for our CrossingGuard products and the need for far lower development costs with our speed enforcement technology.

Selling and marketing expenses for the first quarter of 2007 totaled $196,000 as compared to $514,000 in the first quarter of 2006, a decline of $318,000. The decline is primarily due to the cost reduction actions taken as mentioned above. In 2006, the Company significantly increased its sales force relative to prior years. After evaluating this effort, the Company restructured its sales activities back to utilizing a smaller sales force and our existing management team to sell and promote our products and services.

General and administrative expenses for the first quarter of 2007 totaled $776,000 as compared to $1,444,000 in the first quarter of 2006, a decline of $668,000. The decline is primarily attributable to a $514,000 decline in our non-cash stock compensation charges in the first quarter of 2007 due to the completion of certain executive option vesting in the fourth quarter of 2006 on grants issued in previous years as well as a benefit taken in the quarter from the cancellation of options to employees terminated in our recent workforce reduction program. The first quarter of 2006 also included legal fees associated with our defense in an Akron Ohio lawsuit.

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Derivative instrument income (expense), net

Derivative instrument income for the first quarter of 2007 totaled $1,329,000 as compared to $552,000 for the first quarter of 2006.

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 first quarter of 2007 was 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 first quarter of 2007 totaled $1,008,000 as compared to an expense of $484,000 for the first quarter of 2006.

The increase in the quarter ending March 31, 2007 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 first quarter of 2007 totaled $548,000 as compared to $323,000 in the first quarter of 2006. The increase is primarily attributable to interest on higher levels of debt in the first quarter of 2007.

The interest rate on our 7% Senior Secured Convertible Notes is subject to adjustment for certain changes in the Company’s consolidated EBITDA. If consolidated EBITDA as reported on the Company’s Quarterly Report on 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. We expect consolidated EBITDA to be less than $1.25 million for the fiscal quarter ending June 30, 2007.

Net Income/(Loss)

Net loss for the first quarter of 2007 was $1,509,000 or 7 cents per share as compared to a net loss of $3,492,000 or 17 cents per share for the first quarter of 2006, a decline in the loss of $1,983,000 or 10 cents per share. The reduction in our net loss between the quarters was primarily attributable to (1) the increase in revenues, (2) the cost reduction actions taken in the fourth quarter of 2006, and January 2007, (3) the reduction in our non-cash stock compensation costs in the first quarter of 2007, (4) the reduction in depreciation related to our Transol contracts, and (5) the increase in non-cash derivative instrument income, offset by (5) additional debt discount amortization and 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 $60,000 at March 31, 2007, 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 March 31, 2007, we had an unrealized gain of $2,000 on securities held at March 31, 2007. 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 note payable with interest fixed at 5% and 7% through their maturity in May 2011. Interest on the 7% Senior Convertible Notes is subject to change based on the financial performance of the Company starting in the third quarter of 2007. 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 March 31, 2007. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that as of March 31, 2007, 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 March 31, 2007 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

With respect to both of the above cases, the Court certified a question to the Ohio Supreme Court:

On February 7, 2007, the Ohio Supreme Court accepted the case for determination of the question presented.

With respect to the underlying actions, discovery was complete at the time the Court certified the question to the Ohio Supreme Court.

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Item 1A. Risk Factors

Information regarding risk factors appears in “MD&A — Forward-Looking Statements” in Part I — Item 2 of this Form 10-Q and in Part I — Item 1A, “Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2006.

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

Item 5: Other Information

None

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Item 6: Exhibits

Exhibit Number Description

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: May 11, 2007	NESTOR, INC.
	(REGISTRANT)




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

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