UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

 

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 July 31, 2004, 12,503,285 shares of our Common Stock were outstanding.

 

 

PART 1:                FINANCIAL INFORMATION

 

ITEM 1                   CONDENSED FINANCIAL STATEMENTS

 

FARGO ELECTRONICS, INC.

CONDENSED BALANCE SHEETS

(In thousands, except per share data)

(Unaudited)

 

		June 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents		$	17,516		$	13,445
Accounts receivable, net		9,911			7,015
Inventories, net		4,806			4,848
Prepaid expenses		419			233
Deferred income taxes		3,412			3,412
Total current assets		36,064			28,953
Equipment and leasehold improvements, net		2,143			2,107
Deferred income taxes		18,420			19,730
Other		30			17
Total assets		$	56,657		$	50,807
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	6,185		$	3,802
Accrued liabilities		2,740			2,765
Total current liabilities		8,925			6,567
Commitments and contingencies		—			—
Stockholders’ equity:
Common stock, $.01 par value; 50,000 shares authorized, 12,503 and 12,455 shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively		125			125
Additional paid-in capital		149,497			149,179
Accumulated deficit		(101,890		)	(105,064		)
Total stockholders’ equity		47,732			44,240
Total liabilities and stockholders’ equity		$	56,657		$	50,807

 

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

 

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FARGO ELECTRONICS, INC.

CONDENSED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
Net sales		$	17,545		$	16,492		$	33,099		$	31,971
Cost of sales		10,733			9,820			19,766			19,109
Gross profit		6,812			6,672			13,333			12,862
Operating expenses:
Research and development		1,218			1,115			2,504			2,346
Selling, general and administrative		3,039			2,924			6,133			5,933
Total operating expenses		4,257			4,039			8,637			8,279
Operating income		2,555			2,633			4,696			4,583
Other income (expense):
Interest expense		(2		)	(5		)	(7		)	(20		)
Interest income		34			5			61			8
Total other income (expense)		32			—			54			(12		)
Income before provision for income taxes		2,587			2,633			4,750			4,571
Provision for income taxes		840			867			1,576			1,490
Net income		$	1,747		$	1,766		$	3,174		$	3,081
Net income per common share:
Basic earnings per share		$	0.14		$	0.14		$	0.25		$	0.25
Diluted earnings per share		$	0.14		$	0.14		$	0.25		$	0.24
Weighted average common shares outstanding:
Basic		12,491			12,377			12,482			12,373
Diluted		12,788			12,733			12,821			12,714

 

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

 

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FARGO ELECTRONICS, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

		Six Months Ended June 30,
		2004			2003
Cash flows from operating activities:
Net income		$	3,174		$	3,081
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		489			494
Provision for excess and obsolete inventory		58			—
Loss on disposal of equipment		—			14
Deferred income taxes		1,310			1,415
Deferred compensation		—			14
Tax benefit recognized for stock options		16			—
Changes in operating assets and liabilities
Accounts receivable		(2,896		)	797
Inventories		(16		)	(105		)
Prepaid expenses and other assets		(199		)	(256		)
Accounts payable		2,330			(150		)
Accrued liabilities		(25		)	(797		)
Net cash provided by operating activities		4,241			4,507
Cash flows from investing activities:
Purchases of equipment and leasehold improvements		(472		)	(650		)
Net cash used in investing activities		(472		)	(650		)
Cash flows from financing activities:
Proceeds from issuance of common stock		302			90
Net cash provided by financing activities		302			90
Net increase in cash and cash equivalents		4,071			3,947
Cash and cash equivalents, beginning of period		13,445			2,511
Cash and cash equivalents, end of period		$	17,516		$	6,458
Significant noncash financing and investing activities:
Purchases of equipment included in accounts payable		$	53		$	369

 

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

 

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FARGO ELECTRONICS, INC.

NOTES TO CONDENSED FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1 – BASIS OF PRESENTATION

 

The interim condensed financial statements presented herein as of June 30, 2004, and for the three and six months ended June 30, 2004 and 2003, 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 six months ended June 30, 2004, and the cash flows for the six months ended June 30, 2004, do not necessarily indicate the results to be expected for the full year.  The December 31, 2003, balance sheet data was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. 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, 2003.

 

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 June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
Net income available to common stockholders (in thousands):
As reported		$	1,747		$	1,766		$	3,174		$	3,081
Deduct: Total stock based employee compensation expense determined under fair value based method, net of related tax effects		(154		)	(418		)	(297		)	(826		)
Pro forma		$	1,593		$	1,348		$	2,877		$	2,255
Basic earnings per common share:
As reported		$	0.14		$	0.14		$	0.25		$	0.25
Pro forma		$	0.13		$	0.11		$	0.23		$	0.18
Diluted earnings per common share:
As reported		$	0.14		$	0.14		$	0.25		$	0.24
Pro forma		$	0.12		$	0.11		$	0.22		$	0.18

 

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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 June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
BASIC EARNINGS PER SHARE:
Net income available to common stockholders		$	1,747		$	1,766		$	3,174		$	3,081
Weighted average common shares outstanding		12,491			12,377			12,482			12,373
Per share amount		$	0.14		$	0.14		$	0.25		$	0.25
DILUTED EARNINGS PER SHARE:
Net income available to common stockholders		$	1,747		$	1,766		$	3,174		$	3,081
Weighted average common shares outstanding		12,491			12,377			12,482			12,373
Add: Dilutive effect of stock options		297			356			339			341
Weighted average dilutive shares outstanding		12,788			12,733			12,821			12,714
Per share amount		$	0.14		$	0.14		$	0.25		$	0.24

 

Options to purchase 311,000 and 45,000 shares of common stock were outstanding but not included in the computation of diluted earnings per share for the three and six months ended June 30, 2004, respectively because the exercise prices were greater than the average market price of the common shares for the periods.  Options to purchase 298,000 shares of common stock were outstanding but not included in the computation of diluted earnings per share for the three and six months ended June 30, 2003 because the exercise prices were greater than the average market price of the common shares for the periods.

 

NOTE 4 – INVENTORIES (IN THOUSANDS)

 

		(Unaudited)
		June 30, 2004			December 31, 2003
Raw materials and purchased parts		$	3,738		$	3,630
Finished goods		1,888			1,989
		5,626			5,619
Less: Allowance for excess and obsolete inventories		(820		)	(771		)
Total inventories		$	4,806		$	4,848

 

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.

 

		(Unaudited)
		Three Months Ended June 30,						Six Months Ended June 30,
		2004			2003			2004			2003
Accrued warranties (in thousands):
Beginning of period		$	511		$	584		$	525		$	557
Settlements made		(96		)	(170		)	(202		)	(350		)
Change in liability related to product warranties issued		35			140			127			347
End of period		$	450		$	554		$	450		$	554

 

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NOTE 6 – CREDIT AGREEMENT

 

In April 2004, we further amended our $5.0 million revolving credit facility, on which there was no outstanding balance at June 30, 2004 or at any point during 2004 and 2003.  Changes made under the terms of the April 2004 amendment include changing the term of the credit facility to automatically renew for a period of 364 days unless either party delivers a non-renewal notice, as well as eliminating the unused commitment fee.  Borrowings under the revolving credit facility are limited to eligible accounts receivable and inventories, as defined by the agreement.  Under the terms of the amendment, 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 restrictions on payment of dividends and operating lease expenditures, as defined in the agreement.

 

NOTE 7 – RECENTLY ISSUED ACCOUNTING PRONOUNCMENTS

 

In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104 (“SAB No. 104”), Revenue Recognition, which codifies, revises and rescinds certain sections of SAB No. 101, Revenue Recognition, in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations.  The adoption of this standard did not impact the Company’s financial statements.

 

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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.  This report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995.  The statements contained in this report that are not historic in nature, particularly those that utilize terminology such as “may,” “will,” “should,” “expects,” “anticipates,” “estimates,” “believes,” or “plans” or comparable terminology are forward-looking statements based on current expectations and assumptions.

 

Various risks and uncertainties could cause actual results to differ materially from those expressed in forward-looking statements. These risks and uncertainties include: our ability to protect or enforce our intellectual property rights, particularly with respect to our proprietary consumable supplies; risks and uncertainties associated with litigation; our reliance on sole and single-source suppliers; our ability to obtain rights to third-party technologies that we may want to incorporate into new products; potential manufacturing delays and other problems due to the complex design of our systems; the efforts of our independent distributors and resellers to effectively market and sell our products; and the other factors set forth in our Annual Report on Form 10-K.

 

All forward-looking statements in this document are based on information currently available to us as of the date of this report, and except as required by law, we assume no obligation to update any forward-looking statements.  Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements.

 

Overview

 

We are a leading developer, manufacturer and supplier of 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, 2003, we have manufactured and sold more than 80,000 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 five years, the proportion of our total revenues provided by consumable supplies has increased to 60% of total revenues in 2003 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, the sale of consumable supplies for use in these systems provides us with a significant recurring, and growing, revenue stream.

 

8

 

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 drivers’ 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 October 2003, we introduced a new distribution program for our United States channel partners.  The new program categorizes distribution partners into four complementary, yet separate, 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 and Persona Series resellers.  Fargo Manufacturing Resellers are companies that have a core business of developing and manufacturing products where the sale of identification card printers is a secondary portion of its sale.  Each category has the option to work exclusively with Fargo to develop market share and expertise in the markets they serve.  The program continues our two-product line strategy with restricted distribution on our Professional Series products and broad distribution of our Persona products.  The new program resulted from a review of our existing and future channel requirements, our distribution partners’ needs and the products that are under development by us.  We believe that this new distribution structure is working well with our distribution partners.

 

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 June 30,				Six Months Ended June 30,
		2004		2003		2004		2003
Net sales		100.0	%	100.0	%	100.0	%	100.0	%
Cost of sales		61.2		59.5		59.7		59.8
Gross profit		38.8		40.5		40.3		40.2
Operating expenses:
Research and development		6.9		6.8		7.6		7.3
Selling, general and administrative		17.3		17.7		18.5		18.6
Total operating expenses		24.2		24.5		26.1		25.9
Operating income		14.6		16.0		14.2		14.3
Other income (expense), net		0.2		0.0		0.2		0.0
Income before provision for income taxes		14.8		16.0		14.4		14.3
Provision for income taxes		4.8		5.3		4.8		4.7
Operating income		10.0	%	10.7	%	9.6	%	9.6	%

 

Comparison of Three Months Ended June 30, 2004 and 2003

 

Net sales.  Net sales increased to $17.5 million for the three-month period ended June 30, 2004, from $16.5 million in the same period of 2003.  Sales of equipment decreased 1.8% to $6.9 million from $7.1 million in the second quarter of 2003, and sales of

 

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supplies increased 12.5% to $10.6 million from $9.4 million in the second quarter of 2003. The decrease in sales of equipment is due to a decrease in average selling price, especially at the entry level of the market, partially offset by an increase in unit volume.  The decrease in average selling price is primarily due to a change in unit mix and more aggressively promoting our printer lines through higher discounts to our channel partners.  The increase in sales of supplies was primarily due to changes in sales mix as well as volume increases for the three months ended June 30, 2004.

 

International sales increased 13.3% to $7.2 million in the second quarter of 2004 from $6.4 million in the same period of 2003 and accounted for 41.0% of net sales for the three months ended June 30, 2004, compared to 38.5% of net sales in the same period of 2003.  The increase in international sales was principally attributable to increased sales of equipment in Australia and the Middle East, partially offset by a decrease in equipment sales in Asia and Canada.  International sales of supplies increased in Australia and the Middle East, but were partially offset by a decrease in Asia supply sales.

 

Gross profit.  Gross profit as a percentage of net sales decreased to 38.8% for the three months ended June 30, 2004, from 40.5% in the same period of 2003.  The change is due primarily to promotional activity on printers and changes in product mix, offset by reduced warranty expenses due to improved product quality.

 

Research and development.  Research and development expenses increased to $1.2 million for the three months ended June 30, 2004, from $1.1 million in the same period of 2003.  Research and development expenses as a percentage of net sales were 6.9% for the second quarter of 2004, compared to 6.8% for the same period of 2003.  The increase in research and development expenses is mainly due to increased purchases of prototype parts and depreciation expenses related to activities in research and development of new products.

 

Selling, general and administrative.  Selling, general and administrative expenses increased to $3.0 million for the three months ended June 30, 2004, from $2.9 million in the same period of 2003.  As a percentage of net sales, selling, general and administrative expenses were 17.3% in the second quarter of 2004, compared to 17.7% for the same period of 2003.  The increase in selling, general and administrative expenses is due to higher general and administrative expenses, primarily from higher legal fees related to our ongoing patent litigation in Asia and the U.S.  As described in Part II, Item 1 - Legal Proceedings, on July 19, 2004, we filed a patent infringement suit against Toppan Printing Co. Ltd.(“Toppan”) and Trans Digital Technologies Corporation,(“TDT”) a wholly owned subsidiary of Viisage Technology, Inc. alleging that a reverse image printer manufactured by Toppan and distributed by TDT, infringes four US patents that we own.  Given the costs of prosecuting this kind of litigation and the likely duration before a resolution is achieved, we anticipate that cost of this litigation will affect our financial results for 2004.  We anticipate that this litigation will be expensive and will require the time and attention of management that could otherwise be focused on internal business issues.

 

Operating income.  Operating income remained steady at approximately $2.6 million for the three months ended June 30, 2004, from nearly the same amount incurred during the same period of 2003.  As a percentage of net sales, operating income was 14.6% in the second quarter of 2004 compared to 16.0% in the same period of 2003.  The decrease resulted mainly from the increased operating expenses, partially offset by the increased gross profit described above.

 

Income tax expense.  Income tax expense was $840,000 for the three months ended June 30, 2004, which results in an effective tax rate of 32.5%, compared to income tax expense of $867,000 and an effective tax rate of 32.9% for the same period of 2003.  The change in the effective tax rate is mainly due to the timing of the recognition of research and experimentation credits.

 

Comparison of Six Months Ended June 30, 2004 and 2003

 

Net sales.  Net sales increased to $33.1 million for the six-month period ended June 30, 2004, from $32.0 million in the same period of 2003.  Sales of equipment decreased 4.0% to $12.4 million from $12.9 million in the same period of 2003, and sales of supplies increased 8.6% to $20.7 million from $19.1 million for the same period of 2003.  The decrease in sales of equipment is due to a decrease in average selling price, partially offset by an increase in unit volume.  The decrease in average selling price is primarily due to a change in unit mix and higher discounts to our channel partners through more aggressively promoting our printer lines.  The increase in sales of supplies was mainly the result of changes in sales mix as well as volume increases.  Sales of software also contributed to the increase in supplies for the six months ended June 30, 2004.  We did not have any software sales for the six-month period ended June 30, 2003.

 

International sales increased 7.7% to $14.6 million for the six months ended June 30, 2004 from $13.5 million in the same period of 2003 and accounted for 44.0% of net sales for the six months ended June 30, 2004, compared to 42.3% of net sales in the same period of 2003.  Total international equipment sales remained steady with increases in Canada and the Middle East sales, offset by decreases in Europe and Asia.  The increase in international sales was principally attributable to increased sales of supplies.  International sales of supplies increased in Australia, Europe, and the Middle East, but were partially offset by a decrease in Asia and South America supply sales.

 

Gross profit.  Gross profit as a percentage of net sales increased to 40.3% for the six months ended June 30, 2004, from 40.2% in the same period of 2003.  Results for the six months ended June 30, 2004 included a $360,000 reduction of cost of sales related to the settlement of prior years’ duty drawback claims.  Also, lower manufacturing costs associated with improved quality

 

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positively impacted gross profit.  Gross profit was negatively impacted by promotional activity on printers and changes in product mix.

 

Research and development.  Research and development expenses increased to $2.5 million for the six months ended June 30, 2004, from $2.3 million in the same period of 2003.  Research and development expenses as a percentage of net sales were 7.6% for the six months ended June 30, 2004, compared to 7.3% for the same period of 2003.  The increase in research and development expenses is mainly due to increased salary and payroll expense, as well as increased purchases of prototype parts and depreciation expenses related to activities in research and development of new products.

 

Selling, general and administrative.  Selling, general and administrative expenses increased to $6.1 million for the six months ended June 30, 2004, from $5.9 million in the same period of 2003.  As a percentage of net sales, selling, general and administrative expenses were 18.5% in the six months ended June 30, 2004, compared to 18.6% for the same period of 2003.  The increase in selling, general and administrative expenses is due to higher general and administrative expenses, related primarily to higher legal fees and health insurance expenses.  The increase in legal fees is related to our ongoing patent litigation in Asia and the U.S.  The increase in health insurance expenses is due mainly to an increase in our major claims experience in the first quarter of 2004.

 

Operating income.  Operating income increased 2.5% to $4.7 million for the six months ended June 30, 2004, from $4.6 million during the same period of 2003.  As a percentage of net sales, operating income was 14.2% in the six months ended June 30, 2004 compared to 14.3% in the same period of 2003.  The percentage decrease resulted mainly from the increased operating expenses, partially offset by the increased gross profit described above.

 

Income tax expense.  Income tax expense was $1.6 million for the six months ended June 30, 2004, which results in an effective tax rate of 33.2%, compared to income tax expense of $1.5 million and an effective tax rate of 32.6% for the same period of 2003.  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 $27.1 million and $22.4 million, respectively, at June 30, 2004, and December 31, 2003.  At June 30, 2004 and throughout 2003, we had no bank debt outstanding.

 

We believe, based on our current cash levels as well as the operating cash flows expected in 2004 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 $17.5 million at June 30, 2004, an increase of $4.1 million from $13.4 million at December 31, 2003.  This increase was primarily due to positive net cash flows provided by our operating activities.

 

Cash provided by operating activities was $4.2 million for the six-month period ended June 30, 2004 due to net income of $3.2 million and non-cash charges of $1.9 million primarily for deferred income taxes and depreciation and amortization.  Cash provided by operating activities was negatively impacted by an increase in accounts receivable of $2.9 million, but partially offset by an increase in accounts payable of $2.3 million.  The increase in accounts receivable is mainly due to the timing of sales and a decrease in prepaid accounts.  The increase in accounts payable is primarily related to the timing of our payments to vendors and increased revenue activity in the second quarter of 2004.  Cash used by investing activities was $472,000 solely for purchases of equipment and leasehold improvements.  Cash provided by financing activities was $302,000 due to proceeds received from the exercise of stock options.

 

Cash provided by operating activities was $4.5 million for the six-month period ended June 30, 2003. Cash provided by operating activities for the six months ended June 30, 2003 was mainly due to net income of $3.1 million, non-cash charges of $1.9 million mainly for depreciation and deferred income taxes and a decrease in accounts receivable of $797,000 primarily related to the timing of sales.  These cash flows were partially offset by an increase in inventories of $105,000 and a decrease in accounts payable and accrued liabilities of $947,000.  The increase in inventories was mainly due to the timing of purchases and the decrease in accounts payable and accrued liabilities was mainly due to the timing of payments.  Net cash flows used in investing activities were $650,000 for the six months ended June 30, 2003, solely for the purchases of equipment in each period.  Net cash flows provided by financing activities were $90,000 during the six months ended June 30, 2003, due to proceeds from the issuance of common stock.

 

In April 2004, we further amended our $5.0 million revolving credit facility, on which there was no outstanding balance at June 30, 2004 or at any point during 2004 and 2003.  Changes made under the terms of the April 2004 amendment include changing the term of the credit facility to automatically renew for a period of 364 days unless either party delivers a non-renewal notice, as well

 

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as eliminating the unused commitment fee.  Borrowings under the revolving credit facility are limited to eligible accounts receivable and inventories, as defined by the agreement.  Under the terms of the amendment, 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 restrictions on payment of dividends and 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—We recognize revenue when title passes, which generally is at the time of shipment. We provide for estimated warranty costs and estimated returns in the period 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 collectively represented 17.3%, 11.7% and 10.2%, respectively, of net sales for the years ended December 31, 2003, 2002 and 2001. Under the terms of the stock balancing agreements, we estimate that the maximum amount of returns is approximately $275,000 at June 30, 2004, of which we have recorded an allowance of $131,000 for stock balancing estimated returns. This reserve is included in our allowance for doubtful accounts and sales returns.

 

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.  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 $350,000 at June 30, 2004.

 

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 was $820,000 at June 30, 2004.

 

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 was $450,000 at June 30, 2004.

 

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 were $21,832,000 at June 30, 2004.

 

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Recently Issued Accounting Standards

 

In December 2003, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 104 (SAB No. 104), “Revenue Recognition”, which codifies, revises and rescinds certain sections of SAB No. 101, “Revenue Recognition”, in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations.  The adoption of this standard did not have an impact on our financial statements.

 

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, 2003.

 

ITEM 4.     CONTROLS AND PROCEDURES.

 

As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer, of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were adequate.  There were no changes identified by the principal executive officer and principal financial officer in the Company’s internal control over financial reporting during the Company’s most recently completed fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

PART II:  OTHER INFORMATION

 

ITEM 1 – LEGAL PROCEEDINGS

 

On December 19, 2003, we filed two separate lawsuits with Seoul Central District Court, Civil Division, claiming that certain entities and individuals were selling and manufacturing printer ribbon products that infringed upon one or more of our patents.  In one of the lawsuits, we named Mr. Nak Dong Lee doing business as “Intra Korea” and “Intra Worldwide” as defendant.  On May 24, 2004, we reached a settlement with Nak Dong Lee. The settlement acknowledges the validity of our ribbon sensor patent (US patent #5,755,519 and its Korean counterpart, Korean patent 343602) and acknowledges that Mr. Lee has sold products in violation of the Korean patent. It requires Mr. Lee to deliver to us all infringing product in his possession. In addition, the settlement contains a clause that if Mr. Lee or any associates are found to be in violation of the settlement agreement, a liquidated damages amount of $75,000 will be paid to us. The settlement is applicable worldwide.  Further, Intra Peru, an affiliated company and its owner, Jong-Eun Pak, have also agreed to the same terms.

 

On July 19, 2004 we filed a patent infringement suit against Toppan Printing Co. Ltd. (Toppan), and Trans Digital Technologies Corporation (TDT), a wholly owned subsidiary of Viisage, in US Federal District Court, Eastern District of Virginia.  Our lawsuit alleges that a reverse image printer manufactured by Toppan and distributed by TDT, infringes four US patents that we own. Two of these patents relate to lamination, the third patent relates to flipping the card, and the fourth patent describes technology related to our reverse image printer.  We are seeking a permanent injunction against the sale of the Toppan printer, damages for any past sales and attorney’s fees. Further, we are alleging willful infringement of these patents by Toppan and TDT and asking for all damages to be trebled in accordance with the patent statute.

 

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 4 – SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

Our Annual Meeting of Stockholders was held on May 4, 2004.  The following individuals were elected at the Annual Meeting to serve as directors of Fargo for terms of three years expiring at our 2007 Annual Meeting of Stockholders or until their

 

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successors are elected and qualified.  Shares voted in favor of these directors and shares withheld were as follows (there were no broker non-votes):

 

Name		Shares Voted FOR		Shares Withheld
David D. Murphy		11,541,097		70,467
Elaine A. Pullen		11,539,113		72,451

 

ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K

 

(a)           Exhibits.

 

Item No.		Description		Method of Filing
10.1		Amended and Restated Credit Agreement, April 2004		Filed electronically herewith.
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.

 

(b)           Reports on Form 8-K

 

On April 21, 2004, we filed a report on Form 8-K furnishing under Item 12 the News Release announcing our earnings for the first quarter ended March 31, 2004.

 

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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.
August 9, 2004	/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)

 

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