FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

OR

Commission File Number: 1-13408

DIGITAL RECORDERS, INC.
(Name of business issuer in its charter)

4018 Patriot Drive, Suite 100
Durham, North Carolina 27703
(Address of Principal Executive Offices)

(919) 361-2155
(Issuer’s Telephone Number)

Securities Registered Pursuant to Section 12(b) of the Exchange Act:

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE EXCHANGE ACT: NONE

Check whether the issuer:     (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes | X |    No | _ |

APPLICABLE ONLY TO CORPORATE ISSUERS

State the number of shares outstanding of each of the issuer’s classes of common equity
Common stock: 3,704,475 shares outstanding as of August 12, 2002

Index to Consolidated Financial Statements

PART I FINANCIAL INFORMATION

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DIGITAL RECORDERS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

Note: The balance sheet at 12/31/2001 has been derived from the audited financial statements at that date.
See accompanying notes to consolidated financial statements.

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DIGITAL RECORDERS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2002 AND 2001

See accompanying notes to consolidated financial statements.

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DIGITAL RECORDERS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THREE AND SIX MONTHS ENDED JUNE 30, 2002 AND 2001

See accompanying notes to consolidated financial statements.

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DIGITAL RECORDERS, INC. AND SUBSIDIARIES

Notes to Consolidated Financial Statements — (Unaudited)

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We directly or through contractors 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.

Our transportation communications segment produces products sold worldwide within the passenger information communication industry and market. Sales are transacted with transportation vehicle equipment customers, including: (1) municipalities; (2) regional transportation districts; (3) federal, state, and local departments of transportation; (4) transit agencies; (5) vehicle manufacturers; and (6) public, private, or commercial operators of those vehicles. Our transportation communications segment consists of the following groups:

Our law enforcement and surveillance segment consists of one wholly owned subsidiary, Digital Audio Corporation in Raleigh, N.C. We acquired Digital Audio Corporation in 1995. This subsidiary serves customers in the U.S. federal, state, and local law enforcement agencies or organizations, as well as their counterparts abroad. It produces a line of digital audio filter systems and tape transcribers used to improve the quality and intelligibility of both live and recorded voices. It also produces other covert surveillance, collection and analytical equipment. We market these 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 on federal, state and local funding that may vary from year to year and quarter to quarter. These factors may contribute to significant period over period fluctuations in revenue. We attribute our sales growth in this segment to strategic acquisitions, introduction of new products, increased market penetration, competitive prices, strong customer service and growing markets for our products.

We recognize revenue upon shipment of products to customers. Because our operations are characterized by significant research and development expenses preceding product introduction, net sales and certain related expenses may not be recorded in the same period, thereby producing fluctuations in operating results. Our dependence on large contracts and orders, as well as on 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.

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

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Results of Operations

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

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Comparison of Three Months Ended June 30, 2002 and 2001

Our net sales for the quarter ended June 30, 2002 increased $3,965,116, or 46.8%, from $8,469,339 in 2001 to $12,434,455 in 2002. The increase was the result of 2002 Mobitec (which was acquired June 27, 2001) sales for the current quarter and higher domestic sales in the transportation communications segment.

For the quarter ended June 30, 2002, sales for our transportation communications segment increased $3,930,249, or 48.2 percent, from $8,148,969 in 2001 to $12,079,218 in 2002. Of this increase, $2,781,398 was generated from higher 2002 sales of Mobitec over the prior year. The remaining sales increase of $1,148,851 reflects higher shipments in our domestic transportation communications segment. Sales growth in the transportation communications segment will continue to be dependent upon the expansion of new products and technology, as well as our expansion into new geographic areas. Certain product prices have declined moderately in the second quarter of 2002 as compared to the same period last year due to competition. As noted above, we frequently have a long lead-time between when our customers express an interest in our products and an actual order, manufacture and shipment of the product. The efforts we expend in any given period to acquire new customers and sell our products may not translate into additional sales until future periods.

Our gross profit for the quarter ended June 30, 2002 was $4,661,101, an increase of $1,430,303, or 44.3 percent, as compared to our gross profit of $3,230,798 in 2001. As a percentage of sales, our gross profit was 37.5 percent of our net sales in 2002 as compared to 38.1 percent during 2001. Mobitec contributed $1,267,894 of the increase in gross profit for the second quarter. The remaining domestic increase in gross profit was $162,409 despite lower margins of the domestic transportation communications segment. We believe improvement in our gross profit percentage is dependent upon overall economic and competitive conditions in the transportation sector, introduction of new technology products, and on-going cost reduction programs.

Our selling, general and administrative expenses during the quarter ended June 30, 2002 were $3,241,127, an increase of $997,045, or 44.4 percent, as compared to $2,244,082 for such expenses during 2001. Mobitec accounted for $1,022,637 of additional cost over the prior year quarter. As a percentage of our sales, these expenses decreased from 26.5 percent in 2001 to 26.1 percent in 2002. Management believes that these expenses will decrease slightly as a percentage of our sales in future quarters as the existing level of personnel will be able to meet the demands of higher sales revenues.

Our research and development expenses for the quarter ended June 30, 2002 were $713,560, an increase of $110,827, or 18.4 percent, as compared to such expenses of $602,733 in 2001. As a percentage of net sales, these expenses decreased from 7.1 percent in 2001 to 5.7 percent in 2002. The increase in total dollars was primarily related to the addition of Mobitec. This category of expenses includes internal engineering personnel and outside engineering expense for software and hardware development, sustaining product engineering and new product development. We intend to hold these expenses in the 7 percent to 9 percent range as a percentage of sales to support our continued product development.

The net change in our operating results for the quarter ended June 30, 2002 was an increase of $322,431 from income of $383,983 in 2001 to $706,414 in 2002. This increase was due primarily to the factors set forth above.

Our total other expense for the quarter ended June 30, 2002 was $302,697, a net increase in expense of $179,370 as compared to $123,327 for 2001. This increase was primarily the result of higher interest expense due to an increase in long-term debt resulting from our acquisition of Mobitec and increased short-term borrowings.

Our net income tax benefit was $53,843 for the quarter ended June 30, 2002, as compared with the income tax expense of $54,156 for the quarter ended June 30, 2001. In both periods income tax expense in certain foreign jurisdictions was offset by income tax benefits in certain domestic jurisdictions. The income tax benefit for the quarter ended June 30, 2002 also was favorably impacted by $75,000 for a reduction in the valuation allowance for certain deferred tax assets that were realized during the period.

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Comparison of Six Months Ended June 30, 2002 and 2001

Our net sales for the six months ended June 30, 2002 increased $5,607,790, or 36.3%, from $15,450,313 in 2001 to $21,058,103 in 2002. The increase was the result of 2002 Mobitec (which was acquired June 27, 2001) sales for the current period and higher domestic sales in the transportation communications segment.

For the six months ended June 30, 2002, sales for our transportation communications segment increased $5,535,522, or 37.5 percent, from $14,776,353 in 2001 to $20,311,875 in 2002. Of this increase, $5,591,607 was generated from higher 2002 sales of Mobitec over the prior year. Sales growth in the transportation communications segment will continue to be dependent upon the expansion of new products and technology, as well as our expansion into new geographic areas. We believe our relatively high market share positions held by the company in most markets preclude significant sales growth from increased market share. Certain product prices have declined moderately in the first half of 2002 as compared to the same period last year due to competition. As noted above, we frequently have a long lead-time between when our customers express an interest in our products and an actual order, manufacture and shipment of the product. The efforts we expend in any given period to acquire new customers and sell our products may not translate into additional sales until future periods.

Our gross profit for the six months ended June 30, 2002 was $7,750,331, an increase of $1,958,120, or 33.8 percent, as compared to our gross profit of $5,792,211 in 2001. As a percentage of sales, our gross profit was 36.8 percent of our net sales in 2002 as compared to 37.5 percent during 2001. Mobitec contributed $2,484,339 of the increase in gross profit for 2002. This was offset by a decrease of $526,219 due to lower margins of the domestic transportation communications segment that occurred primarily in the first quarter of 2002. We believe improvement in our gross profit percentage is dependent upon overall economic and competitive conditions in the transportation sector, introduction of new technology products, and on-going cost reduction programs.

Our selling, general and administrative expenses during the six months ended June 30, 2002 were $6,067,949, an increase of $1,887,708, or 45.2 percent, as compared to $4,180,241 for such expenses during 2001. Mobitec contributed $1,890,580 of additional cost over the prior year quarter. As a percentage of our sales, these expenses increased from 27.1 percent in 2001 to 28.8 percent in 2002. Despite this increase for the six month period, management believes that these expenses will decrease slightly as a percentage of our sales in future quarters as the same level of personnel will be able to meet the demands of higher sales revenues.

Our research and development expenses for the six months ended June 30, 2002 were $1,400,055, an increase of $261,920, or 23 percent, as compared to such expenses of $1,138,135 in 2001. As a percentage of net sales, these expenses decreased from 7.3 percent in 2001 to 6.7 percent in 2002. The increase in total dollars was primarily related to Mobitec. This category of expenses includes internal engineering personnel and outside engineering expense for software and hardware development, sustaining product engineering and new product development. We intend to hold these expenses in the 7 percent to 9 percent range as a percentage of sales to support our continued product development.

The net change in our operating results for the six months ended June 30, 2002 was a decrease of $191,508 from income of $473,835 in 2001 to $282,327 in 2002. This decrease was due primarily to the factors set forth above.

Our total other expense for the six months ended June 30, 2002 was $589,059, a net increase in expense of $327,045 as compared to $262,014 for 2001. This increase was primarily the result of higher interest expense due to an increase in long-term debt resulting from our acquisition of Mobitec and increased short-term borrowings.

Our net income tax benefit was $38,138 for the six months ended June 30, 2002, as compared with income tax expense of $54,156 for the six months ended June 30, 2001. In both periods income tax expense in certain foreign jurisdictions was offset by income tax benefits in certain domestic jurisdictions. The income tax benefit for the six months ended June 30,2002 also was favorably impacted by $75,000 for a reduction in the valuation allowance for certain deferred tax assets that were realized during the period.

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Liquidity and Capital Resources

As of June 30, 2002, our principal sources of liquidity included cash and cash equivalents of $261,162, trade accounts receivable of $9,745,883, inventories of $8,427,503, short-term bank borrowings of $1,139,499, and trade accounts payable of $7,448,872, providing the Company with net working capital of $8,096,390. Substantially all of the assets are pledged as security for various elements of the long-term debt described below.

Our operating activities provided cash of $32,180 and $875,063 during the quarters ended June 30, 2002 and 2001, respectively. For the quarter ended June 30, 2002, the operating income of $441,107 and decrease in inventories $558,499 was offset by an increase in accounts receivable of $1,362,715. For the quarter ended June 30, 2001, the increase in accounts receivable of $322,610 was offset by the operating profit of $202,195, the increase in accounts payable of $364,772 and decrease in other assets of $418,393. Working capital requirements will increase with growth in our sales, primarily due to the time span between when we must pay our suppliers and the time we receive payment from our customers.

Our investing activities used cash of $31,207 and $5,419,877 for the quarters ended June 30, 2002 and 2001, respectively. The primary use of cash for the prior year related to the purchase of Mobitec.

Our financing activities generated net cash of $84,639 and $5,684,140 during the quarters ended June 30, 2002 and 2001, respectively. The primary cash provided for the prior year related to the proceeds obtained for the acquisition of Mobitec.

The Company has an asset-based lending agreement (the “Credit Agreement”) with Guarantee Business Credit Corporation that expires August 22, 2003. At June 30, 2002, the Credit Agreement provided up to $11.25 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 June 30, 2002 to a combined maximum limit of $6.25 million. On July 10, 2002, the Credit Agreement was amended to provide up to $11.75 million in borrowing with the working capital portion increasing to $6.75 million. The interest rate on the revolving credit portion of the agreement is the published prime lending rate plus 1.75 percent. Credit extended for acquisitions bears an interest rate of prime plus 2 percent. Outstanding debt under this agreement at June 30, 2002 was $5,900,315. The period ending available collateral based on the value of eligible trade accounts receivable and inventories was $6,378,377, resulting in additional borrowing availability of $478,062. The outstanding debt under this agreement is substantially secured by all U.S.-based assets including the assets of the Company’s subsidiaries.

As amended, the Credit Agreement includes customary covenants and conditions relating to the conduct and operation of the Company’s business. Specifically, as amended, the Credit Agreement limits the payment of dividends on any class of stock to $177,000 annually and subjects the Company to a 1:1 Earnings Before Interest, Taxes, Depreciation and Amortization to interest coverage ratio to be calculated on a quarterly basis. In addition, any acquisition requires approval from the lender. The Company was in compliance with the interest coverage ratio for the quarter ended June 30, 2002.

Mobitec 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 $1,089,147. At June 30, 2002, 8,895,998 krona (SEK) or $968,905 was outstanding, resulting in additional borrowing availability of 1,104,002 krona (SEK) or $120,242. 3,000,000 krona (SEK) ($326,744) of the 10,000,000 krona (SEK) maximum borrowing is secured by cash on deposit with the bank. 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 agreement expires on December 31, 2002. Upon expiration, the Company expects to renew or replace this agreement with an agreement substantially similar in terms and conditions.

Mobitec also has an agreement with its bank in Sweden from which it may borrow up to 6,000,000 krona (SEK), or $653,488. Based on the availability formula under this agreement, 1,558,117 krona (SEK) or $169,702 was outstanding at June 30, 2002, resulting in additional borrowing availability of 4,441,883 krona (SEK) or $483,786. The line of credit bears interest at 5.1 percent and is collateralized by accounts receivable. The agreement expires on December 31, 2002. Upon expiration, the Company expects to renew or replace this agreement with an agreement substantially similar in terms and conditions.

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Long-term debt consists primarily of three notes, the proceeds of which were used to finance the Mobitec acquisition. An unsecured note and obligation in the amount of $2,516,235 are to a shareholder. The unsecured note in the amount of $2,111,235 is payable in full June 28, 2004 with an annual interest of 9% paid quarterly. The obligation balance of $405,000 at June 30, 2002 is due in eight remaining non-interest bearing variable quarterly installments. A term loan from the Company’s Swedish bank dated June 28, 2001 having a balance of 17,600,000 krona (SEK), or $1,916,898, at June 30, 2002 is payable in seventeen remaining quarterly payments of 1,100,000 krona (SEK), or $119,806, at an annual interest rate of 5.35% and is secured by stock of the Swedish holding company and the consolidated subsidiary. A convertible debenture in the amount of $3,000,000 dated June 22, 2001 with an investment funds company is payable in full on June 28, 2008, if not sooner redeemed or converted, with annual interest at 8%. 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 Company was in compliance with the interest coverage ratio for the quarter ended June 30, 2002.

The Company on July 31, 2002 consummated privately negotiated sales of a convertible subordinated debenture to Renaissance Capital Group, shares of its common stock to Lite Vision Corporation, and expects to consummate the sale of an additional convertible subordinated debenture to a private investor in the near future. The first completed transaction included a $1.15 million convertible subordinated debenture through Renaissance Capital Group payable in full on June 29, 2009, if not sooner redeemed, with annual interest at 8%. It also provides for monthly principal redemption installments commencing July 31, 2005, 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 second completed transaction is a $300,000 sale of 100,000 shares of restricted, unregistered common stock to Lite Vision Corporation. The pending transaction involves a sale of $250,000 convertible subordinated debenture with a private investor that is subject to senior lender approval, which is expected to be completed in August 2002

We intend to improve liquidity by decreasing our consolidated inventory by December 31, 2002, decreasing the average days sales outstanding in trade accounts receivable, securing higher borrowing base availability in trade receivables and inventory availability from our asset based lenders in Europe and the U.S. and pursuing other methods of financing. Further the Company’s investment bankers are examining the Company’s non-core operations and related strategic alliance and divestiture opportunities.

Forward-Looking Statements

The statements contained herein in this Report on Form 10-Q and other SEC Filings and public disclosures of the Company 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 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 continued 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, all under Item 1 hereof; and (2) our belief that continued high sales growth depends upon expansion of new products, technology and geographic territories, our expectations that the term portion of our Credit Facility will be used for certain purposes, our belief that investing expenditures will not change significantly in 2002, our belief that a combination of borrowing under our Credit Facility will provide necessary liquidity and capital to satisfy our needs in other than acquisitions, all under Item 6 hereof. All forward-looking statements included in this document are based on information available on the date hereof and we assume no obligation to update any such forward-looking statements. It is important to note our actual results could differ materially from those in such forward-looking statements. You should consult the risk factors listed from time to time in the Company’s Reports in Forms 10-Q and 8-K and the Company’s Annual Report to Stockholders.

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PART II.
OTHER INFORMATION

We, in the normal course of operations, are involved in several legal actions incidental to our business. In our opinion, the ultimate resolution of these matters will not have a material adverse effect on our financial position.

On February 7, 2001, NextBus Information Systems, Inc, (“NextBus”) a California Corporation, filed suit in the United States District Court for the Northern District of California accusing us of infringing U.S. Patent 6,006,159 (“the 159 patent”). NextBus based the case on a news release of ours and not on an allegedly infringing act. NextBus dismissed that lawsuit without prejudice. However, since we were unsure as to how to proceed in our business and technology development, we filed a complaint for declaratory relief on June 25, 2001, in the United States District Court, Northern District of Texas, Dallas Division, asking the court to interpret the scope of the 159 patent. In reaction, NextBus again sued us in the United States District Court for the Northern District of California, alleging infringement of the 159 Patent and asserting essentially what it had previously said in the earlier dismissed suit. The actions of NextBus named both us and our CEO, David L. Turney, as defendants. Subsequently, the California court dismissed Mr. Turney from the action.

Our action in the United States District Court, Northern District of Texas, Dallas Division, was dismissed by the court, without prejudice on May 6, 2002 finding that it lacked jurisdiction over the matter.

The NextBus action in the United States District Court for the Northern District of California proceeded to hearing on Claims Construction on July 3, 2002. The findings of the Court were substantially consistent with the arguments of our Intellectual Property Counsel. Since we do not have a specific product on the market where, in our opinion, the NextBus patent would have relevance, this matter remains, as it has been since the inception of actions by NextBus, speculative in its entirety. As such, it is not, in our opinion, a matter worthy of litigation or the Court’s time. The Company has made clear that it has no intention of infringing the intellectual property rights of NextBus.

In response to the recent findings of the courts as noted above, we will now attempt to resolve and settle or dismiss the remaining action by NextBus in the United States District Court for the Northern District of California. We have approached legal counsel of NextBus accordingly and are now awaiting a response.

In our opinion, the action of NextBus is, has been, and remains totally without merit. We further believe we have not violated any rights granted to NextBus for the 159 Patent. Our policy is to adhere to all laws and regulations while vigorously defending our rights to pursue commercial applications for our products.

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NONE

NONE

On August 2, 2002, Digital Recorders, Inc. issued a press release announcing that it has consummated privately negotiated sales of a convertible subordinated debenture to Renaissance Capital Group, shares of its common stock to Lite Vision Corporation, and that it expects to consummate the sale of an additional convertible subordinated debenture to a private investor in the near future. The two completed transactions include a $1.15 million convertible subordinated debenture through Renaissance Capital Group and a $300,000 sale of 100,000 shares of restricted, unregistered common stock to Lite Vision Corporation. The pending transaction involves the sale of a $250,000 convertible subordinated debenture with a private investor that is subject to senior lender approval, which is expected to be completed in August 2002. A copy of the press release is attached to our Form 8-K filing dated August 8, 2002 as Exhibit 99.1, and copies of the definitive agreement governing the consummated sales of securities are attached to our Form 8-K of the same date as Exhibits 99.2, 99.3, 99.4, 99.5 and 99.6.

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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:

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Legend

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SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

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