DIGITAL RECORDERS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q

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

DIGITAL RECORDERS, INC.
(Exact name of Registrant as specified in its Charter)

5949 Sherry Lane, Suite 1050
Dallas, Texas 75225
(Address of principal executive offices, Zip Code)

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 an accelerated filer (as defined in Exchange Act Rule 12b-2): Yes ( ) No (x)

Indicate the number of shares outstanding of each of the Registrant’s classes of common stock as of November 12, 2003:


INDEX			Page No.

PART I		FINANCIAL INFORMATION
	Item 1	Financial Statements
		Consolidated Balance Sheets — September 30, 2003 (Unaudited) and December 31, 2002		3
		Consolidated Statements of Operations — Three and Nine Months Ended September 30,
		2003 and 2002 (Unaudited)		4
		Consolidated Statements of Cash Flows — Three and Nine Months Ended September 30,
		2003 and 2002 (Unaudited)		5
		Notes to Consolidated Financial Statements (Unaudited)		6
	Item 2	Management's Discussion and Analysis of Financial Condition and Results of Operations		14
	Item 3	Quantitative and Qualitative Disclosures About Market Risk		24
	Item 4	Controls and Procedures		24
PART II		OTHER INFORMATION
	Item 1	Legal Proceedings		25
	Item 2	Changes in Securities and Use of Proceeds		25
	Item 3	Defaults Upon Senior Securities		25
	Item 4	Submission of Matters to a Vote of Security Holders		26
	Item 5	Other Information		26
	Item 6	Exhibits and Reports on Form 8-K		26
SIGNATURES				28


				September 30, 2003			December 31, 2002
				(Unaudited)			(Note)

ASSETS
Current Assets
		Cash and cash equivalents		$	447,940		$	504,758
		Trade accounts receivable, less allowance for doubtful accounts of $96,529 at September 30, 2003 and $146,066 at December 31, 2002			7,354,100			10,137,955
		Other receivables			335,132			251,454
		Inventories (Note 2)			9,439,145			8,830,522
		Prepaids and other current assets			376,108			452,882

			Total current assets		17,952,425			20,177,571

Property and equipment, less accumulated depreciation of $2,000,639 at September 30, 2003 and $1,459,953 at December 31, 2002					2,257,689			1,572,259
Goodwill, less accumulated amortization of $1,125,885 at September 30, 2003 and $1,066,643 at December 31, 2002					10,082,547			8,960,396
Intangible assets, less accumulated amortization of $519,781 at September 30, 2003 and $362,922 at December 31, 2002					1,481,972			1,392,533
Deferred tax assets					518,078			865,663
Other assets					715,062			414,764

			TOTAL ASSETS	$	33,007,773		$	33,383,186

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
		Lines of credit (Note 3)		$	1,431,139		$	7,503,791
		Current maturities of long-term debt (Note 3)			1,010,550			763,360
		Accounts payable			6,432,190			7,198,962
		Accrued expenses			1,977,350			2,162,309
		Deferred tax liabilities			157,730			138,695
		Preferred stock dividends payable			109,364			88,500

			Total current liabilities		11,118,323			17,855,617

Long-term debt and other obligations, less current maturities (Notes 1 & 3)					11,039,912			7,737,940

Series AAA Mandatory Redeemable, Convertible, Nonvoting Preferred Stock, $.10 par value, Liquidation Preference of $5,000 per share; 20,000 shares authorized; 354 shares issued and outstanding at December 31, 2002 (Note 1)					—			1,770,000

Minority interest in consolidated subsidiary					356,712			267,566

Commitments and contingencies (Notes 3 and 7)
Stockholders’ Equity
		Series E Redeemable, Nonvoting, Convertible Preferred Stock, $.10 par value, Liquidation Preference of $5,000 per share; 500 shares authorized; 323 and zero shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively (Note 6)			1,372,277			—
		Series AAA Redeemable, Nonvoting Preferred Stock, $.10 par value, Liquidation Preference of $5,000 per share; 20,000 shares authorized; 354 shares issued and outstanding at September 30, 2003; redeemable at the discretion of the Company (Note 1)			1,770,000			—
	Common stock, $.10 par value, 25,000,000 and 10,000,000 shares authorized; 3,944,475 and 3,804,475 shares issued and outstanding at September 30, 2003 and December 31, 2002, respectively				394,447			380,447
		Additional paid-in capital			12,532,105			12,349,726
		Accumulated other comprehensive income — foreign currency translation			1,560,947			421,175
		Accumulated deficit			(7,136,950	)		(7,399,285	)

			Total stockholders’ equity		10,492,826			5,752,063

			TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	33,007,773		$	33,383,186

Note: The consolidated balance sheet at December 31, 2002 has been derived from the audited financial statements at that date.

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002


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

			2003			2002			2003			2002
						(As Restated						(As Restated
						Note 1)						Note 1)

Net sales			$	10,612,407		$	11,044,009		$	34,050,514		$	32,102,112
Cost of sales				6,262,212			7,295,111			20,209,804			20,602,883

	Gross profit			4,350,195			3,748,898			13,840,710			11,499,229

Operating expenses:
	Selling, general and administrative			3,591,308			3,150,542			11,130,658			9,093,949
	Research and development			241,106			516,015			1,423,066			1,916,070

		Total operating expenses		3,832,414			3,666,557			12,553,724			11,010,019

	Operating income			517,781			82,341			1,286,986			489,210

Other income (expense)				25,355			(22,516	)		58,976			(59,954	)
Foreign currency translation gain (loss)				82,137			(36,709	)		210,810			249,335
Interest expense, net				(243,556	)		(289,854	)		(832,998	)		(841,474	)

		Total other expense and interest expense		(136,064	)		(349,079	)		(563,212	)		(652,093	)

	Income (loss) before income tax expense			381,717			(266,738	)		723,774			(162,882	)
Income tax benefit (expense)				(172,721	)		29,811			(372,293	)		(54,489	)

	Income (loss) before minority interest in income of consolidated subsidiary			208,996			(236,927	)		351,481			(217,371	)
Minority interest in income of consolidated subsidiary				(39,522	)		(37,876	)		(89,146	)		(54,160	)

	Net income (loss)			169,474			(274,803	)		262,335			(271,531	)
Preferred stock dividends				(65,114	)		(44,250	)		(153,614	)		(132,750	)

	Net income (loss) applicable to common shareholders		$	104,360		$	(319,053	)	$	108,721		$	(404,281	)

Earnings per share:
	Net income (loss) per share:
		Basic	$	0.03		$	(0.08	)	$	0.03		$	(0.11	)

		Diluted	$	0.02		$	(0.08	)	$	0.03		$	(0.11	)

	Weighted average number of common shares and common equivalent shares outstanding:
		Basic		3,944,475			3,769,692			3,854,219			3,726,453

		Diluted		6,320,130			3,769,692			3,992,626			3,726,453

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002


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

			2003			2002			2003			2002
						(As Restated						(As Restated
						Note 1)						Note 1)

Cash flows from operating activities:
Net income (loss)			$	169,474		$	(274,803	)	$	262,335		$	(271,531	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
	Deferred income taxes, net			160,000			13,327			350,000			13,327
	Depreciation of property and equipment			141,525			94,823			431,529			244,720
	Amortization of intangible assets			34,897			26,298			111,011			93,103
	Other non-cash credits			(87,224	)		—			(274,681	)		—
	Minority interest			39,522			8,970			89,146			25,254
Changes in operating assets and liabilities:
	(Increase) decrease in trade accounts receivable			1,609,729			919,396			3,081,042			(350,057	)
	(Increase) decrease in other receivables			(41,990	)		(186,160	)		107,705			(199,342	)
	(Increase) decrease in inventories			(260,175	)		(183,622	)		(225,495	)		633,422
	(Increase) decrease in prepaids and other current assets			31,590			(254,008	)		94,635			(407,018	)
	(Decrease) in accounts payable			(840,288	)		(770,185	)		(873,816	)		(371,581	)
	(Decrease) in accrued expenses			(87,228	)		(187,160	)		(334,559	)		(74,578	)

		Net cash provided by (used in) operating activities		869,832			(793,124	)		2,818,852			(664,281	)

Cash flows from investing activities:
	Purchases of property and equipment			(463,550	)		(107,531	)		(988,639	)		(549,673	)
	Other			(97,441	)		15,874			(461,563	)		(538	)

		Net cash used in investing activities		(560,991	)		(91,657	)		(1,450,202	)		(550,211	)

Cash flows from financing activities:
	Proceeds from bank borrowings and lines of credit			10,472,011			13,908,965			35,842,667			24,604,605
	Principal payments on bank borrowings and lines of credit			(11,335,447	)		(12,805,921	)		(37,997,324	)		(22,517,990	)
	Proceeds from issuance of Series E preferred stock			1,100,000			—			1,540,000			—
	Payments related to issuance of Series E preferred stock			(133,355	)		—			(242,723	)		—
	Payment of dividends on preferred stock			(44,250	)		(44,250	)		(132,750	)		(132,750	)

		Net cash provided by (used in) financing activities		58,959			1,058,794			(990,130	)		1,953,865

Effect of exchange rate changes on cash and cash equivalents				(58,718	)		(16,202	)		(435,339	)		(831,117	)

Net increase (decrease) in cash and cash equivalents				309,082			157,811			(56,819	)		(91,744	)
Cash and cash equivalents at beginning of period				138,858			261,164			504,759			510,719

Cash and cash equivalents at end of period			$	447,940		$	418,975		$	447,940		$	418,975

Supplemental Disclosure of Cash Flow Information:
	Cash paid during the period for interest		$	312,290		$	303,929		$	834,422		$	780,650

	Cash paid during the period for income taxes		$	—		$	6,815		$	43,374		$	40,886

Supplemental disclosure of non-cash investing and financing activities:
	Exchange of preferred stock for reduction in trade payables		$	75,000		$	—		$	75,000		$	—

	Issuance of common stock for reduction in trade payables		$	—		$	300,000		$	—		$	300,000

	Exchange of common stock for reduction in long-term debt		$	—		$	—		$	350,000		$	—

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements

The unaudited interim consolidated financial statements and related notes of Digital Recorders, Inc. and Subsidiaries (the “Company” or “DRI”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted pursuant to such rules and regulations. However, in the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting only of normal recurring accruals) and information considered necessary to present fairly the results for the interim periods presented.

The accompanying consolidated financial statements and related notes should be read in conjunction with the Company’s audited financial statements included in its Annual Report on Form 10-K/A for the year ended December 31, 2002. The results of operations for the three and nine months ended September 30, 2003 are not necessarily indicative of the results to be expected for the full calendar year. As previously discussed in Note 20 to the Consolidated Financial Statements in the Annual Report on Form 10-K/A for the year ended December 31, 2002, the results of operations and cash flows for the three and nine months ended September 30, 2002 have been restated from the previously reported amounts.

On March 6, 2003, the Series AAA Preferred Stock shareholders approved an amendment to the Articles of Incorporation to remove the December 31, 2003 mandatory redemption date. As a result, the Series AAA Preferred Stock has been reclassified as equity in the accompanying consolidated balance sheet at September 30, 2003.

The Company’s asset-based line of credit with Guaranty Business Credit Corporation (“GBCC”) was reclassified from a short- to long-term obligation at September 30, 2003 due to securing a long-term asset-based facility with LaSalle Business Credit, LLC on November 6, 2003, prior to issuance of the financial statements. The new line of credit has a due date of November 15, 2006. (See “Note 3 — New Credit Facility,” “Note 8 — Subsequent Events,” and “Financing Activities in 2003.”)

Mobitec AB, the Company’s wholly owned Swedish subsidiary, has an agreement with its bank in Sweden from which it may currently borrow up to a maximum of 10,000,000 krona (SEK) or $1,301,000. At September 30, 2003, 9,741,376 krona (SEK), or $1,267,354 was outstanding, resulting in additional borrowing availability of 258,624 krona (SEK), or $33,646. The maximum borrowing in the amount of 10,000,000 krona (SEK) is secured by cash on deposit with the bank in the amount of 2,200,000 krona (SEK), or $286,220. The terms of this agreement require payment of an unused credit line fee equal to 0.5 percent of the unused portion and interest at 5 percent of the outstanding balance. This agreement is secured by substantially all assets of Mobitec AB. The line of credit agreement has an expiration date of December 31, 2003. On or before expiration, the Company expects to renew this credit agreement with an agreement substantially similar in terms and conditions.

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements — Continued

Mobitec AB also has an agreement with the same bank from which it may borrow up to 6,000,000 krona (SEK), or $780,600. Based upon the availability formula under this agreement, 1,258,918 krona (SEK), or $163,785 was outstanding at September 30, 2003, resulting in additional borrowing availability of 4,741,082 krona (SEK), or $616,815. The line of credit bears interest at 5.1 percent and is collateralized by accounts receivable. The agreement has an expiration date of December 31, 2003. On or before expiration, the Company expects to renew this credit agreement with an agreement substantially similar in terms and conditions.

Lines of credit at September 30, 2003 and December 31, 2002 consist of the following:


		September 30,			December 31,
		2003			2002

Credit line with Guaranty Business Credit Corporation, dated August 23, 1999, payable in full August 23, 2003, extended through November 21, 2003, secured by accounts receivable, inventory and all assets of the U.S. based domestic entities of the Company.		$	-	*	$	6,489,729
Line of credit with Swedish bank due December 31, 2003, secured by assets of the Swedish subsidiary, Mobitec AB, and a cash deposit, with interest at 5% annually.			1,267,354			862,110
Line of credit with Swedish bank due December 31, 2003 secured by accounts receivable of the Swedish subsidiary, Mobitec AB, with interest at 5.1% annually.			163,785			151,952

	Total lines of credit	$	1,431,139		$	7,503,791

Reclassified as a long-term obligation due to the expiration date of the Company’s new credit facility executed on November 6, 2003 being more than one year from the balance sheet date.

Long-term debt consists of the following line of credit, notes and obligations, the proceeds of which were used to finance the Mobitec acquisition and for working capital requirements.

On November 6, 2003, the Company replaced its asset-based lending agreement formerly with Guaranty Business Credit Corporation (“GBCC”) with a three year agreement (the “Credit Agreement”) with LaSalle Business Credit LLC (“LBC”). At November 6, 2003, the Credit Agreement provided up to $10.0 million in borrowing to be used for acquisitions, working capital and general corporate purposes. The borrowing is inclusive of $2.0 million for Letters of Credit and $0.5 million for term loans. The interest rate on loans under this agreement is the published prime lending rate (4.00 percent at November 6, 2003) plus 1 percent. There is a fee equal to 2.5 percent on the aggregate undrawn face amount of all Letters of Credit outstanding. At November 6, 2003, available collateral based on the value of eligible trade accounts receivable and inventories was $5,202,859 which, given the outstanding debt balance under this agreement of $3,684,070, resulted in additional borrowing availability of $1,518,789. The outstanding debt under this agreement is secured by substantially all U.S.-based assets of the Company.

The Credit Agreement includes customary covenants and conditions relating to the conduct and operation of the Company’s business. Specifically, the Credit Agreement subjects the Company to an escalating fixed charge coverage ratio from 1.0 to 1.5 and an escalating tangible net worth value (as defined) from $2.5 million to $3.9 million over the term of the agreement calculated on a quarterly and rolling 12 month basis; and limits annual capital expenditures to $1.5 million.

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements — Continued

The Company had an asset-based lending agreement (the “Prior Credit Agreement”) with Guaranty Business Credit Corporation (“GBCC”). At September 30, 2003, the Prior Credit Agreement provided up to $11.75 million in borrowing to be used for acquisitions, working capital and general corporate purposes. The working capital (accounts receivable and inventory) borrowing portion of the agreement was limited at September 30, 2003 to a combined maximum limit of $6.75 million. The interest rate on the revolving credit portion of the agreement was the published prime lending rate (4.00 percent at September 30, 2003) plus 1.75 percent. Credit extended for acquisitions bore an interest rate of prime (4.00 percent at September 30, 2003) plus 2 percent. At September 30, 2003, available collateral based on the value of eligible trade accounts receivable and inventories was $5,124,527 which, given the outstanding debt balance under this agreement of $4,031,007, resulted in additional borrowing availability of $1,093,520. The outstanding debt under this agreement was secured by substantially all U.S.-based assets including the assets of the Company’s subsidiaries. The Prior Credit Agreement was to expire August 23, 2003 but was extended for an additional 90 days to November 21, 2003 to allow additional time to secure new financing. The Company replaced this asset based line on November 6, 2003 with a long-term agreement substantially similar in terms and conditions. (See Note 3 — New Credit Facility, Note 8— Subsequent Events and “Financing Activities in 2003” in Item 2 below).

As amended, the Prior Credit Agreement with GBCC included customary covenants and conditions relating to the conduct and operation of the Company’s business. Specifically, as amended, the Prior Credit Agreement limited the payment of dividends upon any class of stock to $177,000 annually, subjected the Company to a 1:1 Earnings Before Interest, Taxes, Depreciation and Amortization to interest coverage ratio to be calculated upon a quarterly and year-to-date basis and limited annual capital expenditures to $25,000 for individual transactions and $250,000 in aggregate. In addition, over advances were permitted under the agreement up to $400,000 and acquisitions required approval from the lender. At September 30, 2003, the Company was in compliance with all agreement covenants except for the capital expenditure covenant. Due to the close proximity of the loan expiration date and pending new financing, GBCC did not require the Company to secure a waiver for this covenant violation.

An unsecured note in the amount of $1,765,235 and obligation in the amount of $295,000 are due a shareholder. On June 26, 2003, the Company and the shareholder agreed to: (1) convert $350,000 of the original note, which was issued June 28, 2001, was payable in full June 28, 2004 and had a balance of $2,111,235, to common stock and (2) extend the due date on the remaining note balance of $1,761,235 to June 28, 2005. The note, as amended, requires three incrementally increasing quarterly payments beginning July 1, 2004 in the amounts of $50,000, $75,000 and $100,000 with the remaining balance in the amount of $1,536,235 due June 28, 2005. The unsecured note has an annual interest rate of nine (9%) percent paid annually increasing to ten (10%) percent beginning July 1, 2004. The obligation balance of $295,000 at September 30, 2003 is non interest bearing and is due in full June 30, 2004.

A term loan from a Swedish bank dated June 28, 2001 having a balance of 13,200,000 krona (SEK), or $1,718,398, at September 30, 2003 is payable in 12 remaining quarterly payments of 1,100,000 krona (SEK), or $143,110, at an annual interest rate of 5.35 percent and is secured by stock of the Company’s Swedish holding company, DRI Europa AB, and its consolidated subsidiary, Mobitec AB.

Two convertible subordinated debentures in the amount of $3,000,000 dated June 22, 2001 and $1,150,000 dated July 31, 2002, collectively the “Renaissance Notes”, are payable to two investment funds managed by Renaissance Capital Group, Inc. The president of Renaissance Capital Group, Inc. is a member of the Company’s Board of Directors. The $3,000,000 debenture is payable in full on June 28, 2008, if not sooner redeemed or converted, with annual interest at 8 percent paid monthly. It also provides for monthly principal redemption installments commencing June 27, 2004, each of such installments to be in the dollar amount of ten dollars ($10) per thousand dollars ($1,000) of the then remaining principal amount. The $1,150,000 debenture is payable in full on July 31, 2008, if not sooner redeemed or converted, with annual interest at 8 percent paid monthly. It also provides for monthly principal redemption installments commencing July 31, 2004, each of such installments to be in the dollar amount of ten dollars ($10) per thousand dollars ($1,000) of the then remaining principal amount. The loan agreement under which the convertible debenture was issued subjects the Company to a 1:1 Earnings Before Interest, Depreciation and Amortization to interest coverage ratio to be

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements — Continued

calculated quarterly on a rolling four quarter basis and a 1.3:1 current ratio to be calculated at each quarter end. The Company was in compliance with all agreement covenants at September 30, 2003.

A convertible subordinated debenture in the amount of $250,000 dated August 26, 2002, is payable to a stockholder and member of the Board of Directors, and is due in full August 26, 2008, if not sooner redeemed or converted, with annual interest at 8 percent paid monthly. It also provides for monthly principal redemption installments commencing August 26, 2004, each of such installments to be in the dollar amount of ten dollars ($10) per thousand dollars ($1,000) of the then remaining principal amount. The loan agreement under which the convertible debenture was issued subjects the Company to a 1:1 Earnings Before Interest, Depreciation and Amortization to interest coverage ratio to be calculated quarterly on a rolling four quarter basis and a 1.3:1 current ratio to be calculated at each quarter end. The Company was in compliance with all agreement covenants at September 30, 2003.

Long-term debt at September 30, 2003 and December 31, 2002 consists of the following:


		September 30,			December 31,
		2003			2002

Credit line with Guaranty Business Credit Corporation, dated August 23, 1999, payable in full August 23, 2003, extended through November 21, 2003, secured by accounts receivable, inventory and all assets of the U.S. based domestic entities of the Company		$	4,031,007	*	$	—
Unsecured note to a stockholder, dated June 28, 2001, payable in full June 28, 2005, with interest at 9% annually			1,761,235			2,111,235
Unsecured obligation to a stockholder dated June 28, 2001, payable in 12 quarterly installments having commenced on September 30, 2001, without interest			295,000			360,000
Note payable to a Swedish bank, dated June 28, 2001, payable in 20 quarterly installments having commenced September 30, 2001 of $143,110 including interest at 5.35% annually. Note collateralized by stock of Company’s Swedish holding company and its consolidated subsidiary			1,718,398			1,763,050
Convertible debentures dated June 22, 2001, payable in full June 22, 2008, with interest at 8% annually			2,829,000	**		2,802,000	***
Convertible debentures dated July 31, 2002, payable in full July 31, 2008, with interest at 8% annually			1,150,000			1,150,000
Convertible debenture dated August 26, 2002, payable in full August 26, 2008, with interest at 8% annually			250,000			250,000

	Total long-term debt		12,034,640			8,436,285
	Less current maturities		1,010,550			763,360

			11,024,090			7,672,925
	Long-term portion of capital lease		15,822			65,015

		$	11,039,912		$	7,737,940

Reclassified as a long-term obligation due to the expiration date of the new agreement with LaSalle Business Credit being more than one year from the balance sheet date.

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements — Continued

Comprehensive income for the three and nine months ended September 30, 2003 and 2002 consists of the following:

The Company has two principal business segments, which are based upon differences in products and technology: (1) transportation communications segment, and (2) law enforcement and surveillance segment. The transportation communications segment produces products sold worldwide within the passenger information communications industry and market. The Company transacts its sales with transportation vehicle equipment customers generally in two broad categories. The first category consists of end customers including: (1) municipalities; (2) regional transportation districts; (3) federal, state, and local departments of transportation; (4) transit agencies; (5) public, private, or commercial operators of such vehicles; and (6) rental car agencies. The second category consists of Original Equipment Manufacturers (“OEM”) of those vehicles listed in the first category. The law enforcement and surveillance segment serves customers in the U.S. federal, state, and local law enforcement agencies or organizations, as well as their counterparts abroad.

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements — Continued

Operating income (loss) for each segment is total sales less operating expenses applicable to the segment. Certain corporate overhead expenses including executive salaries and benefits, public company administrative expenses, legal and audit fees, and interest expense are not included in segment operating income (loss). Segment identifiable assets include accounts receivable, inventories, net property and equipment, net intangible assets and net goodwill. Sales, operating income (loss), identifiable assets, capital expenditures, long-lived assets, depreciation and amortization, and geographic information for the operating segments are as follows:


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

		2003			2002			2003			2002

Net sales
	Transportation communications	$	10,395,741		$	10,715,822		$	32,855,071		$	31,027,697
	Law enforcement and surveillance		216,666			328,187			1,195,443			1,074,415

		$	10,612,407		$	11,044,009		$	34,050,514		$	32,102,112

Income (loss) from operations
	Transportation communications	$	1,629,050		$	1,073,255		$	4,334,835		$	3,024,633
	Law enforcement and surveillance		(28,025	)		(19,675	)		214,725			21,118
	Parent entities		(1,083,244	)		(971,239	)		(3,262,574	)		(2,556,541	)

		$	517,781		$	82,341		$	1,286,986		$	489,210

Depreciation and amortization
	Transportation communications	$	100,322		$	74,907		$	312,058		$	196,687
	Law enforcement and surveillance		30,829			5,619			89,608			17,729
	Parent entities		45,271			40,595			140,874			123,407

		$	176,422		$	121,121		$	542,540		$	337,823

Capital expenditures
	Transportation communications	$	444,792		$	16,896		$	835,015		$	149,361
	Law enforcement and surveillance		16,173			14,261			127,386			319,798
	Parent entities		2,585			76,374			26,238			80,514

		$	463,550		$	107,531		$	988,639		$	549,673

Geographic information — net sales
	NAFTA	$	7,076,833		$	6,942,662		$	20,604,040		$	21,113,646
	Europe		2,604,202			3,360,105			11,093,528			8,525,721
	Pacific and other		931,372			741,242			2,352,946			2,462,745

		$	10,612,407		$	11,044,009		$	34,050,514		$	32,102,112


		September 30, 2003			December 31, 2002

Identifiable assets
	Transportation communications	$	30,408,691		$	29,440,853
	Law enforcement and surveillance		2,058,763			2,144,347
	Parent entities		540,319			1,797,986

		$	33,007,773		$	33,383,186

Long-lived assets
	Transportation communications	$	12,996,763		$	10,748,888
	Law enforcement and surveillance		1,381,481			1,224,509
	Parent entities		159,026			366,555

		$	14,537,270		$	12,339,952

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements — Continued

During the second quarter of 2003, the Company began issuing pursuant to private placements shares of Series E Redeemable, Nonvoting, Convertible Preferred Stock (“Series E Stock”). The Series E Stock is convertible at any time into shares of the Company’s common stock at a conversion price of $3.00 per share of common stock, subject to certain adjustments, and, prior to conversion, does not entitle the holders to any voting rights, except as may be required by law. The Company does not have the right to require conversion. Holders of Series E Stock are entitled to receive cumulative quarterly dividends when, and if declared by the Board of Directors, at the rate of 7% per annum on the liquidation value of $5,000 per share. Series E Stock is redeemable at the option of the Company at any time, in whole or in part, at a redemption price equal to the liquidation value plus accrued and unpaid dividends. Holders of Series E Stock do not have the right to require redemption. As of September 30, 2003, the Company had issued 323 shares and raised $1,372,277 net of offering costs of $242,723. The Company has used the funds to pay down debt and for other general purposes.

On or about September 17, 2002 the Company received a letter from Clever Devices, Ltd, a New York corporation with principal place of business located in Syosset, New York (“Clever”). That letter alleged that the StealthMic product of Digital Recorders, Inc. (“the Company”), as introduced to the market in 1999, would infringe U.S. patent number 6,522,754 (“’754 patent”) entitled “Digital Vehicle Microphone System and Method,” which was issued to Clever by the U.S. Patent Office on February 18, 2003. Upon investigation, and further review by intellectual property counsel of the Company, the Company and its intellectual property counsel were unable to find any basis whatsoever for this allegation of infringement and so informed Clever on several occasions. Nevertheless, Clever proceeded to assert its position without being willing to engage in constructive dialogue to identify the basis for its allegations or to advance understanding of the issues. Therefore, being uncertain as to the intent of Clever, on April 3, 2003 the Company filed in the United States District Court for the Northern District of Texas, Dallas Division (“Court”), an action under the Federal Declaratory Judgment Act, 28 USC 2210 and 2201, and under the Patent Laws of the United States, 35 USC 271. This “declaratory judgment action” seeks a finding by the Court to the effect that the Company is not infringing the 754 patent. On May 23, 2003 Clever counter claimed seeking injunctive relief and unspecified damages. Subsequently, the Company filed further action with the Court asking that a hearing on claims construction, referred to as a “Markman” hearing, be held prior to any other actions or discovery in this matter. On August 19, 2003, the Court issued an order so requiring and a Markman hearing is now scheduled for February 3, 2004. Further, that action by the Court also requires that, pending the completion of the Markman hearing, all other discovery be placed on hold.

The Company, to the best of its ability at all times, seeks to avoid infringing and will not knowingly violate the intellectual property rights of others. The Company firmly believes that the allegations of Clever are totally without merit and will proceed to defend its rights to freely conduct business while not infringing the legitimate intellectual property rights of Clever.

On November 6, 2003, the Company entered into a Loan and Security Agreement with LaSalle Business Credit, LLC, pursuant to which the Company received a three-year senior secured $10 million revolving credit facility (the “New Credit Facility”). Borrowings under the New Credit Facility will bear interest at LaSalle Bank’s publicly announced prime rate plus one (1%) percent and will be secured by substantially all the assets of the Company’s domestic operations. The Company immediately borrowed $3,584,070 under the New Credit Facility to fully retire the outstanding debt under its then existing senior line of credit with Guaranty Business Credit Corporation, which line of credit was terminated. Available borrowings under the New Credit Facility will be used for acquisitions, working capital and general corporate purposes in connection with the Company’s domestic operations. See Note 3(b), “Long-Term Debt — New Credit Facility.”

DIGITAL RECORDERS, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements — Continued

On November 6, 2003, the Company closed the sale of 300 shares of Series F Convertible Preferred Stock (“Series F Stock”), par value $.10 to Dolphin Offshore Partners, L.P. (“Dolphin”) for a purchase price of $1.5 million. The Series F Stock is convertible at any time into shares of the Company’s common stock at a conversion price of $2.35 per share of common stock, subject to certain adjustments, which was the market price of the Company’s common stock at the time the parties reached agreement on terms, prior to conversion, the Series F Stock votes as a single class with holders of common stock on an as-if-converted basis. The shares are mandatorily convertible into common stock if the Company’s common stock hits certain targeted trading prices or upon the conversion of certain subordinated debentures previously issued by the Company (two investment funds managed by Renaissance Capital Group, Inc. — See Note 3(b) “Long-Term Debt — Other Long-Term Debt).” Dividends are not payable on the Series F Stock for the first five years after issuance. If certain trading price targets are not met by the Company’s common stock within five years after issuance, the conversion price will be reduced and dividends will thereafter begin to accrue and be payable quarterly on the Series F Stock at the rate of 10% per annum on the liquidation value (initially, $1.5 million, or $5,000 per share). The Series F Stock is not redeemable at the option of holder, and is redeemable by the Company only if and when dividends begin to accrue. In connection with the sale of the Series F Stock to Dolphin, the Company issued warrants (the “Dolphin warrants”) to Dolphin to purchase 319,149 shares of the Company’s common stock at an exercise price of $3.00 per share, subject to certain adjustments. The Dolphin warrants are exercisable at any time for a period of seven years after issuance. The Company also granted to Dolphin a right of first refusal to purchase, in connection with future equity offerings by the Company, for a period of five years after the Series F issuance date, a sufficient number of the securities issued in such equity offering to maintain its proportionate ownership interest in the Company, on a diluted basis. The Company also granted to Dolphin certain rights to have the shares of common stock underlying the Series F Stock and issuable upon the exercise of the Dolphin warrants registered with the Securities and Exchange Commission. Pursuant to the registration rights agreement, the conversion price of the Series F Stock and the exercise price of the Dolphin warrants are subject to being decreased if the Company does not file appropriate registration statements or cause such registration statements to be declared effective by certain dates. In connection with the issuance of the Series F preferred Stock and the associated warrants, the Company will record during the fourth quarter a charge against income available for common shareholders based upon the relative fair values of the stock and warrants. At this date the fair value determination has not been completed.

Subsequent to September 30, 2003, the Company issued in private placements an additional 85 shares of Series E Stock and redeemed 50 shares of Series E Stock. The proceeds to the Company of such transactions, net of redemption costs and offering expenses in the amount of approximately $14,000, was approximately $161,000. The Company has used these additional Series E proceeds to pay down debt and for other general corporate purposes. See Note 6, “Preferred Stock,” for a description of the terms of the Series E Stock and issuances prior to September 30, 2003.

The Series E Stock and the Series F Stock have equal priority with respect to liquidation, and shares of both series have liquidation preferences prior to the Company’s outstanding shares of Series AAA Preferred Stock and common stock.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS AND THE RELATED NOTES THAT ARE IN ITEM 1 OF THIS DOCUMENT.

Directly or through contractors, we design, manufacture, sell, and service information technology and audio surveillance technology products through two major business segments. These two business segments are: (1) the transportation communications segment; and (2) the law enforcement and surveillance segment. While service is a significant aspect of our marketing strategy, it is not yet a material generator of revenue and has been approximately one percent to two percent of net sales in prior periods.

Our transportation communications segment produces products sold worldwide within the passenger information communication industry and market. We transact our sales with transportation vehicle equipment customers generally in two broad categories. Those categories are end customers including (1) municipalities; (2) regional transportation districts; (3) federal, state, and local departments of transportation; (4) transit agencies; (5) public, private, or commercial operators of such vehicles; (6) rental car agencies; and (7) Original Equipment Manufacturers (“OEM”) of those vehicles. The relative percentage of sales to end customers as compared to OEM customers varies widely and frequently from period-to-period and within the products and product lines comprising our mix of total revenue in any given period.

Our law enforcement and surveillance segment serves customers in the U.S. federal, state, and local law enforcement agencies or organizations, as well as their counterparts abroad. We produce a line of digital audio filter systems and tape transcribers used to improve the quality and intelligibility of both live and recorded voices. We market our law enforcement and surveillance products domestically and internationally to law enforcement entities and other customers in support of government organizations.

Sales to our customers are characterized by a lengthy sales cycle that generally extends for a period of two to 24 months. In addition, purchases by a majority of our customers are dependent upon federal, state and local funding that may vary from year to year and quarter to quarter.

We recognize product revenue upon shipment of products to customers and service revenue upon completion of the service. Because our operations are characterized by significant expenses preceding product introduction and shipment, certain related period expenses such as deferred engineering may not be recorded in the same period thereby producing fluctuations in operating results. Our dependence upon large contracts and orders, as well as upon a small number of relatively large customers or projects, increases the magnitude of fluctuations in operating results particularly on a period-to-period, or period-over-period, comparison basis.

Our significant accounting policies and methods used in the preparation of the unaudited consolidated financial statements are discussed in Notes 1 and 3 of the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K/A. The following is a listing of the Company’s critical accounting policies:

The following discussion provides an analysis of our results of operations and liquidity and capital resources. This should be read in conjunction with our unaudited consolidated financial statements and related notes thereto. The operating results of the periods presented were not significantly affected by inflation.

The following table sets forth the percentage of our revenues represented by certain items included in our Statements of Operations:


NOTE: 2002 INFORMATION MUST USE M&P RESTATED DATA

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

			2003			2002			2003			2002

Net sales				100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales				59.0			66.1			59.4			64.2

	Gross profit			41.0			33.9			40.6			35.8

Operating expenses:
	Selling, general and administrative			33.8			28.5			32.7			28.3
	Research and development			2.3			4.7			4.2			6.0

		Total operating expenses		36.1			33.2			36.9			34.3

	Operating income			4.9			0.7			3.7			1.5
Other expense, foreign currency translation and interest				(1.3	)		(3.2	)		(1.7	)		(2.0	)

	Income (loss) before income tax expense			3.6			(2.5	)		2.0			(0.5	)
Income tax (expense) benefit				(1.6	)		0.3			(1.1	)		(0.2	)

	Income (loss) before minority interest in income of consolidated subsidiary			2.0			(2.2	)		0.9			(0.7	)
Minority interest in income of consolidated subsidiary				(0.4	)		(0.3	)		(0.3	)		(0.2	)

Net income (loss)				1.6	%		(2.5	)%		0.6	%		(0.9	)%

COMPARISON OF OUR RESULTS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

Our net sales for the three months ended September 30, 2003 decreased $431,602, or 3.9 percent, from $11,044,009 for the three months ended September 30, 2002 to $10,612,407 for the three months ended September 30, 2003. Our gross profit for the three months ended September 30, 2003 increased $601,297, or 16.0 percent, from $3,748,898 for the three months ended September 30, 2002 to $4,350,195 for the three months ended September 30, 2003. Following is a discussion of these changes in net sales and gross profit by segment.

For the three months ended September 30, 2003, sales for our transportation communications segment decreased $320,081, or 3.0 percent; from $10,715,822 for the three months ended September 30, 2002 to $10,395,741 for the three months ended September 30, 2003. The net revenue decrease in this segment resulted primarily from a decrease in international sales of $535,735 offset partially by an increase in domestic sales of $215,654. The decrease in international sales is primarily attributed to the decrease in sales in the Scandinavian markets due to delays in expected customer shipments resulting from contract renegotiations between an OEM and its end user. The increase in domestic sales is primarily attributed to the shift in customer contracts and orders between periods. The shift results from some transit authorities requesting earlier deliveries and others postponing deliveries. Product prices on sales of products, which comprise a majority of our revenue, have declined due to competition in the three months ended September 30, 2003 as compared to the prior year. Sales growth in the transportation communications segment will continue to be dependent upon the development of new products and technology, as well as our expansion into new geographic areas. We believe our relatively high existing market share precludes significant sales growth from additional market share.

Our transportation communications segment gross profit for the three months ended September 30, 2003 increased $676,288, or 19.3 percent, from $3,499,017 for the three months ended September 30, 2002 to $4,175,305 for the three months ended September 30, 2003. As a percentage of segment sales, our gross profit was 40.2 percent of our net segment sales for the three months ended September 30, 2003 as compared to 32.7 percent during the three months ended September 30, 2002. Of the $676,288 net increase in gross profit, $781,748 was attributed to the domestic operations and a decrease of $105,460 attributed to international operations. The average gross margins improved for the three months ended September 30, 2003 as compared to the same period a year ago due to lower material costs of products and systems sold plus an increase of higher margin product sales, primarily in the domestic operations. The Company has implemented cost savings programs including in-house manufacturing and assembly of certain component parts, volume purchasing, re-work of certain stock inventory for current orders and improvement in component and

system designs. The Company expects to realize the continued gross margin improvements in future periods. We believe continued improvement in our gross profit percentage is dependent upon overall economic and competitive conditions in the transportation sector, introduction of new technology products, and the continued success of our on-going cost reduction programs.

For the three months ended September 30, 2003, sales for our law enforcement and surveillance segment decreased $111,521, or 34.0 percent, from $328,187 for the three months ended September 30, 2002 to $216,666 for the three months ended September 30, 2003. The decrease is primarily attributed to various U.S. Federal Government orders that were delayed during the quarter.

Our segment gross profit for the three months ended September 30, 2003 decreased $73,990 or 29.7 percent, from $248,881 for the three months ended September 30, 2002 to $174,891 for the three months ended September 30, 2003. As a percentage of segment sales, our gross profit was 80.7 percent of our net segment sales for the three months ended September 30, 2003 as compared to 76.1 percent during the three months ended September 30, 2002. The average gross margins increased for the three months ended September 30, 2003 as compared to the same period a year ago as a product mix of higher margin products was sold during the period. We believe improvement in our gross profit percentage is dependent upon overall economic and competitive conditions in the law enforcement and surveillance sector, introduction of new technology products, and the continued success of our on-going cost reduction programs.

Our selling, general and administrative expenses for the three months ended September 30, 2003 increased $440,766, or 14.0 percent, from $3,150,542 for the three months ended September 30, 2002 to $3,591,308 for the three months ended September 30, 2003. The majority of this increase was due to general increases in compensation and benefits plus higher expense for legal and audit, depreciation and amortization. As a percentage of our sales, these expenses increased 5.3 percent from 28.5 percent for the three months ended September 30, 2002 to 33.8 percent for the three months ended September 30, 2003. While our selling, general and administrative expenses may increase in future periods due to: (1) expansion into other geographic areas; (2) expansion through acquisition; (3) continued weakening of the U.S. dollar when translating from foreign currencies; and (4) introduction of new products and services, management believes these expenses will decrease as a percentage of our sales in future periods.

Our research and development expenses for the three months ended September 30, 2003 decreased $274,909, or 53.3 percent, from $516,015 for the three months ended September 30, 2002 to $241,106 for the three months ended September 30, 2003. This category of expenses includes internal engineering personnel and outside engineering expense for software and hardware development, sustaining product engineering and new product development. As a percentage of net sales, these expenses decreased from 4.7 percent for the three months ended September 30, 2002 to 2.3 percent for the three months ended September 30, 2003. Certain engineering personnel were used in the development of software and other expense was incurred that met the capitalization criteria of SFAS No. 86, “Capitalization of Software Development Costs” during the three months ended September 30, 2003. In addition, the Company capitalized the development costs for the new DR600 vehicle logic control unit introduced during the three months ended September 30, 2003. The total amount of personnel and other expense capitalized in the three months ended September 30, 2003 was $353,901 as compared to $184,162 for the three months ended September 30, 2002. In the longer term, we expect research and development expenditures, including capitalized amounts, to be in the general range of approximately 4 to 7 percent as a percentage of sales.

The net change in our operating income for the three months ended September 30, 2003 was an increase of $435,440 from operating income of $82,341 for the three months ended September 30, 2002 to operating income of $517,781 for the three months ended September 30, 2003. This increase is primarily due to decreased cost of sales from cost reduction programs implemented in the Transportation Communications Segment.

Our total other expense for the three months ended September 30, 2003 was $136,064, a net decrease in expense of $213,015 as compared to $349,079 for the three months ended September 30, 2002. This decrease was primarily due to lower interest expense ($243,556 for 2003 as compared to $289,854 in 2002) and increases of other income of $25,355 in 2003 as compared to other expense of $22,516 in 2002. In the three months ended September 30, 2003, the Company recorded net favorable foreign currency exchange gains in the amount of $82,137 as compared to net unfavorable foreign currency exchange losses of $36,709 for the three months ended September 30, 2002. The decrease in interest expense was primarily due to the decrease in the weighted average outstanding balance of long-term debt and lower revolver debt

The Company is subject to income tax in domestic federal and state jurisdictions as well as the foreign countries in which it has operations. Our income tax expense of $172,271 for the quarter ended September 30, 2003 was primarily the result of domestic taxable income. Our income tax benefit of $29,811 for the quarter ended September 30, 2002 was primarily the result of foreign taxable losses. Our income tax expense and benefit for both periods varies from the customary relationship primarily due to foreign losses in one jurisdiction for which the income tax benefits are not likely to be realized.

COMPARISON OF OUR RESULTS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002

Our net sales for the nine months ended September 30, 2003 increased $1,948,402 or 6.1 percent, from $32,102,112 for the nine months ended September 30, 2002 to $34,050,514 for the nine months ended September 30, 2003. Our gross profit for the nine months ended September 30, 2003 increased $2,341,481, or 20.4 percent, from $11,499,229 for the nine months ended September 30, 2002 to $13,480,710 for the nine months ended September 30, 2003. Following is a discussion of these changes in net sales and gross profit by segment.

For the nine months ended September 30, 2003, sales for our transportation communications segment increased $1,827,374 or 5.9 percent; from $31,027,697 for the nine months ended September 30, 2002 to $32,855,071 for the nine months ended September 30, 2003. The net revenue growth in this segment resulted from an increase in international sales of $2,071,333 and a decrease in domestic sales of $243,959. The increase in international sales is primarily attributed to increases in sales in the Scandinavian and German markets. The decrease in domestic sales is primarily attributed to the shift in contracts to subsequent periods. Product prices on sales of products, which comprise a majority of our revenue, have declined due to competition in the nine months ended September 30, 2003 as compared to the prior year. Sales growth in the transportation communications segment will continue to be dependent upon the development of new products and technology, as well as our expansion into new geographic areas. We believe our relatively high existing market share precludes significant sales growth from additional market share.

Our transportation communications segment gross profit for the nine months ended September 30, 2003 increased $2,271,185, or 21.3 percent, from $10,676,168 for the nine months ended September 30, 2002 to $12,947,353 for the nine months ended September 30, 2003. As a percentage of segment sales, our gross profit was 39.4 percent of our net segment sales for the nine months ended September 30, 2003 as compared to 34.4 percent during the nine months ended September 30, 2002. Of the $2,271,185 net increase in gross profit, $1,148,262 was attributed to the international operations and $1,122,923 attributed to domestic operations. The average gross margins improved for the nine months ended September 30, 2003 as compared to the same period a year ago due to lower material costs of products and systems sold plus an increase of higher margin product sales, primarily in international operations. The Company has implemented cost savings programs including in-house manufacturing and assembly of certain component parts, volume purchasing; re-work of certain stock inventory for current orders and improvement in component and system designs. The Company expects to realize the continued gross margin improvements in future periods. We believe continued improvement in our gross profit percentage is dependent upon overall economic and competitive conditions in the transportation sector, introduction of new technology products, and the continued success of our on-going cost reduction programs.

For the nine months ended September 30, 2003, sales for our law enforcement and surveillance segment increased $121,028, or 11.3 percent, from $1,074,415 for the nine months ended September 30, 2002 to $1,195,443 for the nine months ended September 30, 2003. The increase is primarily attributed to higher U.S. Federal Government orders shipped in the first quarter of 2003.

Our segment gross profit for the nine months ended September 30, 2003 increased $70,297 or 8.5 percent, from $823,061 for the nine months ended September 30, 2002 to $893,358 for the three months ended September 30, 2003. As a percentage of segment sales, our gross profit was 74.7 percent of our net segment sales for the nine months ended September 30, 2003 as compared to 76.6 percent during the nine months ended September 30, 2002. The average gross margins declined for the nine months ended September 30, 2003 as compared to the same period a year ago as new products have a higher content of material costs including additional costs incurred for third party turn-key components. We believe improvement in our gross profit percentage is dependent upon overall economic and competitive conditions in the law enforcement and surveillance sector, introduction of new technology products, and the continued success of our on-going cost reduction programs.

Our selling, general and administrative expenses for the nine months ended September 30, 2003 increased $2,036,709, or 22.4 percent, from $9,093,949 for the nine months ended September 30, 2002 to $11,130,658 for the nine months ended September 30, 2003. A significant amount of this increase was attributed to foreign currency fluctuations between the two periods in our Swedish and German operations. This increase was also attributed to general increases in compensation and benefits plus higher expense for legal and audit, depreciation and amortization, and tax advisory services. As a percentage of our sales, these expenses increased 4.4 percent from 28.3 percent for the nine months ended September 30, 2002 to 32.7 percent for the three months ended September 30, 2003. While our selling, general and administrative expenses may increase in future periods due to: (1) expansion into other geographic areas; (2) expansion through acquisition; (3) continued weakening of the U.S. dollar when translating from foreign currencies; and (4) introduction of new products and services, management believes these expenses will decrease as a percentage of our sales in future periods.

Our research and development expenses for the nine months ended September 30, 2003 decreased $493,005, or 25.7 percent, from $1,916,070 for the nine months ended September 30, 2002 to $1,423,066 for the nine months ended September 30, 2003. This category of expenses includes internal engineering personnel and outside engineering expense for software and hardware development, sustaining product engineering and new product development. As a percentage of net sales, these expenses decreased from 6.0 percent for the nine months ended September 30, 2002 to 4.2 percent for the nine months ended September 30, 2003. Certain engineering personnel were used in the development of software and other expense was incurred that met the capitalization criteria of SFAS No. 86, “Capitalization of Software Development Costs” during the nine months ended September 30, 2003. The total amount of personnel and other expense capitalized in the nine months ended September 30, 2003 was $620,590 as compared to $259,353 for the nine months ended September 30, 2002. In the longer term, we expect research and development expenditures, including capitalized software, to be in the general range of approximately 4 to 7 percent as a percentage of sales.

The net change in our operating income for the nine months ended September 30, 2003 was an increase of $797,776 from operating income of $489,210 for the nine months ended September 30, 2002 to operating income of $1,286,986 for the nine months ended September 30, 2003. This increase is primarily due to increased sales revenues in both operating segments and lower cost of materials due to cost savings programs implemented in the Transportation Communications Segment partially offset by increases in personnel and other operating expenses.

Our total other expense for the nine months ended September 30, 2003 was $563,212, a net decrease in expense of $88,881 when compared to $652,093 for the nine months ended September 30, 2002. This decrease was primarily due to lower interest expense ($832,998 for 2003 as compared to $841,474 in 2002) and other income of $58,976 in 2003 as compared to other expense of $59,954 in 2002. In the nine months ended September 30, 2003, the Company recorded net favorable foreign currency exchange gains in the amount of $210,810 as compared to net favorable foreign currency exchange gains of $249,335 for the nine months ended September 30, 2002. The decrease in interest expense was primarily due to the decrease in the average outstanding balance of long-term debt and lower revolver debt.

The Company is subject to income tax in domestic federal and state jurisdictions as well as the foreign countries in which it has operations. Our income tax expense of $372,293 for the nine months ended September 30, 2003 was primarily the result of domestic taxable income. Our income tax expense of $54,489 for the nine months ended September 30, 2002 was primarily the result of foreign taxable income. Our income tax expense for the nine months ended September 30, 2003 varies from the customary relationship primarily due to foreign losses in one jurisdiction for which the income tax benefits are not likely to be realized. The income tax expense for the nine months ended September 30, 2002 varies from the customary relationship primarily due to foreign losses in one jurisdiction for which the income tax benefits are not likely to be realized that were offset by a favorable $75,000 reduction in the Company’s deferred tax asset valuation reserve.

The Company’s net working capital as of September 30, 2003 was $6,834,102 compared to $2,321,954 as of December 31, 2002. The increase in net working capital in the amount of $4,512,148 is due primarily to the classification of our line of credit with Guaranty Business Credit Corporation from a current- to a long-term obligation. The Company’s asset-based line was to expire August 23, 2003 but was extended for an additional 90 days to November 21, 2003 to allow additional time to secure new financing. The Company replaced its asset based line on November 6, 2003 with a long-term agreement substantially similar in terms and conditions. See Note 8 — Subsequent Events and “Financing Activities in 2003” below. Substantially all of our assets are pledged as security for various elements of long- and short-term debt described below.

Our principal sources of liquidity from current assets included cash and cash equivalents of $447,940, trade and other receivables of $7,689,232, inventories of $9,439,145 and prepaid and other current assets of $376,108. Liquidity required for current liabilities included short-term bank and asset based borrowings of $1,431,139, accounts payable of $6,432,190, accrued expenses of $1,977,350, and current maturities of long-term debt, deferred tax liabilities and dividends payable of $1,010,550, $157,730 and $109,364, respectively.

Operating activities provided cash of $869,832 and $2,818,852 for the three and nine months ended September 30, 2003 compared to cash used of ($793,124) and ($664,281) for the three and nine months ended September 30, 2002.

For the three months ended September 30, 2003, primary sources of cash from operations resulted from net income of $169,474 and decreases in trade receivables and prepaids and other current assets totaling $1,641,319. Primary uses of cash for the three months ended September 30, 2003 resulted from an increase in other receivables and inventories and decreases in trade accounts payable and accrued expenses totaling $1,229,681. The balance of cash provided by operating activities totaling $288,720 resulted from non-cash credits and expenses for deferred taxes, depreciation, amortization, minority interest and other non-cash credits in the amounts of $160,000, $141,525, $34,897, $39,522 and ($87,224), respectively.

For the three months ended September 30, 2002 primary sources of cash from operations resulted from decreases in trade accounts receivable in the amount of $919,396. Primary uses of cash for the three months ended September 30, 2003 resulted from a net loss of $274,803 and increases in other receivables, inventories and prepaids and other current assets in the amount of $623,790. Additional uses of cash during the period resulted from decreases in trade accounts payable and accrued expenses in the amounts of $770,185 and $187,160, respectively. The balance of cash provided by operating activities totaling $143,418 resulted from non-cash expenses for deferred taxes, depreciation, amortization and minority interest in the amounts of $13,327, $94,823, $26,298 and $8,970, respectively. The Company’s working capital requirements will continue to increase with growth in our sales.

Investing activities used cash of $560,991 and $1,450,202 for the three and nine months ended September 30, 2003, respectively. For the three and nine months ended September 30, 2003, the primary uses of cash were for expenditures relating to capitalized software; purchases of computer, test and office equipment; and for deferred development and financing costs. We do not anticipate any significant change in expenditures for or sales of capital equipment in the near future.

Financing activities provided cash in the amount of $58,959 for the three months ended September 30, 2003 and used cash of $990,130 for the nine months ended September 30, 2003.

Sources of cash for the three months ended September 30, 2003 were from short-term bank borrowings in the amount of $10,472,011 and from the issuance of Series E preferred stock net of issuance cost in the amount of $966,665. Uses of cash for the period were for repayment of short-term borrowings and payment of dividends in the amount of $11,335,447 and $44,250, respectively.

Sources of cash for the nine months ended September 30, 2003 were from short-term bank borrowings in the amount of $35,842,667 and from the issuance of Series E preferred stock net of issuance costs in the amount of $1,372,277. Uses of cash for the period were for repayment of short- and long-term borrowings and payment of dividends in the amount of $37,997,324 and $132,750, respectively.

Short-term debt consists of the following lines of credit which are used for working capital requirements.

Mobitec AB, the Company’s wholly owned Swedish subsidiary, has an agreement with its bank in Sweden from which it may currently borrow up to a maximum of 10,000,000 krona (SEK) or $1,301,000. At September 30, 2003, 9,741,376 krona (SEK), or $1,267,354 was outstanding, resulting in additional borrowing availability of 258,624 krona (SEK), or $33,646. The maximum borrowing in the amount of 10,000,000 krona (SEK) is secured by cash on deposit with the bank in the amount of 2,200,000 krona (SEK), or $286,220. The terms of this agreement require payment of an unused credit line fee equal to 0.5 percent of the unused portion and interest at 5 percent of the outstanding balance. This agreement is secured by substantially all assets of Mobitec AB. The line of credit agreement has an expiration date of December 31, 2003. Upon expiration, the Company expects to renew this credit agreement with an agreement substantially similar in terms and conditions.

Mobitec AB also has an agreement with the same bank from which it may borrow up to 6,000,000 krona (SEK), or $780,600. Based upon the availability formula under this agreement, 1,258,918 krona (SEK), or $163,785 was outstanding at September 30, 2003, resulting in additional borrowing availability of 4,741,082 krona (SEK), or $616,815. The line of credit bears interest at 5.1 percent and is collateralized by accounts receivable. The agreement has an expiration date of December 31, 2003. Upon expiration, the Company expects to renew this credit agreement with an agreement substantially similar in terms and conditions.

Long-term debt consists of the following line of credit, notes and obligations, the proceeds of which were used to finance the Mobitec acquisition and for working capital requirements.

An unsecured note in the amount of $1,765,235 and obligation in the amount of $295,000 are due a shareholder. On June 26, 2003, the Company and the shareholder agreed to: (1) convert $350,000 of the original note, which was issued June 28, 2001, was payable in full June 28, 2004 and had a balance of $2,111,235, to common stock and (2) extend the due date on the remaining note balance of $1,761,235 to June 28, 2005. The note, as amended, requires three incrementally increasing quarterly payments beginning July 1, 2004 in the amounts of $50,000, $75,000 and $100,000 with the remaining balance in the amount of $1,536,235 due June 28, 2005. The unsecured note has an annual interest rate of 9 percent paid quarterly and increases to 10 percent beginning July 1, 2004. The obligation balance of $295,000 at September 30, 2003 is non interest bearing and is due in full June 30, 2004.

Two convertible subordinated debentures in the amount of $3,000,000 dated June 22, 2001 and $1,150,000 dated July 31, 2002, collectively the (“Renaissance Notes,”) are payable to two investment funds managed by Renaissance Capital Group, Inc. The president of Renaissance Capital Group, Inc. is a member of the Company’s Board of Directors. The $3,000,000 debenture is payable in full on June 28, 2008, if not sooner redeemed or converted, with annual interest at 8 percent paid monthly. It also provides for monthly principal redemption installments commencing June 27, 2004, each of such installments to be in the dollar amount of ten dollars ($10) per thousand dollars ($1,000) of the then remaining principal amount. The $1,150,000 debenture is payable in full on July 31, 2008, if not sooner redeemed or converted, with annual interest at 8 percent paid monthly. It also provides for monthly principal redemption installments commencing July 31, 2004, each of such installments to be in the dollar amount of ten dollars ($10) per thousand dollars ($1,000) of the then remaining principal amount. The loan agreement under which the convertible debenture was issued subjects the Company to a 1:1 Earnings Before Interest, Depreciation and Amortization to interest coverage ratio to be calculated quarterly on a rolling four quarter basis and a 1.3:1 current ratio to be calculated at each quarter end. The Company was in compliance with all agreement covenants at September 30, 2003.

(a)

During the second quarter of 2003, the Company began issuing pursuant to private placements shares of Series E Redeemable, Nonvoting, Convertible Preferred Stock. As of November 11, 2003, the Company had sold a net 358 shares to 23 private investors for an aggregate purchase price of $1.79 million. See Part II, Item 2, “Changes in Securities and Use of Proceeds,” for a description of the terms of the Series E Stock. The Company has used the proceeds of its sale of Series E stock, after payment of offering expenses, to pay down debt and for other general purposes.

(b)

On March 6, 2003, the Company announced that at a special meeting of the Series AAA Preferred Stock shareholders, the holders of the Series AAA Preferred Stock approved an amendment to the Articles of Incorporation to remove the mandatory redemption date, which would have been in December 2003. The Company may now redeem the Series AAA Preferred Stock at its sole discretion upon providing preferred shareholders with appropriate written notice. Had the holders of the Series AAA Preferred Stock not approved the amendment, the Company would have to pay the redemption price, which is equal to the liquidation preference, in December 2003. The liquidation preference equals $5,000 per share, plus all accrued and unpaid dividends, which at December 31, 2002 was $1,858,500.

(c)

On June 26, 2003, the Company and a shareholder, who held an unsecured promissory note of the Company, agreed to: (1) convert $350,000 of the note, which was issued June 28, 2001, was payable in full June 28, 2004 and had a balance of $2,111,235, to common stock and (2) extend the due date on the remaining note balance of $1,761,235 to June 28, 2005. The note requires three incrementally increasing quarterly payments beginning July 1, 2004 in the amounts of $50,000, $75,000 and $100,000 with the remaining balance in the amount of $1,536,235 due June 28, 2005. The unsecured note has an annual interest rate of nine (9%) percent paid annually increasing to ten (10%) percent beginning July 1, 2004.

(d)

On November 6, 2003, the Company entered into a Loan and Security Agreement with LaSalle Business Credit, LLC, pursuant to which the Company received a three-year senior secured $10 million revolving credit facility (the “New Credit Facility”). Borrowings under the New Credit Facility will bear interest at LaSalle Bank’s publicly announced prime rate plus one (1%) and will be secured by substantially all the assets of the Company’s domestic operations. The Company immediately borrowed $3,684,070 under the New Credit Facility to fully retire the outstanding debt under its then existing senior line of credit with Guaranty Business Credit Corporation, which line of credit was terminated and pay closing costs. Available borrowings under the New Credit Facility will be used for acquisitions, working capital and general corporate purposes in connection with the Company’s domestic operations.

(e)

On November 6, 2003, the Company closed the sale of 300 shares of Series F Convertible Preferred Stock (“Series F Stock”), par value $.10, to Dolphin Offshore Partners, L.P. (“Dolphin”) for a purchase price of $1.5 million. See Note 8 — Subsequent Events, for a description of the transaction with Dolphin and the terms of the Series F Stock.

We believe that inflation has not had a material impact upon our results of operations for each of our periods in the three and nine months ended September 30, 2003 and 2002. However, there can be no assurance that future inflation would not have an adverse impact upon our future operating results and financial condition.

Certain portions of this report on Form 10-Q which do not relate to historical financial information may be deemed to constitute forward-looking statements that are subject to various factors which could cause actual results to differ materially from our expectations or from results which might be projected, forecast, estimated or budgeted by us in such forward looking statements.

Federal funding in the U.S. is an important part of the overall funding of purchase and operation of transit equipment for most of our U.S. customers. This funding is provided in the Transportation Equity Act for the 21st Century (“TEA 21”), which is administered by the U.S. Department of Transportation. TEA 21 expires this year. Reauthorization legislation is underway but passage may or may not occur this federal fiscal year; further, it is not presently possible to forecast the likely outcome of this legislation although it is the position and belief of the industry trade association (American Public Transportation Association, or “APTA” (http://www.apta.com)) that not only will reauthorization occur, but further that an increase in funding is likely. Interim funding for the federal programs was authorized, at prior year funding levels, on a short-term basis pending emergence of the anticipated long-term reauthorization. While there can be no absolute assurance that any of this legislative action will materialize to continue federal funding of purchase and operation of transit equipment for most of our U.S. customers, we believe that the necessary legislative action will occur as has generally been the case in various forms for more than the past ten years. We also believe, consistent with APTA, that ultimately an increase in this funding is likely.

Additional factors include, but are not limited to, those listed below and under the heading “Forward-Looking Statements” below:

•

General economic conditions

•

Dependence on suppliers

•

International activities

•

Fluctuations in operating results

•

Governmental legislation

•

Technological changes and product transitions

•

Product development activities

•

Financing

For a more detailed discussion of these additional factors, please see “Factors Affecting Our Business and Prospects” in Item 7 of our Annual Report on Form 10-K/A for the year ended December 31, 2002.

The statements contained in this Report on Form 10-Q herein that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, hopes, beliefs, goals, objectives, intentions or strategies regarding the future. Forward-looking statements include statements utilizing words such as “anticipate”, “expect”, “believe”, “plan”, “expect” or “project” relating to our beliefs with respect to future events and includes statements regarding: (1) our expectations that the percentage of buses with automatic voice systems will increase over the next few years, our belief that future acquisitions, new relationships and pilot projects may enable us to accelerate growth, our expectation that we will be able to integrate certain licensed technologies into our products, our commitment to continued enhancement of all of our products, our expectation that certain products will continue to be enhanced and that such enhancements should increase our ability to integrate those products with other technologies, and our belief that a convergence of core technologies, combined with other factors, will justify high levels of research and development costs; and (2) our belief that continued sales growth depends upon expansion of new products, technology and geographic territories, our belief that investing expenditures will not change significantly in 2003 and our belief that a combination of borrowing under our Credit Facility and new equity will provide necessary liquidity and capital to satisfy our needs. It is important to note our actual results could differ materially from those contemplated in our forward-looking statements as a result of various factors, including those described in Item 2, Management’s Discussion and Analysis under the caption “Factors Affecting Our Business and Prospects”. Among other factors, our results will be affected, perhaps materially, by general economic conditions, the availability of national government assistance to local transportation authorities, the adoption and implementation of regulations concerning public transportation services, the plans and prospects of competitors, currency fluctuations and our ability to attract and retain personnel.

We are subject to certain risks arising from transactions in the normal course our business and from debt instruments. Such risk is principally associated with interest rate and foreign exchange fluctuations. Our market risk exposure at September 30, 2003 is consistent with, and not greater than; the types of market risk and amount of exposures presented in our Annual Report on Form 10-K/A for the year ended December 31, 2002.

As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There was no change in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

On or about September 17, 2002 the Company received a letter from Clever Devices, Ltd, a New York corporation with principal place of business located in Syosset, New York (“Clever”). That letter alleged that the StealthMic product of Digital Recorders, Inc. (“the Company”), as introduced to the market in 1999, would infringe U.S. patent number 6,522,754 (“’754 patent”) entitled “Digital Vehicle Microphone System and Method,” which was issued to Clever by the U.S. Patent Office on February 18, 2003. Upon investigation, and further review by intellectual property counsel of the Company, the Company and its intellectual property counsel were unable to find any basis whatsoever for this allegation of infringement and so informed Clever on several occasions. Nevertheless, Clever proceeded to assert its position without being willing to engage in constructive dialogue to identify the basis for its allegations or to advance understanding of the issues. Therefore, being uncertain as to the intent of Clever, on April 3, 2003 the Company filed in the United States District Court for the Northern District of Texas, Dallas Division (“Court”), an action under the Federal Declaratory Judgment Act, 28 USC 2210 and 2201, and under the Patent Laws of the United States, 35 USC 271. This “declaratory judgment action” seeks a finding by the Court to the effect that the Company is not infringing the 754 patent. On May 23, 2003, Clever counter claimed seeking injunctive relief and unspecified damages. Subsequently, the Company filed further action with the Court asking that a hearing on claims construction, referred to as a “Markman” hearing, be held prior to any other actions or discovery in this matter. On August 19, 2003, the Court issued an order so requiring and a Markman hearing is now scheduled for February 3, 2004. Further, that action by the Court also requires that, pending the completion of the Markman hearing, all other discovery be placed on hold.

The Company, to the best of its ability at all times, seeks to avoid infringing and will not knowingly violate the intellectual property rights of others. We firmly believe that the allegations of Clever are totally without merit and will proceed to defend our rights to conduct business freely while not infringing the legitimate intellectual property rights of Clever.

During the second quarter of 2003, the Company began issuing pursuant to private placements shares of Series E Redeemable Nonvoting, Convertible, Preferred Stock (Series E Stock). As of September 30, 2003, the Company had sold 323 shares of the Series E Stock for an aggregate purchase price of $1,615,000. Of those shares, 235 were issued and sold to 23 private investors during the quarter ended September 30, 2003, for an aggregate purchase price $1,175,000. Series E Stock is convertible at any time into shares of the Company’s common stock at a conversion price of $3.00 per share of common stock, subject to certain adjustments, and, prior to conversion, does not entitle the holders to any voting rights, except as may be required by law. The Company does not have the right to require conversion. Holders of Series E Stock are entitled to receive cumulative quarterly dividends when, and if declared by the Board of Directors, at the rate of 7 percent per annum on the liquidation value of $5,000 per share. Series E Stock is redeemable at the option of the Company at any time, in whole or in part, at a redemption price equal to the liquidation value plus accrued and unpaid dividends. Holders of Series E Stock do not have the right to require redemption.

Series E Stock ranks superior to the Company’s Series AAA Preferred Stock and common stock with respect to liquidation, dissolution, or winding up of the Company. The right of holders of Series E Stock to receive dividends, as described above, is in preference to the payment of any dividends to holders of Series AAA Preferred Stock or common stock of the Company.

The offer and sale of the shares of Series E Stock by the Company were exempt from registration under the Securities Act of 1933 pursuant to Rule 506 of Regulation D or otherwise under Section 4(2) of that Act as transactions not involving any public offering. Each purchaser of such shares was an “accredited investor” as defined in Regulation D.

The Company has used the proceeds from its sale of Series E Stock, net of offering expenses, to pay down debt and for other general corporate purposes.

On October 4, 2003 the Company received a letter of resignation from Director Joseph Tang. Mr. Tang, formerly an executive with Lite Vision Corporation, served on the Board of Directors of the Company since 1998. He is not an officer or employee of the Company. Mr. Tang’s resignation letter noted that his resignation was necessary because his new business and personal focus “requires my direct attention,” and not because of any disagreement with the Company relating to its operations, policies or practices or any other matter. The Company has no immediate plans to fill the Board position vacated by Mr. Tang.

The following documents are filed herewith or have been included as exhibits to previous filings with the Securities and Exchange Commission and are incorporated herein by this reference:


Exhibit No.		Document

	3.1	Articles of Incorporation of the Company (1)





	3.2	Articles of Amendment to the Articles of Incorporation of the Company (2)





	3.3	Articles of Amendment to Articles of Incorporation containing Certificate of Designation of Series E Redeemable Nonvoting Convertible Preferred Stock of Digital Recorders, Inc. (3)





	3.4	Articles of Amendment to Articles of Incorporation containing Certificate of Designation of Series F Convertible Preferred Stock of Digital Recorders, Inc. (3)










	31.1	Section 302 Certification of David L. Turney (filed herewith)





	31.2	Section 302 Certification of Lawrence A. Taylor (filed herewith)





	32.1	Section 906 Certification of David L. Turney (filed herewith)





	32.2	Section 906 Certification of Lawrence A. Taylor (filed herewith)

During the quarter ended September 30, 2003, the Company filed the following Current Reports on Form 8-K:

Current Report on Form 8-K dated July 14, 2003 reporting under Item 9. Regulation FD Disclosure and Item 12—Results of Operations and Financial Condition, that Digital Recorders, Inc. issued a news release on July 14, 2003 announcing the Company’s preliminary results for its second quarter, ended June 30, 2003, a copy of which is posted on the Company’s Web site.

Current Report on Form 8-K dated August 14, 2003 reporting under Item 12—Results of Operations and Financial Condition, that Digital Recorders, Inc. issued a news release on August 14, 2003 announcing the Company’s results for its second quarter, ended June 30, 2003, a copy of which is posted on the Company’s Web site.

Current Report on Form 8-K dated September 17, 2003 reporting under Item 9. Regulation FD Disclosure, that Digital Recorders, Inc. issued a news release on September 17, 2003 announcing the Company’s three-year Teaming Agreement with GE Transportation Systems Global Signaling, LLC, a copy of which is posted on the Company’s Web site.

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.


North Carolina		56-1362926

(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification Number)


Common Stock, Par Value $.10 per share		3,944,475

(Class of Common Stock)		Number of Shares


	CONSOLIDATED BALANCE SHEETS
	CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
	CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
	Notes to Unaudited Consolidated Financial Statements
	ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
PART II — OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
	ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
	ITEM 3. DEFAULTS UPON SENIOR SECURITIES
	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
	ITEM 5. OTHER INFORMATION
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
EX-31.1 Section 302 Certification
EX-31.2 Section 302 Certification
EX-32.1 Section 906 Certification
EX-32.2 Section 906 Certification


	September 30,		December 31,
	2003		2002

Raw materials and system components	$	8,036,213	$	7,237,385
Work in process		101,049		148,105
Finished goods		1,301,883		1,445,032

	$	9,439,145	$	8,830,522


Signature:		/S/ DAVID L. TURNEY

By: Title: Date:		David L. Turney Chairman of the Board, Chief Executive Officer and President (Principal Executive Officer) November 11, 2003

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Common Stock, $.10 Par Value (Title of Each Class)		The NASDAQ SmallCap Market^SM Boston Stock Exchange, Inc. (Name of Each Exchange on Which Registered)


Exhibit No.		Document

Legend

	(1)	Incorporated by reference from Exhibit to our Registration Statement on Form SB-2 (SEC File No. 33-82870-A)





	(2)	Incorporated by reference from our Form 10-KSB dated March 31, 1997.





	(3)	Incorporated by reference from exhibits filed with the Company’s Report on Form 8-K, filed on November 12, 2003.


Signature:		/S/ LAWRENCE A. TAYLOR

By: Title: Date:		Lawrence A. Taylor Chief Financial Officer, Secretary, and Principal Financial and Accounting Officer November 11, 2003