Fargo Electronics 10Q 2005 Q3 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

(Mark One)

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

		For the quarterly period ended September 30, 2005

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 No.: 000-29029

FARGO ELECTRONICS, INC.

(Exact name of registrant as specified in its charter)

Delaware		41-1959505
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

6533 Flying Cloud Drive Eden Prairie, Minnesota		55344
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (952) 941-9470

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

As of November 4, 2005, 12,772,762 shares of our Common Stock were outstanding.

PART 1: FINANCIAL INFORMATION

ITEM 1 FINANCIAL STATEMENTS

FARGO ELECTRONICS, INC.

CONDENSED BALANCE SHEETS

(In thousands, except per share data)

(Unaudited)

	September 30,			December 31,
ASSETS	2005			2004

Current assets:
Cash and cash equivalents	$	34,231		$	23,435
Accounts receivable, net	11,414			9,702
Inventories, net	6,535			6,219
Prepaid expenses	544			271
Deferred income taxes	3,259			3,259

Total current assets	55,983			42,886

Equipment and leasehold improvements, net	3,238			2,026

Deferred income taxes	14,792			16,966
Other	21			27

Total assets	$	74,034		$	61,905

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable	$	8,479		$	6,018
Accrued liabilities	3,615			2,806

Total current liabilities	12,094			8,824

Commitments and contingencies	—			—

Stockholders' equity:
Common stock, $.01 par value; 50,000 shares authorized, 12,772 and 12,603 shares issued and outstanding at September 30, 2005 and December 31, 2004, respectively	128			126
Additional paid-in capital	151,574			150,303
Accumulated deficit	(89,762		)	(97,348		)

Total stockholders' equity	61,940			53,081

Total liabilities and stockholders' equity	$	74,034		$	61,905

The accompanying notes are an integral part of the unaudited condensed financial statements.

FARGO ELECTRONICS, INC.

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended September 30,				Nine Months Ended September 30,
	2005		2004		2005		2004

Net sales	$	22,456	$	19,626	$	59,999	$	52,725

Cost of sales	12,719		11,558		33,999		31,324

Gross profit	9,737		8,068		26,000		21,401

Operating expenses
Research and development	1,428		1,337		4,225		3,841
Selling, general and administrative	3,984		3,572		11,452		9,705

Total operating expenses	5,412		4,909		15,677		13,546

Operating income	4,325		3,159		10,323		7,855

Other income
Interest, net	246		52		556		106
Other, net	—		—		393		—
Total other income	246		52		949		106

Income before provision for income taxes	4,571		3,211		11,272		7,961

Provision for income taxes	1,500		906		3,686		2,482

Net income	$	3,071	$	2,305	$	7,586	$	5,479

Net income per common share
Basic earnings per share	$	0.24	$	0.18	$	0.60	$	0.44
Diluted earnings per share	$	0.23	$	0.18	$	0.58	$	0.43

Weighted average common shares outstanding
Basic	12,756		12,519		12,683		12,494
Diluted	13,145		12,780		13,127		12,817

The accompanying notes are an integral part of the unaudited condensed financial statements.

FARGO ELECTRONICS, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Nine Months Ended September 30,
	2005			2004

Cash flows from operating activities:
Net income	$	7,586		$	5,479
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	820			781
Provision for excess and obsolete inventory	303			103
Loss on disposal of equipment	8			—
Deferred income taxes	2,174			2,385
Tax benefit recognized for stock options	—			16
Changes in operating assets and liabilities
Accounts receivable	(1,712		)	(3,829		)
Inventories	(619		)	(878		)
Prepaid expenses and other assets	(273		)	(27		)
Accounts payable	2,145			2,785
Accrued liabilities	809			(191		)

Net cash provided by operating activities	11,241			6,624

Cash flows from investing activities:
Purchases of equipment and leasehold improvements	(1,718		)	(681		)

Net cash used in investing activities	(1,718		)	(681		)

Cash flows from financing activities:
Proceeds from issuance of common stock	1,273			464

Net cash provided by financing activities	1,273			464

Net increase in cash and cash equivalents	10,796			6,407

Cash and cash equivalents, beginning of period	23,435			13,445

Cash and cash equivalents, end of period	$	34,231		$	19,852

Significant noncash activities:
Purchases of equipment included in accounts payable	$	316		$	105

The accompanying notes are an integral part of the unaudited condensed financial statements.

FARGO ELECTRONICS, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 – BASIS OF PRESENTATION

The interim condensed financial statements presented herein as of September 30, 2005, and for the three and nine months ended September 30, 2005 and 2004, are unaudited; however, in our opinion, the interim condensed financial statements include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of financial position, results of operations and cash flows for the periods presented.

The results of operations for the three and nine months ended September 30, 2005, and the cash flows for the nine months ended September 30, 2005, do not necessarily indicate the results to be expected for the full year. The December 31, 2004, balance sheet data was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These unaudited interim condensed financial statements should be read in conjunction with our financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2004.

NOTE 2 – STOCK BASED COMPENSATION

The Company measures compensation expense for its stock-based compensation plan using the intrinsic value method. Accordingly, compensation cost for stock options granted to employees is measured as the excess, if any, of the value of the Company’s stock at the date of the grant over the amount an employee must pay to acquire the stock. The Company provides disclosure of the effect on net income as if the fair value-based method has been applied in measuring compensation expense.

Had compensation cost for the plan been determined based on the fair value of options at the date of grant, the Company’s net income available to common stockholders and basic and diluted net income per share would have been reduced to the following pro forma amounts:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2005			2004			2005			2004
Net income available to common stockholders (in thousands):
As reported	$	3,071		$	2,305		$	7,586		$		5,479
Deduct: Total stock-based employee compensation expense determined under fair value based method, net of related tax effects	(176		)	(154		)	(487		)	(452			)
Pro forma	$	2,895		$	2,151		$	7,099		$		5,027

Basic earnings per common share:
As reported	$	0.24		$	0.18		$	0.60		$		0.44
Pro forma	$	0.23		$	0.17		$	0.56		$		0.40
Diluted earnings per common share:
As reported	$	0.23		$	0.18		$	0.58		$	0.43
Pro forma	$	0.22		$	0.17		$	0.54		$	0.39

NOTE 3 – EARNINGS PER SHARE

Basic earnings per share is calculated using the weighted average number of shares outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average basic shares outstanding plus the dilutive effect of outstanding stock options using the “treasury stock” method.

The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share data):

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2005		2004		2005		2004
BASIC EARNINGS PER SHARE:
Net income available to common stockholders	$	3,071	$	2,305	$	7,586	$	5,479
Weighted average common shares outstanding	12,756		12,519		12,683		12,494
Per share amount	$	0.24	$	0.18	$	0.60	$	0.44

DILUTED EARNINGS PER SHARE:
Net income available to common stockholders	$	3,071	$	2,305	$	7,586	$	5,479
Weighted average common shares outstanding	12,756		12,519		12,683		12,494
Add: Dilutive effect of stock options	389		261		444		323

Weighted average dilutive shares outstanding	13,145		12,780		13,127		12,817
Per share amount	$	0.23	$	0.18	$	0.58	$	0.43

There were no options to purchase shares of common stock outstanding with exercise prices greater than the average market price of common shares for the three months and nine months ended September 30, 2005. Options to purchase 309,600 shares of common stock were outstanding but not included in the computation of diluted earnings per share for the three and nine months ended September 30, 2004, because the exercise prices were greater than the average market price of the common shares for the respective periods.

NOTE 4 – INVENTORIES

	September 30,			December 31,
	2005			2004
	Unaudited

Raw materials and purchased parts	$	4,032		$	4,597
Finished goods	3,144			2,036
	7,176			6,633
Less: Allowance for excess and obsolete inventories	(641		)	(414		)

Total inventories	$	6,535		$	6,219

NOTE 5 – WARRANTIES

The Company’s products are generally covered by a standard one-year warranty. Estimated warranty costs are accrued in the same period in which the related revenue is recognized, based on anticipated parts and labor costs, utilizing historical experience.

	Three Months						Nine Months
	Ended September 30,						Ended September 30,
	2005			2004			2005			2004
	(Unaudited)
Accrued warranties (in thousands):
Beginning of period	$	225		$	450		$	392		$	525
Settlements made	(71		)	(91		)	(258		)	(293		)
Accruals related to pre-existing warranties (includes changes in estimates)	—			(95		)	(115		)	(95		)
Accruals for warranties issued	81			91			216			218
End of period	$	235		$	355		$	235		$	355

NOTE 6 – RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4” (“SFAS 151”), which is effective for fiscal years beginning after June 15, 2005. SFAS 151 amends the guidance in ARB No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). Among other provisions, SFAS 151 requires that items such as idle facility expense, excessive spoilage, double freight and rehandling costs be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. We believe the adoption of SFAS 151 will not have any material effect on our financial statements.

In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”), which replaces SFAS 123 and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees”. SFAS 123R requires that the cost of all share-based payments to employees, including grants of employee stock options, be recognized in the financial statements based on their fair values. That cost will be recognized as an expense over the vesting period of the award. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. In addition, we will be required to determine fair value in accordance with SFAS 123R. SFAS 123R is effective for reporting periods beginning January 1, 2006 and requires the application of a transition methodology for stock options that have not vested as of the date of adoption. We are currently evaluating the impact of SFAS 123R on our financial statements.

In December 2004, the FASB issued FASB Staff Position (FSP) 109-1, Application of FASB No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004. FSP No. 109-1 clarifies Statement of Financial Accounting Standards No. 109’s guidance that applies to the new tax deduction for qualified domestic production activities. FSP No. 109-1 became effective upon issuance and we believe that this pronouncement will not have a significant impact on our effective tax rate in 2005.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The following discussion and analysis should be read in conjunction with our unaudited interim condensed financial statements and related notes included in this report. Statements made in this report concerning our expectations about future results or events, are “forward-looking statements”. When used in this report, words such as “anticipate,” “believe,” “estimate,” “expect,” and “forecast” as they relate to us or our management are intended to identify such forward-looking statements, but are not the exclusive means of identifying these statements. Such statements are subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995, and are necessarily subject to risks and uncertainties. Actual results may differ materially from those reflected in these forward-looking statements. These statements are based on current expectations, forecasts and assumptions, and are subject to the risks and uncertainties inherent in general industry and market conditions, general domestic and international economic conditions, and other factors. These risks and uncertainties include, but are not limited to: product acceptance and customer demand for our card personalization systems and proprietary supplies; actions taken and alternative products marketed by our competitors; supplier relationships, including reliance on sole and single-source suppliers; manufacturing or design defects that we may discover after shipment; challenges in successfully implementing a new enterprise resource planning computer system; lack of inventories of component parts or finished goods; our focus on the identification card personalization market; continuing technological changes in our industry; our dependence on a distribution network and the reaction of this network to changes in distribution programs; domestic and international regulations and standards; our dependence on international sales and foreign suppliers; material changes in orders placed by large end users; challenges in effectively managing growth; our dependence on technologies we do not own; complex design that could result in manufacturing delays; protecting and enforcing our intellectual property rights; inadequate protection against infringement claims; the costs of implementing and complying with new regulations enacted in various countries requiring the reduction of hazardous substances in electrical and electronic equipment, including the European Union Waste Electrical and Electronic Equipment Directive and Restriction of Hazardous Substances Directive; and adverse economic and business conditions, including conditions resulting from the terrorist attack on the U.S. on September 11, 2001 and the resulting hostilities and the war with Iraq. For more detail of the risks, uncertainties and other factors that could affect our future operations and results, see our filings with the Securities and Exchange Commission, particularly the Annual Report on Form 10-K for the year ended December 31, 2004.

Overview

We are a global leader in the development of secure technologies for identity card issuance systems. We manufacture and supply printing systems and consumable supplies that personalize plastic identification cards by printing images and text onto the card. Our printing systems are capable of encoding data onto cards that incorporate bar code, magnetic stripe, smart card or proximity card technology. We believe that our engineering expertise and our ability to offer a broad range of printing systems using multiple printing technologies have led to a reputation for innovation in our industry.

We believe that we are the only manufacturer in our industry to offer three distinct technologies in printing systems - High Definition Printing (reverse image), traditional Direct-to-Card printing (dye-sublimation) and CardJet printing technology (inkjet) - to personalize plastic identification cards, complete with digital images and text, lamination and electronically encoded information. We believe there are between 30 and 35 companies manufacturing digital card printers. The great majority of these are offering direct-to-card dye-sublimation printers. We believe our high definition printing platform currently has two competitors and we are not aware of any other company offering an inkjet solution for printing plastic identification cards.

Concern for personal safety and property protection has led to the need for electronic and visual identification and access control. We believe the demand for our products will increase as governments and corporations worldwide address their security needs. We believe the development and implementation of new technologies that add security features to plastic cards should foster a growing market for our systems.

We market and sell our products exclusively through a distribution channel of independent distributors and resellers in more than 80 countries worldwide. We estimate that as of December 31, 2004, we have manufactured and sold more than 100,000 of our printing systems. End-users of our printing systems create personalized cards for a wide variety of applications including corporate security and access; drivers’ licenses, government and military identification; student identification and access; public transportation access; and recreation and gaming.

We sell both printing systems and consumable supplies used in those systems. We produce a diverse array of card printing systems that allow us to meet the needs of end-users, ranging from those who desire a premium system to address

complex applications to those focused on lower priced systems with fewer features. We also sell consumable supplies that are used with our systems, including dye sublimation ribbons, overlaminates, thermal resin ribbons, printheads, inkjet cartridges, inkjet card cartridges and blank cards. Over the past six years, the proportion of our total revenues provided by consumable supplies has increased to 60% of total revenues in 2004 from 49% in 1999. Factors affecting our net sales of card printing systems each year include the mix of systems sold, declines in average selling price and the number of major projects we are successful in winning. As the number of Fargo systems installed and in use continues to grow, it is our belief that the sale of consumable supplies for use in these systems will provide us with a significant recurring, and growing, revenue stream.

Our markets can be categorized in three broad tiers - - entry-level, mid-level and high-level. We have historically been successful in each of these markets. End users in the entry-level market are typically using a simple photo identification card. Users in this market are likely more focused on lower priced systems with fewer features. Users in the mid-level tier typically would add functionality such as access control or time and attendance recording features. At the high-end of our markets are government and government-related projects and corporate security programs with multi-level requirements, which typically will use a much more sophisticated and complex identification card and are projects where the end user is looking for the highest levels of functionality and security. Examples of government and government-related projects include national identification programs, military programs and driver’s license programs. These projects typically span multiple years and involve integrating solutions into complex existing infrastructures. The printer component of these projects is typically only a small piece of the overall project. While the company actively pursues such project business, these projects are very competitive and it is very difficult to predict the timing of the bid process, funding and implementation of any such projects.

We have experienced, and expect to continue to experience, quarterly variations in net sales and gross profit as a result of a number of factors, including, among other things, the timing and extent of promotional pricing; the timing of major projects; the number and mix of products sold in the quarter; the availability and cost of components and materials; costs, benefits and timing of new product introductions; customer order size and shipment timing; and seasonable factors affecting timing of purchase orders.

In the United States, our distribution program categorizes our distribution channel into four program tracks. Fargo Solution Providers provide retail customers with sales, service and integration expertise on Fargo’s full line of Professional and Persona Series products and systems. Fargo Value Added Distributors provide in-depth integration expertise and support for Fargo Solution Providers and end user customers on Fargo’s full line of products and systems. Fargo Distributors provide product distribution services to Fargo Solution Providers. Fargo Manufacturing Resellers provide a core business strategy of developing and manufacturing products where the sale of identification card printers is a secondary portion of its sales. Internationally, our distribution program categorizes our distribution into three program tracks. Import Suppliers act as a master distributor in a country. International Dealers sell to retail customers. International Distributors provide product distribution. We continue to implement our two-product line strategy with restricted distribution on our Professional Series products and broad distribution of our Persona Series. From time to time, we adjust selected parts of our distribution system to address changing requirements. In the second half of 2005, we are making some changes, primarily in the areas of harmonizing discounts world-wide, eliminating some exclusivity options for certain of our distribution and increasing the requirements necessary to purchase directly from us.

In the second half of 2004, we began making additional investments in the infrastructure of our business, resulting in an increase in operating expenses. The purpose of these investments is to position ourselves better to capitalize on anticipated market opportunities for our products and to grow our revenue in the future. It is our intention to continue to make these investments. We currently expect our future operating expenses to increase at a faster rate than the increases we have experienced in the past. We believe these expenditures will enhance the future growth of the company for our shareholders; however, the anticipated growth cannot be assured and our operating income may be negatively affected.

Results of Operations

The following table sets forth, for the periods indicated, certain unaudited selected financial data expressed as a percentage of net sales:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2005		2004		2005		2004
Net sales	100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales	56.6		58.9		56.7		59.4

Gross profit	43.4		41.1		43.3		40.6

Operating expenses:
Research and development	6.4		6.8		7.0		7.3
Selling, general and administrative	17.7		18.2		19.1		18.4

Total operating expenses	24.1		25.0		26.1		25.7

Operating income	19.3		16.1		17.2		14.9

Other income	1.1		0.2		1.6		0.2

Income before provision for income taxes	20.4		16.3		18.8		15.1

Provision for income taxes	6.7		4.6		6.2		4.7

Net income	13.7	%	11.7	%	12.6	%	10.4	%

Sales to customers by geographic region, for the periods indicated, were as follows (in thousands):

	Three Months				Nine Months
	Ended September 30,				Ended September 30,
Geographic Region	2005		2004		2005		2004
	(Unaudited)

Europe	$	3,039	$	2,354	$	8,012	$	6,844
Middle East and Africa	1,870		1,758		5,469		4,500
Asia and Australia	1,719		2,462		6,181		5,901
North and South America (other than the U.S.)	2,611		1,919		6,557		5,857
Total international sales	9,239		8,493		26,219		23,102
U.S.	13,217		11,133		33,780		29,623
Total sales	$	22,456	$	19,626	$	59,999	$	52,725

Comparison of Three Months Ended September 30, 2005 and 2004

Net sales. Net sales increased 14.4% to $22.5 million for the three-month period ended September 30, 2005, from $19.6 million in the same period of 2004. Sales of printers/encoders increased 20.5% to $9.0 million from $7.4 million in the third quarter of 2004. The increase in sales of printers/encoders was due to an increase in unit volume, primarily as a result of increased project activity, partially offset by a decrease in average selling price. The decrease in average selling price was primarily due to changes in unit mix and increased sales of new products introduced in the second half of 2004. Sales of secure materials increased 10.7% to $13.5 million from $12.2 million in the third quarter of 2004. Sales of secure materials increased due to volume increases and changes in unit mix, partially offset by decreased large product revenue and sales of boxed software.

International sales increased 8.8% to $9.2 million in the third quarter of 2005 from $8.5 million in the same period of 2004 and accounted for 41.1% of net sales for the three months ended September 30, 2005, compared to 43.3% of net sales in the same period of 2004. International sales increased $0.7 million in the third quarter of 2005 compared to the same period of 2004, primarily due to growth of $1.4 million in the Europe and North and South America region (other than the U.S.), offset by decreased sales of $0.7 million to the Asia and Australia region. We believe the growth in international sales is a result of our new product introductions that meet a broader array of user needs and our increased sales and marketing initiatives. Sales decreased in the Asia and Australia region primarily due to timing of sales of secure materials for an on-going project in Australia. As a percentage of net sales, international sales decreased 2.2%. This decrease is mainly due to an increase in our domestic sales which benefited from large project sales. The increase in domestic large project sales resulted in a lower proportion of international business during the third quarter of 2005 compared to the same period of 2004.

Gross profit. Gross profit increased 20.7% to $9.7 million for the three months ended September 30, 2005 from $8.1 million in the same period of 2004. Gross profit as a percentage of net sales increased to 43.4% for the three months ended September 30, 2005, from 41.1% in the same period of 2004. The gross profit percentage benefited from increased volume, product mix and cost improvements.

Research and development. Research and development expenses increased 6.8% to $1.4 million for the three months ended September 30, 2005, from $1.3 million of expenses in the same period of 2004. Research and development expenses as a percentage of net sales were 6.4% for the third quarter of 2005, compared to 6.8% for the same period of 2004. The increase in research and development expenses is mainly due to increased compensation expense due to growth.

Selling, general and administrative. Selling, general and administrative expenses increased 11.5% to $4.0 million for the three months ended September 30, 2005, from $3.6 million in the same period of 2004. As a percentage of net sales, selling, general and administrative expenses were 17.7% in the third quarter of 2005, compared to 18.2% for the same period of 2004. The increase in selling, general and administrative expenses is primarily due to additional compensation expense of approximately $255,000 due to growth.

Operating income. Operating income increased 36.9% to $4.3 million for the quarter ended September 30, 2005, from $3.2 million during the same period of 2004. As a percentage of net sales, operating income was 19.3% in the third quarter of 2005 compared to 16.1% in the same period of 2004. The increase resulted mainly from the increased gross profit, partially offset by increased operating expenses as described above.

Other income. Other income increased to $246,000 for the quarter ended September 30, 2005 from $52,000 during the same period of 2004. The increase was primarily due to increased interest income mainly as a result of a larger cash balance.

Income tax expense. Income tax expense was $1.5 million for the three months ended September 30, 2005, which results in an effective tax rate of 32.8%, compared to income tax expense of $0.9 million and an effective tax rate of 28.2% for the same period of 2004. The change in the effective tax rate is mainly due to the timing of the recognition of research and experimentation credits. During the third quarter of 2005, the company recognized approximately $80,000 of additional tax credits relating to a prior year, which were settled during the quarter. During the third quarter of 2004, the company recognized approximately $200,000 of additional tax credits relating to a prior year, which were settled in that quarter. Excluding these tax credits, the effective tax rate would have been 34.5% for the third quarter of 2005 and 34.4% for the third quarter of 2004.

Comparison of Nine Months Ended September 30, 2005 and 2004

Net sales. Net sales increased 13.8% to $60.0 million for the nine-month period ended September 30, 2005, from $52.7 million in the same period of 2004. Sales of printers/encoders increased 17.6% to $23.3 million from $19.8 million in the same period of 2004. The increase in sales of printers/encoders was due to an increase in unit volume, partially offset by a decrease in average selling price. The decrease in average selling price was primarily due to changes in unit mix. Sales of secure materials increased 11.5% to $36.7 million from $32.9 million in the nine months ended September 30, 2004. Sales of secure materials increased approximately $3.8 million due to unit volume, changes in unit mix and increases in average selling prices as a result of price increases effective in the first quarter of 2005, partially offset by decreased sales of boxed software.

International sales increased 13.5% to $26.2 million in the nine months ended September 30, 2005 from $23.1 million in the same period of 2004 and accounted for 43.7% of net sales for the nine months ended September 30, 2005, compared to 43.8% of net sales in the same period of 2004. Growth in all geographic regions contributed to a $3.1 million increase in international sales for the nine months ended September 30, 2005 compared to the same period of 2004. We believe the growth in international sales is a result of our new product introductions that meet a broader array of user needs

and our increased sales and marketing initiatives.

Gross profit. Gross profit increased 21.5% to $26.0 million for the nine months ended September 30, 2005 from $21.4 million in the same period of 2004. Gross profit as a percentage of net sales increased to 43.3% for the nine months ended September 30, 2005, from 40.6% in the same period of 2004. The gross profit percentage benefited from increased volume, product mix and cost improvements. Gross profit for the nine months ended September 30, 2004 benefited from a $360,000 reduction of cost of sales related to the settlement of prior years’ duty drawback claims.

Research and development. Research and development expenses increased 10.0% to $4.2 million for the nine months ended September 30, 2005, from $3.8 million of expenses in the same period of 2004. Research and development expenses as a percentage of net sales were 7.0% for the nine months ended September 30, 2005, compared to 7.3% for the same period of 2004. The increase in research and development expenses is mainly due to increased compensation expense due to growth.

Selling, general and administrative. Selling, general and administrative expenses increased 18.0% to $11.5 million for the nine months ended September 30, 2005, from $9.7 million in the same period of 2004. As a percentage of net sales, selling, general and administrative expenses were 19.1% in the nine months ended September 30, 2005, compared to 18.4% for the same period of 2004. The increase in selling, general and administrative expenses is primarily due to increased advertising and promotional expenses of approximately $190,000, increased professional fees of approximately $350,000 primarily related to patent litigation expenses, and additional compensation expense due to growth.

Operating income. Operating income increased 31.4% to $10.3 million for the nine months ended September 30, 2005, from $7.9 million during the same period of 2004. As a percentage of net sales, operating income was 17.2% in the nine months ended September 30, 2005 compared to 14.9% in the same period of 2004. The increase resulted mainly from the increased gross profit, partially offset by increased operating expenses as described above.

Other income. Other income increased to $949,000 for the nine months ended September 30, 2005 from $106,000 during the same period of 2004. Other income during the nine months ended September 30, 2005 included $400,000 as a result of a patent litigation settlement received in the second quarter of 2005. The remaining increase was due to increased interest income mainly as a result of a larger cash balance.

Income tax expense. Income tax expense was $3.7 million for the nine months ended September 30, 2005, which results in an effective tax rate of 32.7%, compared to income tax expense of $2.5 million and an effective tax rate of 31.3% for the same period of 2004. The change in the effective tax rate is mainly due to the timing of the recognition of research and experimentation credits.

Liquidity and Capital Resources

We have historically financed our operations, debt service and capital requirements through cash flows generated from operations. Working capital was $43.9 million and $34.1 million, respectively, at September 30, 2005 and December 31, 2004. At September 30, 2005 and throughout 2005 and 2004, we had no bank debt outstanding.

We believe, based on our current cash levels as well as the operating cash flows expected in 2005 and the funds available to us under our $5.0 million revolving credit facility, that we will have sufficient funds to finance our current operations and planned capital expenditures for at least the next 12 months.

We had cash and cash equivalents of $34.2 million at September 30, 2005, an increase of $10.8 million from $23.4 million at December 31, 2004. This increase was primarily due to positive net cash flows provided by our operating activities.

Cash generated from operating activities for the nine-month period ended September 30, 2005 totaled $11.2 million due to net income of $7.6 million, non-cash charges of $3.3 million and changes in operating assets and liabilities of approximately $0.3 million. The non-cash charges are primarily for deferred income taxes and depreciation and amortization. Cash provided by operating activities increased due an increase in accounts payable of $2.1 million and an increase in accrued liabilities of $0.8 million, but was negatively impacted by an increase in accounts receivable of $1.7 million and an increase in inventory of $0.6 million. The increase in accounts receivable is mainly due to increased revenue and the timing of sales. The increase in account payable is also due to increased revenue activity in the third quarter of 2005 compared to the fourth quarter of 2004. Cash used by investing activities was $1.7 million primarily for the purchase of equipment and leasehold improvements. The increase in cash used by investing activities over 2004 is primarily due to expenditures related to the purchase of a new enterprise resource planning computer system, which the company is currently in the process of implementing. Cash provided by financing activities was $1.3 million due to proceeds received from the exercise of stock options.

Cash provided by operating activities was $6.6 million for the nine-month period ended September 30, 2004 due to net income of $5.5 million and non-cash charges of $3.3 million, partially offset by changes in operating assets and liabilities of approximately ($2.2) million. The non-cash charges are primarily for deferred income taxes and depreciation and amortization. Cash provided by operating activities was negatively impacted by an increase in accounts receivable of $3.8 million and an increase in inventory of $878,000, but partially offset by an increase in accounts payable of $2.8 million. The increase in accounts receivable is mainly due to the timing and increase of sales. The increase in inventory is due to the introduction of new products. The increase in accounts payable is primarily related to the timing of our payments to vendors and increased purchases as a result of increased revenue activity in the third quarter of 2004. Cash used by investing activities was $681,000 solely for purchases of equipment and leasehold improvements. Cash provided by financing activities was $464,000 due to proceeds received from the exercise of stock options.

Under our revolving credit facility, there was no outstanding balance at September 30, 2005 or at any point during 2005 and 2004. The credit facility expires March 31, 2006. At that time, the credit facility will renew, provided each party executes an amendment documenting such renewal. Borrowings under the revolving credit facility are limited to eligible accounts receivable and inventories, as defined by the agreement. Under the terms of the credit facility, we may borrow at the prime rate of interest or LIBOR plus a margin of 1.5%.

The credit facility requires, among other things, the maintenance of a minimum EBITDA and restricts our ability to pay dividends or incur new operating lease expenditures, as defined in the agreement.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of its financial condition and results of operations are based upon our financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. The preparation of financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable based upon the information available to us, the results of which form a basis for making judgments about the carrying value of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The following critical policies relate to the more significant judgments and estimates used in the preparation of the financial statements:

Revenue Recognition— Revenue is recognized when product has been shipped, risk of loss has passed to the purchaser and we have fulfilled all of our obligations. We provide for promotional discounts, estimated early payment discounts, estimated warranty costs and estimated returns in the period the related revenue is recognized. Certain of our customers have arrangements that include stock balancing return provisions. We provide an allowance for stock balancing based on estimated expected returns. Sales to these customers represented 14.0%, 17.3% and 11.7% of net sales for the years ended December 31, 2004, 2003 and 2002, respectively. Under the terms of the stock balancing agreements, we estimate that the maximum amount of returns is approximately $351,000 at September 30, 2005, of which we have recorded an allowance of $302,000 for stock balancing estimated returns. This reserve is included in our allowance for doubtful accounts and sales returns.

We make marketing development funds available to our resellers to support demand generation activity by the resellers. We treat payment of these funds as marketing costs up to the fair value of the benefit received where we receive an identifiable benefit and can reasonably estimate the fair value of the benefit received in accordance with the requirements of EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products). Any payments to resellers that do not meet these requirements, including any promotional discounts for the purchase of product, are recorded as reductions to revenue.

Allowance for doubtful accounts and sales returns—We determine the estimate of the allowance for doubtful accounts and sales returns considering a number of factors, including: (1) historical experience, (2) aging of the accounts receivable, (3) analysis of stock balancing agreements and (4) specific information obtained by us on the financial condition and the current creditworthiness of our customers. If the financing conditions of our customers were to deteriorate and reduce the ability of our customers to make payments on their accounts, we may be required to increase our allowance by recording additional bad debt expense. Likewise, should the financial condition of our customers improve and result in payments or settlements of previously reserved amounts, we may be required to record a reduction in bad debt expense to reverse the recorded allowance. Our allowance for doubtful accounts and sales returns was $680,000 at September 30, 2005.

Allowance for excess and obsolete inventories—We value our inventories at the lower of the actual cost to purchase or manufacture, or the current estimated market value. We regularly review our inventory quantities on hand and record a provision for excess and obsolete inventory based primarily on estimated forecasts of product demand and production requirements for the subsequent twelve and twenty four months. We make every effort to ensure the accuracy of our forecasts of future product demand, however any significant unanticipated changes in demand or technological developments could have a significant impact on the value of inventories and reported operating results. Our allowance for excess and obsolete inventories at September 30, 2005, was $641,000.

Warranty accrual—Our products are generally covered by a standard one-year warranty from the date of sale. Estimated warranty costs are accrued in the same period in which the related revenue is recognized, based on anticipated parts and labor costs, utilizing historical experience. Our warranty accrual at September 30, 2005, was $235,000.

Deferred tax assets—The realization of our deferred tax assets is dependent upon our ability to generate sufficient future taxable income which we believe is more likely than not. We anticipate future taxable income sufficient to realize the recorded deferred tax assets. Historically, we have generated operating income. Future taxable income is based on our forecasts of operating results, and there can be no assurance that such results will be achieved. Our deferred tax assets at September 30, 2005 were $18,051,000.

Recently Issued Accounting Standards

current-period charges regardless of whether they meet the criterion of “so abnormal” as stated in ARB No. 43. In addition, SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. We believe the adoption of SFAS 151 will not have any material effect on our financial statements.

In December 2004, the FASB issued FSP FAS 109-1, Application of FASB No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004. FSP FAS No. 109-1 clarifies SFAS No. 109’s guidance that applies to the new tax deduction for qualified domestic production activities. FSP No. 109-1 became effective upon issuance and we believe that this pronouncement will have an insignificant impact on our effective tax rate in 2005.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

Market risk is the risk of loss to future earnings, to fair values or to future cash flows that may result from changes in the price of a financial instrument. The value of a financial instrument may change as a result of changes in interest rates, commodity prices, equity prices and other market changes. Market risk is attributable to all market sensitive financing instruments, including long-term debt.

For additional information on market risk, refer to the “Quantitative and Qualitative Disclosures About Market Risk” section (Item 7A) of our Annual Report on Form 10-K for the year ended December 31, 2004.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure 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, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective.

Changes in Internal Control over Financial Reporting. There was no change in our internal control over financial reporting that occurred during the third quarter of fiscal 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II: OTHER INFORMATION

ITEM 1 – LEGAL PROCEEDINGS

Iris Ltd. Litigation

We filed a patent infringement complaint against Iris Ltd., Inc. on February 24, 2004 in Federal District Court in the State of Minnesota and served this complaint on Iris Ltd., Inc. on March 26, 2004. Our complaint alleges infringement of one or more of our patents relating to our printer ribbon product. We are seeking injunctive relief, damages and legal fees. In open court on September 8, 2004, Iris agreed to cease selling its infringing ribbons. In early 2005, Iris announced another ribbon core and has begun soliciting orders for this ribbon. We amended our complaint to include the second ribbon offered by Iris and anticipate on-going litigation.

Chinese Patent Litigation

On October 27, 2003, we instituted an administrative action in the Shenzhen Intellectual Property Office, which is a branch of the Chinese Intellectual Property Office, claiming that Shenzhen Kanon Industrial Development Company Ltd. is infringing upon one or more of our patents related to our printer ribbon products. We are seeking a permanent injunction, a request for payment of all costs incurred by us in the case, a public apology and compensation for damages resulting from our lost sales. On November 17, 2004, the Shenzhen Municipal Intellectual Property Office issued an opinion that Shenzhen Kanon Industrial Development Company is infringing upon our patents and has ordered Shenzhen Kanon to cease such infringement. If Shenzhen Kanon does not cease its

activities, criminal charges may be filed against Shenzhen Kanon. As late as May 2005, Shenzhen Kanon reiterated its offers to sell products that infringe upon the ribbon patents. We are evaluating our options but anticipate this lawsuit continuing.

Other Litigation

In addition, we are party to various other litigation matters arising from time to time in the ordinary course of business. We do not believe that any such legal matters exist that would have a material adverse effect on our financial position, results of operations or cash flows.

ITEM 6 - EXHIBITS

Item No.	Description	Method of Filing

31.1	Certification of Gary R. Holland Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.	Filed electronically herewith.

31.2	Certification of Paul W.B. Stephenson Pursuant to Rule 13a-14(a) of the Securities Exchange Act of 1934.	Filed electronically herewith.

32.1	Certification of Gary R. Holland Pursuant to 18 U.S.C Section 1350.	Furnished electronically herewith.

32.2	Certification of Paul W.B. Stephenson Pursuant to 18 U.S.C Section 1350.	Furnished electronically herewith.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	FARGO ELECTRONICS, INC.


November 9, 2005	/s/ GARY R. HOLLAND
	Gary R. Holland
	Chairman of the Board of Directors, President and Chief Executive Officer (Principal Executive Officer)


	/s/ PAUL W.B. STEPHENSON
	Paul W.B. Stephenson
	Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

Positive
Negative
Uncertain
Constraining
Legalese
Litigous
Readability	7th grade Good

Fargo Electronics (FRGO) Inactive 10-Q2005 Q3 Quarterly report

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