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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2008

or

For the transition period from                 to              

Commission File Number 1-10346

EMRISE CORPORATION

(Exact name of registrant as specified in its charter)

9485 Haven Avenue, Suite 100

Rancho Cucamonga, California 91730

(Address of principal executive offices) (Zip code)

(909) 987-9220

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No o

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

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

The number of shares outstanding of the Registrant’s common stock, $0.0033 par value, as of November 5, 2008 was 38,254,250.

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EMRISE CORPORATION

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FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

EMRISE CORPORATION

Condensed Consolidated Balance Sheets

(in thousands, except share and per share amounts)

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

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EMRISE CORPORATION

Condensed Consolidated Statements of Operations

(Unaudited)
(in thousands, except per share amounts)

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

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EMRISE CORPORATION

Condensed Consolidated Statements of Stockholders’ Equity

(Unaudited)
(in thousands)

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

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EMRISE CORPORATION

Condensed Consolidated Statements of Cash Flows

(Unaudited)
(in thousands)

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

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Business

EMRISE Corporation (the “Company”) designs, manufactures and markets proprietary electronic devices and communications equipment for aerospace, defense, industrial, and communications applications. The Company has operations in the United States (“U.S.”), England, France and Japan.  The Company conducts its business through two operating segments: electronic devices and communications equipment. The subsidiaries within the electronic devices segment design, develop, manufacture and market electronic devices for defense, aerospace and industrial markets and operate out of facilities located in the U.S., England and Japan.  The subsidiaries within the communications equipment segment design, develop, manufacture and market network access equipment and network timing and synchronization products and operate out of facilities located in the U.S. and France.

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“Commission”) and therefore do not include all information and footnotes necessary for a complete presentation of the financial position, results of operations and cash flows in conformity with accounting principles generally accepted in the U.S. (“GAAP”).  The year end balance sheet was derived from the audited financial statements at that date, but does not include all of the information and footnotes required by GAAP for complete financial statements.  The unaudited condensed consolidated financial statements do, however, reflect all adjustments, consisting of only normal recurring adjustments, which are, in the opinion of management, necessary to state fairly the financial position as of September 30, 2008 and the results of operations and cash flows for the related interim periods ended September 30, 2008 and 2007. However, these results are not necessarily indicative of results for any other interim period or for the year. The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in its annual report on Form 10-K for the year ended December 31, 2007 as filed with the Commission.

Comprehensive Loss

Comprehensive loss includes all changes in equity during a period except those that resulted from investments by or distributions to the Company’s stockholders.  Other comprehensive income (loss) refers to revenues, expenses, gains and losses that, under GAAP, are included in comprehensive income (loss), but excluded from net income (loss) as these amounts are recorded directly as an adjustment to stockholders’ equity.  The Company’s other comprehensive income (loss) consists of foreign currency translation adjustments.  The following table reflects the components of comprehensive loss (in thousands):

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net income (loss) by the weighted average common shares outstanding during a period.  Diluted earnings (loss) per share is based on the treasury stock method and includes the dilutive effect of stock options and warrants outstanding during the period.  Common share equivalents have been excluded where their inclusion would be anti-dilutive.  As a result of the loss incurred by the Company for certain periods presented, the potentially dilutive common shares have been excluded because their inclusion would have been anti-dilutive.  The following table illustrates the computation of basic and diluted earnings (loss) per share (in thousands, except per share amounts):

The following table shows the common stock equivalents that were outstanding as of September 30, 2008 and 2007, but were not included in the computation of diluted earnings per share as a result of the loss incurred by the Company or because the options’ or warrants’ exercise price was greater than the average market price of the common shares and, therefore, the effect would have been anti-dilutive:

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Recent Accounting Pronouncements

In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits an entity to irrevocably elect fair value on a contract-by-contract basis as the initial and subsequent measurement attribute for many financial assets and liabilities and certain other items including insurance contracts. Entities electing the fair value option would be required to recognize changes in fair value in earnings and to expense upfront cost and fees associated with the item for which the fair value option is elected. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 did not have a material effect on the Company’s financial condition or results of operations.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This new statement provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy, with the highest priority being quoted prices in active markets. The required effective date of SFAS No. 157 is the first quarter of 2008. The adoption of SFAS No. 157 for financial assets and liabilities did not have a material effect on the Company’s consolidated financial statements, but resulted in additional disclosures contained herein.  In February 2008, the FASB issued Staff Position No. 157-2, which delayed by one year the effective date of SFAS No. 157 for all non-financial assets and liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis.  The Company is currently evaluating the impact the adoption of SFAS No. 157 for non-financial assets and liabilities will have on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities. The new standard amends SFAS No. 133 and seeks to enhance disclosure about how and why a company uses derivative and hedging activities, how derivative instruments and related hedged items are accounted for under SFAS No. 133 (and the interpretations of that standard) and how derivatives and hedging activities affect a company’s financial position, financial performance and cash flows.  SFAS No. 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  The adoption of SFAS No. 161 is not expected to have a material effect on the Company’s consolidated financial statements.

In April 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 142-3, “Determination of the Useful Life of Intangible Assets,” (“FSP 142-3”). FSP 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets and also requires expanded disclosure related to the determination of intangible asset useful lives. FSP 142-3 is effective for fiscal years beginning after December 15, 2008. Early adoption is prohibited. The Company is currently evaluating the impact the adoption of FSP 142-3 will have on its consolidated financial statements.

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 2 – INVENTORIES

                Inventories are stated at the lower of cost (first-in, first-out method) or market (net realizable value) and consisted of the following (in thousands):

NOTE 3 – LINES OF CREDIT

The Company and its direct subsidiaries, EMRISE Electronics Corporation, CXR Larus Corporation and RO Associates Incorporated (collectively, the “Borrowers”) are parties to a Credit Agreement (the “Credit Agreement”), as amended, with GVEC Resource IV Inc. (the “Lender”) providing for a three year credit facility in the aggregate amount of $26,000,000 (the “Credit Facility”) and is secured by accounts receivable, other rights to payment and general intangibles, inventories and equipment. The Credit Facility includes a one year revolving credit facility for up to $7,000,000 that may be extended, at the Company’s option, for up to three years (the “Revolver”).

The Revolver is formula-based and which generally provides that the outstanding borrowings under the line of credit may not exceed an aggregate of 85% of eligible accounts receivable, plus 10% of the value of eligible raw materials not to exceed $600,000, plus 50% of the value of eligible finished goods inventory not to exceed $1,500,000, minus the aggregate amount of reserves that may be established by the Lender.

Interest on the Revolver is payable monthly.  The interest rate is variable and is adjusted monthly based on prime rate as published in the “Money Rates” column of The Wall Street Journal (the “Base Rate”) plus 1.25%, subject to a minimum rate of 9.5%.  The interest rate in effect as of September 30, 2008 was the minimum rate of 9.5%.  The Revolver is subject to various financial covenants on a consolidated basis including the following: EBITDA, measured on a fiscal quarter-end basis, must not be less than the scheduled amount for each specified period; the debt service coverage ratio, measured quarterly, must be greater than the lesser of the scheduled amount for each specific period or 1.10:1.00; the leverage ratio, measured quarterly, must not be greater than 1.25:1.00; and the Company must not incur capital expenditures in any fiscal year in excess of $500,000.  As of September 30, 2008, the Company was in default of the capital expenditure limitation described above; which default has been waived by the Lender.

As of September 30, 2008, the Company had outstanding borrowings of $5.8 million under the Revolver with remaining availability under the formula-based calculation of $1.2 million.

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

In the event of a default and continuation of a default, the Lender may accelerate the payment of the principal balance requiring the Company to pay the entire indebtedness outstanding on that date.  Upon the occurrence and during the continuation of an event of default, the Lender may also elect to increase the interest rate applicable to the outstanding balance by four percentage points above the per annum interest rate that would otherwise be applicable.

In connection with entering into the Credit Agreement, the Borrowers issued a Revolver Loan Note dated November 30, 2007 (the “Revolver Note”) to the Lender in the principal amount of $7,000,000.  The Revolver Note is governed by the terms of the Credit Agreement.

NOTE 4 – LONG TERM DEBT

On August 20, 2008, in connection with the acquisition of Advanced Control Components, Inc. (“ACC”) and Custom Components, Inc. (“CCI”) as discussed in Note 6, the Borrowers and the Lender entered into a Amendment Number 1 to Loan Documents (“Amendment to Loan Documents”), pursuant to which certain terms of the Credit Facility were amended to, among other things, include a term loan in an outstanding principal amount of $3,000,000 (the “Term Loan C).  The Credit Facility, as amended, now provides for a three year credit facility in the aggregate amount of $26,000,000 (the “Amended Credit Facility”).

The Amended Credit Facility consists of (i) a one year revolving credit facility for up to $7,000,000 that may be extended for up to three years (the “Revolver”), (ii) a three year term loan in an outstanding principal amount of $6,000,000 which was fully funded on November 30, 2007 (“Term Loan A”), (iii) a term loan in the amount of $10,000,000 (“Term Loan B”), and (iv) a term loan in the amount $3,000,000 (“Term Loan C”).  Term Loans B and C were fully funded on August 20, 2008 in connection with the acquisition of ACC.  Term Loan B requires schedule payments commencing June 2009 and regular payments thereafter until the loan is paid in full in November 2010.  Term Loan C must be paid in full by February 15, 2009.

The Company’s Term Loan C, in the principal amount of $3 million, must be repaid by no later than February 15, 2009.  In order to facilitate the repayment of the Term Loan C, the Company has also agreed with the Lender to raise at least $5 million in net proceeds through either the sale of assets of EMRISE Corporation or any of its subsidiaries or through the sale of equity of EMRISE Corporation by no later than February 15, 2009.  The Company does not believe that its cash on hand and/or cash generated from operations will be sufficient to repay the Term Loan C at its stated maturity date.  Therefore, the Company expects to use all or a portion of the net proceeds from the sale of assets and/or equity to repay the Term Loan C.  If the Company elects to sell assets, the remaining proceeds from such sale(s), after repayment of the Term Loan C, if any, must be used to repay a portion of the principal of Term Loan B pursuant to the terms of the credit facility, which requires that cash proceeds from any voluntary or involuntary sale or disposition by the Company or any of its subsidiaries of property or assets (other than sales or dispositions of inventory or equipment in the ordinary course of business) in excess of $150,000 in any fiscal year must be used to repay the Term Loans. 

Although the Company is currently evaluating a number of options to meet these various obligations under the credit facility, the Company’s preference is to sell non-core assets.  If the Company is unable to repay the Term Loan C by February 15, 2009 and/or is unsuccessful in raising $5 million through the sale of assets or equity by that same date, then the Company would be in default under the terms of the credit facility.  In the event of a default and continuation of a default, the Lender may limit future availability under the revolving line of credit and/or accelerate the payment of all principal balances and accrued interest requiring the Company to pay the entire indebtedness under the credit facility outstanding on that date.  Upon the occurrence and during the continuation of an event of default, the Lender may also elect to increase the interest rate applicable to the outstanding balance of the Term Loans A and B by four percentage points above the per annum interest rate that would otherwise be applicable and increase the rate applicable to the Term Loan C to a per annum interest rate of 24%.  Any of these conditions could have a material adverse effect on the Company’s operations and/or ability to conduct business after that date.

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 5 – STOCK-BASED COMPENSATION

The Company has five stock option plans:

·                  Employee Stock and Stock Option Plan, effective July 1, 1994;

·                  1993 Stock Option Plan;

·                  1997 Stock Incentive Plan;

·                  Amended and Restated 2000 Stock Option Plan; and

·                  2007 Stock Incentive Plan.

The board of directors does not intend to issue any additional options under any of the above plans with the exception of the 2007 Stock Incentive Plan.

Total stock-based compensation expense included in wages, salaries and related costs was $28,000 and $15,000 for the three months ended September 30, 2008 and 2007, respectively, and $55,000 and $60,000 for the nine months ended September 30, 2008 and 2007, respectively. These compensation expenses were charged to selling, general and administrative expenses. As of September 30, 2008, the Company had $317,000 of total unrecognized compensation expense related to stock option grants, which will be recognized over the remaining weighted average period of three years.

NOTE 6 – ACQUISTION OF ADVANCED CONTROL COMPONENTS

On May 23, 2008, the Company and its wholly-owned subsidiary, EEC, entered into a Stock Purchase Agreement (the “Stock Purchase Agreement”) pursuant to which EEC agreed to acquire CCI and its operating subsidiary, ACC.  On August 20, 2008, the Stock Purchase Agreement was amended pursuant to Amendment No. 1 to Stock Purchase Agreement (the “Amendment to Purchase Agreement,” and collectively with the Stock Purchase Agreement, the “Purchase Agreement”) to, among other things, reduce the initial purchase price for all of the capital stock of both CCI and ACC to $12,400,000, subject to adjustments for working capital and net cash.  Additionally, pursuant to the terms of the Amendment to Purchase Agreement, the Company is obligated to pay interest on a principal amount of $600,000 at a rate equal to the prime rate as reported in The Wall Street Journal on August 20, 2008 plus 1% for the period commencing on August 20, 2008 and ending on the later of November 18, 2008 or the actual date such interest payment is made.

The closing of the Purchase Agreement occurred on August 20, 2008.  Under the terms of the Purchase Agreement, EEC acquired all of the issued and outstanding shares of common stock of CCI and all of the issued and outstanding shares of common stock of ACC not owned by CCI (the “Acquisition”).  In addition to the purchase price, the Company is obligated to pay up to an additional $3,000,000 in cash if ACC meets certain operating income targets for one or both of the two twelve month periods following the closing.  Additionally, EEC issued Subordinated Secured Contingent Promissory Notes (the “Notes”) to each of the Sellers in the aggregate principal amount of $2,000,000.  The Notes become payable if ACC meets certain operating income thresholds during the first and second 12 month periods after August 20, 2008.  The Notes bear interest at a rate per annum equal to the prime rate as reported in The Wall Street Journal plus 1%.

In determining the purchase price for the Acquisition, the Company took into account the historical and expected earnings and cash flow of ACC, as well as the value of companies of a size and in an industry similar to ACC, comparable transactions and the market for such companies generally.  The purchase price represented a premium of approximately $3.8 million over the recorded net worth of ACC’s assets.

In conjunction with the Acquisition, the Company commissioned a valuation firm to determine the fair value of ACC’s tangible assets and the portion of the purchase price that should be allocated to identifiable

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

intangible assets.  The Company considered whether the Acquisition included various types of identifiable intangible assets, including trade names, trademarks, patents, covenants not to compete, customers, backlog, workforce, technology and software.  The valuation firm has issued a preliminary report that is currently under review and was not finalized at September 30, 2008.  The Company has recorded the value of the tangible and intangible assets in its Condensed Consolidated Balance Sheets in accordance with the preliminary purchase price allocation.  Any material adjustments to this purchase price allocation in future periods will be disclosed.  The Company has estimated and recorded the identified intangible assets as follows:  trade name of $1,570,000; covenant not to compete of $60,000; backlog of $570,000; and customer relationships of $2,550,000.

The following table summarizes the unaudited assets and liabilities assumed in connection with the Acquisition (in thousands):

The following table summarizes, on an unaudited pro forma basis, the combined results of operations of the Company and ACC as though the Acquisition occurred as of January 1, 2007.  The pro forma adjustments are based upon available information and assumptions that management believes reasonably reflect the transaction.  The Company presents the pro forma results of operations for informational purposes only.  The pro forma results of operations are not necessarily indicative of what the Company’s results of operations would have been had the Company completed the Acquisition as of the dates indicated.  In addition, the pro forma financial statements do not purport to project the future financial position or operating results of the combined company.

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 7 – OPERATING SEGMENTS

The Company has two reportable operating segments: electronic devices and communications equipment. The electronic devices segment manufactures and markets digital and rotary switches, electronic power supplies, radio frequency (“RF”) and microwave devices and subsystem assemblies. The electronic devices segment consists of EEC and its subsidiaries located in the U.S., England and Japan, which offer the same or similar products to similar customers.  The communications equipment segment designs, manufactures and distributes network access products and timing and synchronization products.  The communications equipment segment consists of operating entities CXR Larus Corporation (“CXR Larus”) located in the U.S. and CXR Anderson Jacobson located in France, which offer the same or similar products to similar customers.  Both segments operate in the U.S., European and Asian markets, but have distinctly different customers, design and manufacturing processes and marketing strategies.  Each segment has discrete financial information and a separate management structure.

The Company evaluates performance based upon profit or loss from operations before income taxes exclusive of nonrecurring gains and losses. The Company accounts for intersegment sales at pre-determined prices negotiated between the individual segments.

There were no differences in the basis of segmentation or in the basis of measurement of segment operating income or loss from the amounts disclosed in the Company’s audited consolidated financial statements included in its annual report on Form 10-K for the year ended December 31, 2007.  Included in the Company’s reconciliation of segment financial data to the consolidated amounts is unallocated corporate expenses.

Selected financial data for each of the Company’s operating segments reconciled to the consolidated totals is shown below (in thousands):

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 8 – GOODWILL

The following table reflects changes in our goodwill balances, by segment, for the nine months ended September 30, 2008 (in thousands):

Goodwill in the amount of $3.8 million was recognized in the acquisition of ACC and is not deductible for Federal income tax purposes.

NOTE 9 – INCOME TAXES

The effective tax rate for the three month period ended September 30, 2008 was different than the 34% U.S. statutory rate primarily because the Company’s foreign entities generate a tax obligation and related tax expense as a result of their net income, which cannot be offset by U.S. tax loss carryforwards.

The Company adopted FIN 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, on January 1, 2007. The implementation of FIN 48 did not result in a material adjustment to the Company’s liability for unrecognized income tax benefits. At the time of adoption and as of September 30, 2008, the Company had recorded no net unrecognized tax benefits.

The Company recognizes interest and penalties related to uncertain tax positions in interest expense and selling, general and administrative expense, respectively, in the condensed consolidated statements of operations and comprehensive income. No interest or penalties were recognized during the second quarter of 2008. As of September 30, 2008, the Company had $0 accrued for interest and penalties.

The Company files income tax returns in the U.S. federal jurisdiction, England, France and Japan, and in the state jurisdictions of California, Texas, Pennsylvania and New Jersey. The Company is no longer subject to United States federal and state tax examinations for years before 2004 and 2003, respectively, and is no longer subject to tax examinations for England and Japan for years prior to 2006, and for France for years prior to 2004.

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EMRISE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

NOTE 10 – FAIR VALUE MEASUREMENTS

In September 2006, the FASB issued SFAS No. 157, which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements.  The effective date of the statement is for all entities with fiscal years beginning after November 15, 2007.  In February 2008, the FASB issued FSP No. 157-2, which delays the effective date of SFAS No. 157 for non-financial assets and liabilities to fiscal years beginning after November 15, 2008.  The delay pertains to items including, but not limited to, goodwill and other intangible assets.  The Company adopted the provisions of the standard that were effective as of January 1, 2008.  The Company plans to adopt the remaining provisions of SFAS No. 157 as of January 1, 2009.

SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants and also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The fair value hierarchy distinguishes between three levels of inputs that may be utilized when measuring fair value as follows:

Level 1 – Inputs are unadjusted quoted prices in active markets for identical assets or liabilities available at the measurement date.

Level 2 – Inputs are unadjusted quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets and liabilities in markets that are not active, inputs other than quoted prices that are observable, and inputs derived from or corroborated by observable market data.

Level 3 – Inputs that are unobservable inputs which reflect the reporting entity’s own assumptions on what assumptions the market participants would use in pricing the asset or liability based on the best available information.

As of September 30, 2008, the Company did not have financial assets and liabilities measured at fair value on a recurring basis that would be subject to the disclosure provisions of SFAS No. 157.

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Cautionary Statement

The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our other reports filed with SEC, including our Annual Report on Form 10-K for the year ended December 31, 2007 and subsequent reports on Forms 10-Q and 8-K, which discuss our business in greater detail.  This report and the following discussion contain forward-looking statements, which generally include the plans and objectives of management for future operations, including plans and objectives relating to our future economic performance and our current beliefs regarding revenues we might generate and profits we might earn if we are successful in implementing our business and growth strategies. The forward-looking statements and associated risks may include, relate to or be qualified by other important factors, including, without limitation:

·                  the projected growth or contraction in the electronic devices and communications equipment markets in which we operate;

·                  our strategies for expanding, maintaining or contracting our presence in these markets;

·                  anticipated trends in our financial condition and results of operations;

·                  our ability to distinguish ourselves from our current and future competitors;

·                  our ability to secure long term purchase orders;

·                  our ability to deliver against existing or future backlog;

·                  technical or quality issues experienced by us, our suppliers and/or our customers;

·                  failure to comply with existing or future government or industry standards and regulations;

·                  exposure to and impacts of various international risks including legal, business, political and economic risks associated with our international operations;

·                  our ability to adequately fund the working capital needs of the company

·                  our ability to successfully locate, acquire and integrate any possible future acquisitions;

·                  our ability to successfully dispose of our non-core assets and businesses;

·                  our ability to successfully support the working capital needs of our company; and

·                  our ability to successfully compete against competitors that in many cases are larger than us, have access to significantly more working capital than us and have significant resources in comparison to us.

We do not undertake to update, revise or correct any forward-looking statements.

Any of the factors described above or in the “Risk Factors” section contained in our Annual Report on Form 10-K for the year ended December 31, 2007 or in the Risk Factors section contained within this Report could cause our financial results, including our net income or loss or growth in net income or loss to differ materially from prior results, which in turn could, among other things, cause the price of our common stock to fluctuate substantially.

Business Description

EMRISE designs, manufactures and markets proprietary electronic devices and communications equipment for aerospace, defense, industrial, and communications applications. We have operations in the United States (“U.S.”), England, France and Japan.  We conduct our business through two operating segments: electronic devices and communications equipment. Our subsidiaries within our electronic devices segment design, develop, manufacture and market electronic devices for defense, aerospace and industrial markets.  Our subsidiaries within our communications equipment segment design, develop, manufacture and market network access equipment including network timing and synchronization products, for the communications industry.

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Our electronic devices segment produces a range of power systems, RF and microwave devices and electromechanical switches.  The electronic devices segment is “project” driven with the majority of revenues being derived from custom products with long life cycles and high barriers to entry.  The majority of manufacturing and testing is performed in-house or through sub-contract manufacturers.  Our electronic devices are used in a wide range of military airborne, seaborne and land-based systems, in-flight entertainment systems, including the latest next generation in-flight entertainment and communications (“IFE&C”) systems – such as applications for mobile phone, e-mail and internet communications and real time, on-board satellite and broadcast television – which are being retrofitted in existing commercial aircraft and installed in today’s growing fleet of new commercial aircraft.

Our communications equipment segment produces a range of network access products including network timing and synchronization products, for public and private communications customers.  The communications equipment segment is “end user product” based with a traditional cycle of internally funded development and marketing prior to selling via direct and indirect sales channels.  Manufacturing is primarily outsourced.  Our communications equipment is used in a broad range of applications for military (including defense and homeland security), utility companies and regional and national communications carriers as well as private communications networks.

Acquisition of Advanced Control Components

On August 20, 2008, EMRISE Corporation and its wholly-owned subsidiary, EEC, acquired Custom Components, Inc. (“CCI”) and its operating subsidiary, Advanced Control Components, Inc. (“ACC”) for $12,400,000, subject to adjustments for working capital and net cash, pursuant to the terms of a Stock Purchase Agreement dated May 23, 2008, as amended on August 20, 2008.

Advanced Control Components, Inc. is part of our electronic devices segment. The company is a supplier of high performance solid-state RF and microwave components and sub-systems serving military, aerospace and instrumentation markets.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of net sales and expenses for each period. The following represents a summary of our critical accounting policies, defined as those policies that we believe are the most important to the portrayal of our financial condition and results of operations and that require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effects of matters that are inherently uncertain.

Revenue Recognition

We derive revenues from sales of electronic devices and communications equipment products and services.  Our sales are based upon written agreements or purchase orders that identify the type and quantity of the item and/or services being purchased and the purchase price.  We recognize revenues when shipment of products has occurred or services have been rendered, no significant obligations remain on our part, and collectability is reasonably assured based on our credit and collections practices and policies.

We recognize revenues from U.S. sales of our electronic devices and communications equipment at the point of shipment of those products.  An estimate of warranty costs are recorded at the time the revenue is recognized.  Product returns are infrequent and require prior authorization because our sales are final and we quality test our products prior to shipment to ensure the products meet the specifications of the binding purchase orders under which those products are shipped. Normally, when a customer requests and receives authorization to return a product, the request is accompanied by a purchase order for a repair or for a replacement product.

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Revenue recognition for products and services provided by our subsidiaries in England depends upon the type of contract involved.  Engineering/design services contracts generally entail design and production of a prototype over a term of up to several years, with revenue deferred until each milestone defined in the contract is reached.  Production contracts provide for a specific quantity of products to be produced over a specific period of time.  Customers issue binding purchase orders or enter into binding agreements for the products to be produced.  We recognize revenues on these orders as the products are shipped.  Returns are infrequent and permitted only with prior authorization because these products are custom made to order based on binding purchase orders and are quality tested prior to shipment.  An estimate of warranty costs are recorded at the time revenue is recognized.

We recognize revenues for products sold by our French subsidiary at the point of shipment.  Customer discounts are included in the product price list provided to the customer.  Returns are infrequent and permitted only with prior authorization because these products are shipped based on binding purchase orders and are quality tested prior to shipment.  An estimate of warranty costs are recorded at the time revenue is recognized.

Revenues from services such as repairs and modifications are recognized when the service is completed and invoiced.  For repairs that involve shipment of a repaired product, we recognize repair revenues when the product is shipped back to the customer. Service revenues contribute less than 5% of total revenue and, therefore, are considered to be immaterial to overall financial results.

Product Warranty Liabilities

Generally, our products carry a standard one-year, limited parts and labor warranty.  In certain circumstances, we provide a two-year limited parts and labor warranty on our communications test instruments and network access products.  We offer extended warranties beyond two years for an additional cost to our customers.  Products returned under warranty typically are tested and repaired or replaced at our option.  Historically, we have not experienced significant warranty costs or returns.

We record a liability for estimated costs that we expect to incur under our basic limited warranties when product revenue is recognized.  Factors affecting our warranty liability include the number of units sold, historical and anticipated rates of claim and costs per claim.  We periodically assess the adequacy of our warranty liability accrual based on changes in these factors.

Inventory Valuation

Our finished goods electronic devices inventories generally are built to order.  Our communications equipment inventories generally are built to forecast, which requires us to produce a larger amount of finished goods in our communications equipment business so that our customers can be served promptly.  Our products consist of numerous electronic and other parts, which necessitates that we exercise detailed inventory management.  We value our inventory at the lower of the actual cost to purchase or manufacture the inventory (first-in, first-out) or the current estimated market value of the inventory (net realizable value). We perform cycle counts of inventories using an ABC inventory methodology, which groups inventory items into cycle counting categories, or conduct physical inventories at least once a year.  We regularly review inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on our estimated forecast of product demand and production requirements for the next 12 to 24 months. Additionally, to determine inventory write-down provisions, we review product line inventory levels and individual items as necessary and periodically review assumptions about forecasted demand and market conditions.  Any inventory that we determine to be obsolete, either in connection with the physical count or at other times of observation, are reserved for and subsequently written-off.  As of September 30, 2008, our total inventory reserves amounted to $6.7 million of which $5.0 million, representing 25% of total inventory, related to our electronic devices segment and $1.7 million, representing 8% of total inventory, related to our communications equipment segment.

The communications equipment industry is characterized by rapid technological change, frequent new product development, and rapid product obsolescence that could result in an increase in the amount of obsolete inventory quantities on hand. The electronic devices industry is characterized by the demand for long-term product stability and a rapidly changing market for the components and materials we use in our products, which

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could result in an increase in the amount of obsolete inventory quantities on hand.  Also, our estimates of future product demand may prove to be inaccurate, in which case we may have understated or overstated the provision required for excess and obsolete inventory. Although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results.

Foreign Currency Translation

We have foreign subsidiaries that together accounted for approximately 67.1% and 71.4% of our net revenues, 29.5% and 59.4% of our assets and 20.7% and 57.4% of our total liabilities as of and for the nine months ended September 30, 2008 and 2007, respectively.  In preparing our consolidated financial statements, we are required to translate the financial statements of our foreign subsidiaries from the functional currencies in which they keep their accounting records into U.S. dollars. Assets and liabilities denominated in foreign currencies were translated into U.S. dollars (the reporting currency) at the exchange rate prevailing at the balance sheet date (“translation adjustments”). Equity accounts denominated in foreign currencies were translated into U.S. dollars at historical exchange rates. Revenues and expenses denominated in foreign currencies were translated into U.S. dollars at the monthly average exchange rate for the period.  Gains and losses resulting from foreign currency transactions are included in the results of operations within our statement of operations under the caption “other income (expense).” Translation adjustments are reported as an element of other comprehensive income, which is a component of equity on the balance sheet.

Under relevant accounting guidance, the treatment of these translation gains or losses depends upon management’s determination of the functional currency of each subsidiary. This determination involves consideration of relevant economic facts and circumstances affecting the subsidiary. Generally, the currency in which the subsidiary transacts a majority of its transactions, including billings, financing, payroll and other expenditures, would be considered the functional currency. However, management must also consider any dependency of the subsidiary upon the parent and the nature of the subsidiary’s operations.

If management deems any subsidiary’s functional currency to be its local currency, then any gain or loss associated with the translation of that subsidiary’s financial statements is included as a separate component of stockholders’ equity in accumulated other comprehensive income (loss).  However, if management deems the functional currency to be U.S. dollars, then any gain or loss associated with the translation of these financial statements would be included in other income (expense) within our statement of operations.

If we dispose of any of our subsidiaries, any cumulative translation gains or losses associated with that entity would be realized into our statement of operations. If we determine that there has been a change in the functional currency of a subsidiary to U.S. dollars, then any translation gains or losses arising after the date of the change would be included within our statement of operations.

Based on our assessment of the factors discussed above, we consider the functional currency of each of our international subsidiaries to be each subsidiary’s local currency. Accordingly, we had cumulative translation losses of $0.4 million and cumulative translation gains of $1.1 million that were included as part of accumulated other comprehensive income within our balance sheets at September 30, 2008 and December 31, 2007, respectively. During the three months ended September 30, 2008 and 2007, we included a translation loss of $1.6 million and gain of $0.2 million, respectively, and during the nine months ended September 30, 2008 and 2007 we included a translation loss of $1.4 million and gain of $0.3 million, respectively, under accumulated other comprehensive income.

If we had determined that the functional currency of our subsidiaries was U.S. dollars, these gains or losses would have decreased or increased our net loss for the three months ended September 30, 2008 and 2007. The magnitude of these gains or losses depends upon movements in the exchange rates of the foreign currencies in which we transact business as compared to the value of the U.S. dollar. These currencies include the euro, the British pound sterling and, to a lesser extent, the Japanese yen. Any future translation gains or losses could be significantly higher or lower than those we recorded for these periods.

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A 2.5 million British pound sterling loan payable by one of our subsidiaries in England to EMRISE Corporation was outstanding as of September 30, 2008 ($4.5 million based on the exchange rate at September 30, 2008).  Exchange rate losses and gains on the long-term portion of this loan are recorded in cumulative translation gains or losses in the equity section of the balance sheet.

Intangibles, Including Goodwill

We periodically evaluate our intangibles, including goodwill, for potential impairment. Our judgments regarding the existence of impairment are based on legal factors, market conditions and operational performance of our acquired businesses.

In assessing potential impairment of goodwill, we consider these factors as well as forecasted financial performance of the acquired businesses.  If forecasts are not met, we may have to record additional impairment charges not previously recognized. In assessing the recoverability of our goodwill and other intangibles, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of those respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets that were not previously recorded.  If that were the case, we would have to record an expense in order to reduce the carrying value of our goodwill.  Under Statement of Financial Accounting Standards (“SFAS”) No. 142, Goodwill and Other Intangible Assets, we are required to analyze our goodwill for impairment issues at least annually or more frequently if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount.  At September 30, 2008, our reported goodwill totaled $16.3 million.  During the nine months ended September 30, 2008, we did not record any impairment losses related to goodwill and other intangible assets.

Overview

The majority of our products are customized to the unique specifications of our customers and are subject to variable timing of delivery.  Shipments of products can be accelerated or delayed due to many reasons including, but not limited to, exceeding or not meeting customer contract requirements, a change in customer timing or specifications, technology related issues and production related issues.  Comparability of our revenues and gross profit is difficult from period to period as we typically do not have recurring orders.  Exceptions to this include U.S. government stocking orders, foreign military contracts and certain long-term telecommunications contracts.

Overall sales increased 22% and 14% in the three and nine months ended September 30, 2008, respectively, as compared to the same periods in 2007.  Included in the three and nine months net sales results is approximately $1.7 million in net sales contributed as a result of our recent acquisition of ACC which was completed on August 20, 2008 and which accounted for a 13% and 5% increase in total net sales in the three and nine months ended September 30, 2008, respectively.  Sales for our electronic devices segment were up strongly with increases in net sales generated by all of our electronic devices subsidiaries excluding RO Associates, which experienced a slight decline on a quarterly basis, but is up 11% on a year to date basis.  ACC’s $1.7 million in net sales in the period ended September 30, 2008, resulted in approximately a 19% and 7% increase in sales for the electronic devices segment on a quarter to date and year to date basis, respectively.  Sales for our communications equipment segment decreased 20% and 5% for the three and nine month periods in 2008, respectively, as compared to the same periods in 2007.  The effect of exchange rates between the euro, British pound sterling and the U.S. dollar on the translation of our European operations had an unfavorable impact on the sales of both segments.  We expect to continue to experience quarter over quarter increases in sales for the remainder of 2008 with total 2008 sales expectations exceeding $60 million, including the additional contribution of net sales from our recent acquisition of ACC.  However, the impact of exchange rates remains an uncertainty and could negatively or positively impact our overall revenue results in future periods.

Overall gross margins increased to 40.1% and 37.4% in the three and nine months ended September 30, 2008, respectively, from 31.1% and 32.4% in the three and nine months ended September 30, 2007, respectively.  Gross margins were not significantly impacted on a quarter to date or year to date basis by the inclusion of ACC’s in our 2008 results.  Rather, the significant improvement in gross margin is primarily due to improved sales prices

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of our products, improved efficiency in manufacturing and/or favorable changes in product mix, particularly at our U.S. electronic devices subsidiaries, where overall gross margins increased to 40.3% and 36.2% on a quarter-to-date and year-to-date basis, respectively compared to 28.6% and 30.8% a year ago.  Our communication equipment segment also experienced improved gross margins increasing to 39.2% and 41% on a quarter-to-date and a year-to-date basis, respectively, compared to 37.4% and 36.3% a year ago.  Overall margins were impacted unfavorably in the most recent quarter by the translation of foreign unit financial results from local (foreign) currencies to U.S. dollars due to the large variability in exchange rate between the U.S. dollar, the British pound sterling and the euro compared to the prior year and prior quarters of 2008.  We expect gross margin levels in the fourth quarter of 2008 to be consistent with the third quarter of 2008, excluding the possible impact, favorable or unfavorable, of exchange rates on the translation of foreign operating unit financial results.

We generated a profit in the third quarter.  We attribute this to higher sales levels, improved gross margins and reduced selling, general and administrative, or SG&A, expenses in the quarter compared to a year ago.  Included within the quarters results are certain one-time restructuring costs, partially offset by a gain on the sale of certain non-core assets, which together had a negative impact of approximately $0.1 million on the quarter’s results.  Furthermore, we are encouraged by the fact that despite our recent acquisition of ACC having contributed only 40 days to our third quarter results, we were able to offset the additional interest cost associated with the acquisition of ACC with even higher pretax net income that ACC contributed in the same short period.  Net income for the quarter improved to $0.3 million, or $0.01 per share, from a net loss of $0.5 million, or $0.01 loss per share, for the third quarter of 2007.

The following is a more detailed discussion of our results of operations by segment.

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Results of Operations

Comparison of the Three Months Ended September 30, 2008 to the Three Months Ended September 30, 2007

Net Sales