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 March 31, 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 April 28, 2005, 12,636,101 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)

 

		March 31, 2005			December 31, 2004
ASSETS
Current assets:
Cash and cash equivalents		$	27,039		$	23,435
Accounts receivable, net		8,590			9,702
Inventories, net		5,909			6,219
Prepaid expenses		500			271
Deferred income taxes		3,259			3,259
Total current assets		45,297			42,886
Equipment and leasehold improvements, net		2,546			2,026
Deferred income taxes		16,298			16,966
Other		25			27
Total assets		$	64,166		$	61,905
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	5,497		$	6,018
Accrued liabilities		3,202			2,806
Total current liabilities		8,699			8,824
Commitments and contingencies		—			—
Stockholders’ equity:
Common stock, $.01 par value; 50,000 shares authorized, 12,636 and 12,603 shares issued and outstanding at March 31, 2005 and December 31, 2004, respectively		126			126
Additional paid-in capital		150,540			150,303
Accumulated deficit		(95,199		)	(97,348		)
Total stockholders’ equity		55,467			53,081
Total liabilities and stockholders’ equity		$	64,166		$	61,905

 

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 March 31,
		2005			2004
Net sales		$	18,657		$	15,554
Cost of sales		10,713			9,033
Gross profit		7,944			6,521
Operating expenses:
Research and development		1,253			1,286
Selling, general and administrative		3,670			3,093
Total operating expenses		4,923			4,379
Operating income		3,021			2,142
Other income (expense):
Interest, net		122			21
Other, net		(8		)	—
Total other income		114			21
Income before provision for income taxes		3,135			2,163
Provision for income taxes		986			736
Net income		$	2,149		$	1,427
Net income per common share:
Basic earnings per share		$	0.17		$	0.11
Diluted earnings per share		$	0.17		$	0.11
Weighted average common shares outstanding:
Basic		12,615			12,472
Diluted		12,971			12,836

 

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)

 

		Three Months Ended March 31,
		2005			2004
Cash flows from operating activities:
Net income		$	2,149		$	1,427
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		247			242
Provision for doubtful accounts		92			20
Loss on disposal of equipment		8			—
Deferred income taxes		668			634
Tax benefit recognized for stock options		—			16
Changes in operating assets and liabilities
Accounts receivable		1,112			(1,703		)
Inventories		218			124
Prepaid expenses and other assets		(229		)	(200		)
Accounts payable		(798		)	1,288
Accrued liabilities		396			(306		)
Net cash provided by operating activities		3,863			1,542
Cash flows from investing activities:
Purchases of equipment and leasehold improvements		(496		)	(248		)
Net cash used in investing activities		(496		)	(248		)
Cash flows from financing activities:
Proceeds from issuance of common stock		237			164
Net cash provided by financing activities		237			164
Net increase in cash and cash equivalents		3,604			1,458
Cash and cash equivalents, beginning of period		23,435			13,445
Cash and cash equivalents, end of period		$	27,039		$	14,903
Significant noncash financing and investing activities:
Purchases of equipment included in accounts payable		$	277		$	62

 

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 March 31, 2005, and for the three months ended March 31, 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 and cash flows for the three months ended March 31, 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:

 

 

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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):

 

 

Options to purchase 45,000 shares of common stock were outstanding but not included in the computation of diluted earnings per share for each of the three months ended March 31, 2005 and the three months ended March 31, 2004 because the exercise prices were greater than the average market price of the common shares for the periods.

 

NOTE 4 – INVENTORIES (IN THOUSANDS)

 

 

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.

 

 

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NOTE 6 – RECENTLY ISSUED ACCOUNTING PRONOUNCMENTS

 

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 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 not have a significant impact on our effective tax rate in 2005.

 

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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.

 

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.  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; 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.

 

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

 

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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.

 

Our U.S. distribution 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 integrators. 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. In each category, our distribution partners have 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 Series.

 

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 also anticipate continued legal expenses in connection with patent litigation we have initiated. 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.

 

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Results of Operations

 

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

 

 

Comparison of Three Months Ended March 31, 2005 and 2004

 

Net sales.  Net sales increased 19.9% to $18.7 million for the three-month period ended March 31, 2005, from $15.6 million in the same period of 2004.  Sales of equipment increased 22.8% to $6.7 million from $5.4 million in the first quarter of 2004.  The increase in sales of equipment 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 supplies increased 18.4% to $12.0 million from $10.2 million in the first quarter of 2004. Sales of supplies increased approximately $1.8 million due to changes in unit mix and increases in average selling prices as a result of price increases during the first quarter of 2005, partially offset by decreased sales of Imageware software.

 

International sales increased 4.8% to $7.7 million in the first quarter of 2005 from $7.4 million in the same period of 2004 and accounted for 41.4% of net sales for the three months ended March 31, 2005, compared to 47.4% of net sales in the same period of 2004.  International sales increased approximately $300,000 primarily due to a $512,000 increase in sales in the Asia and Australia region and a $480,000 increase in the Middle East and Africa region, offset by decreases in sales in North and South America (other than the United States).  The increase in sales in the Asia and Australia region is primarily related to an increase in supplies for a major government project in Australia.  The increase in sales in the Middle East is due to enhanced distribution efforts in this geographical area.  As a percentage of net sales, international sales decreased 6% mainly due to increased growth in the United States as a result of products launched in 2004 and our new distribution program introduced in October of 2003.

 

Gross profit.  Gross profit increased 21.8% to $7.9 million for the three months ended March 31, 2005 from $6.5 million in the same period of 2004. Gross profit as a percentage of net sales increased to 42.6% for the three months ended March 31, 2005, from 41.9% in the same period of 2003.  The gross profit percentage benefited from unit mix, the mix of sales between equipment and supplies, and cost improvements.  Gross profit in the first quarter of 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 were $1.3 million for the three months ended March 31, 2005, consistent with the $1.3 million of expenses in the same period of 2004.  Research and development expenses as a percentage of net sales were 6.7% for the first quarter of 2005, compared to 8.3% for the same period of 2004.  The decrease in research and development expenses is mainly due to decreased purchase of prototype parts.

 

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Selling, general and administrative.  Selling, general and administrative expenses increased 18.7% to $3.7 million for the three months ended March 31, 2005, from $3.1 million in the same period of 2004.  As a percentage of net sales, selling, general and administrative expenses were 19.7% in the first quarter of 2005, compared to 19.8% 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 $150,000, increased professional fees of approximately $116,000 related to patent litigation expenses and Sarbanes-Oxley Section 404 costs, and additional compensation costs.

 

Operating income.  Operating income increased 41.0% to $3.0 million for the quarter ended March 31, 2005, from $2.1 million during the same period of 2004.  As a percentage of net sales, operating income was 16.2% in the first quarter of 2005 compared to 13.8% in the same period of 2004.  The increase resulted mainly from the increased gross profit described above, partially offset by increased operating expenses.

 

Income tax expense.  Income tax expense was $986,000 for the three months ended March 31, 2005, which results in an effective tax rate of 31.5%, compared to income tax expense of $736,000 and an effective tax rate of 34.0% for the same period of 2004.  The change in the effective tax rate is mainly due to the recognition of approximately $70,000 in tax credits related to a prior year tax contingency that was settled during the first quarter of 2005.

 

Liquidity and Capital Resources

 

We have historically financed our operations, debt service and capital requirements through cash flows generated from operations.  Working capital was $36.6 million and $34.1 million, respectively, at March 31, 2005 and December 31, 2004.  At March 31, 2005 and throughout 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 $27.0 million at March 31, 2005, an increase of $3.6 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 three-month period ended March 31, 2005 totaled $3.9 million due to net income of $2.2 million, non-cash charges of $1.0 million and changes in operating assets and liabilities of approximately $700,000. The non-cash charges are primarily for deferred income taxes and depreciation and amortization. The changes in operating assets and liabilities relate primarily to a decrease in accounts receivable of $1.1 million, offset by a decrease in accounts payable and accrued liabilities of $402,000. Accounts receivable decreased due to the timing of sales and a decrease in sales during the first quarter of 2005 compared to the fourth quarter of 2004. The decrease in accounts payable is due to decreased revenue activity in the first quarter of 2005 compared to the fourth quarter of 2004 and the timing of purchases.  Cash used by investing activities was $496,000 exclusively for the purchase of equipment and leasehold improvements. Cash provided by financing activities was $237,000 due to proceeds received from the exercise of stock options.

 

Cash generated from operating activities for the three-month period ended March 31, 2004 totaled $1.5 million due to net income of $1.4 million and non-cash charges of $912,000, offset by changes in operating assets and liabilities of $800,000.  The non-cash charges are primarily for deferred income taxes and depreciation and amortization. The changes in operating assets and liabilities relate primarily to an increase in accounts receivable of $1.7 million, offset by a decrease in accounts payable and accrued liabilities of $982,000. The increase in accounts receivable is mainly due to a reduction in customer prepayments and the timing of sales.  The increase in accounts payable is primarily related to the timing of our payments to vendors.    Cash used by investing activities was $248,000 solely for purchases of equipment and leasehold improvements.  Cash provided by financing activities was $164,000 due to proceeds received from the exercise of stock options.

 

We have a $5.0 million revolving credit facility, on which there was no outstanding balance at March 31, 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.

 

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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 $320,000 at March 31, 2005, of which we have recorded an allowance of $135,000 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 $350,000 at March 31, 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 March 31, 2005, was $470,000.

 

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 March 31, 2005, was $375,000.

 

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 March 31, 2005 were $19,557,000.

 

Recently Issued Accounting Standards

 

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

 

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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 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 first 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

 

Toppan and TDT Patent Litigation

 

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., 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

 

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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. This suit involves a Japanese corporation (Toppan), and we have had to serve this suit upon Toppan under international treaty rules, and all depositions of Toppan employees must occur at the United States Embassy in Tokyo, Japan, unless Toppan waives this right. We anticipate a trial in the early fall of 2005.

 

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 believe this product infringes upon our patents and may violate the cessation of sales agreed to in open court. We are evaluating our options but anticipate this lawsuit continuing.

 

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 product. 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.

 

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 5 – OTHER INFORMATION

 

Credit Agreement

 

Effective March 22, 2005, the Company entered into Amendment No. 2 (“Amendment No. 2”) to the Amended and Restated Credit Agreement with LaSalle Bank National Association dated December 18, 2002, as previously amended by Amendment No. 1 dated as of April 1, 2004 (“Amendment No. 1” and, collectively with the Amended and Restated Credit Agreement, the “Agreement”).  Amendment No. 2, among other things, extends the maturity date of the credit facility under the Agreement by one year to March 31, 2006.

 

Amendment No. 2 is filed herewith as Exhibit 10.1.  The foregoing description of Amendment No. 2 is qualified in its entirety by reference to the full text of such document, which is incorporated by reference herein.

 

Determination of 2004 Bonus Payout

Pursuant to the Company’s bonus plan established for 2004, our Compensation and Human Resources Committee determined, and our Board of Directors approved, incentive bonus awards payable to all Company employees.  These incentive bonus awards were determined by multiplying the particular individual’s base salary by (1) his or her designated bonus percentage and (2) a performance factor based upon Fargo’s achievement of targeted levels of operating profit, sales growth and asset utilization.  Designated bonus percentages are based upon relative positions within Fargo’s organizational structure.  The following bonuses were payable with respect to 2004 to the Company’s “named executive officers” (defined in Regulation S-K Item 402(a)(3)) (the “Named Executive Officers”):

 

 

 

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ITEM 6 - EXHIBITS

 

(a)           Exhibits.

 

Item No.		Description		Method of Filing
10.1		Amended Credit Agreement, March 2005		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.

 

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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.
May 5, 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)

 

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