Zareba Systems (ZRBA) 10-Q 2007 Q3 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

For the Fiscal Quarter ended
March 31, 2007
Commission file number 0-1388

ZAREBA SYSTEMS, INC.

State of Incorporation: Minnesota
IRS Employer Identification No. 41-0832194
13705 26th Avenue N., Suite 102, Minneapolis, MN 55441 (763) 551-1125

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months, and (2) has been subject to such filing requirements for the past 90 days.

Yesþ Noo

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined by Rule 12b-2 of the Exchange Act).

Large accelerated filero          Accelerated filero          Non-accelerated filerþ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yeso Noþ

The number of shares outstanding of the Company’s Common Stock on May 7, 2007 was 2,432,341.

INDEX TO FORM 10-Q

The following documents are filed as part of this report:

		Page Number
	PART I: FINANCIAL INFORMATION
Item 1	Financial Statements		3
	Condensed Consolidated Balance Sheets		3
	Condensed Consolidated Statements of Operations		4
	Condensed Consolidated Statements of Cash Flows		5
	Notes to Condensed Consolidated Financial Statements		6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations		11
Item 3	Quantitative and Qualitative Disclosures About Market Risk		15
Item 4	Controls and Procedures		15
	PART II: OTHER INFORMATION
Item 1A	Risk Factors		16
Item 6	Exhibits		16
	SIGNATURES		17
Certification of Chief Executive Officer
Certification Chief Financial Officer
Certification of Chief Executive Officer
Certification of Chief Financial Officer

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 2

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

ZAREBA SYSTEMS, INC.

Condensed Consolidated Balance Sheets

	March 31,		June 30,
(In thousands)	2007		2006
	(Unaudited)
Current assets
Cash and cash equivalents	$	873	$	1,414
Accounts receivable, net		6,411		8,239
Inventories		6,886		6,722
Other current assets		1,537		947
Total current assets		15,707		17,322
Property, plant and equipment, net		3,275		3,777
Other assets
Goodwill		6,349		6,151
Trademarks		2,674		2,638
Customer relationships, net		1,504		1,647
Other, net		212		302
Total other assets		10,739		10,738
TOTAL ASSETS	$	29,721	$	31,837
Current liabilities
Accounts payable	$	4,253	$	4,527
Accrued liabilities		2,160		2,812
Short-term borrowing		—		300
Current maturities of long-term debt and non-compete agreement		5,878		1,413
Total current liabilities		12,291		9,052
Deferred income taxes		873		923
Long-term debt, less current maturities		2,590		8,234
Total liabilities		15,754		18,209
Stockholders’ equity
Undesignated shares as of March 31, 2007 and June 30, 2006, $0.01 par value, 39,950,000 shares authorized, none issued or outstanding;		—		—
Series A Preferred Stock as of March 31, 2007 and June 30, 2006, $0.01 par value per share, 50,000 shares authorized, none issued or outstanding		—		—
Common stock as of March 31, 2007 and June 30, 2006, par value $.01 per share; authorized: 20,000,000 shares; issued and outstanding 2,432,341 and 2,424,786, respectively		24		24
Additional paid-in capital		2,040		1,987
Accumulated other comprehensive income:
Foreign currency translation adjustment		604		152
Retained earnings		11,299		11,465
Total stockholders’ equity		13,967		13,628
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	29,721	$	31,837

See notes to the condensed consolidated financial statements.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 3

ZAREBA SYSTEMS, INC.

Condensed Consolidated Statements of Operations

(Unaudited)

	Three months						Nine months
	ended March 31,						ended March 31,
(In thousands, except per share data)	2007			2006			2007			2006
Net sales	$	9,240		$	7,497		$	24,840		$	22,035
Cost of goods sold		6,137			5,018			16,502			14,909
Gross profit		3,103			2,479			8,338			7,126
Operating expenses
Selling, general and administrative		2,293			2,436			6,795			6,986
Research and development		372			383			1,082			1,033
Total operating expenses		2,665			2,819			7,877			8,019
Income (loss) from operations		438			(340	)		461			(893	)
Other income (expense), net
Interest income		10			9			24			25
Interest expense		(192	)		(185	)		(580	)		(575	)
Other income (expense), net		(84	)		(72	)		(164	)		(228	)
Income (loss) before income taxes		172			(588	)		(259	)		(1,671	)
Income tax provision (benefit)		62			(207	)		(93	)		(598	)
Net income (loss)	$	110		$	(381	)	$	(166	)	$	(1,073	)
Net income (loss) per common and common equivalent share:
basic	$	0.05		$	(0.16	)	$	(0.07	)	$	(0.45	)
diluted	$	0.04		$	(0.16	)	$	(0.07	)	$	(0.45	)
Cash dividends per share:	$	—		$	—		$	—		$	0.04
Weighted average number of shares outstanding
basic		2,432,341			2,410,161			2,427,268			2,406,484
diluted		2,473,124			2,410,161			2,427,268			2,406,484

See notes to the condensed consolidated financial statements.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 4

ZAREBA SYSTEMS, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

	For the nine months
	ended March 31,
(In thousands)	2007			2006
Reconciliation of net income to net cash provided by operations
Net income (loss)	$	(166	)	$	(1,073	)
Adjustments to reconcile net income to cash flows from operating activities:
Depreciation and amortization		976			1,088
Loss on disposal of plant and equipment		—			47
Stock-based compensation expense		23			—
Inventory valuation adjustment		—			641
Deferred income taxes		(73	)		(67	)
Changes in assets and liabilities:
Accounts receivable, net		1,942			2,148
Inventories		(21	)		(1,668	)
Other assets		(104	)		139
Accounts payable and accrued expenses		(1,490	)		(3	)
Net cash provided by operations		1,087			1,252
Cash flows provided by (used in) investing activities:
Acquisition of business, net of cash acquired		(11	)		(46	)
Purchase of property and equipment		(86	)		(210	)
Net cash provided by (used in) investing activities		(97	)		(256	)
Cash flows provided by (used in) financing activities:
Proceeds from long-term borrowing		—			1,510
Proceeds from sale of common stock		31			38
Cash dividend payment		—			(96	)
Net advances (payments) on short-term borrowings		(300	)		—
Payments on non-compete liability		(250	)		(250	)
Payments on long-term debt		(1,110	)		(2,831	)
Net cash provided by (used in) financing activities		(1,629	)		(1,629	)
Effect of exchange rate changes in cash		98			274
Net increase (decrease) in cash and cash equivalents		(541	)		(359	)
Cash and cash equivalents — beginning of period		1,414			1,054
CASH AND CASH EQUIVALENTS — END OF PERIOD	$	873		$	695

See notes to the condensed consolidated financial statements.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 5

ZAREBA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements

March 31, 2007 and 2006

(Unaudited)

Zareba Systems, Inc., (the Company) prepared the condensed financial statements without audit and pursuant to the rules and regulations of the Securities and Exchange Commission. The information furnished in the financial statements includes normal recurring adjustments and reflects all adjustments, which are, in the opinion of management, necessary in order to make the financial statements not misleading. Certain information and footnote disclosures normally included in financial statements prepared in accordance with general accepted accounting principles have been condensed or omitted pursuant to such rules and regulations.

These condensed financial statements should be read in conjunction with the financial statements and the accompanying notes included in the Company’s 10-KSB for the year ended June 30, 2006, and the Fiscal Year 2006 Annual Report. Reclassifications have been made in the prior year to conform to classifications in the current year.

The results of operations for the three and nine month periods ended March 31, 2007 are not necessarily indicative of the operating results to be expected for the full fiscal year.

Preparation of the Company’s condensed consolidated financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and related net sales and expenses. Actual results could differ from those estimates.

1. Net Income (Loss) Per Share

The following table sets forth the computation of basic and diluted income (loss) and income (loss) per share:

	Three months					Nine months
	ended March 31,					ended March 31,
(Dollars in thousands, except per share amounts)	2007		2006			2007			2006
Numerator:
Net income (loss)	$	110	$	(381	)	$	(166	)	$	(1,073	)
Denominator:
Weighted average common shares outstanding-basic		2,432,341		2,410,161			2,427,268			2,406,484
Dilution associated with the company’s stock-based compensation plans		40,783		—			—			—
Weighted average common shares outstanding-diluted		2,473,124		2,410,161			2,427,268			2,406,484
Net income (loss) per share-basic	$	0.05	$	(0.16	)	$	(0.07	)	$	(0.45	)
Net income (loss) per share-diluted	$	0.04	$	(0.16	)	$	(0.07	)	$	(0.45	)

2. Comprehensive Income (Loss)

The components of comprehensive income (loss), net of related tax, for the three and nine month periods ended March 31, 2007 and 2006 were as follows:

	Three months					Nine months
	ended March 31,					ended March 31,
(In thousands)	2007		2006			2007			2006
Net income (loss)	$	110	$	(381	)	$	(166	)	$	(1,073	)
Foreign currency translation adjustment		90		362			452			94
Comprehensive income (loss)	$	200	$	(19	)	$	286		$	(979	)

3. Stock-Based Compensation

Commencing July 1, 2006, we adopted Statement of Financial Accounting Standard No. 123(R),Share Based Payment(SFAS 123(R)), and SEC Staff Accounting Bulletin No. 107,Share Based Payment, (“SAB 107”) requiring all share-based payments, including grants of stock options, to be recognized in the income statement as an operating expense, based on their fair value over the requisite service period. We recorded $8,000 and $23,000 of related compensation expense to general and administrative expense, for the three and nine month periods ended March 31, 2007, respectively. The related tax benefit from recording this non-cash expense for the three and nine month periods ended March 31, 2007 was $3,000

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 6

and $9,000, respectively and the corresponding net compensation expense of $5,000 and $14,000 had no impact on basic or diluted income per share for the respective periods. As of March 31, 2007, a total of $804,000 of unrecognized compensation costs related to non-vested stock option awards was outstanding, including $735,000 of unrecognized compensation costs related to performance-based vesting stock options that in management’s current best estimate are not likely to vest and will be cancelled prior to vesting. The remaining balance of $69,000 of unrecognized compensation expense is expected to be recognized within the next five years.

We have applied the modified prospective method in adopting SFAS 123(R). Under the modified prospective approach, SFAS 123R applies to new awards and to awards that were outstanding on July 1, 2006 that are subsequently modified, repurchased, cancelled or vested. Under the modified prospective approach, compensation cost recognized in fiscal 2007 includes compensation cost for all share-based payments granted prior to, but not yet vested on, July 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R, and compensation cost for all shared-based payments granted subsequent to July 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R.

Prior to adopting SFAS 123(R), we accounted for stock-based compensation under Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees. Accordingly, periods prior to adoption have not been restated. The following table illustrates the effect on net loss and loss per share if the fair value based method had been applied to the prior period:

	Three months			Nine months
	ended March 31,			ended March 31,
(In thousands, except per share amounts)	2006			2006
Net Income (Loss)
As reported	$	(381	)	$	(1,073	)
Less pro forma stock-based compensation cost		(4	)		(62	)
Pro forma	$	(385	)	$	(1,135	)
Basic Net Income (Loss) per Share
As reported	$	(0.16	)	$	(0.45	)
Pro forma	$	(0.16	)	$	(0.47	)
Diluted Net Income (Loss) per Share
As reported	$	(0.16	)	$	(0.45	)
Pro forma	$	(0.16	)	$	(0.47	)

We use the Black-Scholes option pricing model to determine the weighted average fair value of options. The volatility factor used in the Black-Scholes option pricing model is based on historical stock price fluctuations. The current forfeiture rate is based on a reasonable estimate by management. No options were granted during the three month periods ended March 31, 2007 or 2006. The weighted average fair value of options granted during the nine months ended March 31, 2007, was $3.38. The assumptions we used to determine fair value were as follows:

	Nine months
	ended March 31,
	2007			2006
Expected dividend yield		0.00	%		4.46	%
Expected stock price volatility		73.07	%		83.07	%
Risk-free interest rate		4.38	%		4.38	%
Expected life of options	3 years			3 years

The Company’s stock options generally vest over five years of service and have a contractual life of 10 years. Recent stock option grants to executive management, however, have performance-based vesting upon achieving specific revenue and income objectives, otherwise vesting on the fifth anniversary of the grant date. We have 562,000 and 550,000 shares authorized for grant under the 1995 Stock Option Plan and the 2004 Equity Incentive Plan (the 2004 Plan), respectively. However, since fiscal 2004, all options grants have been under the 2004 Plan.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 7

Options granted and forfeited under both plans during the nine months ended March 31, 2007 were as follows:

				Weighted Avg.		Aggregate
	Number			Exercise Price		Intrinsic
	of Options			Per Share		Value
Options outstanding, June 30, 2006		368,325		$	6.21
Granted		28,350			6.71
Exercised		—			—
Forfeited		(14,625	)		3.82
Options outstanding, March 31, 2007		382,050		$	6.34	$	192,715
Exercisable, March 31, 2007		156,200		$	4.27	$	192,715

As of March 31, 2007, the options outstanding have a weighted average remaining contractual life of 6.5 years, and exercise prices and unexercised options as follows:

Options outstanding						Options exercisable
			Weighted	Weighted				Weighted
Exercise	Outstanding		Average	Average		Number		Average
Price	Shares		Contractual Life	Exercise Price		Exercisable		Exercise Price
$2.67 to $3.83		89,925	2.6 years	$	3.08		89,925	$	3.08
$4.00 to $5.90		71,250	4.2  years	$	5.00		41,250	$	4.35
$6.71 to $8.47		220,875	8.7  years	$	8.10		25,025	$	8.40
$2.67 to $8.47		382,050	6.5 years	$	6.34		156,200	$	4.27

4. Inventories

Inventories consisted of the following.

	March 31,		June 30,
(In thousands)	2007		2006
	Unaudited
Raw materials	$	2,309	$	2,662
Work-in-process		45		86
Finished goods		4,532		3,974
TOTALS	$	6,886	$	6,722

5. Goodwill and Intangible Assets

Effective July 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” which established new standards related to how acquired goodwill and indefinite-lived intangible assets are to be recorded upon their acquisition as well as how they are to be accounted for after they have been initially recognized in the financial statements.

At June 30, 2006, the Company completed its annual impairment tests for acquired goodwill and indefinite lived intangible assets using methodologies consistent with those applied for its transitional impairment tests performed as of July 1, 2002. Such testing resulted in no impairment charge.

Intangible assets are amortized on a straight-line basis over the estimated periods benefited; a seven-year useful life has been assigned to the acquired customer relationships and five-year useful life for the non-compete. Amortization expenses related to definite lived intangible assets for the three month and nine month periods ended March 31, 2007 were $82,000 and $265,000, respectively, compared to $221,000 and $492,000 for the comparable periods of the prior fiscal year.

6. Bank Debt Disclosure

In September 2004, the Company paid in full the previous Wells Fargo Bank (WF) $3.0 million bank line of credit and term debt facility and executed a new WF business credit facility for the Rutland acquisition. The WF credit facility initially included an aggregate credit limit of $7.8 million, consisting of revolving credit up to $6.0 million and term credit of $1.8 million. Under this credit facility, the Company borrowed approximately $5.1 million for the Rutland acquisition. Under the terms of the new WF credit facility agreement and subsequent amendments, interest is charged on outstanding balances at the rate of one half of one percent (or .50 percent) above base rate. The initial term of the revolving credit agreement runs for three years, expiring in September 2007, and it is renewable on an annual basis thereafter. As a result, the entire balance due under the revolving credit facility of $4.6 million at March 31, 2007 is classified as a current liability. The effective interest rate on March 31, 2007 and the average interest rate for the nine month period then ended was 8.75 percent. The term notes require monthly principal payments of $19,168 plus interest. As of March 31, 2007, an additional $0.4 million was available for the future draws. Future WF availability is determined by the daily eligible

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 8

collateral net of the outstanding loan balance. The Company is in compliance with the covenants related to the WF facility at March 31, 2007.

Also, in September 2004, Zareba Systems Europe secured a £2,214,000 term loan (approximately $4.0 million) from the Bank of Scotland (BoS) in the United Kingdom for the Rutland acquisition. Under the terms of the BoS credit facility agreement, interest is charged on outstanding balances at the rate of two and one eighth percent (or 2.125 percent) above the base rate with a five-year term. On March 31, 2007, the effective interest rate was 7.375 percent, and the average interest rate for the nine month period then ended was 7.069 percent. The BoS term loan matures on September 27, 2009, with monthly principal and interest payments of £49,355 (approximately $96,000). The balance outstanding under this facility at March 31, 2007 was £1.3 million, or approximately $2.6 million. In September 2006, the BoS waived all previous covenant violations for fiscal 2006 and agreed to work with the Company to establish new covenant levels for fiscal 2007 and the future. The Company and BoS continue to work on finalizing the new covenants, which the Company believes will be met going forward.

Total bank debt outstanding is summarized as follows:

	March 31,			June 30,
(In thousands)	2007			2006
Note payable to bank	$	8,468		$	9,347
Short-term borrowings		—			300
		8,468			9,647
Less current maturities and short-term borrowings		(5,878	)		(1,413	)
TOTALS	$	2,590		$	8,234

Both the WF Business Credit and the BoS credit facilities are collateralized by substantially all of the assets of the Company and Zareba Systems Europe, in their respective localities. Line of credit borrowings are limited to eligible accounts receivable and inventory.

7. Industry Segments

The Company’s two reportable industry segments, Zareba Systems and Waters Medical Systems, are strategic business units that provide different products and are managed separately as each requires different technology and manufacturing processes.

Operating income is total revenue less operating expenses, excluding interest and general corporate expenses. The Company did not have any sales between industry segments. Identifiable assets by industry segment include both assets directly identified with those operations and an allocable share of jointly used assets. General corporate assets consist primarily of cash, cash equivalents and building costs. The accounting policies applied to determine segment information are the same as those described in the summary of significant accounting policies. Management evaluates the performance of each segment based on profit and loss from operations before income taxes, exclusive of non-recurring gains or losses. The following table summarizes data by industry segment.

	Three months					Nine months
	ended March 31,					ended March 31,
(Unaudited – in thousands)	2007		2006			2007		2006
Net sales:
Zareba Systems	$	8,679	$	6,999		$	23,254	$	20,408
Waters Medical Systems		561		498			1,586		1,627
TOTAL	$	9,240	$	7,497		$	24,840	$	22,035
Operating income (loss):
Zareba Systems	$	335	$	(499	)	$	203	$	(1,377	)
Waters Medical Systems		103		159			258		484
TOTAL	$	438	$	(340	)	$	461	$	(893	)

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 9

	March 31,		June 30,
(Unaudited – in thousands)	2007		2006
Identifiable assets:
Zareba Systems	$	27,225	$	29,045
Waters Medical Systems		804		1,013
Corporate		1,692		1,779
Total	$	29,721	$	31,837

8. Dividend Payment

The Company’s board of directors voted at its October 26, 2006 board meeting to suspend payment of an annual dividend in fiscal 2007 for fiscal year 2006 operating results. Accordingly, no dividend payments were made in the current fiscal year. During the second quarter of fiscal 2006, the Company paid a cash dividend of $0.04 per share on the Company’s common stock, totaling approximately $96,000, based on fiscal year 2005 operating results.

9. Contingencies

In October 2005, the Wisconsin department of natural resources (“WDNR”) notified the Company it is a “responsible party” with respect to a site on which certain TCE contaminated ground water was alleged to be present. Although it may become necessary for the Company to undertake actions in connection with the WDNR’s letter, we do not have sufficient information to determine what liability the Company will incur, if any. The Company expenses all associated legal and professional costs as incurred, which have totaled $59,000 from the date of notification through March 31, 2007.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 10

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

Results from Continuing Operations

Overview

Zareba Systems, Inc. has four direct subsidiaries: Zareba Systems Europe Limited, Zareba Security, Inc., Waters Medical Systems, Inc. and Zareba Systems of Canada LTD. The Zareba Systems division, comprised of the parent company activities related to the Zareba line of products and the activities of its subsidiaries, Zareba Systems of Canada, Zareba Systems Europe, and Zareba Security, Inc., manufactures electronic perimeter fence systems, and Waters Medical Systems (WMS) manufactures renal perfusion devices and whole blood oximetery products.

On September 27, 2004, through its newly formed subsidiary, Zareba Systems Europe, the Company acquired Rutland Electric Fencing Co., Ltd., the largest manufacturer of electronic perimeter fence systems in the United Kingdom. To facilitate the acquisition, the Company and Zareba Systems Europe utilized credit facilities provided by Wells Fargo Bank and Bank of Scotland. The Company completed the Rutland acquisition in accordance with FAS No. 141, Business Combinations. Financial results from the Zareba Systems Europe subsidiary have been included in the Company’s consolidated financial statements since the date of acquisition. This acquisition significantly affected net sales.

In the third quarter of fiscal year 2005, the Company introduced two new product lines within the Zareba Systems division, perimeter security systems and electric gate opener systems and accessories. The perimeter security system is designed to deter, detect, delay, assess and respond to intrusions or escapes in a wide range of applications including utilities, airports, correctional facilities and other commercial and government properties. The Company commenced system deliveries in fiscal 2006. Zareba Systems established a distribution agreement with a key distributor in the UK and is working to establish similar agreements with other distributors to sell both non-lethal electric fencing and its U.S. patent-pending Guard Tower® product lines in various countries around the world. In September 2006, the Company announced an order for its electronic perimeter security fence system products to be installed at several prisons. Shipments under this order occurred in April 2007.

Products comprising the automatic gate opener systems and accessories initially target the Do-It-Yourself (traditional) Zareba market and are sold through existing retail channels, often to the same customer that purchased products of the traditional Zareba product line. During fiscal 2006, the Company introduced a new family of professional series automatic gate openers available to the professional installer distribution channels, which began shipping late in the third quarter of fiscal 2007.

Zareba Systems’ business is seasonal, with peak customer demand occurring in the late spring, summer and early autumn months. Waters Medical Systems revenue is recognized substantially non-seasonally throughout the fiscal year. We believe the new Zareba products will decrease the impact of seasonality as the new products become a more significant percentage of sales. Backlog is not significant in either of the Company’s operating units since most orders are filled within days after receipt of a customer’s order. As a result of Zareba Systems seasonality, there is a resulting variability in sales, manufacturing fixed overhead absorption and a further resulting impact on gross margin, working capital and cash flow during the Company’s fiscal year.

Results of Continuing Operations

Net sales for the third quarter of fiscal year 2007, ended March 31, 2007 were $9.2 million, an increase of $1.7 million, or 23.3%, from $7.5 million in the same quarter of the prior year. Net sales for the Zareba Systems division, including Zareba Systems of Canada, Zareba Systems Europe and Zareba Security, Inc., were $8.7 million versus $7.0 million in the third quarter of fiscal 2006. Increased sales of the Company’s electronic perimeter fence products across its established customer base in North America and the UK, aided by mild weather conditions which extended the season for these products, accounted for the increase. Waters Medical Systems’ net sales for the three months ended March 31, 2007, were $0.6 million compared to $0.5 million for the comparable period in the prior year.

Net sales for the nine months ended March 31, 2007 were $24.8 million, an increase of $2.8 million, or 12.8% from $22.0 million in the same period of the prior year. Net sales for the Zareba Systems division, including Zareba Systems of Canada, Zareba Systems Europe and Zareba Security, Inc., were $23.3 million versus $20.4 million in the first nine months of fiscal 2006, reflecting the same conditions that contributed to the quarterly sales increase. Waters Medical Systems’ net sales were $1.6 million for each of the nine months ended March 31, 2007 and 2006.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 11

Third quarter fiscal 2007 gross margins were 33.6% compared to gross margins for the third quarter fiscal 2006 of 33.1%. Gross margins for both periods reflect the seasonal impact of lower production levels and corresponding decrease in manufacturing overhead absorption during the quarter. Current year margins benefited from price increases implemented during the first quarter of fiscal 2007. Gross margins for the nine month period ended March 31, 2007 were 33.6% versus 32.4% for the first nine months of the prior fiscal year, including the prior year inventory valuation adjustment which amounted to $641,000, or a 2.8% reduction in gross margins. During the first quarter of fiscal 2007 the Company implemented price increases in its Zareba Systems division to offset the impact of material cost increases incurred beginning in the previous fiscal year, the benefit of which was not fully realized until the third quarter of fiscal 2007. The Company continues to experience cost pressures on certain components for its Zareba Systems products primarily sold in North America. The Company intends to address these situations through a combination of further negotiation with existing suppliers, identification of alternative suppliers and selective price adjustments to customers.

Selling, general and administrative expenses for the three and nine months ended March 31, 2007 were $2.3 million and $6.8 million, respectively, down from $2.4 million and $7.0 million for the comparable quarters of the prior year. Prior year costs related to hiring and severance costs for management changes made up the majority of the differences for the respective periods.

Research and development expenses for the three and nine months ended March 31, 2007 were $0.4 and $1.1 million, respectively, compared to $0.4 million and $1.0 million for the comparable periods of the prior year. Continued product enhancements for both WMS and Zareba Systems and additional new product development for Zareba Systems automatic gate opener systems and perimeter security systems continue to be the focus of our development efforts. The Company’s long-term investments are designed to protect and enhance our future financial performance.

Interest expense, principally related to the Company’s term debt to finance the Rutland acquisition, was $192,000 and $580,000 for the three and nine months ended March 31, 2007, respectively compared to $185,000 and $575,000 for the comparable periods of fiscal 2006, as a result of increased interest rates in the current year.

Net income for the third quarter of fiscal 2007 was 110,000, or $0.05 and $0.04 per basic and diluted share, respectively, compared to a net loss of $381,000, or $0.16 per basic and diluted share in the same period of the prior year. Net loss for the nine months ended March 31, 2007 was $166,000, or $0.07 per share versus a net loss of $1,073,000, or $0.45 per share in the comparable period of the prior year. The current year increased sales and reductions in operating expenses and the impact of the prior year inventory valuation adjustment were the primary reasons for the improvement over the prior year.

Liquidity and Capital Resources

The Company’s cash balance was $0.9 million at March 31, 2007 compared to $1.4 million at June 30, 2006. Accounts receivable decreased to $6.4 million at March 31, 2007 from $8.2 million at June 30, 2006, as a result of the seasonal trends of the business producing lower sales as compared to the quarter ended June 30, 2006. Inventories were $6.9 million at March 31, 2007 compared to $6.7 million at June 30, 2006 reflecting inventories on hand to meet projected requirements.

Capital expenditures were $86,000 in the first nine months of fiscal year 2007 versus $210,000 in the comparable period of fiscal 2006 and were used primarily for purchases of manufacturing and office equipment and tooling. The Company estimates capital expenditures for the current year to be comparable to prior year levels.

In September 2004, the Company paid in full the previous Wells Fargo Bank (WF) $3.0 million bank line of credit and term debt facility and executed a new WF business credit facility for the Rutland acquisition. The WF credit facility initially included an aggregate credit limit of $7.8 million, consisting of revolving credit up to $6.0 million and term credit of $1.8 million. Under this credit facility, the Company borrowed approximately $5.1 million for the Rutland acquisition. Under the terms of the new WF credit facility agreement and subsequent amendments, interest is charged on outstanding balances at the rate of one half of one percent (or .50 percent) above base rate. The initial term of the revolving credit agreement runs for three years, expiring in September 2007, and it is renewable on an annual basis thereafter. As a result, the entire balance due under the revolving credit facility of $4.6 million at March 31, 2007 is classified as a current liability. The effective interest rate on March 31, 2007 and the average interest rate for the nine month period then ended was 8.75 percent. The term notes require monthly principal payments of $19,168 plus interest. As of March 31, 2007, an additional $0.4 million was available for the future draws. Future WF availability is determined by the daily eligible

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 12

collateral net of the outstanding loan balance. The Company is in compliance with the covenants related to the WF facility at March 31, 2007.

Also, in September 2004, Zareba Systems Europe secured a £2,214,000 term loan (approximately $4.0 million) from the Bank of Scotland (BoS) in the United Kingdom for the Rutland acquisition. Under the terms of the BoS credit facility agreement, interest is charged on outstanding balances at the rate of two and one eighth percent (or 2.125 percent) above the base rate with a five-year term. On March 31, 2007, the effective interest rate was 7.375 percent, and the average interest rate for the nine month period then ended was 7.069 percent. The BoS term loan matures on September 27, 2009, with monthly principal and interest payments of £49,355 (approximately $96,000). The balance outstanding under this facility at March 31, 2007 was £1.3 million, or approximately $2.6 million. In September 2006, the BoS waived all previous covenant violations for fiscal 2006 and agreed to work with the Company to establish new covenant levels for fiscal 2007 and the future. The Company and BoS continue to work on finalizing the new covenants, which the Company believes will be met going forward.

Both the WF Business Credit and the BoS credit facilities are collateralized by substantially all of the assets of the Company and Zareba Systems Europe, in their respective localities. Line of credit borrowings are limited to eligible accounts receivable and inventory.

The Company believes that its existing funds, additional cash generated from operations, borrowings under the Company’s current bank debt facilities and the expectation of financing through the successful renewal of its current WF facility or through securing an alternative financing arrangement will be adequate to meet the Company’s foreseeable operating activities and outlays for capital expenditures for at least the next twelve months.

Critical Accounting Policies

The Company’s critical accounting polices are discussed below.

Revenue Recognition

The Company recognizes revenue in accordance with the Securities Exchange Commission’s Staff Accounting Bulletin No. 104 (SAB104) Revenue, which requires that four basic criteria be met before revenue can be recognized: (i) persuasive evidence of a customer arrangement exists; (ii) the price is fixed or determinable; (iii) collectibility is reasonably assured; and (iv) product delivery has occurred or services have been rendered. Sales are not conditional based on customer acceptance provisions or installation obligations. The Company primarily utilizes independent manufacturers’ representatives to facilitate sales orders (with no right of return or other Company obligation), as well as having direct sales for key accounts or product lines. The Company recognizes revenue as products are shipped based on FOB shipping point terms when title passes to the customer. The Company accounts for customer rebates on the accrual basis when they are probable and can be estimated. The Company estimates and accrues for sales returns based upon historical experience.

Allowance for Doubtful Accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of the Company’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

The allowance for doubtful accounts is an estimate based on specifically identified accounts. The Company evaluates specific accounts where information that the customer may have an inability to meet its financial obligations is known. In these cases, management uses its judgment, based on the best available facts and circumstances, and records a specific reserve for that customer against amounts due to reduce the receivable to the amount that is expected to be collected. These specific reserves are re-evaluated and adjusted as additional information is received that impacts the amount reserved. If circumstances change, the Company’s estimates of the recoverability of amounts due could be reduced or increased by a material amount. Such a change in estimated recoverability would be accounted for in the period in which the facts that give rise to the change become known.

Valuation of Inventories

Our inventories are stated at the lower of cost or market. Cost is determined by the first-in, first-out (“FIFO”) method. We maintain a standard costing system for our inventories, which approximates the FIFO method. Assumptions with respect to direct labor utilization, standard direct and indirect cost rates, vendor pricing and utilization of factory capacities are formulated in the development of our standard costing system. Changes in production levels due to the seasonality of the markets we serve can result in production variances from our standard rates. These variances directly impact our gross profit performance and may cause variability in gross profit results from reporting period-to-reporting period. Our labor

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 13

and overhead rates are set for production rates that match typical market conditions. Production variances are charged to cost of sales each quarter as incurred. Material standards are based upon normal purchase volumes. Purchase price variances are charged to costs of sales each quarter as incurred.

Provisions to reduce inventories to the lower of cost or market are made based on a review of excess and obsolete inventories through an examination of historical component consumption, current market demands and shifting product technology. Significant assumptions with respect to market trends are utilized to formulate our provision methods. Sudden or downward changes in markets we serve may cause us to record additional inventory revaluation charges in future periods.

Amortization of Intangible Assets

Customer relationships and non-compete agreements are amortized on a straight-line basis over seven and five years, respectively. Intangible assets are amortized on a basis that corresponds to the Company’s projections of future cash flows directly related to these intangible assets. The estimates that are included in its projection of future cash flows are based on the best available information at the time of the determination of useful life and amortization method. A change in circumstances could result in a determination that the related assets are impaired and impairment charges to reduce the carrying value of intangible assets may be necessary.

Impairment of Long-Lived Assets

The Company evaluates the carrying value of long-lived assets, including identifiable intangibles, for impairment when events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If impairment indicators are present and the estimated future undiscounted cash flows are less than the carrying value of the assets, the carrying value is reduced to the estimated fair value as measured by the associated discounted cash flows.

Under SFAS No. 142, the Company currently evaluates goodwill and indefinite lived intangible assets (trade names) for impairment using a two-step test based upon a fair value approach. The first step is used to identify a potential impairment through an estimate of the fair value of certain reporting units (as defined by SFAS No. 142), while the second step calculates the amount of impairment, if any. Additionally, goodwill shall be tested for impairment between annual tests if an event occurs or circumstances change that would reduce the fair value of an entity below its carrying value. The Company evaluated goodwill for impairment using the method described in the preceding paragraph and determined the fair value of its reporting units by application of a discounted cash flow analysis. The Company makes estimates that are included in its discounted cash flow analyses based upon the best available information at the time of the fair value determination. If circumstances change, the estimates of fair value will also change and could necessitate additional impairment charges that reduce the carrying value of goodwill.

Contingencies

We are subject to the possibility of various loss contingencies, including legal claims, in the normal course of business. We accrue for loss contingencies when a loss is probable and can be estimated. See footnote 9 to the financial statements for additional information.

Forward-Looking Statements and Risk Factors

Certain statements in this Report are forward-looking statements that involve a number of risks and uncertainties that may cause the Company’s future operations and results of operations to differ materially from those anticipated. Specifically, these include statements relating to (a) the sufficiency of capital, which depends on the Company successfully maintaining adequate levels of bank financing and successfully negotiating waivers and/or amendments to covenants relating to its current UK bank financing, the Company meeting its expenses and revenue projections and the success of the Company’s new products, which further depend on the management’s ability to realize desired sales synergies, the impact new Zareba Systems products have on the traditional seasonality of sales, as well as general competitive, market and economic conditions; (b) growth in Zareba Systems’ sales generally and as a result of its new products, including sales within the corrections marketplace, and the expectation that the security systems and gate openers will become an emerging and growing market opportunity, which depend on the cost and success of the Company’s development efforts and new products, including the professional series of automatic gate opener systems, the success of the Zareba Systems Europe subsidiary, the actual development of the perimeter security system market, the extent to which weather and UK farm subsidies affect sales and timing, the Company’s ability to finalize distribution agreements with key distributors on acceptable terms, the success of new distribution channels, the actual costs of supplies and raw materials, the effect of consolidation within the agricultural retail industry, as well as actual competition, market and economic conditions; (c) that the demand for customized electronic perimeter security systems will increase, which depends on the quality of the product

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 14

offerings, the effectiveness of our sales force, the need and perceived need for increased security in the markets we serve, and competition from other suppliers; and, (d) the anticipation that additional agreements will be established with other distributors following the recently obtained agreement with a key distributor in the UK, which depends on the effectiveness of our sales force and the quality of our products versus those otherwise available in Europe and elsewhere.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 15

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Market Risk

Zareba has foreign subsidiaries in Canada and the United Kingdom, and we generate approximately 25% of our net sales from outside North America. Our ability to sell our products in foreign markets may be affected by changes in economic, political or market conditions in the foreign markets in which we do business.

The Company’s net investment in its foreign subsidiaries was $6.2 million and $6.1 million at March 31, 2007 and June 30, 2006, respectively, translated into U.S. dollars at the closing exchange rates. The potential loss based on end-of-period balances and prevailing exchange rates resulting from a hypothetical 10% strengthening of the dollar against foreign currencies was not material for the three and nine month periods ended March 31, 2007 and 2006. Although the Company may decide to enter into foreign exchange contracts as a hedge against specific foreign currency receivables, the Company did not enter into any foreign exchange contracts in the fiscal-year-to-date period and in fiscal 2006.

Interest Rate Risk

Substantially all of our senior debt and the associated interest expense are sensitive to changes in the level of interest rates. A hypothetical 100 basis point (one percentage point) increase in interest rates would result in incremental interest expense of approximately $19,000 and $59,000 and $14,000 and $60,000 in the three and nine months ended March 31, 2007, and 2006, respectively.

Item 4. Controls and Procedures

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, and although it continues to improve its inventory valuation and transaction processes and procedures at Zareba Systems Europe, 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 controls 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.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 16

PART II: OTHER INFORMATION

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the “Risk Factors” discussed in Part II, Item 1A (Risk Factors) of the Company’s Form 10-Q for the period ended September 30, 2006. Those factors, if they were to occur, could cause our actual results to differ materially from those expressed in our forward-looking statements in this report, and materially adversely affect our financial condition or future results. Although we are not aware of any other factors that we currently anticipate will cause our forward-looking statements to differ materially from our future actual results, or materially affect the Company’s financial condition or future results, additional risks and uncertainties not currently known to us or that we currently deem to be immaterial might materially adversely affect our actual business, financial condition and/or operating results.

Item 6. Exhibits

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 17

SIGNATURES

In accordance with the requirements of the Exchange Act, the Company caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

May 9, 2007

Zareba Systems, Inc.
By:	/s/ Jerry W. Grabowski
	Jerry W. Grabowski
	President and Chief Executive Officer (Principal executive officer)
By:	/s/ Jeffrey S. Mathiesen
	Jeffrey S. Mathiesen
	Chief Financial Officer (Principal financial officer and principal accounting officer)

Zareba Systems, Inc. Form 10-Q, March 31, 2007 page 18