Zareba Systems (ZRBA) 10-Q 2008 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)

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

For the quarterly period endedMarch 31, 2008

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

For the transition period from                    to                    

Commission file number 0-1388

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 Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesþ Noo

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):

Large accelerated filero Accelerated filero Non-accelerated filero
(Do not check if a smaller reporting company) Smaller reporting companyþ

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 5, 2008 was 2,465,696.

INDEX TO FORM 10-Q

		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		12
Item 4	Controls and Procedures		17
	PART II: OTHER INFORMATION
Item 1A	Risk Factors		18
Item 5	Other Information		18
Item 6	Exhibits		18
	SIGNATURES		19
Third Amendment to Lease Agreement
Section 302 Certification
Section 302 Certification
Section 906 Certification
Section 906 Certification

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 2

PART I: FINANCIAL INFORMATION

Item 1. Financial Statements

ZAREBA SYSTEMS, INC.

Condensed Consolidated Balance Sheets

	March 31,			June 30,
(In thousands, except share amounts)	2008			2007
	(Unaudited)
Current assets
Cash and cash equivalents	$	531		$	1,614
Accounts receivable, net		4,177			7,671
Inventories		7,634			6,503
Other current assets		1,244			1,227
Current assets of discontinued operations		—			729
Total current assets		13,586			17,744
Property, plant and equipment, net		2,792			3,150
Other assets
Goodwill		6,580			6,616
Trademarks		2,679			2,686
Customer relationships, net		1,179			1,447
Other, net		405			230
Total other assets		10,843			10,979
TOTAL ASSETS	$	27,221		$	31,873
Current liabilities
Accounts payable	$	3,564		$	4,712
Accrued liabilities		1,809			2,419
Income taxes payable		439	��		207
Current maturities of long-term debt		1,093			6,326
Current liabilities of discontinued operations		—			123
Total current liabilities		6,905			13,787
Deferred income taxes		993			1,096
Other long-term liability		175			—
Long-term debt, less current maturities		3,249			2,269
Total liabilities		11,322			17,152
Stockholders’ equity
Undesignated shares as of March 31, 2008 and June 30, 2007, $0.01 par value, 39,950,000 shares authorized, none issued or outstanding		—			—
Series A Preferred Stock as of March 31, 2008 and June 30, 2007, $0.01 par value per share, 50,000 shares authorized, none issued or outstanding		—			—
Common stock as of March 31, 2008 and June 30, 2007, par value $.01 per share; authorized: 20,000,000 shares; issued and outstanding 2,465,696 and 2,452,291shares, respectively		25			25
Additional paid-in capital		2,320			2,133
Accumulated other comprehensive income:
Foreign currency translation adjustment		350			488
Retained earnings		13,204			12,075
Total stockholders’ equity		15,899			14,721
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	27,221		$	31,873

See notes to the condensed consolidated financial statements.

Zareba Systems, Inc. Form 10-Q, March 31, 2008 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)	2008			2007			2008			2007
Net sales	$	7,074		$	8,678		$	22,770		$	23,253
Cost of goods sold		4,963			5,891			16,139			15,819
Gross profit		2,111			2,787			6,631			7,434
Operating expenses
Selling, general and administrative		2,366			2,143			7,162			6,298
Research and development		303			309			939			932
Total operating expenses		2,669			2,452			8,101			7,230
Income (loss) from operations		(558	)		335			(1,470	)		204
Other income (expense), net
Interest income		6			10			28			24
Interest expense		(86	)		(193	)		(297	)		(581	)
Other income (expense), net		(101	)		(84	)		(162	)		(164	)
Income (loss) before income taxes		(739	)		68			(1,901	)		(517	)
Income tax provision (benefit)		(250	)		25			(646	)		(186	)
Income (loss) from continuing operations		(489	)		43			(1,255	)		(331	)
Gain from discontinued operations, net of tax		—			67			13			165
Gain from sale of subsidiary, net of tax		—			—			2,546			—
Net income (loss)	$	(489	)	$	110		$	1,304		$	(166	)
Income (loss) from continuing operations per common and common equivalent share:
basic	$	(0.20	)	$	0.02		$	(0.51	)	$	(0.14	)
diluted	$	(0.20	)	$	0.02		$	(0.51	)	$	(0.14	)
Gain from discontinued operations per common and common equivalent share:
basic	$	—		$	0.03		$	0.01		$	0.07
diluted	$	—		$	0.03		$	0.01		$	0.07
Gain from sale of subsidiary per common and common equivalent share:
basic	$	—		$	—		$	1.04		$	—
diluted	$	—		$	—		$	1.04		$	—
Net income (loss) per common and common equivalent share:
basic	$	(0.20	)	$	0.05		$	0.53		$	(0.07	)
diluted	$	(0.20	)	$	0.04		$	0.52		$	(0.07	)
Weighted average number of shares outstanding
basic		2,464,212			2,432,341			2,456,236			2,427,268
diluted		2,464,212			2,473,124			2,456,236			2,427,268

See notes to the condensed consolidated financial statements.

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 4

ZAREBA SYSTEMS, INC.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

	For the nine months
	ended March 31,
(In thousands)	2008			2007
Cash flows provided by (used in) operations:
Reconciliation of net income (loss) to net cash provided by operations
Net income (loss)	$	1,304		$	(166	)
Adjustments to reconcile net income (loss) to cash flows from operating activities:
Depreciation and amortization		843			976
Gain on sale of subsidiary		(2,546	)		—
Loss on disposal of plant and equipment		9			—
Stock-based compensation expense		134			23
Deferred income taxes		(216	)		(73	)
Changes in assets and liabilities:
Accounts receivable, net		3,490			1,942
Inventories		(1,197	)		(21	)
Other assets		(461	)		(104	)
Accounts payable and accrued expenses		(3,056	)		(1,490	)
Net cash provided by (used in) operations		(1,696	)		1,087
Cash flows provided by (used in) investing activities:
Purchases of property and equipment		(167	)		(86	)
Acquisition of business, net of assets acquired		—			(11	)
Proceeds from sale of subsidiary		5,000			—
Net cash provided by (used in) investing activities		4,833			(97	)
Cash flows provided by (used in) financing activities:
Net advances (payments) on short-term borrowings		—			(300	)
Net proceeds from long-term debt – revolving credit facility		2,748			—
Proceeds from sale of common stock		53			31
Payments on non-compete liability		—			(250	)
Payments of debt issue costs		(40	)		—
Payments on long-term debt		(6,987	)		(1,110	)
Net cash provided by (used in) financing activities		(4,226	)		(1,629	)
Effect of exchange rate changes in cash		6			98
Net increase (decrease) in cash and cash equivalents		(1,083	)		(541	)
Cash and cash equivalents — beginning of period		1,614			1,414
CASH AND CASH EQUIVALENTS — END OF PERIOD	$	531		$	873
Supplemental Schedule of Non-Cash Activities
Long-term liability recorded for adoption of FIN 48 (See Note 8)	$	175			—
Change in deferred income taxes and income tax payable related to other comprehensive income		96			—

See notes to the condensed consolidated financial statements.

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 5

ZAREBA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements

March 31, 2008 and 2007

(Unaudited)

Zareba Systems, Inc., (the Company) prepared the condensed consolidated 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 generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations.

These condensed consolidated financial statements should be read in conjunction with the financial statements and the accompanying notes included in the Company’s 10-K for the year ended June 30, 2007, and the Fiscal Year 2007 Annual Report.

The results of operations for the three and nine months ended March 31, 2008 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)	2008			2007		2008		2007
Numerator:
Net income (loss)	$	(489	)	$	110	$	1,304	$	(166	)
Denominator:
Weighted average common shares outstanding-basic		2,464,212			2,432,341		2,456,236		2,427,268
Dilution associated with the company’s stock-based compensation plans		—			40,783		—		—
Weighted average common shares outstanding-diluted		2,464,212			2,473,124		2,456,236		2,427,268
Net income (loss) per common share-basic	$	(0.20	)	$	0.05	$	0.53	$	(0.07	)
Net income (loss) per common share-diluted	$	(0.20	)	$	0.04	$	0.53	$	(0.07	)
Dilutive potential shares excluded because the effect would be antidilutive:
In-the-money stock options		87,300			—		87,300		145,800
Stock options with exercise prices greater than the average market price of the common shares for those periods		222,525			250,875		222,525		250,875

2. Comprehensive Income (loss)

The components of comprehensive income (loss), net of related tax, for the three and nine months ended March 31, 2008 and 2007 were as follows:

	Three months					Nine months
	ended March 31,					ended March 31,
(In thousands)	2008			2007		2008			2007
Net income (loss)	$	(489	)	$	110	$	1,304		$	(166	)
Foreign currency translation adjustment		(90	)		90		(138	)		452
Comprehensive income (loss)	$	(579	)	$	200	$	1,166		$	286

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 6

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 $96,000 of related compensation expense, or $60,000 net of tax or $0.02 per basic and diluted share, to the gain on sale of subsidiary during the first quarter of fiscal 2008 as a result of accelerated vesting of certain options upon closing of the transaction. We also recorded $13,000 and $38,000 of related compensation expense, all to general and administrative expense, for the three and nine months ended March 31, 2008, respectively as compared to $8,000 and $23,000 for the respective comparable periods in the prior year. The related tax benefit from recording this non-cash general and administrative expense was $5,000 and $14,000, and the net compensation expense to operations was $8,000, or $0.00 per basic and diluted share, and $24,000, or $0.01 per basic and diluted share, for the three and nine months ended March 31, 2008, respectively. The related tax benefit from recording this non-cash general and administrative expense was $3,000 and $9,000, and the net compensation expense to operations was $5,000, or $0.00 per basic and diluted share, and $14,000, or $0.01 per basic and diluted share, for the three and nine months ended March 31, 2007. As of March 31, 2008, a total of $678,000 of unrecognized compensation costs related to non-vested stock option awards was outstanding, including $639,000 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 $39,000 of unrecognized compensation expense is expected to be recognized within the next four 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 vest. Under the modified prospective approach, compensation cost recognized in fiscal 2007 and 2008 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.

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. Expected dividend yield is based upon the Company’s historical and projected dividend activity and the risk free interest rate is based upon US Treasury rates appropriate for the expected term of the options. The expected term is based on estimates regarding projected employee stock option exercise behavior. No options were granted during the three and nine months ended March 31, 2008. The weighted average fair value of options granted during both the three and nine months ended March 31, 2007 was $3.38, determined using an expected dividend yield of 0.00%, an expected stock price volatility of 73.07%, a risk-free interest rate of 4.38% and expected option lives of 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 550,000 shares authorized for grant under the 2004 Equity Incentive Plan.

Option activity under both plans during the nine months ended March 31, 2008 were as follows:

			Weighted Avg.		Aggregate
	Number		Exercise Price		Intrinsic
	of Options		Per Share		Value
Options outstanding, June 30, 2007		362,100	$	6.48
Granted		—		—
Exercised		4,500	$	3.83
Forfeited		47,775	$	5.70
Options outstanding, March 31, 2008		309,825	$	6.63	$	56,623
Exercisable, March 31, 2008		113,825	$	4.39	$	56,623

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 7

As of March 31, 2008, the options outstanding have a weighted average remaining contractual life of 6.0 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		66,150	2.2 years	$	2.90		66,150	$	2.90
$4.00 to $5.90		51,150	4.6 years	$	5.17		21,150	$	4.12
$6.71 to $8.47		192,525	7.6 years	$	8.31		26,525	$	8.31
$2.67 to $8.47		309,825	6.0 years	$	6.63		113,825	$	4.39

4. Inventories

Inventories consisted of the following.

	March 31,		June 30,
(In thousands)	2008		2007
	(Unaudited)
Raw materials	$	2,414	$	2,024
Finished goods		5,220		4,479
TOTALS	$	7,634	$	6,503

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.

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 and nine months ended March 31, 2008 were $83,000 and $256,000, respectively, compared to $83,000 and $265,000 in the respective comparable periods ended March 31, 2007.

At June 30, 2007, 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. Foreign currency translation adjustments comprise the change in goodwill for the periods presented.

If circumstances change, the estimates of fair value will also change and could necessitate impairment charges that reduce the carrying value of goodwill. Management considered whether the loss from continuing operations constituted a triggering event to assess impairment of goodwill and/or identifiable intangible assets, however, based on the seasonality of the Company's sales cycle and growth initiatives, management believes that it is too early to assess if the unfavorable conditions are short-term in nature that will be recovered in the future. Thus management believes a triggering event has not occurred. The Company is in the process of evaluating its forward projections and growth initiatives in light of the current economic conditions which are scheduled to be completed in the fiscal fourth quarter. If any impairment is identified, the related adjustment to goodwill and/or other identifiable intangible assets will be recorded against fourth quarter operations, and could be material.

6. Bank Debt Disclosure

On August 29, 2007, the Company entered into a secured revolving credit facility with JPMorgan Chase Bank, N.A. (Chase), subsequently terminating the Wells Fargo Business Credit (WF) facility and paying in full all outstanding balances under the WF facility, totaling approximately $1.1 million on August 30, 2007. The Chase facility provides for a $6 million secured revolving credit facility (the “Credit Facility”), with the option to increase borrowings in additional $500,000 increments with the consent of the Lender, up to a total of $7.5 million. Amounts under the facility may be borrowed, repaid and reborrowed from time to time until its maturity on August 29, 2010. Loans under the 2007 Credit Agreement will bear interest at either a base rate minus 1.0 percent to 0 percent, based upon financial performance, or a Eurocurrency rate equal to the London Inter-Bank Offered Rate (“LIBOR”) for the relevant term plus 1.5 percent to 2.5 percent, based upon financial performance. The outstanding balance under this revolving credit facility at March 31, 2008 was $2.7 million. The effective interest rate at March 31, 2008 was 4.25 percent, and the average effective interest rate for the three and nine months then ended was 5.22 percent and 6.23 percent, respectively.

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

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 8

the base rate with a five-year term. On March 31, 2008, the effective interest rate was 7.03 percent and the average effective interest rate for the three and nine months then ended was 7.51 percent and 7.74 percent, respectively, versus 7.19 percent and 6.98 percent, respectively, for the same periods in the prior year. The BoS term loan matures on September 27, 2009, with monthly principal and interest payments of £49,355 (approximately $98,000). The balance outstanding under this facility at March 31, 2008 was £0.8 million, or approximately $1.6 million.

The following table summarizes the debt outstanding:

United States Bank Debt as of
	March 31,			June 30,
(In thousands)	2008			2007
Note payable to bank	$	2,748		$	6,211
Other		3			4
		2,751			6,215
Less current maturities and short-term borrowings		(1	)		(5,275	)
Total	$	2,750		$	940

United Kingdom Bank Debt as of
	March 31,			June 30,
(In thousands)	2008			2007
Note payable to bank	$	1,591		$	2,380
Less current maturities and short-term borrowings		(1,092	)		(1,051	)
Total	$	499		$	1,329

Both the Chase 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. Discontinued Operation and Sale of Waters Medical Systems, Inc.

On July 24, 2007 the Company entered in to a Stock Purchase Agreement for the sale of the Company’s Waters Medical Systems, Inc., (WMS) subsidiary to a third party. The WMS subsidiary, a provider of medical products was initially formed on June 30, 2005, when all the assets of the WMS division of Zareba were transferred to the newly-formed subsidiary, and has operated in a separate business segment of the Company. Accordingly, all results of operations and assets and liabilities of WMS for all periods presented prior to the transaction date have been restated and classified as discontinued operations.

The sale of WMS was completed on August 1, 2007. The transaction involved the sale of 100 percent of the stock of WMS, including all assets and liabilities of WMS at close, for $5 million cash.

The gain on the sale of WMS recorded in the first quarter of fiscal 2008 was calculated as follows:

Cash received	$	5,000
Less: investment in WMS		(665	)
transaction costs		(228	)
Gain on sale before tax		4,107
Income tax (estimated rate of 38 %)		(1,561	)
Gain on sale, net of tax	$	2,546

Assets and liabilities of WMS at June 30, 2007 were as follows:

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 9

(In thousands)
Accounts receivable, net	$	259
Inventories		454
Other current assets		16
Current assets of discontinued operations		729
Property and equipment, net		19
Other assets of discontinued operations		19
Accounts payable		63
Accrued compensation and other liabilities		60
Current liabilities of discontinued operations	$	123

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 10

Condensed consolidated statements of operations for WMS for three and nine months ended March 31, 2008 and 2007 are as follows:

	Three months ended				Nine months ended
	March 31,				March 31,
(In thousands)	2008		2007		2008		2007
Net sales	$	—	$	561	$	142	$	1,586
Gross profit		—		316		79		904
Selling, general and administrative		—		151		47		497
Research and development		—		61		11		149
Income tax provision		—		37		8		93
Gain from discontinued operations, net of tax	$	—	$	67	$	13	$	165

8. Income Taxes

The Company adopted the provisions of FASB Interpretation 48,Accounting for Uncertainty in Income Taxes(Interpretation 48), on July 1, 2007. Previously, the Company had accounted for tax contingencies in accordance with Statement of Financial Accounting Standards 5,Accounting for Contingencies. As required by Interpretation 48, which clarifies Statement 109,Accounting for Income Taxes, the Company recognizes the financial statement benefit of a tax position only after determining that the relevant tax authority would more likely than not sustain the position following an audit. For tax positions meeting the more-likely-than-not threshold, the amount recognized in the financial statements is the largest benefit that has a greater than 50 percent likelihood of being realized upon ultimate settlement with the relevant tax authority. At the adoption date, the Company applied Interpretation 48 to all tax positions for which the statute of limitations remained open. As a result of the implementation of Interpretation 48, the Company recognized an increase of approximately $175,000 in the liability for unrecognized income tax benefits, which was accounted for as a reduction to the July 1, 2007 balance of retained earnings.

Upon adoption, the increase in the liability for unrecognized income tax benefits is the result of the Company’s de-recognition of certain positions taken in prior years that management no longer believes are more likely than not of being sustained upon examination. At March 31, 2008, the balance of unrecognized tax benefits is unchanged from the adopted balance of $175,000. The March 31, 2008, balance of unrecognized tax benefits, if ultimately recognized, will reduce the Company’s annual effective tax rate.

The Company is subject to income taxes in the U.S. Federal jurisdiction, Minnesota, and the United Kingdom. Tax regulations within each jurisdiction are subject to the interpretation of the related tax laws and regulations and require significant judgment to apply. With few exceptions, the Company is no longer subject to U.S. federal, state or local income tax examinations by tax authorities for the fiscal years ended before June 30, 2005.

The Company is not currently under examination by any taxing jurisdiction.

The Company recognizes interest and penalties accrued related to unrecognized tax benefits in income tax expense for all periods presented. The Company accrued $12,201 for the payment of interest and penalties as of July 1, 2007, the date of adoption.

Zareba Systems, Inc. Form 10-Q, March 31, 2008 page 11

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

The following discussion of the Company’s results of operations and financial condition should be read together with the other financial information and Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended June 30, 2007. The results of operations relate to continuing operations unless noted. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of a variety of factors, including those discussed in Part I, Item 1ARisk Factors, on our Annual Report on Form 10-K for the year ended June 30, 2007 and in Part II, Item 1ARisk Factors, of our Form 10-Q for the quarter ended September 30, 2007.

Executive Summary

Zareba Systems, Inc. (“Zareba”, “Zareba Systems” or the “Company”) experienced decrease in net sales of 18% and 2% to $7.1 million and $22.8 million, respectively, for the third quarter and first nine months of fiscal year 2008, ended March 31, 2008, versus net sales of $8.7 million and $23.3 million for the comparable periods of the prior year. Net sales decreased across all areas of the business, with the largest decrease occurring in electric fencing systems in North America and the UK. Unfavorable weather leading to late spring seasons in both the North American and UK markets and the adverse economic environment in the US market were the primary contributors to this decline in sales.

Loss from continuing operations was $1,255,000, or $0.51 per basic and diluted share, for the nine months ended March 31, 2008, compared to a loss from continuing operations of $331,000, or $0.14 per basic and diluted share in the same period of the prior year. The increase in loss from operations over the prior year resulted from the combination of lower sales revenues, lower gross margins, and increased operating expenses associated with newer products.

On July 24, 2007, the Company entered into a Stock Purchase Agreement to sell the Company’s Waters Medical Systems, Inc., (WMS) subsidiary to a third party. The WMS subsidiary, a provider of medical products was initially formed on June 30, 2005, when all the assets of the WMS division of Zareba were transferred to the newly-formed subsidiary, and has operated in a separate business segment of the Company. Accordingly, all results of operations and assets and liabilities of WMS for all periods presented prior to the transaction date have been restated and classified as discontinued operations. The sale of WMS, was completed on August 1, 2007 for $5 million cash, resulting in a gain, net of tax, of approximately $2.5 million. Cash proceeds from the sale were used to reduce borrowing under the Company’s Wells Fargo credit facility.

On August 29, 2007, the Company entered into a $6 million secured revolving credit facility with JPMorgan Chase Bank, N.A. Proceeds from the facility will be used for general working capital purposes and were used to repay the prior Wells Fargo Business Credit facility, totaling approximately $1.1 million.

Overview

Zareba Systems, Inc. designs, manufactures and markets electronic perimeter fence and access control systems, operating in one world-wide business segment. Zareba has three subsidiaries, Zareba Systems Europe Limited, Zareba Security, Inc. and Zareba Systems of Canada LTD.

On September 27, 2004, through its newly formed subsidiary, Zareba Systems Europe, the Company acquired Rutland, 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 recorded 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 impacted net sales significantly.

In the first quarter of calendar 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 completed initial systems deliveries and established a distribution agreement with a key distributor in the UK in fiscal 2006. The Company completed additional systems deliveries in fiscal 2007 and the first half of fiscal 2008, along with a large shipment of perimeter security products for several prisons in fiscal 2007. The Company continues to work to establish similar

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agreements with other distributors to sell both electric fencing and its patent-pending Guard Tower^® product lines in various countries around the world.

Products comprising the automatic gate opener systems and accessories targeting the Do-It-Yourself (traditional) Zareba market are sold through existing retail channels in North America and the UK, often to the same customer that purchased products of the traditional Zareba product line. During the second half of fiscal 2007, the Company further expanded its product offerings and began shipping a new family of professional series automatic gate openers available to the professional installer distribution channels.

Zareba Systems’ business is seasonal, with peak customer demand occurring in the late spring, summer and early autumn months. Backlog is not significant 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 three months ended March 31, 2008 were $7.1 million, compared to $8.7 million for the comparable period of the prior year,for a decrease of 18%.Net sales for the nine months ended March 31, 2008 were $22.8 million, a decrease of 2% from $23.3 million for the comparable period of the prior year. The fiscal quarter and year-to-date sales decreases were spread across the major product lines;:electric fencing systems, automatic gate openers and perimeter security systems. The unexpectedly sharp decrease in the current year quarterly sales resulted from a combination of seasonally lower sales in the UK and North American markets, and the adverse economic environment in the US. Continued adverse economic and/or weather conditions in the primary markets we serve may further inhibit the Company’s sales growth and profitability though the remainder of the current fiscal year as compared to fiscal 2007.

Gross margins for the three and nine months ended March 31, 2008 were 29.8% and 29.1%, respectively compared to 32.1% and 32.0% for the respective periods in the previous year. The year to year decreases resulted from factors including a higher concentration of sales to lower margin customers, higher concentration of sales of certain lower margin electric fencing system and automatic gate opener products, and lower margins related to the production ramp up of the professional series of automatic gate opener products. Management expects actions it has recently taken and plans to take to improve margins through cost reductions and price increases will improve margins in the fourth quarter of fiscal 2008 from the third quarter levels.

Selling, general and administrative expenses were $2.4 million and $7.2 million, respectively, for the three and nine months ended March 31, 2008 compared to $2.1 million and $6.3 million, respectively, in the prior year. Costs related to expanded sales and marketing activities supporting the automatic gate openers and perimeter security products in both North America and the UK made up the majority of the increase. In addition, third quarter fiscal 2008 general and administrative costs increased as the Company prepared for compliance with additional provisions of the Sarbanes-Oxley Act by the end of fiscal 2008. Management expects to continue to invest in selling, general and administrative expenses toward the growth of the newer product lines, adjusting variable spending based upon projected sales and gross profit levels throughout the remainder of the fiscal year.

Research and development expenses were $303,000 and $939,000, respectively, for the three and nine months ended March 31, 2008 versus $309,000 and $932,000, respectively, for the same period in the prior year. Current year expenditures are directed toward new product development and Zareba Systems automatic gate openers and perimeter security systems as well as continued product enhancements of existing electric fencing systems products. 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 $86,000 and $297,000, respectively, for the three and nine months ended March 31, 2008 compared to $193,000 and $581,000, respectively, in the prior year. The decrease in current year expense resulted from the decrease in outstanding debt from the proceeds of the sale of WMS, and the lower interest rate under the new credit facility.

Losses from continuing operations of $489,000 or $0.20 per basic and diluted share and $1,255,000, or $0.51 per basic and diluted share, respectively, for the three and nine months ended March 31, 2008 compared to income from continuing operations of $43,000, or $0.02 per basic and diluted share and loss from continuing operations of $331,000, or $0.14 per basic and diluted share, respectively for the three and nine months ended March 31, 2007. Lower sales revenues

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and gross margins and increased investments in growth initiatives were the primary reasons for the increased losses in the current year.

Results of Discontinued Operations, Gain from the Sale of Subsidiary and Net Income

Gain from discontinued operations, net of tax was $13,000, or $0.01 per basic and diluted share for the nine months ended March 31, 2008, versus $67,000, or $0.03 per basic and diluted share and $165,000, or $0.07 per basic and diluted share, respectively for the three and nine months ended March 31, 2007, reflecting the net results of the WMS operations for the respective periods prior to the sale of WMS on August 1, 2007.

Gain from sale of subsidiary, net of tax was $2.5 million, or $1.04 per basic and diluted share for the nine months ended March 31, 2008, reflecting that sale of the WMS subsidiary on August 1, 2007.

Net loss for the third quarter of fiscal 2008 was $489,000, or $0.20 per basic and diluted share, versus net income of $110,000, or $0.05 per basic and $0.04 per diluted share in the same period of the previous year, reflecting the differences in results from continuing and discontinued operations. Net income for the nine months ended March 31, 2008 was $1,304,000, or $0.53 per basic and diluted share, compared to net loss of $166,000, or $0.07 per basic and diluted share in the same period of fiscal 2007, reflecting the differences in results from continuing and discontinued operations and the gain from the sale of WMS.

Liquidity and Capital Resources

The Company’s cash and working capital balances at March 31, 2008 were $0.5 million and $6.8 million, respectively, as compared to $1.6 million and $4.0 million at June 30, 2007. The increase in working capital resulted primarily from the reduction of debt, much of which had been classified as current at June 30, 2007, from the proceeds from the sale of WMS.

Accounts receivable decreased to $4.2 million at March 31, 2008 from $7.7 million at June 30, 2007 reflecting the seasonality of our sales. Inventories increased to $7.6 million at March 31, 2008, versus $6.5 million at June 30, 2007, reflecting preparation for projected fiscal fourth quarter seasonal demand.

Capital expenditures were $167,000 in the first nine months of fiscal 2008 versus $86,000 in same period of the prior year, and were used primarily for manufacturing and computer equipment and purchases of new product tooling. The Company expects total capital expenditures for fiscal 2008 to be approximately $0.5 million, with the additional expenditures primarily related to a specific business opportunity.

On August 1, 2007, the Company completed the sale of the WMS subsidiary, receiving $5 million cash, which was used to reduce the outstanding debt with Wells Fargo Business Credit (WF).

On August 29, 2007, the Company entered into a secured revolving credit facility with JPMorgan Chase Bank, N.A. (Chase), subsequently terminating the Wells Fargo Business Credit (WF) facility and paying in full all outstanding balances under the WF facility, totaling approximately $1.1 million on August 30, 2007. The Chase facility provides for a $6 million secured revolving credit facility (the “Credit Facility”), with the option to increase borrowings in additional $500,000 increments with the consent of the Lender, up to a total of $7.5 million. Amounts under the facility may be borrowed, repaid and reborrowed from time to time until its maturity on August 29, 2010. Loans under the 2007 Credit Agreement will bear interest at either a base rate minus 1.0 percent to 0 percent, based upon financial performance, or a Eurocurrency rate equal to the London Inter-Bank Offered Rate (“LIBOR”) for the relevant term plus 1.5 percent to 2.5 percent, based upon financial performance. The outstanding balance under this revolving credit facility at March 31, 2008 was $2.7 million. The effective interest rate at March 31, 2008 was 4.25 percent, and the average effective interest rate for the three and nine months then ended was 5.22 percent and 6.23 percent, respectively.

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, 2008, the effective interest rate was 7.03 percent and the average effective interest rate for the three and nine months then ended was 7.51 percent and 7.74 percent, respectively, versus 7.19 percent and 6.98 percent, respectively, for the same periods in the prior year. The BoS term loan matures on September 27, 2009, with monthly principal and interest payments of £49,355 (approximately $98,000). The balance outstanding under this facility at March 31, 2008 was £0.8 million, or approximately $1.6 million.

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Both the Chase 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, and borrowings under the Company’s bank debt facility 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) collectability 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. Customer rebate programs are offered based upon purchasing volume, on a percentage of sales basis. The Company accounts for customer rebates as a reduction to net sales on the accrual basis, in the period of the corresponding sale, 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 and include materials, labor and overhead. Cost is determined by the first-in, first-out (“FIFO”) method. 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

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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 impairment charges that reduce the carrying value of goodwill. Management considered whether the loss from continuing operations constituted a triggering event to assess impairment of goodwill and/or identifiable intangible assets, however, based on the seasonality of the Company's sales cycle and growth initiatives, management believes that it is too early to assess if the unfavorable conditions are short-term in nature that will be recovered in the future. Thus management believes a triggering event has not occurred. The Company is in the process of evaluating its forward projections and growth initiatives in light of the current economic conditions which are scheduled to be completed in the fiscal fourth quarter. If any impairment is identified, the related adjustment to goodwill and/or other identifiable intangible assets will be recorded against fourth quarter operations, and could be material.

Stock-based Compensation

Effective July 1, 2006, the Company adopted SFAS 123(R), which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including employee stock options based on fair values. Management’s determination of fair value of share-based payment awards is based on the date of grant using an option-pricing model which incorporates a number of highly complex and subjective variables. These variables include, but are not limited to, the Company’s expected stock price volatility over the two year period prior to the grant date of the awards and estimates regarding projected employee stock option exercise behaviors and forfeitures. The Company recognizes the expense related to the fair value of the award straight-line over the vesting period.

In accordance with SFAS 123(R), the Company has reviewed the performance requirements of the performance-based stock options granted to certain executives and determined that none of the performance-based options should be assumed to vest until greater certainty exists based on the performance measures. Therefore, the Company has not recorded the compensation cost associated with these options as the performance conditions are not likely to be achieved. A change in expected vested options could have a material impact on results of operations.

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.

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 and adequacy of capital, including existing funds, additional cash generated from operations, and borrowings under the Company’s bank debt facility and cash proceeds from the sale of the WMS subsidiary, which depends on the Company successfully maintaining adequate levels of 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 fiscal fourth quarter demand and growth inZareba Systems’ sales generally and as a result of its new products, including sales within the corrections marketplace, and the expectation that the new family of professional series automatic gate openers available to the professional installer distribution channels will offer market growth opportunities, which depend on the cost and success of the Company’s development efforts and new products, customer acceptance of new products, 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 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; (d) the anticipation that additional agreements will be

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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; and, (e) management’s belief that gross margins will improve from third quarter fiscal 2008 levels during the remainder of fiscal 2008, which depends on the Company’s success in achieving timely cost reductions and price increases, and customer acceptance of those price increases, and is subject to variations in product and customer mix and our product costs, including materials and transportation costs.

Item 4. Controls and Procedures

The Company maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) that are designed to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

In connection with the filing of this Form 10-Q, management evaluated, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of March 31, 2008. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of March 31, 2008.

There have been no changes in the Company’s internal control over financial reporting during the period covered by this report that have materially affected, or are reasonably likely to materially affect internal control over financial reporting.

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PART II: OTHER INFORMATION

Item 1A. Risk Factors

In addition to the other information set forth elsewhere in this report, you should carefully consider the “Risk Factors” discussed in Part I, Item 1A (Risk Factors) of the Company’s Form 10-K for the period ended June 30, 2007 and in Part II, Item 1A (Risk Factors) of the Company’s Form 10-Q for the period ended September 30, 2007. 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 5. Other Information

On February 25, 2008, the Company entered into a lease amendment agreement (Agreement) with Plymouth Properties Realty LLC, to extend the term of the lease of approximately 6,895 square feet for the Company’s corporate headquarters and office space located in Plymouth Minnesota. The Agreement was effective February 1, 2008.

Item 6. Exhibits

10.1*	Third Amendment to Lease Agreement with Plymouth Properties Realty LLC, dated February 25, 2008.
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.

* Filed herewith

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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 7, 2008

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)

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