** **

**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-K**

 

| ** ** | ** ** | **(Mark One)**                                                                                                                                                                                                                                                                   |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **ý** | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  for the fiscal year ended December 31, 2004**                                                                                                                                           |
| ** ** | ** ** | **OR**                                                                                                                                                                                                                                                                           |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  for the transition period from            to            .** |

 

**Commission file number: 0-13875**

 

**LANCER CORPORATION**

(Exact name of Registrant asspecified in its charter)

 
| **Texas**                                 | ** ** | **74-1591073**                        |
|-------------------------------------------|------------|---------------------------------------|
| (State of incorporation or  organization) | * *   | (I.R.S. Employer  Identification No.) |

 

**6655 Lancer Blvd.,San Antonio, Texas 78219**

(Address of principal executiveoffices)

(Zip code*)*

 

**Registrant’s telephone numberincluding area code:**

**(210) 310-7000**

 

**Securities registered pursuantto Section 12(b) of the Act:**

None

 

**Securities registered pursuantto Section 12(g) of the Act:**

| Common Stock, par value  $0.01 per share |   | American Stock Exchange |
|------------------------------------------|--------|-------------------------|

 

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

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form10-K.      o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Exchange Act Rule12b-2).      Yes  o      No  ý

 

On June 30, 2004, (the last business day ofthe registrant’s most recently completed second fiscal quarter on which thecommon equity was traded) the aggregate market value of common stock held bynon-affiliates (based on the closing market price) was $34,674,593. Forpurposes of this computation, all executive officers, directors and 5%beneficial owners of the registrant are deemed to be affiliates. Suchdetermination should not be deemed to be an admission that such officers,directors or 5% beneficial owners are, in fact, affiliates of the registrant.

 

The number of shares of the registrant’scommon stock outstanding as of March 11, 2005 was 9,465,428.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Parts of the definitive proxy statement forthe Registrant’s 2005 annual meeting of stockholders are incorporated byreference into Part III of this Form 10-K.

 

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# **PART I**

 

## **ITEM 1.**                             BUSINESS

## ** **

**General**

 

We design, engineer, manufacture and market fountain soft drink, beerand citrus beverage dispensing systems, and other equipment for use in the foodservice and beverage industry.  We also market frozen beverage dispensersmanufactured by Lancer FBD Partnership, Ltd., a joint venture that is 50% ownedby us.  Our products are sold by our personnel and through independentdistributors and agents principally to major soft drink companies (primarilyThe Coca-Cola Company), bottlers, equipment distributors, beer breweries,restaurants and convenience stores for use in various food and beverageoperations.  We are a vertically integrated manufacturer with tooling,production, assembly and testing capabilities that enable us to fabricate asubstantial portion of the components used in our products.  In addition,we are an innovator of new products in the beverage dispensing industry. Wehave a large technical staff supported by state-of-the-art engineeringfacilities to develop new products and to enhance our existing product lines inresponse to changing industry requirements and specific customer demands.

 

We were incorporated in Texas on December 18, 1967, and initiallymanufactured parts for beverage dispensing equipment.  We designed,engineered, manufactured and marketed our first mechanically cooled soft drinkdispensing system in 1971.  Since that time, we have expanded ourengineering and production facilities and have developed new products,including various configurations of our mechanically and ice cooled beveragedispensing systems, valves, syrup pumps, and other related equipment,accessories and parts.

 

**The Beverage Dispensing Industry**

 

The manufacture of fountain soft drink and other beverage dispensingsystems is a rapidly changing industry.  Technological changes andimprovements continue to be reflected in the development, manufacture andintroduction of new products and processes.  Manufacturers of suchbeverage dispensing systems generally sell most of their products to a smallnumber of major soft drink companies, licensed bottlers, large internationalbreweries, equipment distributors and food service chains.  In order tofacilitate sales of their beverage products to end-users, soft drink companiesand some breweries, and their respective affiliates, in turn sell or lease thedispensing systems to restaurants, convenience stores, concessionaires andother food and beverage operators.  Soft drink companies generallyrecommend that their affiliates purchase beverage dispensing systems fromapproved manufacturers.  Informal, long-term relationships between certainmanufacturers and soft drink companies have become the norm in the industry.

 

**Products**

 

Our products can be divided into four major categories: (i) soft drinkand citrus dispensing systems; (ii) post-mix dispensing valves; (iii) beerdispensing systems; and (iv) other products and services.

 

Soft Drink and Citrus Dispensing Systems

 

We manufacture and sell a broad range of mechanically cooled and icecooled soft drink and citrus dispensing systems.  These systems arenon-coin operated.  The type of equipment and configuration of each modelvaries according to intended use and specific customer needs.  Ourmechanically cooled dispensing systems chill beverages as they run throughstainless steel tubing inside a self-contained refrigeration unit.  In ourice cooled dispensing systems, the beverage is cooled as it runs throughstainless steel tubing encased in an aluminum cold plate which serves as theheat transfer element when covered with ice.  Several of the ice cooledsystems also dispense ice.  We manufacture both post-mix and pre-mixdispensing equipment for each of the mechanically cooled and ice cooledfountain systems.

 

We manufacture several models of mechanically cooled citrus dispensingsystems for counter top use. The Coca-Cola Company is the primary customer forour citrus dispensing products.

 

Lancer FBD Partnership, Ltd., a joint venturein which we own a 50% interest, manufactures frozen beverage dispensers. The joint venture sells directly to most third party customers, and in certainsituations, pays a commission to us in return for our marketing services.

 

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The prices of our dispensing systems varydepending on dispensing capacity, number of drink selections, speed of beverageflow and other customer requirements.  Sales of soft drink and citrusdispensing systems for the years ended December 31, 2004, 2003 and 2002,accounted for approximately 36%, 37% and 45% of total net sales, respectively.

 

Post-Mix Dispensing Valves

 

We manufacture and sell post-mix dispensing valves which mix syrup andcarbonated water at a preset ratio.  The valves are designed to beinterchangeable with existing post-mix valves used with Coca-Colaproducts.  We manufacture accessories for the valves, includingpush-button activation, water-only dispensing mechanisms, portion controls andother automatically activated valve controls.  Our primary valve, the LEV,has been designated by The Coca-Cola Company as the standard valve for the U.S.market.  We use the LEV in many of our own dispensing systems, and alsosell the valve to competing equipment makers.  For the years endedDecember 31, 2004, 2003 and 2002, sales of valves and related accessoriesaccounted for approximately 13%, 11% and 10% of total net sales, respectively.

 

Beer Dispensing Systems

 

We manufacture and market beer dispensing equipment and relatedaccessories.  Products include chillers, taps, fonts and dispensers. Our operations in Australia and New Zealand account for most of our sales ofbeer related equipment.  Sales of beer equipment represented 12%, 10% and6% of total net sales in the years ended December 31, 2004, 2003 and 2002,respectively.

 

Other Related Products and Services

 

We remanufacture various dispensing systems and sell replacement partsin connection with the remanufacturing process.  Revenues fromremanufacturing activities were 5%, 6% and 6% of net sales in the years endedDecember 31, 2004, 2003 and 2002.

 

We manufacture and/or market a variety of other products includingsyrup pumps, carbonators, stainless steel and brass fittings, carbon dioxideregulator components, water filtering systems, and a variety of other products,accessories, and spare parts for use with beverage dispensing systems.  Wehave an operation in Brisbane, Australia that installs and services beverageequipment.  Together, these parts and services constitute 34%, 36% and 33%of our total net sales for the years ended December 31, 2004, 2003 and2002, respectively.

 

We own a 50% interest in Moo Technologies, LLC, a development stagecompany that markets concentrated shelf-stable milk products.  Theinvestment is accounted for under the equity method.

 

**Product Research and Development**

 

In order to maintain our competitive position, we continuously seek toimprove and enhance our line of existing beverage dispensing systems andequipment, and to develop new products to meet the demands of the food andbeverage industry.  Some projects are originated by our personnel whileothers are initiated by customers.  We have, from time to time, enteredinto agreements with customers to design and develop new products.  Forthe years ended December 31, 2004, 2003 and 2002, our total spending onproduct development and sustaining engineering was $4.8 million, $5.4 millionand $5.2 million respectively. Of those amounts, research and developmentexpenses were $1.2 million, $2.1 million and $2.3 million in 2004, 2003 and2002, respectively.

 

**Production, Inventory and Raw Materials**

 

Our major products typically contain a number of metal and/or plasticparts that we manufacture.  The production of these parts usually requiresmetal dies, fixtures, thermal plastic injection molds, and other tooling, someof which are produced in our tool and die and mold departments.  Othermanufacturing processes include welding, polishing, painting, tube bending,metal turning, stamping, and assembling of printed circuit boards and wireharnesses.  We assemble the various parts and components into finishedproducts, or sell them as spare parts.

 

Substantially all raw materials and parts not manufactured internallyare readily available from other commercial sources.  We have notexperienced any significant shortages in the supply of raw materials and partsover the past several years.  We do not stockpile large amounts of rawmaterials and parts, but attempt to control our inventory through extrapolationof historical production requirements and by using our specific knowledge ofthe market.  In addition, we would likely be able to manufacture somepurchased parts if shortages of these parts were to occur.  If there werea major shortage of required raw

 

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materials, or if there were a major shortage of purchased parts used inassembling our products and we were unable to manufacture such parts ourselves,we could be delayed, limited or prohibited from manufacturing and selling ourproducts, thereby materially and adversely affecting our overall operations.

 

**Backlog**

 

Our manufacturing operations are driven by actual and forecastedcustomer demand. Our backlog of unfilled orders was approximately $5.2 million,$3.7 million and $5.2 million at December 31, 2004, 2003 and 2002,respectively.  It is anticipated that 2004 backlog orders will be filledin 2005.

 

**Marketing and Customers**

 

Our products are marketed in the United States through a network ofindependent distributors and our employees.  The principal purchasers ofour products are major soft drink companies, bottlers, beer breweries, beverageequipment distributors, restaurants, convenience stores and other end users.

 

Substantially more than half of our sales are derived from, orinfluenced by, The Coca-Cola Company.  We are a preferred supplier to TheCoca-Cola Company.  Direct sales to The Coca-Cola Company, our largestcustomer, accounted for approximately 23%, 28% and 35% of our total net salesfor the years ended December 31, 2004, 2003 and 2002, respectively. None of our customers, including The Coca-Cola Company, are contractuallyobligated to purchase minimum quantities of our products.  Consequently,The Coca-Cola Company has the ability to adversely affect, directly orindirectly, the volume and price of the products sold by us.  We do notexpect any significant, long-term volume or price reductions in our businesswith The Coca-Cola Company.  If The Coca-Cola Company were tosubstantially reduce its purchase of our products or require significant pricereductions, our sales and/or profit margins could significantly decrease,causing our results of operations to be materially and adversely impacted.

 

We have entered into a master development agreement with The Coca-ColaCompany that governs development of various products.  Products that aredeveloped pursuant to this agreement may be sold only to The Coca-Cola Companyor its designated agents.  The agreement generally provides that TheCoca-Cola Company will also retain the rights to any tooling it pays for andany resulting patents.  We are obligated under the development agreementto make our manufacturing capabilities available for the benefit of TheCoca-Cola Company as they relate to, and are required for, selectedprojects.  We supply engineering and research and development personnel,design, develop and create prototypes, and obtain either an exclusive or anon-exclusive license to manufacture and market the resulting products. Generally, we warrant all such products for one year.  The Coca-ColaCompany may terminate the development agreement at any time, subject to certainconditions.

 

We have also entered into agreements with The Coca-Cola Company underwhich we remanufacture used products owned by The Coca-Cola Company.

 

**International Sales**

 

For the years ended December 31, 2004, 2003 and 2002, our sales tocustomers outside the United States were approximately 39%, 37% and 31% oftotal net sales, respectively.  We have sales employees, distributors,and/or licensees in Latin America, Europe, Africa and Asia.  Wemanufacture products in Australia and in Piedras Negras, Mexico, and operatewarehouses in Australia, Belgium, Mexico, New Zealand and the United Kingdom.

 

We own subsidiaries with the following functional currencies: theUnited States dollar, the euro, the British pound, the Australian dollar, andthe New Zealand dollar. Our foreign sales and operations could be adverselyaffected by unfavorable foreign currency fluctuations, exchange controls, taxpolicies, deterioration of foreign economies, the expropriation of ourproperty, and other political actions and economic events.  Although weattempt to limit such risks, there can be no assurance that these efforts willbe successful.

 

**Financial Information About Segments and Geographic Areas**

 

We organize our business into the followinggeographical segments:  the North America region, the Latin Americaregion, the Asia/Pacific region, and the Europe region.  The North Americaregion consists of the United States and Canada, as well as our manufacturingfacility in Piedras Negras, Mexico.  The Latin America region consists ofMexico plus Central and South America. The Asia/Pacific region includes Asia,plus Australia, India and New Zealand. The Europe region consists of Europe, aswell as the Middle East and Africa.  The Brazil segment is reported asdiscontinued operations for 2003 and

 

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2002 in the Consolidated Statement ofOperations.  See “Note 2 – Discontinued Operations” in the Notes toConsolidated Financial Statements. Corporate administrative and engineeringexpenses are included in the Corporate segment, rather than allocated among thegeographic regions. Each of the geographical regions contains sales anddistribution related operations. Additionally, the North America andAsia/Pacific regions include manufacturing operations. (We consider ourmanufacturing facility in Piedras Negras, Mexico to be part of our NorthAmerica operations.) A large portion of the costs associated with ourmanufacturing operations is fixed, making gross margin in the North America andAsia/Pacific regions sensitive to changes in sales volume. Because most costsin our other regions are variable, gross margin in those regions is not assensitive to changes in sales volume. Most of our sales and manufacturingactivity occurs in the North America region. Additionally, our corporateheadquarters are located in North America.

 

Our net sales and operating income for 2004, 2003 and 2002 follow(amounts in thousands):

 
| ** **        | ** ** | **North  America** | ** ** | **Latin  America** | ** ** | **Asia/Pacific** | ** ** | **Europe** | ** ** | **Corporate** | ** ** |
|-------------------|------------|--------------------|------------|--------------------|------------|------------------|------------|------------|------------|---------------|------------|
| Net Sales:        |       |               |       |               |       |             |       |       |       |          |       |
| 2004              |       | $                  | 79,528     |               | $          | 5,814            |       | $          | 27,969     |          | $          | 10,938 |   | $ | — |   |
| 2003              |       | 75,924             |       | 7,690              |       | 21,645           |       | 8,241      |       | —        |       |
| 2002              |       | 97,575             |       | 13,351             |       | 18,555           |       | 9,534      |       | —        |       |
|              |       |               |       |               |       |             |       |       |       |          |       |
| Operating Income: |       |               |       |               |       |             |       |       |       |          |       |
| 2004              |       | $                  | 18,002     |               | $          | 92               |       | $          | 2,803      |          | $          | 1,089 |   | $ | (14,377 | ) |
| 2003              |       | 9,385              |       | 117                |       | 3,660            |       | 27         |       | (13,835       | )          |
| 2002              |       | 17,434             |       | 1,979              |       | 1,785            |       | 1,360      |       | (12,999       | )          |

 

Additional financial information about segments and geographic areas isset forth in “Note 13 - Segment and Geographic Information” in the Notes toConsolidated Financial Statements.

 

**Competition**

 

The business of manufacturing and marketing beverage dispensing systemsand related equipment is highly competitive and is characterized by rapidlychanging technology.  Competition is primarily based upon productsuitability, reliability, technological development and expertise, price,product warranty and delivery time.  We believe our competitive positionis strong because of our strong customer relationships and our ability totailor quality products and services to fit the needs of our customers. We frequently compete with other companies that have substantially greaterfinancial resources than we do, which can be a disadvantage.  We have beenable to compete with these companies successfully in the past, however, andbelieve that, by maintaining our strong customer relationships and continuingto tailor our quality products and services to our customers, we will be ableto continue to compete successfully.

 

**Employees**

 

As of December 31, 2004, we had 1,188 full-time employees of whom57 were engaged in engineering and technical support, 967 in manufacturing, 74in marketing and sales and 90 in general management and administrativepositions.  We have 435 employees located in the United States, primarilyat our facilities in San Antonio, Texas.  We have 605 employees that workat our facility in Piedras Negras, Mexico, and a total of 117 people areemployed by our subsidiaries in Australia and New Zealand.  Certain salesrepresentatives are located in various parts of the United States, LatinAmerica, Europe and Asia.  None of our U.S. employees are represented by aunion or are subject to collective bargaining agreements. A majority of ouremployees in Piedras Negras, Mexico are represented by a union and work under acollective bargaining agreement that expires annually.  Substantially allfull-time United States employees are eligible to participate in our employeeprofit sharing plan and various other benefit programs.

 

**Intellectual Property**

 

We presently hold 108 United States patents and numerous correspondingforeign patents.  Additionally, we have 32 pending U.S. patentapplications and corresponding foreign patent applications.  Our productscovered by patents or pending patent applications include food, beverage andice beverage dispensing equipment and components.  These patents have aremaining life ranging from 1 to 18 years.  Our management does notbelieve the expiration of any one of these patents will have a significantadverse impact on continuing operations.

 

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We seek to improve our products and to obtain patents on theseimprovements.  As a result, we believe our patent portfolio will expand,thereby lessening our reliance on any one particular patent.  We alsobelieve our competitive position is enhanced by our existing patents and thatany future patents will continue to enhance this position.  If acompetitor were to successfully provide competing products which do notinfringe on our patents, or if new technologies lessened the need for our protectedideas, the enhanced competitive position we receive from our patent portfoliowould be reduced or even completely eliminated.

 

In addition to our patent ownership, we have assigned certain patentsto our customers, primarily The Coca-Cola Company.  These patents are theresult of special development projects between us and the particularcustomer.  These projects are typically paid for by the customer, and weeither retain licenses to manufacture the products covered by these patents forthe customer, or grant such licenses to the customer.  We occasionallyacquire patent protection for products that are complimentary to products whosepatents are controlled by third parties.

 

The name “Lancer” is our federally registered trademark.  It isalso registered in many foreign countries.  In certain instances, we granta non-exclusive license to our distributors, primarily foreign, to use thetrademark subject to certain requirements and limitations.

 

**Environmental Matters**

 

Our operations are subject to increasingly stringent federal, state,local, and foreign laws and regulations relating to the protection of theenvironment.  In the United States, these environmental laws andregulations, which are implemented by the Environmental Protection Agency andcomparable state agencies, govern the management of hazardous waste, thedischarge of pollutants into the air and into surface and ground water, and themanufacture and disposal of certain substances.

 

There are no material environmental claims pending or, to our knowledge,threatened against us.  We also believe that our operations are inmaterial compliance with current U.S., state, and foreign environmental lawsand regulations.  We estimate that any expenses incurred in maintainingcompliance with current laws and regulations will not have a material effect onour earnings or capital expenditures.  The enactment, however, ofenvironmental laws or regulations that affect our manufacturing operations andare more stringent than current laws, or a stricter interpretation of alreadyexisting environmental laws or regulations may cause a disruption in ouroperations or require additional expenditures by us, some of which could bematerial. We may incur material costs and liabilities in order to comply withany such laws and regulations and such costs and liabilities may have amaterial adverse effect on our business, financial condition or results ofoperations.

 

**Seasonality**

 

Our net sales in the fourth quarter of our fiscal years have frequentlybeen lower than in other quarters because of seasonality in the capitalspending budgets of many of our customers, although sales in the fourth quarterof 2004 did not exhibit this seasonality.  See “Note 12 – QuarterlyFinancial Information (Unaudited)” in the Notes to Consolidated FinancialStatements.

 

## **ITEM 2.**                             PROPERTIES

## ** **

Our primary manufacturing and administrative facility consists of a346,000 square foot building on a 40-acre tract of land in San Antonio, Texas.This facility is pledged as collateral to our primary lender under the terms ofour new credit facility. See “Item 7 – “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations – Liquidity and Capital Resources– New Credit Facility.”  In Piedras Negras, Mexico, we own two buildingswith a combined 195,000 square feet of manufacturing, warehouse and officespace, and lease an additional 30,000 square foot warehouse facility. We alsolease small facilities in Eagle Pass, Texas and Auckland, New Zealand, a 42,846square foot plant in Beverley, South Australia, a suburb of Adelaide, and smallfacilities in Brisbane, Melbourne, and Sydney, Australia; Brussels, Belgium;Cheshire, England; and Monterrey, Mexico.  We lease approximately 176,000square feet of space throughout the world, and we believe that our currentfacilities are generally sufficient for our operations.

 

Our total net rent expense for real estate was $1.0 million, $1.1million and $1.0 million in 2004, 2003 and 2002, respectively.  Total rentexpense includes $52,000 in 2004, and $89,000 in 2003 and 2002, for certainproperties leased from a partnership controlled by certain shareholders. The Company vacated the properties in July 2004. See “Note 11 – Commitments andContingencies” and “Note 14 – Related Transactions” in the Notes toConsolidated Financial Statements for more information.

 

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## **ITEM 3.**                             LEGAL PROCEEDINGS

## ** **

In August 2003, the US Attorney’s Officeinformed us that it was conducting an investigation arising from allegations raisedin a lawsuit against The Coca-Cola Company by a former Coca-Cola employee,Matthew Whitley, and requested certain information, which we supplied. OnJanuary 13, 2004, we received written notice that the Securities and ExchangeCommission had issued a formal order of investigation, dated December 2, 2003,that appeared to concern matters which were the subject of our prior AuditCommittee investigation (which concluded in January 2004) including certainallegations relating to us that were contained in the Whitley lawsuit againstThe Coca-Cola Company. We are unable at this point to predict the scope oroutcome of the Securities and Exchange Commission or US Attorney’s Officeinvestigations. We have cooperated, and intend to continue to cooperate, withboth the US Attorney’s Office and the Securities and Exchange Commissioninvestigations. We have not had substantive contact relating to theseinvestigations with either the US Attorney’s Office or the Securities andExchange Commission since July 2004.

 

## **ITEM 4.**                             SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

## ** **

No matter was submitted to our security holders for a vote by proxy orotherwise during the fourth quarter of the year ended December 31, 2004.

 

# **PART II**

 
| **ITEM 5.** | ** ** | **MARKET FOR REGISTRANT’S COMMON EQUITY,  RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES** |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------|

## ** **

Our common stock is currently traded on theAmerican Stock Exchange (“AMEX”) under the symbol “LAN.”  The followingtable sets forth the range of high and low market price as reported by the AMEXfor the periods indicated.

 

Market Price For Common Stock

 
| ** **  | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| **Quarter** | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First *     |       | $        | 7.65       |     | $          | 5.95 |   | $ | 10.13 |   | $ | 5.80 |   |
| Second *    |       | 6.60     |       | 5.00     |       | 7.35 |   | 5.95 |   |
| Third       |       | 11.40    |       | 6.10     |       | 6.90 |   | 3.71 |   |
| Fourth      |       | 16.75    |       | 10.25    |       | 7.00 |   | 4.52 |   |
|             |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

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*                                    The AMEX haltedtrading in shares of our common stock from February 3, 2004 until May 20,2004.

 

On February 28, 2005, the closing price of our common stock, asreported by the AMEX, was $15.55 per share.  On that date, there were 210holders of record of our common stock, not including shares held by brokers andnominees.  We believe that there are approximately 2,000 beneficial ownersof our common stock.  We have not declared a cash dividend on our common stockto date.  It has been our general policy to retain earnings to supportfuture growth.

 

**Equity Compensation Plan Information**

 
| **Plan Category**                                          | ** ** | **Number of securities to be  issued upon exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted average exercise  price of outstanding  options, warrants  and rights** | ** ** | **Number of securities  remaining available for  future issuance  (excluding securities  reflected in column (a)** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                 | ** ** | **(a)**                                                                                            | ** ** | **(b)**                                                                            | ** ** | **(c)**                                                                                                            | ** ** |
| Equity compensation plan approved by  security holders     |       | 365,683                                                                                            |       | $                                                                                  | 8.54       |                                                                                                               | 345,584    |   |
| Equity compensation plan not approved by  security holders |       | 136,800                                                                                            |       | $                                                                                  | 10.40      |                                                                                                               | 63,200     |   |
| Total                                                      |       | 502,483                                                                                            |       | $                                                                                  | 9.05       |                                                                                                               | 408,784    |   |

 

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We have established the Lancer CorporationStock Option Plan of 2002, which provides for the grant of options to purchaseshares of our common stock to officers, key employees and non-employees, suchas our Board members. The plan is administered by our CompensationCommittee.  Our executives are encouraged to own shares of our commonstock, thereby aligning the interests of management with those of shareholdersand tying executive compensation to our long-term performance. The maximumnumber of shares underlying the awards under the Lancer Corporation StockOption Plan of 2002 is 200,000. All options granted pursuant to this planexpire no later than ten (10) years after the date of grant.  Foradditional information concerning our stock option plans, see “Note 6 –Employee Benefit Plans” in the Notes to Consolidated Financial Statements.

 

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## **ITEM 6.**                             SELECTED FINANCIAL DATA

(In thousands, except per share amounts)

 
| ** **                                                      | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                      | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Operating Data:                                                 |       |                         |       |   |   |   |   |   |   |   |   |
| Net sales                                                       |       | $                            | 124,249    |   | $ | 113,500 |   | $ | 139,015 |   | $ | 122,745 |   | $ | 111,700 |   |
| Gross profit                                                    |       | 36,731                       |       | 29,099 |   | 37,090 |   | 26,868 |   | 25,058 |   |
| Selling, general and administrative  expenses(1)                |       | 28,900                       |       | 28,425 |   | 27,535 |   | 22,235 |   | 21,286 |   |
| Other operating (income) expense                                |       | 172                          |       | 1,320 |   | (4 | ) | — |   | — |   |
| Impairment of goodwill                                          |       | 50                           |       | — |   | — |   | — |   | — |   |
| Operating income (loss)                                         |       | 7,609                        |       | (646 | ) | 9,559 |   | 4,633 |   | 3,772 |   |
| Interest expense                                                |       | 499                          |       | 329 |   | 1,318 |   | 3,128 |   | 3,243 |   |
| Other income (expense), net(2)                                  |       | 8,021                        |       | (194 | ) | 47 |   | 992 |   | 346 |   |
| Earnings (loss) from continuing operations before  income taxes |       | 15,131                       |       | (1,169 | ) | 8,288 |   | 2,497 |   | 875 |   |
| Income tax expense                                              |       | 5,031                        |       | 190 |   | 2,669 |   | 918 |   | 342 |   |
| Earnings (loss) from continuing operations                      |       | 10,100                       |       | (1,359 | ) | 5,619 |   | 1,579 |   | 533 |   |
| Earnings (loss) from discontinued operations                    |       | —                       |       | 592 |   | (1,613 | ) | (177 | ) | 25 |   |
| Net earnings (loss)                                             |       | 10,100                       |       | (767 | ) | 4,006 |   | 1,402 |   | 558 |   |
|                                                                 |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Beginning January 1, 2002,we no longer amortize goodwill in accordance with FAS 142.

(2) In 2004, other income(expense) includes $7.0 million related to the settlement of a developmentproject.

 
| Earnings per share:                           |   |   |   |   |   |   |   |   |   |   |   |
|-----------------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Basic                                         |   |   |   |   |   |   |   |   |   |   |   |
| Earnings (loss) from continuing operations    |   | $      | 1.08   |   | $      | (0.15  | )      | $      | 0.60   |   | $      | 0.17 |   | $ | 0.06 |   |
| Earnings (loss) from discontinued  operations |   | $      | — |   | $      | 0.06   |   | $      | (0.17  | )      | $      | (0.02 | ) | $ | — |   |
| Net earnings (loss)                           |   | $      | 1.08   |   | $      | (0.09  | )      | $      | 0.43   |   | $      | 0.15 |   | $ | 0.06 |   |
|                                          |   |   |   |   |   |   |   |   |   |   |   |
| Diluted                                       |   |   |   |   |   |   |   |   |   |   |   |
| Earnings (loss) from continuing operations    |   | $      | 1.06   |   | $      | (0.15  | )      | $      | 0.60   |   | $      | 0.17 |   | $ | 0.06 |   |
| Earnings (loss) from discontinued  operations |   | $      | — |   | $      | 0.06   |   | $      | (0.17  | )      | $      | (0.02 | ) | $ | — |   |
| Net earnings (loss)                           |   | $      | 1.06   |   | $      | (0.09  | )      | $      | 0.43   |   | $      | 0.15 |   | $ | 0.06 |   |
|                                          |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding:          |   |   |   |   |   |   |   |   |   |   |   |
| Basic                                         |   | 9,388  |   | 9,356  |   | 9,327  |   | 9,127  |   | 9,125  |   |
| Diluted                                       |   | 9,504  |   | 9,356  |   | 9,433  |   | 9,315  |   | 9,290  |   |
|                                          |   |   |   |   |   |   |   |   |   |   |   |
| Cash dividends per share                      |   | $      | — |   | $      | — |   | $      | — |   | $      | — |   | $ | — |   |

 
| ** **                                | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| Balance Sheet Data:                       |       |                         |       |   |   |   |   |   |   |   |   |
| Total assets                              |       | $                            | 85,487     |   | $ | 82,278 |   | $ | 92,755 |   | $ | 96,604 |   | $ | 102,392 |   |
| Short-term debt                           |       | 1,345                        |       | 3,735 |   | 7,726 |   | 18,318 |   | 24,129 |   |
| Long-term debt, less current installments |       | 132                          |       | 8,268 |   | 9,808 |   | 11,872 |   | 12,724 |   |
| Shareholders’ equity                 |       | 63,015                       |       | 51,963 |   | 50,151 |   | 44,286 |   | 43,533 |   |
|                                           |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| **ITEM 7.** | ** ** | **MANAGEMENT’S DISCUSSION AND ANALYSIS OF  FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-------------|------------|-------------------------------------------------------------------------------------------------|

## ** **

This report contains certain “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 1933, asamended, and Section 21E of the Securities Exchange Act of 1934, as amended. Wedesire to take advantage of the “safe harbor” provisions of the PrivateSecurities Litigation Reform Act of 1995 and we are including this statementfor the expressed purpose of availing ourselves of the protection of the safeharbor with respect to all of such forward-looking statements. Theseforward-looking statements describe future plans or strategies and include ourexpectations of future financial results and often include words such as “may,”“will,” “should,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “predict,”“plan,” “potential,” and “continue,” and the negatives of these terms andvariations of them or similar terminology. These forward-looking statementsinvolve known and unknown risks, uncertainties and other factors that may causeour actual results, performance or achievements to be materially different fromresults expressed or implied by the forward-looking statements. Factors thatcould affect actual results include but are not limited to:

 

•                  generaleconomic trends;

•                  abilityto service our debt;

•                  availabilityof capital sources;

•                  currencyfluctuations;

•                  fluctuationsin our operating costs;

•                  competitivepractices in the industry in which we compete;

•                  changesin our labor conditions;

•                  ourcapital expenditure requirements;

•                  technologicalchanges and innovations;

•                  legislativeor regulatory requirements;

•                  operatingchanges and product needs of our main customer, The Coca-Cola Company;

•                  lossesfrom litigation; and

•                  allother factors described herein under “Risk Factors.”

 

These and other factors should be consideredin evaluating the forward-looking statements, and undue reliance should not beplaced on such statements.

 

We do not undertake and specificallydisclaims any obligation to update any forward-looking statements to reflectoccurrence of anticipated or unanticipated events or circumstances after thedate of such statements.

 

The following discussion should beread in connection with our Consolidated Financial Statements, related notesand other financial information included elsewhere in this document.

 

**Overview**

 

***General****.* We design, engineer, manufacture and market fountain softdrink, beer and citrus beverage dispensing systems, and other equipment for usein the food service and beverage industry. We also market frozen beveragedispensers manufactured by Lancer FBD, a partnership in which we own a 50%partnership interest. Our products are sold by our employees and throughindependent distributors and agents predominantly to major soft drink companies(primarily The Coca-Cola Company, which influences substantially more than halfof our sales), bottlers, equipment distributors, beer breweries, restaurantsand convenience stores for use in various food and beverage operations. Ourprimary manufacturing and administrative facility is located in San Antonio,Texas. We have sales employees, distributors, and/or licensees in LatinAmerica, Europe, Africa and Asia. We manufacture products in Australia andPiedras Negras, Mexico, and operate warehouses in Australia, Belgium, Mexico,New Zealand, and the United Kingdom.

 

Our products can be divided into four major categories: (i) fountainsoft drink, citrus, and frozen beverage dispensers, which includes a broadrange of mechanically cooled and ice cooled soft drink and citrus dispensingsystems; (ii) post-mix dispensing valves, which mix syrup and carbonated waterat a preset ratio; (iii) beer dispensing systems and related accessories; and(iv) other products and services, which includes various dispensing systems andreplacement parts in connection with the remanufacturing process.

 

***Events****.* In June 2003, our Audit Committee began conducting aninternal investigation related to allegations raised by a lawsuit against TheCoca-Cola Company be a former Coca-Cola employee, Matthew Whitley. Although wewere not a

 

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defendant to the lawsuit, certain allegations in the lawsuit specificallyinvolved us. The Audit Committee investigation was later expanded to includeallegations raised in certain press articles. On January 30, 2004, we announcedthat our Audit Committee had concluded its internal investigation and releaseda general summary of its findings. On February 2, 2004, our former auditorresigned from its position and subsequently withdrew its audit reports for theperiods ended December 31, 2002, 2001 and 2000, advising us that the financialstatements and related audit reports should no longer be relied upon.

 

On March 1, 2004, our Audit Committee engaged BDO Seidman, LLP as ournew independent auditor to audit our financial information for 2003, as well asfor prior periods for which the former auditor had withdrawn its audit reports,and to review financial information for prior quarterly periods. This processof audit and review was completed by BDO Seidman on June 16, 2004. The reauditdid not result in any adjustment to our previously disclosed financialstatements for the prior periods.

 

Prior to June 30, 2004, we were a party tothe Seventh Amendment and Restated Credit Agreement that provided for termloans in the aggregate amount of $14.8 million, and a $25 million revolvingloan amount, which we refer to as our former credit facility. Effective June30, 2004, our former lenders agreed to amend our former credit facility becausewe were in default on certain of our credit agreement terms. The amendment toour former credit facility provided for, among other things, waivers for ourpast defaults and potential defaults and amended terms of the former creditagreement to accommodate events surrounding these past defaults. See Item 7 – “Management’sDiscussion and Analysis of Financial Condition and Results of Operations – Liquidityand Capital Resources – Former Credit Facilities.”

 

On July 1, 2004, we filed the followingreports with the Securities and Exchange Commission: Form 10-K/A for the 2002fiscal year, Form 10-Q/A for the 2003 first quarter, Forms 10-Q for the 2003second and third quarters, Form 10-K for the fiscal year 2003 and Form 10-Q forthe 2004 first quarter. The filing of these reports enabled us to becomecurrent in our filing obligations with the Securities and Exchange Commissionand to regain compliance with Section 1003(d) of the AMEX Company Guide.

 

On September 13, 2004, we entered into an agreement, which we refer toin this report as the settlement agreement, with The Coca-Cola Company relatingto the joint development of the iFountain line of dispensers. Pursuant to thesettlement agreement, The Coca-Cola Company paid us a total of $7.0 million inconsideration of (i) our engineering, research and development and other costsincurred by us on the project, (ii) our inventory related to the project that couldnot be used as intended and did not have feasible alternate uses, and (iii)certain covenants and releases relating to the project. We had previouslywritten-off $1.2 million of inventory associated with the project during thefourth quarter of 2003. We recorded the $7.0 million payment as other incomewhen we received the payment in the third quarter of 2004.

 

On December 17, 2004, we entered into a newcredit facility with a new lender which we refer to in this report as our newcredit facility, effectively replacing the former credit facility. The newcredit facility consists of a $15.0 million revolving loan, and allows us toborrow, repay, and reborrow, on a secured basis and from time to time untilDecember 30, 2007, amounts up to the $15.0 million total. See Item 7 – “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Liquidity and Capital Resources – New Credit Facilities.”

 

**Critical Accounting Policies**

 

The Consolidated Financial Statements and Notes to ConsolidatedFinancial Statements contain information that is important to management’sdiscussion and analysis.  The preparation of financial statements inconformity with generally accepted accounting principles in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities.

 

Critical accounting policies are those that reflect significantjudgments and uncertainties and may result in materially different resultsunder different assumptions and conditions.  We believe that our criticalaccounting policies are limited to those described below.  For a detaileddiscussion on the application of these and other accounting policies, see “Note1 - Summary of Significant Accounting Policies” in the Notes to ConsolidatedFinancial Statements.

 

*Revenue Recognition*

 

We recognize revenue in accordance with the following methods:

 

### **(a)**          At the time of shipment for all products except for those sold underagreements described in (b). We require a purchase order for all sales. At thetime of the shipment, risk of ownership and title passes to our customer. Thegoods are completely assembled and packaged and we have no further performanceobligations.

 

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### **(b)**         Asproduced and at time of title transfer, for certain products manufactured andwarehoused under production and warehousing agreements with certaincustomers.  We had no such arrangements after March 31, 2002.

 

### **(c)**          We have entered into an agreement with The Coca-Cola Company to receivepartial reimbursement for design and development.  The reimbursement isoffset against cost on a percentage of completion basis.

 

### **(d)**         Priorto 2003, we had agreed to provide exclusive rights for use of certain tools toThe Coca-Cola Company.  These tools are included in fixed assets and aredepreciated over the life of the asset.  The corresponding license andmaintenance fees are recorded as deferred income and recognized over the lifeof the agreement, which approximates the life of the corresponding asset. After2002, the Company has agreed to maintain certain tools that are the property ofThe Coca-Cola Company. The corresponding maintenance fees are recorded as deferredincome and recognized over the life of the corresponding tool.

 

*Reserve for Slow Moving and Obsolete Inventory*

 

We provide for slow moving inventory based on an analysis of the agingand utility of the inventory. Obsolete inventory is 100% reserved at the timethe product is deemed obsolete due to technological advances anddiscontinuation of products. In addition, management’s evaluation of thespecific items also influences the reserve.  We believe that the reserveas of December 31, 2004 is adequate to provide for expected losses.

 

*Medical Costs and Worker’s Compensation Accrual*

 

We maintain a self-insurance program for major medical andhospitalization coverage for employees in the United States and theirdependents, which is partially funded by payroll deductions.  The estimateof the accrual necessary for claims is based on our estimate of claims incurredas of the end of the year. We use detail lag reports provided by the insuranceadministrator to determine an appropriate reserve balance. In addition todetail lag reports provided by the insurance administrator, we use an outsideactuary report in determining an appropriate accrual balance. We have providedfor both reported medical costs and incurred but not reported medical costs inthe accompanying consolidated financial statements.  We have a maximumliability of $100,000 per participant per policy year.  Amounts in excessof the stated maximum are covered under a separate policy provided by aninsurance company.

 

We are self-insured for all workers’ compensation claims submitted byTexas employees for on-the-job injuries. The estimate of the accrual necessaryfor claims are based on our estimate of claims incurred as of theDecember 31, 2004. In addition to detail lag reports provided by the insuranceadministrator, we use an injury report to determine an appropriate reservebalance. We have provided for both reported costs and incurred but not reportedcosts of workers’ compensation coverage in the consolidated financialstatements.  In an effort to provide for catastrophic events, we carry anexcess indemnity policy for workers’ compensation claims.  All claims paidunder the policy are subject to an annual deductible of $500,000 per claim tobe paid by us.  Based upon our past experience, management believes thatwe have adequately provided for potential losses.  However, multipleoccurrences of serious injuries to our employees could have a material adverseeffect on our financial position or our results of operations.

 

###### *Classificationof Costs*

###### * *

Cost of sales generally includes costs relating to the procurement,manufacture, and handling of inventory to the point of sale. Cost of salesincludes inbound freight charges, purchasing and receiving costs, inspectioncosts, warehousing costs, internal transfer costs, and other costs ofdistributing product to our customers, internal or external. Gross margins maynot be comparable to those of other entities, since some entities include allof the costs related to their distribution network in cost of sales. We includecompensation, warehousing expenses, office expenses, and other costs relatingto maintaining our distribution subsidiaries in selling, general andadministrative expenses. These expenses from distributor subsidiaries includedin selling, general and administrative expenses were $5.1 million, $5.4 millionand $5.6 million in 2004, 2003 and 2002, respectively. Corporate expensesrelating to product development, accounting, human resources, and informationtechnology are included in selling, general and administrative expenses.

 

*Goodwill*

 

We account for goodwill and other intangible assets in accordance withStatement of Financial Accounting Standards SFAS No. 142, “Goodwill and OtherIntangible Assets,” which requires that goodwill and certain indefinite-livedassets no longer be amortized, but instead be evaluated at least annually forimpairment.  We adopted the provisions of SFAS 142 on January 1,2002.

 

The determination of the value of goodwill and other intangiblesrequires us to make estimates and assumptions about future business trends andgrowth.  If an event occurs which would cause us to revise our estimatesand assumptions uses in analyzing the value of our goodwill or otherintangibles, such revision could result in an impairment charge that could havea material impact on our financial condition and results of operations.

 

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Goodwill is tested for impairment annually on September 30 or wheneveran event occurs or circumstances change that may reduce the fair value of thereporting unit below its book value.  The impairment test is conducted foreach reporting unit in which goodwill is recorded by comparing the fair valueof the reporting unit with its carrying value.  Fair value is determinedprimarily by computing the future discounted cash flows expected to begenerated by the reporting unit.  If the carrying value exceeds the fairvalue, goodwill may be impaired. If this occurs, the fair value of thereporting unit is then allocated to its assets and liabilities in a mannersimilar to a purchase price allocation in order to determine the implied fairvalue of the goodwill of the reporting unit.  The implied fair value isthen compared with the carrying amount of the goodwill of the reporting unit,and, if it is less, we would then recognize an impairment loss.

 

Other intangible assets with definite useful lives are recorded on thebasis of cost in accordance with SFAS No. 142 and are amortized on astraight-line basis over their estimated useful lives, which range fromeighteen months to fifteen years. In accordance with SFAS No. 142, we subjectedthese assets to tests of impairment and we determined that certain patents wehold no longer have value due to technological changes and obsolescence.

 

*Allowance for Doubtful Accounts*

 

We maintain our allowance for doubtful accounts at a balance adequateto reduce accounts receivable to the amount of cash expected to be realized oncollection. The methodology used to determine the allowance is based on ourprior collection experience. Specific customers’ financial strength andcircumstance also influence the balance of our allowance for doubtful accounts.Accounts that are determined to be uncollectible are written-off in the periodin which they are determined to be uncollectible.

 

*Guaranties*

 

We guaranty the debt of certain of our joint venture investments. Atthe time we enter into the guaranty, we record a liability in the amount of theestimated value of the guaranty. The guaranty value is assumed to equal thecost of obtaining a standby letter of credit in favor of the lender.

 

***Segments.***Oursegments reflect the fact that we manage our business by geographic regions.Corporate administrative and engineering expenses are included in the Corporatesegment, rather than allocated among our geographic region segments. Each ofthe geographic regions contains sales and distribution related operations. Additionally,the North America and Asia/Pacific regions include manufacturing operations. (Weconsider our maquiladora in Piedras Negras, Mexico to be part of our NorthAmerica operations.) A large portion of the costs associated with themanufacturing operations is fixed, making gross margin in North America andAsia/Pacific sensitive to changes in sales volume. Because most costs in ourother regions are variable, gross margin in those regions is not as sensitiveto changes in sales volume. Most of our sales and manufacturing activity occursin the North America region. Additionally, our corporate headquarters arephysically located in North America, though corporate expenses are included inthe Corporate segment.

 

**Results of Operations**

 

**Continuing Operations**

 

*Non-Recurring Payment.*

During 2004, we recorded other income of $7.0 million from the settlementagreement. See Item 7 “Management’s Discussion and Analysis of FinancialCondition and Results of Operations – Overview – Events.”

 

*Revenues.*

 

Revenues by Geographic Segment

(Amounts in thousands)

 
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **% Change**     | ** ** |
|----------------------|------------|------------|------------|------------|------------|------------|------------|------------------|------------|
| ** **           | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** | **2004 vs 2003** | ** ** | **2003 vs 2002** | ** ** |
| North America region |       | $          | 79,528     |       | $          | 75,924     |       | $                | 97,575     |   | 5 | % | -22 | % |
| Latin America region |       | 5,814      |       | 7,690      |       | 13,351     |       | -24              | %          | -42 | % |
| Asia/Pacific region  |       | 27,969     |       | 21,645     |       | 18,555     |       | 29               | %          | 17 | % |
| Europe region        |       | 10,938     |       | 8,241      |       | 9,534      |       | 33               | %          | -14 | % |
|                 |       | $          | 124,249    |       | $          | 113,500    |       | $                | 139,015    |   | 9 | % | -18 | % |

 

Our net sales rose 9% in 2004, afterdeclining 18% in 2003. Changes in unit volume caused substantially all of theyear-to-year fluctuations. Currency exchange rate fluctuations had a positiveimpact of 3% on net sales in both 2004 and 2003. Sales

 

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in the North America region rose 5% in 2004,driven largely by sales to convenience store customers. Sales in North Americadeclined 22% in 2003 because of weak market conditions in the foodserviceindustry, and a significant customer’s restructuring activities. In the LatinAmerica region, sales declined sharply from 2002 to 2004. Much of the declineoccurred in Mexico, where an unusually large order boosted sales in 2002. Marketconditions are weak in Latin America, and appear likely to remain so. Currencyexchange rate movements had a negative impact on Latin America sales of 4% in2004. Sales growth in the Asia/Pacific region was 29% in 2004 and 17% in 2003. During2004, sales of beer and fountain equipment were strong in the region. Some ofthe improved demand for fountain equipment in 2004 was attributable to a largeproject for a single customer that is not expected to recur in 2005. Sales inthe Europe region rose 33% in 2004, after declining 14% in 2003. Thefluctuations were partly caused by production problems with one of our valveproducts during most of 2003. Valve sales in the Europe region rebounded in2004. Additionally, currency exchange rate fluctuations had a positive effecton sales of 12% in 2004, and 13% in 2003. We expect sales to improve in theEurope region during 2005 because of approximately $5.0 million of anticipatedsales relating to soft drink and beer dispensing systems for a stadium in theUnited Kingdom. Approximately $2.0 million of the $5.0 million totalanticipated sales from the project will consist of service work that we willsubcontract to third-party suppliers.

 

*Gross Margin*.

 

Gross Marginby Geographic Segment

 
| ** **           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
| North America region |       | 30.2     | %          | 25.1     | %          | 24.2     | %          |
| Latin America region |       | 25.1     | %          | 25.2     | %          | 35.0     | %          |
| Asia/Pacific region  |       | 27.6     | %          | 28.9     | %          | 29.7     | %          |
| Europe region        |       | 32.0     | %          | 23.0     | %          | 34.1     | %          |
|                 |       | 29.6     | %          | 25.6     | %          | 26.7     | %          |

 

Gross margin was 29.6%, 25.6% and 26.7% in2004, 2003 and 2002, respectively.  In North America, gross marginimproved sharply in 2004 due to the positive effects of manufacturing costreductions, including a reduction in the number of manufacturing employees, andimproved manufacturing efficiency. These positive factors more than offset a$0.6 million charge for the impairment of certain inventory and higher costsfor some raw materials including stainless steel and plastic resin. NorthAmerican gross margin rose in 2003 because of spending reductions that more thanoffset an inventory impairment of $1.2 million. In the Latin America region,gross margin was unusually high in 2002 because of the profitability associatedwith atypically large sales volume in Mexico. Factory relocation expenses of$0.2 million lowered 2004 gross margin in the Asia/Pacific region. We expect toincur additional relocation expense of approximately $0.2 million in theAsia/Pacific region in the first quarter of 2005. Unfavorable changes inproduct mix relating to production problems with one of our valve productscaused gross margin in Europe to be unusually weak in 2003.

 

###### *OperatingExpenses*

###### * *

Selling, General & AdministrativeExpenses by Segment

(Amounts in thousands)

 
| ** **           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|
| North America region |       | $        | 5,804      |     | $          | 5,943    |       | $ | 6,231 |   |
| Latin America region |       | 1,378    |       | 1,998    |       | 2,692    |       |
| Asia/Pacific region  |       | 4,929    |       | 4,576    |       | 3,734    |       |
| Europe region        |       | 2,412    |       | 2,083    |       | 1,886    |       |
| Corporate            |       | 14,377   |       | 13,825   |       | 12,992   |       |
|                 |       | 28,900   |       | $        | 28,425     |     | $          | 27,535 |   |
|                      |            |          |            |          |            |          |            |  |  |  |

 

Selling, general and administrative expenses were $28.9 million, $28.6million and $27.5 million in 2004, 2003 and 2002, respectively.  Spendingin the Latin America region has declined during the past two years as we closedsome of our sales offices and reduced employment in response to poor economicconditions in the region. In the Asia/Pacific region, most of the increase inspending relates to higher employment expense stemming from our acquisition ofa service operation in 

 

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Brisbane, Australia and the opening of our sales office in Melbourne,Australia, both in 2002. We formed an operation in the United Kingdom during2003, which drove the spending increase in the Europe region in 2003 and 2004. Inthe Corporate segment, audit-related expenses and costs associated with theinvestigations conducted by our Audit Committee, the Securities and ExchangeCommission and the US Attorney’s Office were $2.2 million in 2004 and $2.5million in 2003. In 2004, a $1.8 million increase in variable compensation expensebased on the improvement in our financial performance was partially offset by a$0.9 million decrease in research and development expense. In 2005, we willincur costs in the corporate segment to comply with the requirements of Section404 of the Sarbanes-Oxley Act of 2002. Although we are unable to predict theamount of the costs with any certainty, we expect to spend between $0.6 millionand $0.8 million on compliance with the Sarbanes-Oxley Act during 2005.

 

Other operating expense in 2003 consisted of a $0.2 million loss on thesale of assets, a $0.2 million loss from the impairment of patents, and a $0.9million write-off of our investment in Lancer Ice Link, LLC, a consolidatedjoint venture in which we own a 60% interest. Other operating income in 2004includes a $0.3 million of income from the write-off of tooling and deferredrevenue relating to the settlement agreement, and a $0.2 million loss from theimpairment of patents. Additionally in 2004, we incurred a $0.4 million gainrelating to insurance proceeds from a fire claim that occurred in 2003, and a$0.4 million loss from the impairment of tooling from a discontinued project. The$0.1 million impairment of goodwill in 2004 relates to our Latin Americaoperations.

 

*Non-Operating Income/Expenses.* Non-operatingIncome/Expenses included the following items:

 

•                  Other income in 2004 included $7.0 million paid tous pursuant to the settlement agreement. Other income also included $0.3million of bank facility closing costs in 2004, and a $0.2 million gain in 2003from the sale of our holdings of common stock in Packaged Ice, Inc.

 

•                  Interest expensewas $0.5 million, $0.3 million and $1.3 million in 2004, 2003 and 2002,respectively. Interest expense declined in 2003 from 2002 levels because of thecombined effects of lower average borrowings under our credit facility andlower average market interest rates. Interest expense rose in 2004 because ofhigher interest spreads on borrowings under our credit facility, as well ashigher market interest rates.

 

•                  Income fromjoint ventures was $1.1 million in 2004, compared to losses of ($0.2 million)and ($0.7 million) in 2003 and 2002, respectively. The improvement in recentyears was driven by the profitability of Lancer FBD. During 2003, Lancer FBDimpaired $0.5 million of inventory related to a terminated project. During2004, the intended customer for the inventory reimbursed Lancer FBD for theinventory, resulting in income of $0.5 million. Moo Technologies, LLC, adevelopmental stage company in which we own 50% of the outstanding equity, hasexperienced losses since its inception. Our portion of Moo Technology’s losswas $0.3 million, $0.2 million, and $0.1 million in 2004, 2003 and 2002,respectively.

 

•                  Our effectivetax rate was 33.2% in 2004 and 32.2% in 2002. The effective tax rate wasnegative in 2003. During 2003, we decided to terminate the DomesticInternational Sales Corporation election for our subsidiary that exportsproducts from the United States.  The termination resulted in a $0.8 millioncharge to income tax expense.  Additionally, the IRS completed its auditof our deduction of our investment in our Brazilian operations, and othermatters.  As a result, we reversed certain tax accruals, resulting in anincome tax benefit of $0.3 million.

 

*Income/Loss from Continuing Operations*. Income from continuing operations was $10.1 million in 2004, a loss of ($1.4million) in 2003, and income of $5.6 million in 2002.  The improvement in2004 was partly attributable to the $7.0 million settlement relating to adevelopment project, as well as higher net sales. The loss in 2003 was mainlydue to the decline in net sales in 2003, and to additional expenses related tothe investigations conducted by our Audit Committee, the Securities andExchange Commission, and the US Attorney’s Office.

 

**Discontinued Operations**

 

We decided to close our Brazilian subsidiary during the second quarterof 2002.  The Brazilian subsidiary’s results are classified asdiscontinued operations.

 

Revenue from discontinued operations was $-0- in 2004 and 2003, and$0.5 million in 2002.  During 2002, we recognized $2.1 million for theestimated loss from disposal of discontinued operations, and incurred a ($0.4million) operating loss from discontinued operations.  Income (net of tax)from discontinued operations was $0 in 2004, $0.6 million in 2003, and a lossof ($1.6 million) in 2002.

 

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**Liquidity and Capital Resources**

 

*General*

Our principal sources of liquidity are cash flows from operations andamounts available under our credit facility. We have met, and currently expectthat we will continue to meet, substantially all of our working capital andcapital expenditure requirements, as well as our debt service requirements,with funds provided by operations and borrowings under our credit facilities.

 

*Cash Provided by Operations and Capital Expenditures*

Cash provided by operating activities was $15.1 million, $6.7 millionand $18.2 million in 2004, 2003 and 2002, respectively. The improvement in 2004was caused largely by our profitability (which was driven by $7.0 million ofother income relating to the settlement agreement). We made capitalexpenditures of $1.9 million, $4.1 million and $3.7 million in 2004, 2003 and2002, respectively. Production equipment and tooling accounted for most of ourcapital spending. In 2003, we spent $1.0 million for the expansion of aproduction facility in Piedras Negras, Mexico. Cash provided by operatingactivities was sufficient to finance capital spending and reduce debt in eachof the past three years. We expect capital spending to increase in 2005 to moreclosely approximate the levels of 2003 and 2002 than the amount spent in 2004,though there are no plans for major capital projects. During 2003, we sold ourholdings of common stock in Packaged Ice, Inc. for $0.3 million.

 

*Former Credit Facilities.*Priorto June 30, 2004, we were a party to the Seventh Amendment and Restated CreditAgreement, which provided for a term loan in the aggregate amount of $14.8million, consisting of $12.9 million in Term A loans and $1.9 million in Term Bloans and a $25.0 million revolving loan amount with The Frost National Bank asthe Administrative Agent and as a lender, Harris Trust and Savings Bank andWhitney National Bank, which we refer to in this report as our former creditfacility. Due to our inability to deliver audited financial statements for theyear 2003 to our lenders on a timely basis, and due to certain other events andcircumstances, we came to be in default of the credit agreement terms of ourformer credit facility.

 

Effective June 30, 2004, our lenders agreed to amend the former creditfacility. The amendment to our former credit facility provided for, among otherthings, waivers for our past defaults and potential defaults and amended termsof the former credit agreement to accommodate events surrounding these pastdefaults. The amended terms also provided for aggregate term loans in theamount of $9.0 million and a $10.0 million revolving loan amount. The term loanamounts were based on the balances that then existed on the term loans.

 

*New CreditFacility.*On December 17, 2004, we entered into a newcredit facility with a new lender, which we refer to in this report as our newcredit facility. The new credit facility consists of a total of $15.0 millionrevolving loan amount, and allows us to borrow, repay, and reborrow, on asecured basis and from time to time until December 30, 2007, up to the $15.0million total.

 

Interest on the outstanding amount under the new credit facility ispayable on a monthly basis at our choice of either (i) the prime rate of JPMorgan Chase & Co., New York, New York, as announced from time to time,minus 0.5%, or (ii) the London Interbank Offered Rate (LIBOR) plus 1.75% to2.0% (depending on our ratio of Total Funded Debt to Consolidated EBITDA, asthose terms are defined in the new credit agreement for the new creditfacility). A commitment fee of 0.125% per annum will accrue on the unusedportion of the total revolving loan amount.

 

The new credit facility is secured by a lien on the real property whereour headquarters is located, including all improvements, and a securityinterest on certain of our accounts receivable, equipment and inventory.

 

Our subsidiary, Lancer Partnership, Ltd., is the actual named “Borrower”under the new credit facility, while Lancer Corporation itself, along with ourwholly-owned subsidiaries, Lancer Capital Corporation and Lancer InternationalSales, Inc., jointly and severally guaranty the new credit facility.

 

Pursuant to the new credit facility, we are required to maintain aratio of Current Consolidated Assets to Current Consolidated Liabilities (asthose terms are defined in the new credit agreement for the new creditfacility) of not less than 1.25 to 1.0, and a ratio of Total Funded Debt toConsolidated EBITDA (as those terms are defined in the new credit agreement forthe new credit facility) of not more than 3.0 to 1.0. Additionally, we arerequired to maintain a consolidated net worth of not less than $47.0 millionplus 75% of cumulative net income after June 30, 2004 (with no reduction forany net loss reported for any quarter).

 

We must repay borrowings under the new credit facility by December 30,2007 unless payment is accelerated upon the occurrence of an event of default.The new credit facility contains customary default events such as paymentdefault, 

 

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covenant default, bankruptcy type defaults, liens, judgments, and theoccurrence of certain other events which could impair or negatively impact usfrom performing our obligations under the new credit facility. Upon certainevents, such as a final money judgment against us (which is not paid orperfected within sixty days) or a challenge to the lender’s first lien andsecurity interest, the lender may reasonably determine whether the event willimpair or impact our ability to perform under the new credit facility.

 

As of December 31, 2004, there were no amounts outstanding underthe new credit facility, and $15.0 million was available for borrowing.  Alsoas of December 31, 2004, we were in compliance with all of the covenants of ournew credit facility.

 

*Disputed Debt*. We have a $1.196 millionprincipal amount of disputed debt payable in relation to our discontinuedBrazilian operations that was due on December 31, 2001. We have recorded thebalance of the disputed debt plus interest in the amount of $0.14 millionaccrued through December 31, 2004 in our financial statements. During thesecond quarter of 2003, the payee demanded payment of the debt, and we made asettlement offer. We have had no discussions with the payee since 2003. We maynot be successful in negotiating a settlement of this disputed debt, in whichcase the total amount would remain due and payable. If that were to occur, wewould have to determine what other options are available to us, includinglitigation. If we determined that the debt should simply be paid at that time,we believe that we would likely have sufficient funding available, through ourcash reserves and/or our available capacity under our new credit facility, topay the disputed debt.

 

*Subsequent Event.* On January 28, 2005, wecompleted the sale of 546.65 acres of land and improvements, located in Bee andKarnes Counties, Texas, to Schroeder Land and Cattle Company, Incorporated(SLCC). The purchase price of $0.7 million approximates the average of twoindependent third party appraisals on the property. SLCC is owned by thechildren of Alfred A. Schroeder and George F. Schroeder. Both Alfred A.Schroeder and George F. Schroeder are our employees, members of our Board, andsignificant shareholders of our stock. Lance M. Schroeder, son of Alfred A.Schroeder, is our Vice President of Corporate Development and is a 25% owner ofSLCC. We had previously used the property, commonly known as the MonteolaRanch, for entertaining customers and other business associates. We expect torealize a gain of $257 thousand on the transaction in the first quarter of 2005.

 

**Contractual Obligations**

 

The following table provides a summary of ourcontractual obligations as of December 31, 2004.  Additional detailsabout these items are included in the notes to the consolidated financialstatements (amounts in thousands).

 
| ** **                         | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------|------------|----------------------------|------------|
| **Contractual obligations**        | ** ** | **2005**                   | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009 and  After** | ** ** | **Total** | ** ** |
| Indebtedness                       |       | $                          | 1,345      |   | $ | 132 |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,477 |   |
| Operating leases                   |       | 885                        |       | 749 |   | 496 |   | 329 |   | 92 |   | 2,551 |   |
| Estimated Interest                 |       | 52                         |       | 42 |   | 38 |   | 38 |   | 38 |   | 208 |   |
| Other                              |       | 147                        |       | — |   | — |   | — |   | — |   | 147 |   |
| Total contractual cash obligations |       | $                          | 2,429      |   | $ | 923 |   | $ | 534 |   | $ | 367 |   | $ | 130 |   | $ | 4,383 |   |

 

There were no amounts outstanding under our revolving credit facilityat December 31, 2004.

 

Estimated Interest is based upon the following assumptions:

 

•                  Because thebalance of our revolving credit facility is subject to wide fluctuations basedon factors that are difficult to project, interest on the revolving facility isnot included in Estimated Interest above.

•                  It is assumedthat there are no prepayments under the capital lease, and that there are nopayments on the Brazilian disputed obligation. The balance of the disputedBrazilian debt was $1,196 at December 31, 2004.

•                  The floatinginterest rate on the Brazilian disputed obligation is assumed to remain at the3.16% in effect on December 31, 2004.

 

Purchase orders are entered intoduring the ordinary course of business in order to establish best pricing andcontinuity of supply for our production. Purchase orders are not included inthe table above as they typically represent our offer to purchase, rather thanbinding contractual obligations.

 

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**Off-Balance Sheet Arrangements**

 

We own 50% of Lancer FBD, a manufacturerof frozen beverage dispensing equipment. We guarantee repayment of Lancer FBD’s$1.5 million facility with a bank. Our portion of Lancer FBD’s net income(loss) was $1.4 million, ($0.1 million) and ($0.6 million) in 2004, 2003 and2002, respectively. On December 31, 2004, there were no amounts outstandingunder Lancer FBD’s credit facility.

 

We own 50% of Moo Technologies, a developmental stage limited liabilitycompany engaged in the commercialization of concentrated shelf-stable milkproducts. We are a guarantor of Moo Technologies’ $0.75 million revolvingcredit facility with a bank. As of December 31, 2004, the balance of the creditfacility was $0.75 million. Our portion of Moo Technology’s loss was ($0.3million), ($0.2 million), and ($0.1 million) in 2004, 2003 and 2002,respectively. We have invested $0.8 million in Moo Technologies, LLC since itsinception, including $0.3 million during 2004, bringing our net investment inthe company to $0.3 million as of December 31, 2004. We expect Moo Technologiesto be unprofitable through at least 2005. During the first quarter of 2005, weinvested an additional $0.5 million in Moo Technologies. The development of MooTechnologies’ business opportunities is likely to require us to investapproximately $0.2 million of additional funds in the company during 2005. Duringthe first quarter of 2005, Moo Technologies retired its bank borrowings, andthe bank released us from our guaranty.

 

**Seasonality**

 

Our net sales in the fourth quarter of our fiscal years have frequentlybeen lower than in other quarters because of seasonality in the capitalspending budgets of many of our customers.  See “Note 12 — QuarterlyFinancial Information (unaudited)” in the Notes to Consolidated FinancialStatements.

 

**Recent Accounting Pronouncements**

 

In November 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “InventoryCosts”, an amendment of ARB No. 43, Chapter 4. The amendments made by SFAS No.151 clarify that abnormal amounts of idle facility expense, freight, handlingcosts and wasted materials (spoilage) should be recognized as current-periodcharges and require the allocation of fixed production overheads to inventorybased on the normal capacity of the production facilities. The pronouncement iseffective for inventory costs incurred during fiscal years beginning after June15, 2005. Earlier application is permitted for inventory costs incurred duringfiscal years beginning after November 23, 2004. We currently recognize, asperiod costs, any abnormal amounts of idle facility expense, freight, handlingcosts and wasted materials and allocates fixed production overhead to inventorybased on the normal capacity of the production facilities. We do not believethat the adoption of this pronouncement will have a significant impact on ourresults of operations or financial position. We will adopt this pronouncementas of June 15, 2005.

 

In December 2004, the FASB issued Statement of Financial AccountingStandards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R),which replaces SFAS No. 123 and supersedes APB Opinion No. 25, “Accounting forStock Issued to Employees.” SFAS No. 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in thefinancial statements based on their fair values beginning with the firstinterim period after June 15, 2005, with early adoption encouraged. The proforma disclosures previously permitted under SFAS No. 123 no longer will be analternative to financial statement recognition. We are required to adopt SFASNo. 123R in the third quarter of 2005. Under SFAS No. 123R, we must determinethe appropriate fair value model to be used for valuing share-based payments,the amortization method for compensation cost and the transition method to beused at date of adoption. The permitted transition methods include eitherretrospective or prospective adoption. Under the retrospective option, priorperiods may be restated either as of the beginning of the year of adoption orfor all periods presented. The prospective method requires that compensationexpense be recorded for all unvested stock options at the beginning of thefirst quarter of adoption of SFAS No. 123R, while the retrospective methodswould record compensation expense for all unvested stock options beginning withthe first period presented. We are currently evaluating the requirements ofSFAS No. 123R and expect that adoption of SFAS No. 123R will have a -significantimpact on our consolidated financial position and consolidated results ofoperations. We have not yet determined the method of adoption or the effect ofadoption SFAS No. 123R.

 

On December 21, 2004, the FASB issued “Application of FASB StatementNo. 109, **Accounting for Income Taxes,**to the Tax Deduction on Qualified Production Activities Provided by theAmerican Jobs Creation Act of 2004”, a FASB Staff Position (FSP) that providesguidance on the application of SFAS No. 109 to the tax deduction on qualifiedproduction activities 

 

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provided by the American Jobs Creation Act of 2004. FSP FAS 109-1states that the qualified production activities deduction should be accountedfor as a special deduction in accordance with SFAS No. 109, whereby thededuction is contingent upon the future performance of specific activities,including wage levels. The FASB also concluded that the special deductionsshould be considered with measuring deferred taxes and assessing a valuationallowance. The impact on our results of operations or financial position of FSPFAS 109-1 has not yet been determined, however, the impact, if any, will bereported in the period in which the deduction is claimed on our tax returns.

 

On December 21, 2004, the FASB issued “Accounting and DisclosureGuidance for the Foreign Earnings Repatriation Provision within the AmericanJobs Creation Act of 2004”, a FSP that provides accounting and disclosureguidance for the foreign earnings repatriation provision within the AmericanJobs Creation Act of 2004. The Act provides special, one-time dividendsreceived deduction on the repatriation of certain foreign earnings to a U.S.taxpayer. FSP FAS 109-2 states that a company is allowed time beyond thefinancial reporting period of enactment to evaluate the effect of the Act onits plan for reinvestment or repatriation of foreign earnings, as it applies tothe application of SFAS No. 109. The decision process to build the plan mayoccur in stages, as an enterprise may separately evaluate the provisions of theAct. We have not begun the evaluation process of the effects of therepatriation provision.

 

**Risk Factors**

 

***Reliance Upon The Coca-Cola Company***

 

Substantially more than half of our sales arederived from, or influenced by, The Coca-Cola Company. Direct sales to TheCoca-Cola Company, our largest customer, accounted for approximately 23%, 28%and 35% of our net sales for the years ended December 31, 2004, 2003 and 2002,respectively. We do not have a long-term supply contract with The Coca-ColaCompany or any of our other customers. As a result, The Coca-Cola Company hasthe ability to adversely affect, directly or indirectly, the volume and priceof the products sold by us. While we do not anticipate the loss or reduction inthis business or the imposition of significant price constraints based upon ourpast experience and current relations with The Coca Cola Company, any suchoccurrence would have a material adverse effect on us and our results of operation.

 

***We are Subject to a Formal Securities andExchange Commission Inquiry and an Investigation by the US Attorney.***

 

In August 2003, the US Attorney’s Officeinformed us that it was conducting an investigation arising from allegationsraised in a lawsuit against The Coca-Cola Company by a former Coca-Colaemployee, Matthew Whitley, and requested certain information, which wesupplied. In January 2004, we received written notice that the Securities andExchange Commission had issued a formal order of investigation that appeared toconcern matters which were the subject of the Investigation. We have fullycooperated, and intend to continue to fully cooperate, with both the USAttorney’s Office and the Securities and Exchange Commission investigations.Although we are unable at this point to predict the scope or outcome of theseinvestigations, it is possible that they could result in the institution ofadministrative, civil injunctive or criminal proceedings, the imposition offines and penalties, and/or other remedies and sanctions. The conduct of theseproceedings could adversely affect our business. We expect to continue to incurexpenses associated with responding to these agencies, regardless of theoutcome, and the efforts and attention of our management team may be divertedfrom normal business operations which could, in turn adversely affect ourbusiness, financial condition, operating results, and cash flow. We cannotpredict when the Securities and Exchange Commission will conclude its inquiry,or the outcome and impact thereof.

 

In addition, under the terms of our new credit facility, certaingovernmentally imposed fines or cease and desist orders are an event of defaultand could result in the termination of the loan commitments and acceleration ofthe outstanding debt thereunder. If we did not have sufficient cash to pay theaccelerated amount, we would need to find alternate funding sources, sellassets, or find other ways to raise the cash, none of which we can guarantee wewould be able to do on commercially reasonable terms or at all.

 

Finally, our future success depends in largepart on the support of our suppliers and customers, who may react adversely tothe investigation by the Securities and Exchange Commission and US Attorney. Negativepublicity about us may cause some of our potential customers to defer purchasesof our products. Our vendors and suppliers may re-examine their willingness todo business with us if they lose confidence in our ability to fulfill ourcommitments.

 

***We have been the Target of SecuritiesLitigation and May Again Be the Target of Further Actions, Which May Be Costlyand Time Consuming to Defend.***

 

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On May 14, 2004, a purported class action naming us as defendants, aswell as George F. Schroeder, David F. Green and The Coca-Cola Company, wasfiled in the United States District Court for the Western District of Texas. OnJuly 15, 2004, the plaintiff’s voluntarily dismissed the lawsuit, withoutprejudice*.* Although this lawsuit was dismissed,securities class action litigation is often brought against a company followinga decline in the market price of its securities. The uncertainty of thecurrently pending Securities and Exchange Commission and US Attorney’s Officeinvestigations could lead to more volatility in our stock price. We may in thefuture be the target of securities class action claims similar to thosedescribed above.

 

If we were to become a target of future class action claims, it wouldlikely require significant commitment of our financial and management resourcesand time, subverting resources and time away from our other business needs,which may materially and adversely affect our business, financial condition andresults of operations.

 

***Provisions in Our Certificate ofIncorporation and Bylaws and Texas Law Could Delay or Discourage a Takeoverwhich Could Adversely Affect the Price of Our Common Stock.***

 

Our Board has the authority to issue up to 5million shares of preferred stock and to determine the price, rights,preferences, privileges, and restrictions, including voting rights, of thoseshares without any further vote or action by holders of our common stock. Ifpreferred stock is issued, the voting and other rights of the holders of ourcommon stock may be subject to, and may be adversely affected by, the rights ofthe holders of our preferred stock. The issuance of preferred stock may havethe effect of delaying or preventing a change of control that could have beenat a premium price to our stockholders.

 

Certain provisions of our certificate ofincorporation and bylaws could discourage potential takeover attempts and makeattempts to change management by stockholders difficult. Our Board has theauthority to impose various procedural and other requirements that could makeit more difficult for our stockholders to effect certain corporate actions. Anyvacancy on our Board may be filled by a vote of the majority of directors thenin office.

 

In addition, certain provisions of Texas lawcould have the effect of delaying or preventing a change in control of ourcompany. Section 13.03 of the Texas Business Corporation Act, for example,prohibits a Texas corporation from engaging in any business combination withany affiliated shareholder for a period of three years from the date the personbecame an affiliated shareholder unless certain conditions are met.

 

***The Trading Price of Our Common Stock HasBeen, and Is Expected to Continue to Be, Volatile.***

 

The American Stock Exchange, where our stocktrades, and stock markets in general, have historically experienced extremeprice and volume fluctuations that have affected companies unrelated to theirindividual operating performance. The trading price of our common stock hasbeen and is likely to continue to be volatile due to such factors as:

 

•                  variationsin quarterly results of our operations;

•                  announcementsof new products or acquisitions by our competitors;

•                  governmentalregulatory action;

•                  resolutionof pending or unasserted litigation;

•                  resolutionof the Securities and Exchange Commission or US Attorney investigations ofwhich we are a subject; and

•                  generaltrends in our industry and overall market conditions.

 

Movements in prices of equity securities ingeneral may also affect the market price of our common stock.

 

***Competition***

 

The business of manufacturing and marketingbeverage dispensing systems and other related equipment is characterized byrapidly changing technology and is highly competitive. In addition, wefrequently compete with companies having substantially greater financialresources than ours. Although we have been able to compete successfully in thepast, if we were to lose any or all of our competitive advantages or if ourcompetitors were able to provide product suitability and reliability, price,product warranty, technical expertise and delivery time, in a manner superiorto ours, we would likely lose our market share and demand for our productswould decline. In addition, if our existing long standing relationships withcertain of our customers, including The Coca-Cola Company, were to be disruptedor become unfriendly, our competitors may be afforded an opportunity to providetheir products to our customers and begin to develop their own strong personal relationshipswith our customers. Since these personal relationship have become so importantin our industry, these events would make our ability to continue to provide ourproducts much more difficult and in turn, the newly formed relationships wouldbecome more difficult barriers to overcome as time progressed.

 

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***Dividends***

 

Since our inception, we have not paid, and wehave no current plan to pay, cash dividends on our common stock. We currentlyintend to retain all earnings to support our operations and future growth. Thepayment of any future dividends will be determined by the Board based upon ourearnings, financial condition and cash requirements, restrictions in financingagreements, business conditions and other factors the Board may deem relevant.

 

***Voting Power***

 

Our directors and executive officersbeneficially own approximately 40% of the outstanding shares of our commonstock. As a result, our directors and executive officers will have the abilityto affect the vote of our shareholders on significant corporate actionsrequiring shareholder approval, including mergers, share exchanges and sales ofall or substantially all of our assets. With such voting power, our directorsand executive offers may also have the ability to delay or prevent a change incontrol of our company.

 

***Investment in Moo Technologies, LLC***

 

We own a 50% interest in Moo Technologies, adevelopmental stage limited liability company engaged in the commercializationof milk products. Our net investment was $0.3 million at December 31, 2004, andwe invested an additional $0.5 million in the first quarter of 2005. MooTechnologies’ inability to generate revenues and/or profits in the future couldlead to the impairment of some or all of our investment.

 

***Doing Business in Foreign Countries CreatesCertain Risks Not Found in Doing Business in the United States.***

 

Doing business in foreign countries carrieswith it certain risks that are not found in doing business in the UnitedStates. We currently derive a portion of our revenues from international salesof our products and services and intend to look for ways to expand ourinternational operations. The risks of doing business in foreign countries thatcould result in losses against which we are not insured include:

 •             exposure to local economic conditions;

 •             potential adverse changes in the diplomatic relations offoreign countries with the United States;

 •             hostility from local populations;

 •             the adverse effect of currency exchange controls;

 •             restrictions on the withdrawal of foreign investment andearnings;

 •             government policies against businesses owned byforeigners;

 •             investment restrictions or requirements;

 •             expropriations of property;

 •             the potential instability of foreign governments;

 •             the risk of insurrections;

 •             foreign exchange restrictions;

 •             withholding and other taxes on remittances and otherpayments by subsidiaries; and

 •             changes in taxation structure.

 

***Exchange Rates May Cause Future Losses in OurInternational Operations.***

 

Because we own assets overseas and deriverevenues from our international operations, we may incur currency translationlosses due to changes in the values of foreign currencies and in the value ofthe U.S. dollar. We cannot predict the effect of exchange rate fluctuations uponfuture operating results.

 

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**ITEM 7A.       QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

## ** **

*Interest Rate Exposure*

 

On December 31, 2004, approximately $1.2 million of our $1.5million of debt outstanding was variable rate debt. Based on exposures onDecember 31, 2004, if interest rates were to change by one percentagepoint, our annual pretax income would be impacted by approximately $12thousand.

 

We had no derivative financial instruments during 2004. Our most recentderivative financial instrument was an interest rate swap that expired inJanuary 2003.

 

*Foreign Exchange Exposure*

 

In 2004, our subsidiaries with a functional currency other than theUnited States dollar incurred operating income of $3.4 million. If the averageannual exchange rate of the functional currencies of those subsidiaries were tofluctuate by 10% against the United States dollar, the operating profit ofthose subsidiaries could be impacted by as much as $0.3 million, when translatedto United States dollars.  This analysis does not consider the effect ofchanges in costs, demand, asset values, or other unpredictable factors thatcould result from currency fluctuations.

 

## **ITEM 8.**                             FINANCIAL STATEMENTS AND SUPPLEMENTARYDATA

## ** **

The financial statements and financial statement schedules are setforth beginning on page F-1 following this annual report, and are incorporatedherein by reference.

 
| **ITEM 9.** | ** ** | **CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE** |
|-------------|------------|-------------------------------------------------------------------------------------------|

## ** **

On February 2, 2004, KPMG LLP resigned from its position as ourindependent auditors, as we previously reported on Form 8-K, filed with theSecurities and Exchange Commission on February 10, 2004 and amended onFebruary 24, 2004 and March 10, 2004.

 

The Form 8-K and its amendments set forth disagreements as described inItem 304(a)(1)(iv) of Regulation S-K and reportable events as defined in Item304(a)(1)(iv) of Regulation S-K. The disagreements relate mainly to the scope,findings and conclusions of the investigation and proposed remedial action.

 

The reportable events that were set forth in the Form 8-K and itsamendments relate to KPMG’s stated (i) inability to rely on management’srepresentations or to be associated with the financial statements due tocertain investigation findings as well as our issuance of the January 30press release and subsequent press statements, and (ii) conclusion that theaccounting for our revenue recognition in connection with our sales ofequipment to Coca-Cola North America Fountain in the years endedDecember 31, 2001 and 2002 was not correct and that it raised concernsthat the accounting was not correct in each of the three quarters of fiscalyear 2003.  The sales of equipment to Coca-Cola North America Fountain weremade pursuant to an agreement in effect from 2001 to 2002. Since KPMG did notinform us what it believed the appropriate accounting method should be inregard to the revenue recognition in connection with our sales of equipment toCoca-Cola North America Fountain, it is not possible to set forth the effect onthe financial statements if an alternate accounting method proposed by theformer auditors had been followed.

 

Our new independent registered public accountants, BDO Seidman, LLP,have issued their reports on our financial statements for the years 2000, 2001,2002 and 2003. There has been no adjustment to the financial statements inrelation to this transaction.

 

## **ITEM 9A - CONTROLS AND PROCEDURES**

## ** **

In responding to a Securities and Exchange Commission review of ourForm 10-K for the fiscal year ended December 31, 2003 and of our Form 10-Q forthe quarter ended September 30, 2004, we discovered that we had misclassifiedtwo items in our income statements appearing in those filings. These itemsconsist of a $279,000 loss on the sale and disposal of assets and an $857,000impairment of an investment in a consolidated joint venture. Both of theseitems were previously presented as non-operating expenses in “Other (Income)Expense”, and were subsequently reclassified as operating expenses (suchreclassifications being reflected in the financial statements contained in thisForm 10-K). Our disclosure controls and procedures did not identify thesemisclassifications, and management’s evaluation of the effectiveness of thedesign and 

 

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operation of our disclosure controls and procedures for the periodcovered by the Form 10-K concluded that the disclosure controls and procedureswere effective, even though these two items had been classified incorrectly.Upon re-evaluation of the effectiveness of the design and operation of ourdisclosure controls and procedures for the 2003 fiscal year, managementrecognizes that, although it continues to believe that the controls andprocedures in place for the period covered were substantially effective, thesemisclassifications illustrated a need for improvement in certain of ourdisclosure controls and procedures. In order to strengthen our disclosurecontrols and procedures, we have engaged an independent third party,experienced in accounting and reporting issues for public companies, to aid usin identifying technical compliance issues and to review future filings, asneeded.

 

An evaluation has been carried out under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures (as defined under Securities andExchange Commission rules). Based upon that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that the design and operation ofthese disclosure controls and procedures were effective as of the end of theperiod covered by this report. Other thanthe changes made to improve our controls described in the preceding paragraph,there were no significant changes in our internal control over financialreporting that occurred during our most recent fiscal quarter that havematerially affected, or would be reasonably likely to materially affect, ourinternal control over financial reporting.

 

**ITEM 9B – OTHER INFORMATION**

 

None

 

# **PART III**

# ** **

## **ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERSOF THE REGISTRANT**

## ** **

The information set forth under the captions “Election****of Directors” and “Executive Officers” in our proxystatement for our 2005 Annual Meeting of Shareholders, which is to be filedwith the Securities and Exchange Commission, describes our executive officersand director nominees as required in response to this item and is incorporatedherein by reference. The information set forth under the caption “Section 16(a)Beneficial Ownership Reporting Compliance” in our proxy statement which is tobe filed with the Commission is incorporated herein by reference.

 

## **ITEM 11                EXECUTIVECOMPENSATION**

## ** **

The information set forth under the caption “Compensation and CertainTransactions” in our proxy statement for our 2005 Annual Meeting ofShareholders, which is to be filed with the Securities and Exchange Commission,sets forth information regarding executive compensation and certaintransactions as required in response to this item and is incorporated herein byreference.

 

**ITEM 12.               SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT**

 

The information set forth under the caption “Security Ownership ofCertain Beneficial Owners and Management” in our proxy statement for its 2005Meeting of Shareholders, which is to be filed with the Securities and ExchangeCommission, describes the security ownership of certain beneficial owners andmanagement as required in response to this item and is incorporated herein byreference.

 

The information required by Item 201(d) of Regulation S-K is set forthunder “Item 5 – Market For Registrant’s Common Equity, Related Stockholder Mattersand Issuer Purchases of Equity Securities” and is incorporated herein byreference.

 

## **ITEM 13                CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

## ** **

The information set forth under the caption “Certain Relationships andRelated Transactions” in our proxy statement for our 2005 Annual Meeting ofShareholders, which is to be filed with the Commission, sets forth informationregarding certain relationships and related transactions as required inresponse to this item and is incorporated herein by reference.

 

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## **ITEM 14                PRINCIPALACCOUNTANT FEES AND SERVICES**

## ** **

The information set forth under the caption “Principal Accountant Feesand Services” in our proxy statement for our 2005 Annual Meeting ofShareholders, which is to be filed with the Commission, sets forth informationregarding certain relationships and related transactions as required inresponse to this item and is incorporated herein by reference.

 

# **PART IV**

# ** **

## **ITEM 15                EXHIBITS,FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K**

## ** **

(a) 1. Financial Statements

 

The following consolidated financial statements of Lancer Corporationare incorporated by reference under Item 8 of this annual report. The index ofour consolidated financial statements appears on page F-1.

 

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2004 and 2003

Consolidated Statements of Operations for the Years ended December 31,2004, 2003 and 2002

Consolidated Statements of Shareholders’ Equity and ComprehensiveIncome (Loss) for the Years ended December 31, 2004, 2003 and 2002

Consolidated Statements of Cash Flows for the Years ended December 31,2004, 2003 and 2002

Notes to Consolidated Financial Statements

 

(a)          2. Financial Statement Schedule

 

The following schedule is incorporated by reference under Item 8 ofthis annual report and is included as Schedule II on page F-32:

 

Schedule II - Valuation andQualifying Accounts

 

(a)          3. Exhibits

 
| 3.1  |   | Restated Articles of Incorporation of Lancer Corporation  (incorporated by reference to the exhibits of Lancer’s Registration Statement  on Form S-1, filed with the Commission on August 5, 1994, as amended by  Amendment No. 1 to the Registration Statement on Form S-1, filed with the  Commission on August 23, 1994).                                                                  |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2  |   | Articles of Amendment to the Restated Articles of Incorporation,  filed with the Texas Secretary of State on June 3, 1988 (incorporated by  reference to the exhibits of Lancer’s Registration Statement on Form S-1,  filed with the Commission on August 5, 1994, as amended by Amendment No. 1 to  the Registration Statement on Form S-1, filed with the Commission on August  23, 1994). |
| 3.3* |   | Articles of Amendment to the Restated Articles of Incorporation,  filed with the Texas Secretary of State on June 9, 1997.                                                                                                                                                                                                                                                                         |
| 3.4  |   | Lancer Corporation Bylaws (incorporated by reference to the exhibits  of Lancer’s Registration Statement on Form S-1, filed with the Commission on  August 5, 1994, as amended by Amendment No. 1 to the Registration Statement  on Form S-1, filed with the Commission on August 23, 1994).                                                                                                  |
| 4.1  |   | Lancer Corporation Specimen Common Stock Certificate, $0.01 par value  (incorporated by reference to the exhibits of Lancer’s Registration Statement  on Form S-1, filed with the Commission on August 5, 1994, as amended by  Amendment No. 1 to the Registration Statement on Form S-1, filed with the  Commission on August 23, 1994).                                                     |
| 10.1 |   | Lancer Corporation Profit Sharing Plan (incorporated by reference to  the exhibits of Lancer’s Registration Statement on Form S-1, filed with the  Commission on August 5, 1994, as amended by Amendment No. 1 to the  Registration Statement on Form S-1, filed with the Commission on August 23,  1994).                                                                                    |
| 10.2 |   | Lancer Corporation Stock Incentive Plan, Effective Date March 1, 1996  (incorporated by reference to the exhibits of Lancer’s Definitive Proxy  Statement on Form DEF 14A, filed with the Commission on April 24, 1996).                                                                                                                                                                      |

 

23

----

 
| 10.3   |   | Lancer Corporation Stock Option Plan of 2002 (incorporated by reference  to the exhibits of Lancer’s Annual Report on Form 10-K, filed with the  Commission on March 27, 2003).                                                                                                                                                                                                               |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.4   |   | Master Development Agreement, dated January 12, 1984, between Lancer  Corporation and The Coca-Cola Company (incorporated by reference to the exhibits  of Lancer’s Registration Statement on Form S-1, filed with the Commission on  August 5, 1994, as amended by Amendment No. 1 to the Registration Statement  on Form S-1, filed with the Commission on August 23, 1994).                |
| 10.5   |   | Master Lease and Supplement between The Frost National Bank and  Lancer Partnership, Ltd. (incorporated by reference to the exhibits of  Lancer’s Annual Report on Form 10-K, filed with the Commission on March 29,  2002).                                                                                                                                                                  |
| 10.6   |   | Net Lease Agreement, dated July 1, 1974, between Lancer Corporation  and Lancer Properties dated as of June 3, 1977 (incorporated by reference to  the exhibits of Lancer’s Registration Statement on Form S-1, filed with the  Commission on August 5, 1994, as amended by Amendment No. 1 to the  Registration Statement on Form S-1, filed with the Commission on August 23,  1994).       |
| 10.7   |   | Amended and Restated Credit Agreement dated June 30, 2004 between  Lancer Partnership, Ltd. and Lancer de Mexico, S.A. de C.V., as Borrowers,  Lancer Corporation and certain of its subsidiaries as Guarantors, and The  Frost National Bank, as Agent (incorporated by reference to the exhibits of  Lancer’s Current Report on Form 8-K, filed with the Commission on September  7, 2004). |
| 10.8   |   | Form of Indemnification Agreement (incorporated by reference to the  exhibits of Lancer’s Current Report on Form 8-K, filed with the Commission on  September 7, 2004).                                                                                                                                                                                                                       |
| 10.9   |   | Letter Agreement between Lancer Corporation and The Coca-Cola  Company, dated September 2, 2004 (incorporated by reference to the exhibits  of Lancer’s Current Report on Form 8-K, filed with the Commission on  September 13, 2004).                                                                                                                                                        |
| 10.10  |   | Agreement by and between Lancer Corporation and Christopher D. Hughes  (incorporated by reference to the exhibits of Lancer’s Current Report on Form  8-K, filed with the Commission on September 17, 2004).                                                                                                                                                                                  |
| 10.11  |   | Agreement by and between Lancer Corporation and Mark L. Freitas  (incorporated by reference to the exhibits of Lancer’s Current Report on Form  8-K, filed with the Commission on September 17, 2004).                                                                                                                                                                                        |
| 10.12  |   | Real Estate Sales Contract, dated November 29, 2004, between Lancer  Corporation and Schroeder Land and Cattle Company, Incorporated (incorporated  by reference to the exhibits of Lancer’s Current Report on Form 8-K, filed  with the Commission on December 2, 2004).                                                                                                                     |
| 10.13  |   | Loan Agreement, effective the 17th day of December, 2004,  by and between International Bank of Commerce and Lancer Partnership, Ltd.  (incorporated by reference to the exhibits of Lancer’s Current Report on Form  8-K, filed with the Commission on December 22, 2004).                                                                                                                   |
| 10.14* |   | Form Guaranty Agreement dated December 17, 2004, executed by Lancer  Corporation, Lancer International Sales, Inc. and Lancer Capital Corporation,  for the benefit of International Bank of Commerce.                                                                                                                                                                                             |
| 10.15* |   | Deed of Trust, Assignment of Rents, Security Agreement and Financing  Statement, with Lancer Partnership, Ltd., as Grantor and Steven E. Englund as  Trustee of International Bank of Commerce, dated December 17, 2004.                                                                                                                                                                           |
| 10.16* |   | Security Agreement, with Lancer Partnership, Ltd. as Debtor and  International Bank of Commerce as the Secured Party, dated December 17, 2004.                                                                                                                                                                                                                                                     |
| 10.17* |   | Promissory Note with Lancer Partnership, Ltd. as Borrrower and  International Bank of Commerce as Lender, dated December 17, 2004.                                                                                                                                                                                                                                                                 |
| 21.1*  |   | List of Significant Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                                                                                |
| 23.1*  |   | Consent of BDO Seidman LLP.                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1*  |   | Certification of Chief Executive Officer of Lancer Corporation  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                         |
| 31.2*  |   | Certification of Chief Financial Officer of Lancer Corporation  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                         |
| 32.1*  |   | Certification of Chief Executive Officer of Lancer Corporation  Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                          |
| 32.2*  |   | Certification of Chief Financial Officer of Lancer Corporation  Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                          |

 

----

* Exhibits filed with this Annual Report on Form 10-K.

 

24

----

 

SIGNATURES

 

Pursuant to the requirements ofSection 13 or 15 (d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

LANCER CORPORATION

 
| by:                     | /s/ CHRISTOPHER D. HUGHES |           |
|-------------------------|---------------------------|----------------|
| Christopher D. Hughes   |                      | March 16, 2005 |
| Chief Executive Officer |                      |
|                         |                           |                |  |  |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**              | ** ** | **Title**                                                   | ** ** | **Date**       |
|----------------------------|------------|-------------------------------------------------------------|------------|----------------|
| ** **                 | ** ** | ** **                                                  | ** ** | ** **     |
| /s/ CHRISTOPHER D. HUGHES  |       | President and Chief Executive Officer                       |       | March 16, 2005 |
| Christopher D. Hughes      |       | (principal executive officer)                               |       | Date           |
|                       |       |                                                        |       |           |
| /s/ MARK L. FREITAS        |       | Chief Financial Officer                                     |       | March 16, 2005 |
| Mark L. Freitas            |       | (principal financial officer, principal accounting officer) |       | Date           |
|                       |       |                                                        |       |           |
| /s/ HAROLD R. SCHMITZ      |       | Chairman of the Board                                       |       | March 16, 2005 |
| Harold R. Schmitz          |       |                                                        |       | Date           |
|                       |       |                                                        |       |           |
| /s/ NORBORNE P. COLE, JR.  |       | Director                                                    |       | March 16, 2005 |
| Norborne P. Cole, Jr.      |       |                                                        |       | Date           |
|                       |       |                                                        |       |           |
| /s/ JAMES F. GALLIVAN, JR. |       | Director                                                    |       | March 16, 2005 |
| James F. Gallivan, Jr.     |       |                                                        |       | Date           |
|                       |       |                                                        |       |           |
| /s/ BRIAN C. FLYNN, JR.    |       | Director                                                    |       | March 16, 2005 |
| Brian C. Flynn, Jr.        |       |                                                        |       | Date           |
|                       |       |                                                        |       |           |
| /s/ OLIVIA F. KIRTLEY      |       | Director                                                    |       | March 16, 2005 |
| Olivia F. Kirtley          |       |                                                        |       | Date           |
|                       |       |                                                        |       |           |
| /s/ RICHARD C. OSBORNE     |       | Director                                                    |       | March 16, 2005 |
| Richard C. Osborne         |       |                                                        |       | Date           |
|                       |       |                                                        |       |           |
| /s/ ALFRED A. SCHROEDER    |       | Director                                                    |       | March 16, 2005 |
| Alfred A. Schroeder        |       |                                                        |       | Date           |
|                       |       |                                                        |       |           |
| /s/ GEORGE F. SCHROEDER    |       | Director                                                    |       | March 16, 2005 |
| George F. Schroeder        |       |                                                        |       | Date           |

 

25

----

 

**LANCER CORPORATION**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTSAND SCHEDULE**

 
| LANCER CORPORATION                                                                                                                               |   |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| Report of Independent Registered Public  Accounting Firm                                                                                         |   |
|                                                                                                                                             |   |
| Consolidated Financial Statements:                                                                                                               |   |
|                                                                                                                                             |   |
| Balance Sheets as of December 31, 2004  and 2003                                                                                            |   |
|                                                                                                                                             |   |
| Statements of Operations for each of the  three years in the period ended December 31, 2004                                                 |   |
|                                                                                                                                             |   |
| Statements of Shareholders’ Equity and  Comprehensive Income (Loss) for each of the three years in the period ended  December 31, 2004 |   |
|                                                                                                                                             |   |
| Statements of Cash Flows for each of the  three-years in the period ended December 31, 2004                                                 |   |
|                                                                                                                                             |   |
| Notes to Consolidated Financial Statements                                                                                                       |   |
|                                                                                                                                             |   |
| Financial Statements Schedule :                                                                                                                  |   |
|                                                                                                                                             |   |
| Schedule II- Valuation and Qualifying  Accounts                                                                                             |   |
|                                                                                                                                             |   |
| Schedule for the years ended  December 31, 2004, 2003 and 2002                                                                         |   |

 

F-1

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

The Board of Directors and Shareholders ofLancer CorporationSan Antonio, Texas

 

We have audited the accompanying consolidated balance sheets of LancerCorporation as of December 31, 2004 and 2003, and the related consolidatedstatements of operations, shareholders’ equity and comprehensive income (loss),and cash flows for each of the three years in the period endedDecember 31, 2004. We have also audited the schedule listed in Item15(a)(2) of this Form 10-K.  These consolidated financial statements andthe schedule are the responsibility of the Company’s management.  Ourresponsibility is to express an opinion on these consolidated financial statementsand schedule based on our audits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An auditincludes consideration of internal controls over financial reporting as a basisfor designing audit procedures that are appropriate in the circumstances, butnot for the purpose of expressing an opinion on the effectiveness on thecompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements andschedule,  the accounting principles used and significant estimates madeby management, as well as evaluating the overall presentation of the financialstatement and schedule. We believe that our audits provide a reasonable basis forour opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of LancerCorporation as of December 31, 2004 and 2003 and the results of itsoperations and its cash flows for each of the three years in the period endedDecember 31, 2004, in conformity with accounting principles generallyaccepted in the United States of America.

 

Also in our opinion, the schedule, presents fairly, in all materialrespects, the information set forth therein.

 
| /s/ BDO Seidman, LLP |   |
|----------------------|--------|
|                 |
| BDO Seidman, LLP     |
| Dallas, Texas        |
| March 7, 2005        |

 

F-2

----

 

**LANCER CORPORATION**

 

**CONSOLIDATED BALANCE SHEETSDecember 31, 2004 and 2003**

 

(Amounts in thousands, except share data)

 

ASSETS

 
| ** **                                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                  |       |     |       |     |       |
| Current assets:                                                       |       |     |       |     |       |
| Cash                                                                  |       | $        | 5,196      |     | $          | 1,129 |   |
| Receivables:                                                          |       |     |       |     |       |
| Trade accounts and notes                                              |       | 16,733   |       | 14,226   |       |
| Other                                                                 |       | 801      |       | 1,268    |       |
|                                                                  |       | 17,534   |       | 15,494   |       |
| Less allowance for doubtful accounts                                  |       | (420     | )          | (745     | )          |
| Net receivables                                                       |       | 17,114   |       | 14,749   |       |
|                                                                  |       |     |       |     |       |
| Inventories, net                                                      |       | 24,495   |       | 24,502   |       |
| Prepaid expenses                                                      |       | 406      |       | 474      |       |
| Tax refund receivable                                                 |       | —   |       | 225      |       |
| Deferred tax asset                                                    |       | 824      |       | 568      |       |
| Total current assets                                                  |       | 48,035   |       | 41,647   |       |
|                                                                  |       |     |       |     |       |
| Net property, plant and equipment                                     |       | 29,999   |       | 34,119   |       |
| Investments in joint ventures                                         |       | 2,388    |       | 1,786    |       |
| Goodwill                                                              |       | 1,879    |       | 1,929    |       |
| Intangibles and other assets, at cost, less  accumulated amortization |       | 3,186    |       | 2,797    |       |
|                                                                  |       | $        | 85,487     |     | $          | 82,278 |   |

 

See accompanying notes to consolidated financialstatements.

 

F-3

----

 

**LANCER CORPORATION**

 

**CONSOLIDATED BALANCE SHEETS (continued)December 31, 2004 and 2003**

 

(Amounts in thousands, except share data)

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 
| ** **                                                                                                                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                                                        |       |     |       |     |       |
| Current liabilities:                                                                                                                        |       |     |       |     |       |
| Accounts  payable                                                                                                                           |       | $        | 7,555      |     | $          | 6,609 |   |
| Current  installments of long-term debt                                                                                                     |       | 1,345    |       | 2,735    |       |
| Line  of credit                                                                                                                             |       | —   |       | 1,000    |       |
| Deferred  licensing and maintenance fees                                                                                                    |       | 451      |       | 1,021    |       |
| Accrued  expenses and other liabilities                                                                                                     |       | 8,029    |       | 6,964    |       |
| Income  taxes payable                                                                                                                       |       | 286      |       | —   |       |
| Total  current liabilities                                                                                                                  |       | 17,666   |       | 18,329   |       |
|                                                                                                                                        |       |     |       |     |       |
| Deferred tax liability                                                                                                                      |       | 3,401    |       | 1,175    |       |
| Long-term debt, excluding  current installments                                                                                             |       | 132      |       | 8,268    |       |
| Deferred licensing and  maintenance fees                                                                                                    |       | 1,273    |       | 2,396    |       |
| Other long-term  liabilities                                                                                                                |       | —   |       | 147      |       |
| Total  liabilities                                                                                                                          |       | 22,472   |       | 30,315   |       |
|                                                                                                                                        |       |     |       |     |       |
| Commitments and  contingencies                                                                                                              |       |     |       |     |       |
|                                                                                                                                        |       |     |       |     |       |
| Shareholders’ equity:                                                                                                                  |       |     |       |     |       |
| Preferred  stock, without par value                                                                                                         |       |     |       |     |       |
| 5,000,000  shares authorized; none issued                                                                                                   |       | —   |       | —   |       |
|                                                                                                                                        |       |     |       |     |       |
| Common  stock, $.01 par value:                                                                                                              |       |     |       |     |       |
| 50,000,000 shares  authorized; 9,522,054 issued and  9,457,828 outstanding in 2004, and 9,426,121 issued and  9,361,895 outstanding in 2003 |       | 95       |       | 94       |       |
|                                                                                                                                        |       |     |       |     |       |
| Additional  paid-in capital                                                                                                                 |       | 13,208   |       | 12,848   |       |
|                                                                                                                                        |       |     |       |     |       |
| Accumulated  other comprehensive income                                                                                                     |       | 523      |       | 6        |       |
|                                                                                                                                        |       |     |       |     |       |
| Deferred  compensation                                                                                                                      |       | (18)     |       | (92)     |       |
|                                                                                                                                        |       |     |       |     |       |
| Retained  earnings                                                                                                                          |       | 49,567   |       | 39,467   |       |
|                                                                                                                                        |       |     |       |     |       |
| Less  common stock in treasury, at cost;                                                                                                    |       |     |       |     |       |
| 64,226  shares in 2004 and 2003                                                                                                             |       | (360)    |       | (360)    |       |
| Total  shareholders’ equity                                                                                                            |       | 63,015   |       | 51,963   |       |
|                                                                                                                                        |       | $        | 85,487     |     | $          | 82,278 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-4

----

 

**LANCER CORPORATION**

 

**CONSOLIDATED STATEMENTS OF OPERATIONSYears ended December 31, 2004, 2003 and 2002**

 

(Amounts in thousands, except share data)

 
| ** **                                                    | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|---------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
|                                                          |       |      |       |      |       |      |       |
| Net sales                                                     |       | $         | 124,249    |      | $          | 113,500   |       | $ | 139,015 |   |
| Cost of sales                                                 |       | 87,518    |       | 84,401    |       | 101,925   |       |
| Gross profit                                                  |       | 36,731    |       | 29,099    |       | 37,090    |       |
|                                                          |       |      |       |      |       |      |       |
| Selling, general and administrative  expenses                 |       | 28,900    |       | 28,425    |       | 27,535    |       |
| Other operating (income) expenses                             |       | 172       |       | 1,320     |       | (4        | )          |
| Impairment of goodwill                                        |       | 50        |       | —    |       | —    |       |
| Operating income                                              |       | 7,609     |       | (646      | )          | 9,559     |       |
|                                                          |       |      |       |      |       |      |       |
| Other income (expense):                                       |       |      |       |      |       |      |       |
| Interest expense                                              |       | (499      | )          | (329      | )          | (1,318    | )          |
| Income (loss) from joint ventures                             |       | 1,107     |       | (217      | )          | (653      | )          |
| Settlement of development project                             |       | 7,000     |       | —    |       | —    |       |
| Minority interest                                             |       | —    |       | —    |       | 55        |       |
| Other, net                                                    |       | (86       | )          | 23        |       | 645       |       |
|                                                          |       | 7,522     |       | (523      | )          | (1,271    | )          |
| Income (loss) from continuing operations before  income taxes |       | 15,131    |       | (1,169    | )          | 8,288     |       |
|                                                          |       |      |       |      |       |      |       |
| Income tax expense (benefit):                                 |       |      |       |      |       |      |       |
| Current                                                       |       | 3,047     |       | 1,430     |       | 1,440     |       |
| Deferred                                                      |       | 1,984     |       | (1,240    | )          | 1,229     |       |
|                                                          |       | 5,031     |       | 190       |       | 2,669     |       |
|                                                          |       |      |       |      |       |      |       |
| Income (loss) from continuing operations                      |       | 10,100    |       | (1,359    | )          | 5,619     |       |
|                                                          |       |      |       |      |       |      |       |
| Discontinued operations:                                      |       |      |       |      |       |      |       |
| (Loss) from operations of discontinued  Brazilian subsidiary  |       | —    |       | (196      | )          | (2,442    | )          |
| Income tax benefit                                            |       | —    |       | 788       |       | 829       |       |
| Income (loss) from discontinued operations                    |       | —    |       | 592       |       | (1,613    | )          |
| Net earnings (loss)                                           |       | $         | 10,100     |      | $          | (767      | )          | $ | 4,006 |   |
|                                                          |       |      |       |      |       |      |       |
| Weighted Average Common Shares Outstanding:                   |       |      |       |      |       |      |       |
| Basic                                                         |       | 9,388,444 |       | 9,356,082 |       | 9,326,529 |       |
| Diluted                                                       |       | 9,503,582 |       | 9,356,082 |       | 9,433,193 |       |
|                                                          |       |      |       |      |       |      |       |
| Earnings Per Share:                                           |       |      |       |      |       |      |       |
| Basic                                                         |       |      |       |      |       |      |       |
| Earnings (loss) from continuing operations                    |       | $         | 1.08       |      | $          | (0.15     | )          | $ | 0.60 |   |
| Earnings (loss) from discontinued  operations                 |       | $         | —     |      | $          | 0.06      |       | $ | (0.17 | ) |
| Net earnings (loss)                                           |       | $         | 1.08       |      | $          | (0.09     | )          | $ | 0.43 |   |
|                                                          |       |      |       |      |       |      |       |
| Diluted                                                       |       |      |       |      |       |      |       |
| Earnings (loss) from continuing operations                    |       | $         | 1.06       |      | $          | (0.15     | )          | $ | 0.60 |   |
| Earnings (loss) from discontinued  operations                 |       | $         | —     |      | $          | 0.06      |       | $ | (0.17 | ) |
| Net earnings (loss)                                           |       | $         | 1.06       |      | $          | (0.09     | )          | $ | 0.43 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-5

----

 

**LANCER CORPORATION**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’EQUITY AND COMPREHENSIVE INCOME (LOSS)Years ended December 31, 2004, 2003 and 2002**

(Amounts in thousands, except share data)

 
| ** **                                                                  | ** ** | **Common Stock** | ** ** | **Additional Paid** | ** ** | **Accumulated  Other Comprehensive** | ** ** | **Deferred  Compens-** | ** ** | **Retained** | ** ** | **Treasury Stock** | ** ** | **Total  Shareholders’** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------|------------|---------------------|------------|--------------------------------------|------------|------------------------|------------|--------------|------------|--------------------|------------|-------------------------------|------------|
| ** **                                                                  | ** ** | **# Shares**     | ** ** | **Amount**          | ** ** | **in Capital**                       | ** ** | **Income (Loss)**      | ** ** | **ation**    | ** ** | **Earnings**       | ** ** | **# Shares**                  | ** ** | **Amount** | ** ** | **Equity** | ** ** |
| Balance December 31, 2001                                                   |       | 9,127,759        |       | $                   | 91         |                                 | $          | 11,943                 |       | $            | (3,976     | )                  | $          | —                        |       | $ | 36,228 |   | — |   | $ | — |   | $ | 44,286 |   |
| Comprehensive income:                                                       |       |             |       |                |       |                                 |       |                   |       |         |       |               |       |                          |       |   |   |   |   |
| Net earnings                                                                |       |             |       |                |       |                                 |       |                   |       |         |       | 4,006              |       |                          |       |   |   | 4,006 |   |
| Cumulative translation adjustment                                           |       |             |       |                |       |                                 |       | 1,567                  |       |         |       |               |       |                          |       |   |   | 1,567 |   |
| Unrealized gain on investment, net of tax                              |       |             |       |                |       |                                 |       | 6                      |       |         |       |               |       |                          |       |   |   | 6 |   |
| Unrealized loss on derivative instruments:                                  |       |             |       |                |       |                                 |       |                   |       |         |       |               |       |                          |       |   |   |   |   |
| Reclassification adjustment of loss included in interest  expense      |       |             |       |                |       |                                 |       | 14                     |       |         |       |               |       |                          |       |   |   | 14 |   |
| Total comprehensive income:                                                 |       |             |       |                |       |                                 |       |                   |       |         |       |               |       |                          |       |   |   | 5,593 |   |
| Exercise of 268,362 stock options for cash and by surrender  of shares |       | 268,362          |       | 2                   |       | 372                                  |       |                   |       |         |       |               |       | 59,190                        |       | (328 | ) | 46 |   |
| Compensatory element of stock options granted                          |       |             |       |                |       | 395                                  |       |                   |       | (395         | )          |               |       |                          |       |   |   | — |   |
| Amortization of deferred compensation                                       |       |             |       |                |       |                                 |       |                   |       | 226          |       |               |       |                          |       |   |   | 226 |   |
| Balance December 31, 2002                                                   |       | 9,396,121        |       | 93                  |       | 12,710                               |       | (2,389                 | )          | (169         | )          | 40,234             |       | 59,190                        |       | (328 | ) | 50,151 |   |
| Comprehensive income:                                                       |       |             |       |                |       |                                 |       |                   |       |         |       |               |       |                          |       |   |   |   |   |
| Net earnings                                                                |       |             |       |                |       |                                 |       |                   |       |         |       | (767               | )          |                          |       |   |   | (767 | ) |
| Cumulative translation adjustment                                           |       |             |       |                |       |                                 |       | 2,395                  |       |         |       |               |       |                          |       |   |   | 2,395 |   |
| Total comprehensive income:                                                 |       |             |       |                |       |                                 |       |                   |       |         |       |               |       |                          |       |   |   | 1,628 |   |
| Exercise of 30,000 stock options for cash and by surrender  of shares  |       | 30,000           |       | 1                   |       | 138                                  |       |                   |       |         |       |               |       | 5,036                         |       | (32 | ) | 107 |   |
| Amortization of deferred compensation                                       |       |             |       |                |       |                                 |       |                   |       | 77           |       |               |       |                          |       |   |   | 77 |   |
| Balance December 31, 2003                                                   |       | 9,426,121        |       | 94                  |       | 12,848                               |       | 6                      |       | (92          | )          | 39,467             |       | 64,226                        |       | (360 | ) | 51,963 |   |
| Comprehensive income:                                                       |       |             |       |                |       |                                 |       |                   |       |         |       |               |       |                          |       |   |   |   |   |
| Net earnings                                                                |       |             |       |                |       |                                 |       |                   |       |         |       | 10,100             |       |                          |       |   |   | 10,100 |   |
| Cumulative translation adjustment                                           |       |             |       |                |       |                                 |       | 523                    |       |         |       |               |       |                          |       |   |   | 523 |   |
| Reclassification adjustment for realized loss                               |       |             |       |                |       |                                 |       | (6                     | )          |         |       |               |       |                          |       |   |   | (6 | ) |
| Total comprehensive income:                                                 |       |             |       |                |       |                                 |       |                   |       |         |       |               |       |                          |       |   |   | 10,617 |   |
| Exercise of 95,933 stock options for cash                              |       | 95,933           |       | 1                   |       | 360                                  |       |                   |       |         |       |               |       |                          |       | — |   | 361 |   |
| Amortization of deferred compensation                                       |       |             |       |                |       |                                 |       |                   |       | 74           |       |               |       |                          |       |   |   | 74 |   |
| Balance December 31, 2004                                                   |       | 9,522,054        |       | $                   | 95         |                                 | $          | 13,208                 |       | $            | 523        |               | $          | (18                           | )          | $ | 49,567 |   | 64,226 |   | $ | (360 | ) | $ | 63,015 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

F-6

----

 

**LANCER CORPORATION**

**CONSOLIDATED STATEMENTS OF CASH FLOWSYears ended December 31, 2004, 2003 and 2002**

(Amounts in thousands)

 
| ** **                                                                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash flow from operating activities:                                                       |       |     |       |     |       |     |       |
| Net earnings (loss)                                                                        |       | $        | 10,100     |     | $          | (767     | )          | $ | 4,006 |   |
| Adjustments to reconcile net earnings  (loss) to net cash provided by operating activities |       |     |       |     |       |     |       |
| Depreciation and amortization                                                              |       | 4,241    |       | 5,328    |       | 4,959    |       |
| Deferred licensing and maintenance fees                                                    |       | (620     | )          | (718     | )          | (1,638   | )          |
| Inventory and receivable reserves                                                          |       | (1,885   | )          | (359     | )          | 2,786    |       |
| Deferred income taxes                                                                      |       | 1,988    |       | (1,393   | )          | 844      |       |
| Loss (gain) on sale and disposal of assets                                                 |       | (57      | )          | 279      |       | (4       | )          |
| Write-down of Brazilian assets, net of  taxes                                              |       | —   |       | —   |       | 1,548    |       |
| Impairment of long lived assets                                                            |       | 229      |       | 1,053    |       | 30       |       |
| Impairment of goodwill                                                                     |       | 50       |       | —   |       | —   |       |
| Gain on sales of long-term investment                                                      |       | —   |       | (220     | )          | —   |       |
| Minority interest                                                                          |       | —   |       | —   |       | (55      | )          |
| (Income) loss from joint ventures                                                          |       | (1,107   | )          | 217      |       | 653      |       |
| Stock-based compensation expense                                                           |       | 74       |       | 77       |       | 226      |       |
| Changes in assets and liabilities:                                                         |       |     |       |     |       |     |       |
| Receivables                                                                                |       | (1,727   | )          | 4,377    |       | 655      |       |
| Prepaid expenses                                                                           |       | 68       |       | (210     | )          | 391      |       |
| Income taxes receivable                                                                    |       | 225      |       | (225     | )          | —   |       |
| Inventories                                                                                |       | 1,863    |       | 5,950    |       | 871      |       |
| Other assets                                                                               |       | (285     | )          | (492     | )          | (649     | )          |
| Accounts payable                                                                           |       | 780      |       | (4,748   | )          | 1,857    |       |
| Accrued expenses                                                                           |       | 871      |       | (1,291   | )          | 2,502    |       |
| Income taxes payable                                                                       |       | 244      |       | (154     | )          | (762     | )          |
| Net cash provided by operating activities                                                  |       | 15,052   |       | 6,704    |       | 18,220   |       |
| Cash flow from investing activities:                                                       |       |     |       |     |       |     |       |
| Proceeds from sale of assets                                                               |       | 556      |       | 89       |       | 20       |       |
| Acquisition of property, plant and  equipment                                              |       | (1,883   | )          | (4,145   | )          | (3,658   | )          |
| Acquisition of a service operation in  Australia                                           |       | —   |       | —   |       | (252     | )          |
| Proceeds from long-term investments                                                        |       | 815      |       | 321      |       | 18       |       |
| Purchase of long-term investments                                                          |       | (310     | )          | —   |       | (520     | )          |
| Net cash used in investing activities                                                      |       | (822     | )          | (3,735   | )          | (4,392   | )          |
| Cash flow from financing activities:                                                       |       |     |       |     |       |     |       |
| Borrowings under line of credit                                                            |       | 4,300    |       | 12,100   |       | 13,700   |       |
| Repayments under line of credit                                                            |       | (5,300   | )          | (16,100  | )          | (24,300  | )          |
| Retirement of long-term debt                                                               |       | (9,526   | )          | (1,531   | )          | (2,056   | )          |
| Net proceeds from exercise of stock options                                                |       | 361      |       | 138      |       | 46       |       |
| Net cash used in financing activities                                                      |       | (10,165  | )          | (5,393   | )          | (12,610  | )          |
| Effect of exchange rate changes on cash                                                    |       | 2        |       | 312      |       | 174      |       |
| Net (decrease) increase in cash                                                            |       | 4,067    |       | (2,112   | )          | 1,392    |       |
| Cash at beginning of year                                                                  |       | 1,129    |       | 3,241    |       | 1,849    |       |
| Cash at end of year                                                                        |       | $        | 5,196      |     | $          | 1,129    |       | $ | 3,241 |   |
| Supplemental cash flow informaton:                                                         |       |     |       |     |       |     |       |
| Cash paid for interest                                                                     |       | $        | 486        |     | $          | 594      |       | $ | 1,658 |   |
| Cash paid (refunded) for income taxes                                                      |       | $        | 1,912      |     | $          | (1,200   | )          | $ | 1,200 |   |

 

See accompanying notes to consolidatedfinancial statements

 

F-7

----

 

**LANCER CORPORATION**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****                                      Summaryof Our Significant Accounting Policies**

 

Nature of Operations

 

We design, engineer, manufacture and marketfountain soft drink and other beverage dispensing systems and related equipmentfor use in the food service and beverage industry. We sell our products throughCompany personnel, and through independent distributors and agents, principallyto major soft drink companies (primarily The Coca-Cola Company), bottlers,equipment distributors, beer breweries and food service chains for use invarious food and beverage operations.  Weare a vertically integrated manufacturer, fabricating a significant portion ofthe components used in our products.  We were incorporated in Texas in1967.

 

Principles of Consolidation

 

The consolidated financial statements includethe accounts of Lancer Corporation and all majority owned domestic and foreignsubsidiaries.  All intercompany balances and transactions have beeneliminated.

 

We are 50% owners of two joint ventures,Lancer FBD Partnership Ltd. and Moo Technologies LLC. These investments areaccounted for on an equity method. Our share of the net income from the jointventures is included in Other Income.

 

Concentrations of Credit Risk

 

We have accounts receivable from customers inthe food service and beverage industry, and our business is not concentrated inany specific geographic region.  We have receivables from one majorcustomer - See “Note 13 - Segment and Geographic Information” to these Notes toConsolidated Financial Statements. The food and beverage industry may beaffected by economic factors, which may impact the accounts receivable.  We do not require collateral from ourcustomers.

 

Accounts Receivable Allowance for Doubtful Accounts

 

We maintain an allowance for doubtfulaccounts at a balance adequate to reduce accounts receivable to the amount ofcash expected to be realized on collection. The methodology used to determinethe allowance is based on our prior collection experience. Specific customers’financial strength and circumstance also influence the balance of our allowancefor doubtful accounts. Accounts that are determined to be uncollectible arewritten-off in the period in which they are determined to be uncollectible.

 

Inventories

 

We state inventories at the lower of cost ormarket on a first-in, first-out basis (average cost as to raw materials andsupplies) or market (net realizable value).

 

Certain items in inventory have becomeobsolete due to technological advances and discontinuation of products. We have taken these items into consideration in valuing our inventory throughan obsolescence reserve.

 

Property, Plant and Equipment

 

We state property, plant and equipment at cost.  We calculatedepreciation on a straight-line basis over the assets estimated useful lives asfollows:

 
| Buildings                     |         | 39 years           |     |
|-------------------------------|--------------|--------------------|----------|
| Machinery & Equipment     | – Light |               | 10 years |   |
|                          | – Heavy |               | 17 years |   |
| Tools & Die               |         | 5 years            |     |
| Office Equipment and Vehicles |         | 5 to 7 years       |     |
| Leasehold Improvements        |         | Life of the  lease |     |

 

Long-lived assets are evaluated for possible impairment when impairmentfactors exist.

 

F-8

----

 

Depreciation expense was $4.1 million, $4.9million and $4.7 million for the years ended December 31, 2004, 2003 and2002, respectively.  Maintenance, repairand purchases of small tools and dies are expensed as incurred.

 

Long-term Investments

 

We own a 50% interest in a joint venture, Lancer FBD Partnership, Ltd.,which manufactures frozen beverage dispensing systems.  The investment isaccounted for under the equity method.  The developer of the technologyutilized by the joint venture owns the remaining 50% interest.  Thedeveloper has assigned his rights to the technology to the joint venture. See “Note3 - Investment in Joint Ventures” to these Notes to Consolidated FinancialStatements.

 

We own a 50% interest in a joint venture, Lauch Lancer LLC, d.b.a. MooTechnologies, which markets concentrated shelf-stable milk for foodservicecustomers.  The investment is accounted for under the equity method. The joint venture is a development stage enterprise that reported an operatingloss and no revenue for the years ended December 31, 2004,  2003 and 2002. See “Note 3 - Investment inJoint Ventures” to these Notes to Consolidated Financial Statements.

 

Also included in long-term investments in2002 is an investment in the common stock of Packaged Ice, Inc., a company thatsells ice bagger machines that we manufacture.  We owned less than 10% ofthe common stock of Packaged Ice, Inc.  The investment, accounted for asan available-for-sale security, is recorded at fair value with net unrealizedgains and losses reported, net of tax, in other comprehensive income.  Thefair value was determined by quoted market prices. We sold our holdings incommon stock of Package Ice, Inc. during 2003, resulting in a gain of $0.2million.

 

Goodwill and Other Intangible Assets

 

We account for goodwill and other intangible assets in accordance withStatement of Financial Accounting Standards SFAS No. 142, “Goodwill and OtherIntangible Assets,” which requires that goodwill and certain indefinite-livedassets no longer be amortized, but instead be evaluated at least annually forimpairment. We adopted the provisions of SFAS 142 on January 1, 2002.

 

The determination of the value of goodwilland other intangibles requires us to make estimates and assumptions aboutfuture business trends and growth.  If an event occurs which would causeus to revise our estimates and assumptions used in analyzing the value of ourgoodwill or other intangibles, such revision could result in an impairmentcharge that could have a material impact on our financial condition and resultsof operations.

 

Goodwill is tested for impairment annually - on September 30 orwhenever an event occurs or circumstances change that may reduce the fair valueof the reporting unit below its book value.  The impairment test isconducted for each reporting unit in which goodwill is recorded by comparingthe fair value of the reporting unit with its carrying value.  Fair valueis determined primarily by computing the future discounted cash flows expectedto be generated by the reporting unit.  If the carrying value exceeds thefair value, goodwill may be impaired. If this occurs, the fair value of thereporting unit is then allocated to its assets and liabilities in a mannersimilar to a purchase price allocation in order to determine the implied fairvalue of the goodwill of the reporting unit.  The implied fair value isthen compared with the carrying amount of the goodwill of the reporting unit,and, if it is less, then we would recognize an impairment loss.

 

Based on the impairment testing, no impairment occurred in 2003. During2004, it was determined that the fair market value of the operating unit Lancerde Mexico was less than the carrying value of the underlying assets.  The entire amount of goodwill of $50 thousandwas impaired.

 

We have approximately $1.9 million of goodwill, net of accumulatedamortization of $0.8 million, at December 31, 2004 and 2003, respectively.

 

Other intangible assets with definite usefullives are recorded on the basis of cost in accordance with SFAS No. 142 and areamortized on a straight-line basis over their estimated useful lives, whichrange from eighteen months to fifteen years. In accordance with SFAS No. 142,we subjected these assets to tests of impairment and we determined that certainpatents we hold no longer have value due to technological changes andobsolescence.  We recorded impairmentcharges for certain patents in the amount of $0.2 million, $0.2 million and $0for the years ended December 31, 2004, 2003 and 2002.

 

We have approximately $3.1 million and $2.6 million of intangibleassets, net of accumulated amortization of $.8 million and $1.1 million, atDecember 31, 2004 and 2003, respectively.  Amortization expenserelated to other intangible assets was $0.2 million, $0.4 million and $0.3million for the years ended December 31, 2004, 2003 and 2002,respectively.  Based on our current patents, estimated expense is $0.2million for each of the five years ending December 31, 2009.  The weighted-average amortization period is13.8 years.

 

F-9

----

 

During 2003, we incurred expense of $0.9 million from the write-off ofan investment and for Lancer Ice Link, LLC, whose performance did not supportthe previous carrying value. See “Note 3 - Investment in Joint Ventures” tothese Notes to Consolidated Financial Statements.  The write-off includes a $0.5 millionimpairment related to certain of our patents.

 

Derivative Instruments

 

We account for derivative instruments usingthe principles of Statement of Financial Accounting Standard (SFAS) No. 133, “Accountingfor Derivative Instruments and Hedging Activities.”  SFAS No. 133 providesguidance on accounting and financial reporting for derivative instruments andhedging activities.  SFAS No. 133 requires the recognition of allderivatives as either assets or liabilities on the consolidated balance sheet,and the periodic measurement of those instruments at fair value.  Wedetermined that hedge accounting would not be elected for derivatives existingat January 1, 2001, which consisted of interest rate swapagreements.  We entered into the swap agreements to effectively fix theinterest rate on a portion of our debt in order to lessen our exposure tofloating rate debt.  Changes in the fair value of those derivatives arerecorded in income.  The adoption of SFAS No. 133 as of January 1,2001, resulted in a cumulative-effect-type expense to other comprehensiveincome of $51 thousand, which is recognized in interest expense over the termof the interest rate swap agreements ranging from 11 months to 24 months. The last of our interest rate swaps expired in January 2003.   Werecognized interest expense of $0, $2 thousand and $14 thousand relating to thetransition adjustment for 2004, 2003 and 2002, respectively.  Changes inthe fair value of the interest rate swap agreements reduced interest expense by$53 thousand and $311 thousand in 2003 and 2002, respectively.  There were no swap agreements outstandingduring 2004.

 

Medical Costs and Worker’s Compensation Accrual

 

We maintain a self-insurance program formajor medical and hospitalization coverage for our employees in the UnitedStates and their dependents, which is partially funded by payrolldeductions.  The estimate of the accrual necessary for claims is based onour estimate of claims incurred as of the end of the year. We use detail lagreports provided by the insurance administrator to determine an appropriateaccrual balance. .  In addition to detaillag reports provided by the insurance administrator, we use an outside actuaryto determine an appropriate accrual balance. We have provided for both reportedmedical costs and incurred but not reported medical costs in the accompanyingconsolidated financial statements.  We have a maximum liability of$100,000 per participant per policy year.  Amounts in excess of the statedmaximum are covered under a separate policy provided by an insurance company.

 

We are self-insured for all workers’compensation claims submitted by our Texas employees for on-the-job injuries.The estimate of the accrual necessary for claims are based on our estimate ofclaims incurred as of December 31, 2004. In addition to detail lag reports provided by the insuranceadministrator, we use an injury report and an outside actuary to determine anappropriate accrual balance. We have provided for both reported costs andincurred but not reported costs of workers’ compensation coverage in theconsolidated financial statements.  In an effort to provide forcatastrophic events, we carry an excess indemnity policy for workers’compensation claims.  All claims paid under the policy are subject to anannual deductible of $500,000 to be paid by us.  Based upon our pastexperience, management believes that we have adequately provided for potentiallosses.  However, multiple occurrences of serious injuries to ouremployees could have a material adverse effect on our financial position or ourresults of operations.

 

Shipping Costs

 

Our outbound shipping and handling costs are included in net sales inthe accompanying consolidated statement of income for all periods presented.

 

F-10

----

 

Net Earnings (Loss) per Share

 

The following reconciliation of thenumerators and denominators of the basic and diluted per common sharecomputations (amounts in thousands, except share data):

 
| ** **                                          | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|-----------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Basic Earnings (loss) per share                     |       |      |       |      |       |      |       |
| Earnings (loss) from Continuing operations          |       | $         | 10,100     |      | $          | (1,359    | )          | $ | 5,619 |   |
| Earnings (loss) from Discontinued  operations       |       | —    |       | 592       |       | (1,613    | )          |
| Net earnings (loss)                                 |       | $         | 10,100     |      | $          | (767      | )          | $ | 4,006 |   |
|                                                |       |      |       |      |       |      |       |
| Weighted average common shares outstanding          |       | 9,388,444 |       | 9,356,082 |       | 9,326,529 |       |
| Net earnings (loss) per share                       |       | $         | 1.08       |      | $          | (0.09     | )          | $ | 0.43 |   |
|                                                |       |      |       |      |       |      |       |
| Diluted Earnings (loss) per share                   |       |      |       |      |       |      |       |
| Earnings (loss) from Continuing operations          |       | $         | 10,100     |      | $          | (1,359    | )          | $ | 5,619 |   |
| Earnings (loss) from Discontinued  operations       |       | —    |       | 592       |       | (1,613    | )          |
| Net earnings (loss)                                 |       | $         | 10,100     |      | $          | (767      | )          | $ | 4,006 |   |
|                                                |       |      |       |      |       |      |       |
| Weighted average common shares outstanding          |       | 9,388,444 |       | 9,356,082 |       | 9,326,529 |       |
| Weighted average shares assuming dilution           |       | 115,138   |       | —    |       | 106,664   |       |
| Weighted average diluted common shares  outstanding |       | 9,503,582 |       | 9,356,082 |       | 9,433,193 |       |
|                                                |       |      |       |      |       |      |       |
| Net earnings (loss) per share                       |       | $         | 1.06       |      | $          | (0.09     | )          | $ | 0.43 |   |

 

Options to purchase approximately 313,550, 114,550 and 82,550 shares in2004, 2003 and 2002, respectively, were outstanding but were not included inthe computation because the exercise price is greater than the average marketprice of the common shares.

 

Revenue Recognition

 

We recognize revenue in accordance with the following methods:

 

(a)          At the time of shipment for all productsexcept for those sold under agreements described in (b). We require a purchaseorder for all sales. At the time of the shipment, risk of ownership and titlepasses to our customer. The goods are completely assembled and packaged and wehave no further performance obligations.

 

(b)         As products are produced and at time of titletransfer, for certain products manufactured and warehoused under production andwarehousing agreements with certain customers.  We had no sucharrangements after March 31, 2002.

 

(c)          We have entered into an agreement with TheCoca-Cola Company to receive partial reimbursement for design and development.The reimbursement is offset against cost on a percentage of completion basis.

 

(d)         Prior to 2003, we had agreed to provideexclusive rights for use of certain tools to The Coca-Cola Company.  Thesetools are included in fixed assets and are depreciated over the life of theasset.  The corresponding license and maintenance fees are recorded asdeferred income and recognized over the life of the agreement, whichapproximates the life of the corresponding asset. After 2002, the Company hasagreed to maintain certain tools that are the property of The Coca-ColaCompany. The corresponding maintenance fees are recorded as deferred income andrecognized over the life of the corresponding tool.

 

#### Selling, General andAdministrative Expenses

####  

Selling, General and Administrative Expenses include corporate expensesrelating to product development, accounting, human resources, and informationtechnology.  Additionally, certain costsof our distributor subsidiaries, including compensation and the related costs,warehousing, and office expenses relating to maintaining a distributionoperation are 

 

F-11

----

 

included in selling, general and administrative expenses.  These expenses from distributor subsidiariesincluded in selling, general and administrative expense were $5.4 million, $5.4million and $ 5.6 million in 2004, 2003 and 2002, respectively.

 

Income Taxes

 

Income taxes are accounted for in accordanceof SFAS No. 109.  Deferred tax assets andliabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases and operating loss and taxcredit carryforwards.  Deferred tax assets and liabilities are measuredusing enacted tax rates expected to apply to taxable income in the years inwhich those temporary differences are expected to be recovered orsettled.  The effect on deferred tax assets and liabilities of a change intax rates is recognized in income in the period that includes the enactmentdate.

 

Provision for U.S. income taxes on theundistributed earnings of foreign subsidiaries is made only on those amounts inexcess of the funds considered to be permanently reinvested.

 

Research and Development

 

Company-sponsored research and development costs are expensed asincurred and totaled approximately $1.2 million, $2.1 million and $2.3 millionfor the years ended December 31, 2004, 2003 and 2002, respectively.  Our total spending on product development andsustaining engineering, which includes research and development, was $4.8million, $5.4 million and $5.2 million in 2004, 2003 and 2002, respectively.

 

Foreign Currency Translation

 

Assets and liabilities of non-U.S.subsidiaries that operate in a local currency environment are translated toU.S. dollars at year-end exchange rates.  Income and expense items aretranslated at average rates of exchange prevailing during the year. Translation adjustments are accumulated in a separate component of shareholders’equity.  Inventories, plant and equipment and other non-monetary assetsand liabilities of non-U.S. subsidiaries that operate in U.S. dollars aretranslated at approximate exchange rates prevailing when acquired.  Allother assets and liabilities are translated at year-end exchange rates.  For those companies that operate in U.S.dollars, gains and losses that result from translation are included in earningswithin other income.

 

Our foreigncurrency transactional gains/(losses) were $(13) thousand, $(59) thousand and$502 thousand for the years ended December 31, 2004, 2003 and 2002,respectively. In 2002, due to the closure of the Brazil subsidiary, $831thousand was transferred from cumulative translation adjustments to loss fromdiscontinued operations.

 

Stock Options

 

At December 31, 2004, we had two stock option plans, which aredescribed further in “Note 6 - Employee Benefit Plans” to these Notes toConsolidated Financial Statements.  Weutilize the intrinsic value method ,as permitted under provisions of APBOpinion No. 25 and related interpretations, in measuring stock-basedcompensation for employees. If we had elected to recognize compensation costbased on the fair value of the options granted at grant date as prescribed bySFAS No. 123, net earnings (loss) and net earnings (loss) per share would havebeen adjusted to the pro forma amounts indicated in the table below (amounts inthousands, except share data):

 
| ** **                                                                                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net earnings (loss)-as reported                                                                                     |       | $        | 10,100     |     | $          | (767     | )          | $ | 4,006 |   |
| Add: Total stock-based compensation expense  determined under the intrinsic value method, net of tax                |       | 49       |       | 51       |       | 150      |       |
| Deduct: Total stock-based compensation  expense determined under fair value based method for all awards, net of tax |       | (111     | )          | (112     | )          | (94      | )          |
| Net (loss) earnings-pro forma                                                                                       |       | $        | 10,038     |     | $          | (828     | )          | $ | 4,062 |   |
|                                                                                                                |       |     |       |     |       |     |       |
| Net earnings (loss) per basic share-as  reported                                                                    |       | $        | 1.08       |     | $          | (0.09    | )          | $ | 0.43 |   |
| Net earnings (loss) per basic share-pro  forma                                                                      |       | $        | 1.07       |     | $          | (0.09    | )          | $ | 0.44 |   |
| Net earnings (loss) per diluted share-as  reported                                                                  |       | $        | 1.06       |     | $          | (0.09    | )          | $ | 0.43 |   |
| Net earnings (loss) per diluted share-pro  forma                                                                    |       | $        | 1.06       |     | $          | (0.09    | )          | $ | 0.43 |   |
| Weighted-average fair value of options,  granted during the period                                                  |       | $        | 6.01       |     | $          | 3.84     |       | $ | 2.88 |   |

 

F-12

----

 

The fair value of each option granted in 2004, 2003 and 2002 isestimated on the date of grant using the Black-Scholes option-pricing modelwith the following assumptions:

 
| ** **              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected life (years)   |       | 7        |       | 7        |       | 5        |       |
| Interest rate           |       | 4.0      | %          | 3.8      | %          | 3.0      | %          |
| Volatility              |       | 46.2     | %          | 47.1     | %          | 42.9     | %          |
| Expected Dividend yield |       | 0.0      | %          | 0.0      | %          | 0.0      | %          |

 

Comprehensive Income 

 

Comprehensive income (loss) consists of net earnings,currency translation adjustment, unrealized gain (loss) on investment, andunrealized loss on derivative instruments and is presented in the consolidatedstatements of shareholders’ equity and comprehensive income.  Reporting ofcomprehensive income requires additional disclosures in the consolidatedfinancial statements but it does not affect our financial position or resultsof operations. See “Note 8 - Disclosure of Accumulated Other ComprehensiveIncome Balances” to these Notes to Consolidated Financial Statements.

 

Use of Estimates

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period.  Inpreparing these financial statements, management has made its best estimatesand judgments of certain amounts included in the financial statements, givingdue consideration to materiality.  Changes in the estimates andassumptions used by management could have significant impact on our financialresults.  Actual results could differ from those estimates.

 

Reclassifications

 

Certain amounts in the consolidated financial statements for prioryears have been reclassified to conform to the current year’s presentation.

 

We have revised our previouslyreported results of operations for the year ended December 31, 2003 toreclassify two items from non-operating to operating expense.  These items consist of a $279,000 loss on thesale and disposal of assets and an $853,000 impairment of an investment in aconsolidated joint venture.  Previously,both of these items were presented as non-operating expenses in “Other (Income)Expense”.  As noted in the followingreconciliation, the reclassifications reduced the amount of our previouslyreported operating income for 2003, but did not affect our previously reportednet earnings, earnings per share, financial position, or cash flows. 

 
| **(Amounts  in 000s)**                                  | ** ** | **2003** | ** ** |
|---------------------------------------------------------|------------|----------|------------|
| Operating income as previously reported                 |       | $        | 486        |   |
| Loss on sale and disposal of assets                     |       | (279     | )          |
| Impairment of investment in consolidated  joint venture |       | (853     | )          |
| Operating (loss) after reclassifications                |       | $        | (646       | ) |

 

#### Recent AccountingPronouncements 

 

In November 2004, the Financial Accounting Standards Board (“FASB”)issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “InventoryCosts”, an amendment of ARB No. 43, Chapter 4. The amendments made by SFAS No.151 clarify that abnormal amounts of idle facility expense, freight, handlingcosts and wasted materials (spoilage) should be recognized as current-periodcharges and require the allocation of fixed production overheads to inventorybased on the normal capacity of the production facilities. The pronouncement iseffective for inventory costs incurred during fiscal years beginning after June15, 2005. Earlier application is permitted for inventory costs incurred duringfiscal years beginning after November 23, 2004. We currently recognize, asperiod costs, any abnormal amounts of idle facility expense, freight, handlingcosts and wasted materials and allocates fixed production overhead to inventorybased on the normal capacity of the production facilities. We do not believethat the adoption of this pronouncement will have a significant impact on ourresults of operations or financial position. We will adopt this pronouncementas of June 15, 2005.

 

In December 2004, the FASB issued Statement of Financial AccountingStandards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R),which replaces SFAS No. 123 and supersedes APB Opinion No. 25, “Accounting forStock Issued to Employees.”  SFAS No.123R requires all share-based payments to employees, including grants ofemployee 

 

F-13

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stock options, to be recognized in the financial statements based ontheir fair values beginning with the first interim period after June 15, 2005,with early adoption encouraged.  The proforma disclosures previously permitted under SFAS No. 123 no longer will be analternative to financial statement recognition. We are required to adopt SFAS No. 123R in the third quarter of2005.  Under SFAS No. 123R, we mustdetermine the appropriate fair value model to be used for valuing share-basedpayments, the amortization method for compensation cost and the transitionmethod to be used at date of adoption. The permitted transition methods include either retrospective orprospective adoption.  Under theretrospective option, prior periods may be restated either as of the beginningof the year of adoption or for all periods presented.  The prospective method requires thatcompensation expense be recorded for all unvested stock options at thebeginning of the first quarter of adoption of SFAS No. 123R, while theretrospective methods would record compensation expense for all unvested stockoptions beginning with the first period presented.  We are currently evaluating the requirementsof SFAS No. 123R and expect that adoption of SFAS No. 123R will have a-significant impact on our consolidated financial position and consolidatedresults of operations.  We have not yetdetermined the method of adoption or the effect of adoption SFAS No. 123R.

 

On December 21, 2004, the FASB issued “Application of FASB StatementNo. 109, **Accounting for Income Taxes,**to the Tax Deduction on Qualified Production Activities Provided by theAmerican Jobs Creation Act of 2004”, a FASB Staff Position (FSP) that providesguidance on the application of SFAS No. 109 to the tax deduction on qualifiedproduction activities provided by the American Jobs Creation Act of 2004. FSPFAS 109-1 states that the qualified production activities deduction should beaccounted for as a special deduction in accordance with SFAS No. 109, wherebythe deduction is contingent upon the future performance of specific activities,including wage levels. The FASB also concluded that the special deductionsshould be considered with measuring deferred taxes and assessing a valuationallowance. The impact on our results of operations or financial position of FSPFAS 109-1 has not yet been determined, however, the impact, if any, will bereported in the period in which the deduction is claimed on our tax returns.

 

On December 21, 2004, the FASB issued “Accounting and DisclosureGuidance for the Foreign Earnings Repatriation Provision within the AmericanJobs Creation Act of 2004”, a FSP that provides accounting and disclosureguidance for the foreign earnings repatriation provision within the AmericanJobs Creation Act of 2004. The Act provides special, one-time dividendsreceived deduction on the repatriation of certain foreign earnings to a U.S.taxpayer. FSP FAS 109-2 states that a company is allowed time beyond thefinancial reporting period of enactment to evaluate the effect of the Act onits plan for reinvestment or repatriation of foreign earnings, as it applies tothe application of SFAS No. 109. The decision process to build the plan mayoccur in stages, as an enterprise may separately evaluate the provisions of theAct. We have not begun the evaluation process of the effects of the repatriationprovision.

 

**2.             DiscontinuedOperations**

 

During the quarter ended June 30, 2002,we decided to close our Brazilian subsidiary.  In connection with theclosure of the Brazilian subsidiary, we recorded an estimated loss fromdisposal of discontinued operations of $1.8 million in the quarter endedJune 30, 2002 related to the write-down of the Brazilian subsidiary assetsnet of expected proceeds, foreign currency translation losses and an accrualfor estimated exit costs.  Accordingly,we have reported the results of operations of the Brazilian subsidiary asdiscontinued operations in the Consolidated Statements of Operations. Forbusiness segment reporting purposes, the Brazil operation was previouslyclassified as the segment “Brazil.”

 

Certain information with respect to the discontinued Brazilianoperation for the years ended December 31, 2004, 2003 and 2002 is as follows(Amounts in thousands):

 
| ** **                                                        | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                        | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net Sales                                                         |       | $                            | —     |   | $ | — |   | $ | 466 |   |
| Pretax (loss) from discontinued operations                        |       | $                            | —     |   | $ | — |   | $ | (378 | ) |
| Pretax (loss) on disposal of discontinued operations,  net of tax |       | —                       |       | (196 | ) | (2,064 | ) |
| Income tax benefit                                                |       | —                       |       | 788 |   | 829 |   |
| Income (loss) from discontinued operations                        |       | $                            | —     |   | $ | 592 |   | $ | (1,613 | ) |

 

During the first quarter of 2003, the IRScompleted its audit of our deduction of our investment in the Brazilianoperations, and other matters.  As a result, we reversed certain taxaccruals resulting in a tax benefit of  $0.7 million from discontinuedoperations for the year ended December 31, 2003.

 

F-14

----

 

Assets and liabilities of the discontinued operation are as follows(amounts in thousands):

 
| ** **                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Current assets                             |       | $        | —     |     | $          | — |   |
| Property, plant and equipment, net         |       | —   |       | —   |       |
| Current liabilities                        |       | —   |       | (1,208   | )          |
| Net liabilities of discontinued operations |       | $        | —     |     | $          | (1,208 | ) |

 

Current liabilities at December 31, 2003 included a $1.196 million notepayable that was due on December 31, 2001.  The note payable is morefully described in “Note 5 - Long-term Debt and Line of Credit with Banks” tothese Notes to Consolidated Financial Statements.

 

The amount of the accrued interest on the Brazilian note payable in theamount of $27 thousand is included in continuing operations in 2004. Theaccrued interest of $23 thousand and $72 thousand for the years  2003 and 2002, respectively, has beenincluded in discontinued operations.

 

We included the Brazilian note payable andthe related interest in discontinued operations in 2003 because, although theimpairment charge for the Brazilian operation was made in 2002, the liquidationof the entity continued until December 2003, and, as recently as the secondquarter of 2003, the payee demanded payment of the debt.  As required by SFAS 144, during the initialone-year period of the discontinued operations, circumstances arose thatpreviously were considered unlikely including the uncertainty regarding thesettlement of the Brazilian disputed debt. As a result, we continued to classify the disputed Brazilian debt indiscontinued operations in 2003.

 

**3.             Investment in JointVentures**

 

At December 31, 2004 and 2003, our long-term investments consisted ofthe following:

 
| ** **                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |
| Investment in Lancer FBD Partnership Ltd. |       | $        | 2,046      |     | $          | 1,475 |   |
| Investment in Moo Technologies, LLC       |       | 342      |       | 311      |       |
| Total long-term investments               |       | $        | 2,388      |     | $          | 1,786 |   |

 

Our 50% share of net earnings from both joint ventures, afterelimination of profit in ending inventory, is included in other income.

 

On May 1, 2002, our joint venture Lancer FBD Partnership, Ltd. whichmanufactures frozen beverage equipment, began selling its products directly tomost third party customers, and paying us a commission on certain sales that wegenerated.  Lancer FBD paid us sales commissionsof $0.4 million, $0.8 million and $0.1 million for the years endedDecember 31, 2004, 2003 and 2002 respectively.  Prior to May 1, 2002,Lancer FBD sold substantially all of its production to us and we distributedthe equipment to third party customers. Lancer FBD’s sales to us were $0.1million, $0.1 million and $3.0 million for the years ended December 31,2004, 2003 and 2002 respectively.  LancerFBD’s purchases from us were $1.4 million, $2.0 million and $0.5 million forthe years ended December 31, 2004, 2003 and 2002 respectively.  Lancer FBD had a balance due to us of $0.2million and $1.5 million at December 31, 2004 and 2003, respectively.

 

F-15

----

 

**Lancer FBDPartnership Ltd.**

 

 
| **(amounts in thousands)**         | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Condensed Statements of Operations | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                          |       | $          | 24,060     |       | $          | 22,817     |       | $ | 9,127 |   |
| Gross profit                       |       | 6,101      |       | 3,906      |       | 885        |       |
| Net (loss) earnings                |       | 2,794      |       | 117        |       | (1,317     | )          |
|                               |       |       |       |       |       |       |       |
| Condensed Balance Sheets           |       |       |       |       |       |       |       |
| Current assets                     |       | $          | 5,176      |       | $          | 6,663      |       | $ | 3,279 |   |
| Non-current assets                 |       | 2,394      |       | 2,632      |       | 2,919      |       |
|                               |       | $          | 7,570      |       | $          | 9,295      |       | $ | 6,198 |   |
|                               |       |       |       |       |       |       |       |
| Current liabilities                |       | $          | 3,390      |       | $          | 6,267      |       | $ | 3,287 |   |
| Non-current liabilities            |       | —     |       | —     |       | —     |       |
| Partners’ capital             |       | 4,180      |       | 3,028      |       | 2,911      |       |
|                               |       | $          | 7,570      |       | $          | 9,295      |       | $ | 6,198 |   |

 

We own 50% of Moo Technologies, a developmental stage limited liabilitycompany engaged in the commercialization of concentrated shelf-stable milkproducts. Our portion of Moo Technology’s loss was ($0.3 million), ($0.2million), and ($0.1 million) in 2004, 2003 and 2002, respectively.  We have invested $0.8 million in MooTechnologies, LLC since its inception, including $0.3 million during 2004,bringing our net investment in the company to $0.3 million as of December 31,2004.  We expect Moo Technologies to beunprofitable through at least 2005.  Wehave guaranteed repayment of Moo Technologies’ $0.75 million revolving creditfacility with a bank. As of December 31, 2004, the balance of the creditfacility was $0.75 million. During the first quarter of 2005, we invested anadditional $0.5 million in Moo Technologies. The development of MooTechnologies’ business opportunities is likely to require us to investapproximately $0.2 million of additional funds in the company during 2005.  Also during the first quarter of 2005, MooTechnologies retired its bank borrowings, and the bank released us from ourguaranty.

 

**MooTechnologies, LLC**

 

 
| **(amounts in thousands)**         | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Condensed Statements of Operations | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                          |       | $          | —     |       | $          | —     |       | $ | — |   |
| Gross profit                       |       | —     |       | —     |       | —     |       |
| Net (loss) earnings                |       | (561       | )          | (320       | )          | (113       | )          |
|                               |       |       |       |       |       |       |       |
| Condensed Balance Sheets           |       |       |       |       |       |       |       |
| Current assets                     |       | $          | 155        |       | $          | 35         |       | $ | 21 |   |
| Non-current assets                 |       | 1,353      |       | 1,341      |       | 1,326      |       |
|                               |       | $          | 1,508      |       | $          | 1,376      |       | $ | 1,347 |   |
|                               |       |       |       |       |       |       |       |
| Current liabilities                |       | $          | 869        |       | $          | 796        |       | $ | 309 |   |
| Non-current liabilities            |       | 1,640      |       | 1,020      |       | 1,151      |       |
| Members’ capital              |       | (1,001     | )          | (440       | )          | (113       | )          |
|                               |       | $          | 1,508      |       | $          | 1,376      |       | $ | 1,347 |   |

 

Lancer Ice Link, LLC is our 60% owned, consolidated joint venture.  During 2003, we incurred expense of $0.9million from the write-off of an investment in Lancer Ice Link, LLC, whoseperformance did not support the previous carrying value. As of the date of theimpairment, Lancer Ice Link LLC had incurred losses of $1.8 million since itsinception and had a negative net worth. Sales of ice transport systems by Lancer Ice Link LLC were negligibleand some of the systems had failed in the field. We projected that the future cashflow from Lancer Ice Link LLC would not be sufficient to return the current netbook value of the investment of $0.9 million. The cash flow loss, combined with the projection of future losses,resulted in an impairment of the investment as required by SFAS No. 144.

 

F-16

----

 

**4.****                                      IncomeTaxes**

An analysis of income tax expense (benefit)follows (amounts in thousands):

 
| ** **               | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total**  | ** ** |
|--------------------------|------------|-------------|------------|--------------|------------|------------|------------|
| 2004                     | ** ** | ** **  | ** ** | ** **   | ** ** | ** ** | ** ** |
| Continuing operations:   |       |        |       |         |       |       |       |
| Federal                  |       | $           | 1,231      |         | $          | 2,229      |       | $ | 3,460 |   |
| State                    |       | 45          |       | 0            |       | 45         |       |
| Foreign                  |       | 1,771       |       | (245         | )          | 1,526      |       |
| Total                    |       | $           | 3,047      |         | $          | 1,984      |       | $ | 5,031 |   |
|                     |       |        |       |         |       |       |       |   |   |   |
| Discontinued operations: |       |        |       |         |       |       |       |
| Federal                  |       | $           | —     |         | $          | —     |       | $ | — |   |
|                     |       |        |       |         |       |       |       |
| 2003                     |       |        |       |         |       |       |       |
| Continuing operations:   |       |        |       |         |       |       |       |
| Federal                  |       | $           | 421        |         | $          | (1,089     | )          | $ | (668 | ) |
| State                    |       | 64          |       | 0            |       | 64         |       |
| Foreign                  |       | 945         |       | (151         | )          | 794        |       |
| Total                    |       | $           | 1,430      |         | $          | (1,240     | )          | $ | 190 |   |
|                     |       |        |       |         |       |       |       |   |   |   |
| Discontinued operations: |       |        |       |         |       |       |       |
| Federal                  |       | $           | (66        | )            | $          | (722       | )          | $ | (788 | ) |
|                     |       |        |       |         |       |       |       |
| 2002                     |       |        |       |         |       |       |       |
| Continuing operations:   |       |        |       |         |       |       |       |
| Federal                  |       | $           | 364        |         | $          | 1,121      |       | $ | 1,485 |   |
| State                    |       | 24          |       | 0            |       | 24         |       |
| Foreign                  |       | 1,052       |       | 108          |       | 1,160      |       |
| Total                    |       | $           | 1,440      |         | $          | 1,229      |       | $ | 2,669 |   |
|                     |       |        |       |         |       |       |       |   |   |   |
| Discontinued operations: |       |        |       |         |       |       |       |
| Federal                  |       | $           | (444       | )            | $          | (385       | )          | $ | (829 | ) |

 

Temporary differences between the financialstatement carrying amounts and tax bases of assets and liabilities that giverise to significant portions of the net deferred tax liability relate to thefollowing (amounts in thousands):

 
| ** **                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |
| Deferred tax assets:                               |       |     |       |     |       |
| Accounts receivable                                |       | $        | 390        |     | $          | 198 |   |
| Inventory                                          |       | 483      |       | 953      |       |
| Compensation and benefits                          |       | 276      |       | 211      |       |
| Net operating loss carryforward                    |       | 0        |       | 2,099    |       |
| Minimum taxes creditable in foreign  jurisdictions |       | 572      |       | 570      |       |
| Asset impairments                                  |       | 305      |       | 404      |       |
| US tax credits                                     |       | 396      |       | 1,119    |       |
| Other                                              |       | 240      |       | 50       |       |
| Total gross deferred tax assets                    |       | $        | 2,662      |     | $          | 5,604 |   |
|                                               |       |     |       |     |       |
| Property, plant and equipment                      |       | 3,305    |       | 3,408    |       |
| DISC income                                        |       | 2,400    |       | 2,667    |       |
| Foreign deferred (assets) liabilities              |       | (466     | )          | 136      |       |
| Total deferred tax liability                       |       | $        | 5,239      |     | $          | 6,211 |   |
| Net deferred tax liability                         |       | $        | 2,577      |     | $          | 607 |   |

 

US tax credits are comprised of Research and Experimentation Credits(R&E) and Alternative Minimum Tax (AMT) credit carry-forward. These creditsexpire in various years beginning in 2020.

 

F-17

----

 

In assessing the realizability of deferred tax assets, managementconsiders whether it is more likely than not that some portion or all of thedeferred tax assets will not be realized.  Based on the expectation offuture taxable income and that the deductible temporary differences will offsetexisting taxable temporary differences, management believes it is more likelythan not we will realize the benefits of these deductible differences atDecember 31, 2004.

 

The actual tax expense (benefit) differs from the “expected” taxexpense (benefit) (computed by applying U.S. Federal corporate rate of 34% toearnings before income taxes) as follows (amounts in thousands):

 
| ** **                                                                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                                            |       |     |       |     |       |     |       |
| Computed “expected” tax expense (benefit)  from continuing operations |       | $        | 5,144      |     | $          | (398     | )          | $ | 2,818 |   |
| Increase (decrease) in taxes resulting  from:                                   |       |     |       |     |       |     |       |
| Effect of tax credits                                                           |       | —   |       | —   |       | (129     | )          |
| Effect of nondeductible expenses                                                |       | 10       |       | 352      |       | 78       |       |
| Liquidation of DISC                                                             |       | —   |       | 791      |       | —   |       |
| Reversal of accruals                                                            |       | —   |       | (206     | )          | —   |       |
| IRS examination                                                                 |       | —   |       | (319     | )          | —   |       |
| State taxes, net of Federal benefit                                             |       | 30       |       | 42       |       | 16       |       |
| Effect of foreign tax rates                                                     |       | (108     | )          | (58      | )          | (26      | )          |
| Other, net                                                                      |       | (45      | )          | (14      | )          | (88      | )          |
| Actual tax expense                                                              |       | $        | 5,031      |     | $          | 190      |       | $ | 2,669 |   |

 

In accordance with SFAS No. 109, no federalincome taxes had been provided for the accumulated undistributed earnings ofthe our Domestic International Sales Corporation (the “DISC”) as ofDecember 31, 1992.  On December 31, 1992, the accumulatedundistributed earnings of the DISC totaled $2.4 million. During the year endedDecember 31, 2003, we decided to terminate the DISC election and recorded$0.8 million in income tax expense for the taxes due prior to December 31,1992.  The  $2.667 million of DISC deferred income tax liability ispayable to the IRS over 10 years from the date of liquidation.

 

During the first quarter of 2003, the IRScompleted its audit of our deduction of our investment in the Brazilianoperations, and other matters.  As a result, we reversed certain taxaccruals resulting in an income tax benefit of $0.9 million. Of this benefit,$0.7 million related to the Brazilian operations was reclassified from taxbenefits of continuing operations to tax benefits of discontinued operationsfor the year ended December 31, 2003. In addition, during 2003 the IRScompleted its examination of our income tax return for the year endedDecember 31, 1999.

 

F-18

----

 

**5.             Current andLong-term Debt**

 

Amounts due under our long-term debt and line of credit facility atDecember 31, 2004 and 2003 were as follows:

 
| **(amounts  in thousands)**                                                                                                                                                                                                                                                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Current debt**                                                                                                                                                                                                                                                                                       |       |     |       |     |       |
| *Line of credit (Former credit facilities)*                                                                                                                                                                                                                                                            |       |     |       |     |       |
| $10,000 reveloving credit facility due in  full at expiration on January 31, 2005.   Interest on oustanding balances was due monthly based on Base Rate (which approximates  prime) plus 2%; secured by substantially all of the Company’s assets in the  United States; Facility retired in 2004 |       | $        | —     |     | $          | 1,000 |   |
|                                                                                                                                                                                                                                                                                                   |       |     |       |     |       |
| **Long-term debt**                                                                                                                                                                                                                                                                                     |       |     |       |     |       |
| *Line of Credit (New credit facility)*                                                                                                                                                                                                                                                                 |       |     |       |     |       |
| $15,000 revolving credit facility due in  full at expiration on December 30, 2007.  Interest is due monthly based on prime and LIBOR; secured by substantially  all of the Company’s assets in the United States                                                                                  |       | $        | —     |     | $          | — |   |
|                                                                                                                                                                                                                                                                                                   |       |     |       |     |       |
| *Notes Payable (Former credit facilities)*                                                                                                                                                                                                                                                             |       |     |       |     |       |
| Notes payable to banks, due in quarterly  installments plus interest based upon prime and LIBOR (weighted average rate  of 2.28% at December 31, 2003) through July 15, 2005; secured by  substantially all of the Company’s assets in the United States; Balance  repaid in 2004                 |       | —   |       | 9,386    |       |
|                                                                                                                                                                                                                                                                                                   |       |     |       |     |       |
| Notes payable to seller of Brazil  subsidiary, due in annual installments plus interest based on LIBOR (weighted  average interest rate of 1.88% at December 31, 2004) through December 31,  2001                                                                                                      |       | 1,196    |       | 1,196    |       |
|                                                                                                                                                                                                                                                                                                   |       |     |       |     |       |
| Capital lease payable to bank, due in  monthly installments plus interest of 6.72% through November 1, 2006                                                                                                                                                                                            |       | 281      |       | 421      |       |
|                                                                                                                                                                                                                                                                                                   |       |     |       |     |       |
| Total debt                                                                                                                                                                                                                                                                                             |       | 1,477    |       | 11,003   |       |
|                                                                                                                                                                                                                                                                                                   |       |     |       |     |       |
| Less current installments of long-term debt                                                                                                                                                                                                                                                            |       | 1,345    |       | 2,735    |       |
|                                                                                                                                                                                                                                                                                                   |       |     |       |     |       |
| Long-term debt excluding current  installements                                                                                                                                                                                                                                                        |       | $        | 132        |     | $          | 8,268 |   |

 

 

Former Credit Facilities

 

Prior to June 30, 2004, we were a party to the Seventh Amendment andRestated Credit Agreement, which provided for a term loan in the aggregateamount of $14.8 million, consisting of $12.9 million in Term A loans and $1.9million in Term B loans and a $25.0 million revolving loan amount  with The Frost National Bank as theAdministrative Agent and as a lender, Harris Trust and Savings Bank and WhitneyNational Bank, which we refer to in this note as our former credit facility.Due to our inability to deliver timely audited financial statements for theyear 2003 to our lenders and due to certain other events and circumstances, wecame to be in default of the credit agreement terms of our former creditfacility.

 

Effective June 30, 2004, our lenders agreed to amend the former creditfacility.  The amendment to our formercredit facility provided for, among other things, waivers for our past defaultsand potential defaults and amended terms of the former credit agreement toaccommodate events surrounding these past defaults. The amended terms alsoprovided for aggregate term loans in the amount of $9.0 million and a $10.0million revolving loan amount. The term loan amounts were based on the balancesthat then existed on the term loans.

 

F-19

----

 

#### New CreditFacility

 

On December 17, 2004, weentered into a new credit facility with a new lender, which we refer to hereinas our new credit facility. The new credit facility consists of a total of$15.0 million revolving loan amount, and allows us to borrow, repay, andreborrow, on a secured basis and from time to time until December 30, 2007, upto the $15.0 million total.

 

Interest on the outstanding amount under the new credit facility ispayable on a monthly basis at our choice of either (i) the prime rate of JPMorgan Chase & Co., New York, New York, as announced from time to time,minus 0.5%, or (ii) the London Interbank Offered Rate (LIBOR) plus 1.75% to2.0% (depending on our ratio of Total Funded Debt to Consolidated EBITDA, asthose terms are defined in the new credit agreement for the new credit facility).A commitment fee of 0.125% per annum will accrue on the unused portion of thetotal revolving loan amount.

 

The new credit facility is secured by a lien on the real property whereour headquarters is located, including all improvements, and a security interestin certain of our accounts receivable, equipment and inventory.

 

Our subsidiary, Lancer Partnership, Ltd., is the actual named “Borrower”under the new credit facility, while Lancer Corporation itself, along with ourwholly-owned subsidiaries, Lancer Capital Corporation and Lancer InternationalSales, Inc., jointly and severally guaranty the new credit facility.

 

Pursuant to the new credit facility, we are required to maintain aratio of Current Consolidated Assets to Current Consolidated Liabilities (asthose terms are defined in the new credit agreement for the new creditfacility) of not less than 1.25 to 1.0, and a ratio of Total Funded Debt toConsolidated EBITDA (as those terms are defined in the new credit agreement forthe new credit facility) of not more than 3.0 to 1.0.  Additionally, we are required to maintain aconsolidated net worth of not less than $47.0 million plus 75% of cumulativenet income after June 30, 2004 (with no reduction for any net loss reported forany quarter).

 

We must repay borrowings under the new credit facility by December 30,2007 unless payment is accelerated upon the occurrence of an event of default.The new credit facility contains customary default events such as paymentdefault, covenant default, bankruptcy type defaults, liens, judgments, and theoccurrence of certain other events which could impair or negatively impact usfrom performing our obligations under the new credit facility. Upon certainevents, such as a final money judgment against us (which is not paid orperfected within sixty days) or a challenge to the lender’s first lien andsecurity interest, the lender may reasonably determine whether the event willimpair or impact our ability to perform under the new credit facility.  As of December 31, 2004, we were incompliance with all of the covenants.

 

As of December 31, 2004, there were no amounts outstanding underthe new credit facility, and $15.0 million was available for borrowing.

 

##### *Disputed Debt*

##### *We have a $1.196million principal amount of disputed debt payable in relation to ourdiscontinued Brazilian operations that was due on December 31, 2001.  We have recorded the balance of the disputeddebt plus interest in the amount of $0.14 million accrued through December 31,2004 in our financial statements. During the second quarter of 2003, the payeedemanded payment of the debt, and we made a settlement offer. We have had nodiscussions with the payee since 2003. We may not be successful in negotiatinga settlement of this disputed debt, in which case the total amount would remaindue and payable.  If that were to occur,we would have to determine what other options are available to us, includinglitigation. If we determined that the debt should simply be paid at that time,we believe that we would likely have sufficient funding available, through ourcash reserves and/or our available capacity under our new credit facility, topay the disputed debt.*

##### * *

#### Annual Maturities onLong-Term Debt

Annual maturities on long-term debt outstanding at December 31, 2004are as follows (amounts in thousands):

 

| 2005   |   | $   | 1,345  |   |
|--------|--------|-----|--------|--------|
| 2006   |   | 132 |   |
|   |   | $   | 1,477  |   |

 

To manage our exposure to fluctuations in interest rates, we enteredinto interest rate swap agreements in recent years.  The last of theseswap agreements expired in the first quarter of 2003.

 

F-20

----

 

**6.             Employee BenefitPlans**

 

Stock Options

 

We have stock option plans under whichincentive and non-qualified options may be granted.  Options are grantedat the market price of our common stock at the grant date.  Optionsgenerally become exercisable in 20% increments beginning on the grant date andexpire ten years from the grant date.

 

During 2002, our Board extended the life ofour then outstanding stock options by five years.  The change resulted incompensatory element of stock options granted in the amount of $0.4 million, ofwhich $0.1 million, $0.1 million and $0.2 million of which was recognized in2004, 2003 and 2002, respectively.

 

A summary of transactions for all options follows:

 
| ** **                       | ** ** | ** **         | ** ** | **Option Price** | ** ** |
|----------------------------------|------------|--------------------|------------|------------------|------------|
| ** **                       | ** ** | **Stock  Options** | ** ** | **Low**          | ** ** | **High** | ** ** | **Weighted  Average** | ** ** |
|                             |       |               |       |             |       |   |   |   |   |
| Outstanding at December 31, 2001 |       | 602,413            |       | $                | 1.29 -     |   | $ | 16.54 |   | $ | 4.12 |   |
| Granted                          |       | 110,300            |       | $                | 3.60 -     |   | $ | 9.00 |   | $ | 5.86 |   |
| Forfeited                        |       | (57,700            | )          | $                | 3.56 -     |   | $ | 16.54 |   | $ | 11.56 |   |
| Exercised                        |       | (268,362           | )          | $                | 1.30 -     |   | $ | 3.56 |   | $ | 1.40 |   |
|                             |       |               |       |             |       |   |   |   |   |
| Outstanding at December 31, 2002 |       | 386,651            |       | $                | 3.56 -     |   | $ | 13.63 |   | $ | 5.40 |   |
| Granted                          |       | 66,000             |       | $                | 5.15 -     |   | $ | 9.70 |   | $ | 7.23 |   |
| Forfeited                        |       | (47,935            | )          | $                | 3.56 -     |   | $ | 6.57 |   | $ | 5.26 |   |
| Exercised                        |       | (30,000            | )          | $                | 3.56 -     |   | $ | 7.75 |   | $ | 4.58 |   |
|                             |       |               |       |             |       |   |   |   |   |
| Outstanding at December 31, 2003 |       | 374,716            |       | $                | 3.56 -     |   | $ | 13.63 |   | $ | 5.81 |   |
| Granted                          |       | 255,000            |       | $                | 11.40 -    |   | $ | 12.54 |   | $ | 11.62 |   |
| Forfeited                        |       | (31,300            | )          | $                | 3.56 -     |   | $ | 9.70 |   | $ | 3.76 |   |
| Exercised                        |       | (95,933            | )          | $                | 3.56 -     |   | $ | 7.75 |   | $ | 7.45 |   |
|                             |       |               |       |             |       |   |   |   |   |
| Outstanding at December 31, 2004 |       | 502,483            |       | $                | 3.56 -     |   | $ | 13.63 |   | $ | 9.05 |   |

 

A summary of exercisable options follows:

 
| ** **    | ** ** | **Options Outstanding** | ** ** | ** **         | ** ** | ** **      | ** ** |
|---------------|------------|-------------------------|------------|--------------------|------------|-----------------|------------|
| ** **    | ** ** | ** **              | ** ** | ** **         | ** ** | **Weighted**    | ** ** | **Options Excercisable** | ** ** |
| ** **    | ** ** | ** **              | ** ** | **Weighted**       | ** ** | **Avg. of**     | ** ** | **Number of** | ** ** | **Weighted** | ** ** |
| **Range of**  | ** ** | ** **              | ** ** | **Average of**     | ** ** | **Remaining**   | ** ** | **Exercisable** | ** ** | **Average of** | ** ** |
| **Prices**    | ** ** | **Number**              | ** ** | **Exercise Price** | ** ** | **Life (yrs.)** | ** ** | **Options** | ** ** | **Exercise Price** | ** ** |
|          |       |                    |       |               |       |            |       |   |   |   |   |
| 2002          |       |                    |       |               |       |            |       |   |   |   |   |
| $1.0 to 5.0   |       | 234,100                 |       | $                  | 3.88       |            | 7.67       |   | 128,100 |   | $ | 3.84 |   |
| $5.1 to 10.0  |       | 141,050                 |       | $                  | 7.27       |            | 8.1        |   | 64,010 |   | $ | 7.94 |   |
| $10.1 to 17.0 |       | 11,500                  |       | $                  | 13.52      |            | 5.28       |   | 11,500 |   | $ | 13.52 |   |
|          |       |                    |       |               |       |            |       |   |   |   |   |
| 2003          |       |                    |       |               |       |            |       |   |   |   |   |
| $1.0 to 5.0   |       | 197,166                 |       | $                  | 3.85       |            | 6.64       |   | 154,799 |   | $ | 3.87 |   |
| $5.1 to 10.0  |       | 166,050                 |       | $                  | 7.59       |            | 7.69       |   | 86,770 |   | $ | 7.86 |   |
| $10.1 to 17.0 |       | 11,500                  |       | $                  | 13.52      |            | 4.28       |   | 11,500 |   | $ | 13.52 |   |
|          |       |                    |       |               |       |            |       |   |   |   |   |
| 2004          |       |                    |       |               |       |            |       |   |   |   |   |
| $1.0 to 5.0   |       | 96,933                  |       | $                  | 4.00       |            | 5.54       |   | 96,933 |   | $ | 4.00 |   |
| $5.1 to 10.0  |       | 139,050                 |       | $                  | 7.47       |            | 5.92       |   | 96,130 |   | $ | 7.55 |   |
| $10.1 to 17.0 |       | 266,500                 |       | $                  | 11.71      |            | 9.42       |   | 43,500 |   | $ | 12.22 |   |

 

F-21

----

 

#### Self-Insured Medical Plan

 

We maintain a self-insurance program formajor medical and hospitalization coverage for substantially all of our UnitedStates employees and their dependents, which is partially funded by payrolldeductions.  We have provided for both reported, and incurred but notreported, medical costs in the accompanying consolidated balance sheets. We have a maximum liability of $100,000 per participant per year.  Amountsin excess of the stated maximum are covered under a separate policy provided byan insurance company. The accompanying consolidated statements of operationsfor the years ended December 31, 2004, 2003 and 2002 include our costs ofthe plan of approximately $1.0 million, $1.9 million and $1.5 million,respectively.

 

Workers’ Compensation Coverage

 

We are self-insured for all workers’compensation claims submitted by substantially all United States employees foron-the-job injuries.  We have provided for both reported, and incurred butnot reported, costs of workers’ compensation coverage in the accompanyingconsolidated balance sheets.

 

In an effort to provide for catastrophicevents, we carry an excess indemnity policy for workers’ compensationclaims.  All claims paid under the policy are subject to a deductible of$500,000 to be paid by us.  Based upon our past experience, managementbelieves that we have adequately provided for potential losses.  However,multiple occurrences of serious injuries to employees could have a materialadverse effect on our financial position and our results of operations.

 

Employee Profit Sharing Plan

 

We have established an employee profitsharing and 401(k) plan, which covers substantially all United States employeeswho meet the eligibility requirements.  Participants may elect tocontribute up to 15% of their annual wages, subject to certain IRSlimitations.  We match employee 401(k) contributions to the plan at a rateof 50% of the first 6% of the salary contributed to the plan through salarydeferral.  In addition, we, at the discretion of the Board, may makeprofit sharing contributions to the plan.  The accompanying consolidatedstatements of operations for the years ended December 31, 2004, 2003 and2002 include our contributions to the plan of approximately $0.8 million, $0.3million and $0.5 million, respectively.

 

**7.             Fair Value ofFinancial Instruments**

 

We are required to disclose estimated fairvalue of our financial instruments, including derivative financial instruments,for which it is practicable to estimate fair value.  The following methodsand assumptions were used to estimate the fair market value of each class offinancial instrument for which it is practicable to estimate that value.

 

Cash, Trade Receivables, and Trade Payables

 

The carrying amounts of our cash, tradereceivables and trade payables approximate market value.

 

Long-term Investments

 

Long-term investments, excluding investment in joint ventures, arestated at approximate market value based upon the current nature of theinvestments. Our investment in Packaged Ice, Inc. was sold in 2003, resultingin a gain of $0.2 million.

 

Debt

 

The carrying amount of our long-term debt andshort-term debt approximate market value as the rates are variable or are fixedat current market rates.

 

**8.****                                      Disclosureof Accumulated Other Comprehensive Income Balances**

 

The accumulated balances for eachclassification of accumulated other comprehensive income (loss) in a mannerconsistent with the following:

 

F-22

----

 

**Disclosure of Accumulated Other Comprehensive Income Balances**

(amountsin thousands)

 
| ** **                   | ** ** | **Cumulative  Translation  Adjustment** | ** ** | **Unrealized Loss  on Investments** | ** ** | **Initial Adoption of  FAS 133 for mark-  to-market of swap  agreements** | ** ** | **Total** | ** ** |
|------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|---------------------------------------------------------------------------|------------|-----------|------------|
| Balance at December 31, 2001 |       | $                                       | (3,962     | )                                   | $          | —                                                                    |       | $         | (14        | ) | $ | (3,976 | ) |
| Current period change        |       | 1,567                                   |       | 6                                   |       | 14                                                                        |       | 1,587     |       |
| Balance at December 31, 2002 |       | $                                       | (2,395     | )                                   | $          | 6                                                                         |       | $         | —     |   | $ | (2,389 | ) |
| Current period change        |       | 2,395                                   |       | —                              |       | —                                                                    |       | 2,395     |       |
| Balance at December 31, 2003 |       | —                                  |       | 6                                   |       | —                                                                    |       | 6         |       |
| Current period change        |       | 523                                     |       | (6                                  | )          | —                                                                    |       | 517       |       |
| Balance at December 31, 2004 |       | $                                       | 523        |                                | $          | —                                                                    |       | $         | —     |   | $ | 523 |   |

 

**Disclosureof reclassification amounts**

(amounts in thousands)

 
| **2002**                                                                                      |   |   |   |
|-----------------------------------------------------------------------------------------------|--------|--------|--------|
| Cumulative translation adjustment                                                             |   | $      | 736    |   |
| Reclassification adjustment for the  Brazilian subsidiary included in discontinued operations |   | 831    |   |
| Net Adjustment                                                                                |   | $      | 1,567  |   |
|                                                                                          |   |   |   |
| Initial Adoption of FAS 133 mark-to-market  adjustment of swap agreements from prior periods  |   | $      | (14    | ) |
| Reclassification adjustment for amount  included in interest expense                          |   | 14     |   |
| Net Adjustment                                                                                |   | $      | — |   |
|                                                                                          |   |   |   |
| **2003**                                                                                      |   |   |   |
| Net Adjustment                                                                                |   | $      | — |   |
|                                                                                          |   |   |   |
| **2004**                                                                                      |   |   |   |
| Unrealized loss on investment                                                                 |   | $      | 6      |   |
| Reclassifiaction adjustment for loss  realized                                                |   | (6     | )      |
| Net Adjustment                                                                                |   | $      | — |   |

 

**Disclosure of related tax effects allocated to each componentof Other Comprehensive Income**

 
| ** **                                                           | ** ** | **Before-tax  amount** | ** ** | **Tax (expense)  benefit** | ** ** | **Net of tax  amount** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|------------------------|------------|
| **2002**                                                             |       |                   |       |                       |       |                   |       |
| Cumulative translation adjustments                                   |       | $                      | 1,567      |                       | $          | —                 |       | $ | 1,567 |   |
| Reclassification adjustment for realized  loss                       |       | 9                      |       | (3                         | )          | 6                      |       |
| Mark-to-market adjustment                                            |       |                   |       |                       |       |                   |       |
| Reclassification adjustment for amount  included in interest expense |       | 14                     |       | —                     |       | 14                     |       |
| Total Other Comprehensive income                                     |       | $                      | 1,590      |                       | $          | (3                     | )          | $ | 1,587 |   |
|                                                                 |       |                   |       |                       |       |                   |       |
| **2003**                                                             |       |                   |       |                       |       |                   |       |
| Cumulative translation adjustments                                   |       | $                      | 2,395      |                       | $          | —                 |       | $ | 2,395 |   |
| Total Other Comprehensive income                                     |       | $                      | 2,395      |                       | $          | —                 |       | $ | 2,395 |   |
|                                                                 |       |                   |       |                       |       |                   |       |
| **2004**                                                             |       |                   |       |                       |       |                   |       |
| Cumulative translation adjustments                                   |       | $                      | 523        |                       | $          | —                 |       | $ | 523 |   |
| reclassifiaction adjustment for realized  loss                       |       | $                      | (6         | )                          | $          | —                 |       | $ | (6 | ) |
| Total Other Comprehensive income                                     |       | $                      | 517        |                       | $          | —                 |       | $ | 517 |   |

 

F-23

----

 

**9.             SupplementalBalance Sheet and Income Statement Information**

 

Inventory components are as follows (amounts in thousands):

 
| ** **                | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
| Finished goods            |       | $        | 11,143     |     | $          | 9,327 |   |
| Work in process           |       | 5,593    |       | 6,504    |       |
| Raw material and supplies |       | 7,759    |       | 8,671    |       |
|                      |       | $        | 24,495     |     | $          | 24,502 |   |

 

Net property, plant and equipment consist of the following (amounts in thousands):

 
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Land                                            |       | $        | 1,082      |     | $          | 1,432 |   |
| Buildings                                       |       | 22,056   |       | 22,211   |       |
| Machinery and equipment                         |       | 19,633   |       | 22,769   |       |
| Tools and dies                                  |       | 10,775   |       | 12,709   |       |
| Leaseholds, office equipment and vehicles       |       | 8,542    |       | 10,796   |       |
| Assets in progress                              |       | 1,365    |       | 2,597    |       |
| Assets available for sale                       |       | 780      |       | —   |       |
|                                            |       | 64,233   |       | 72,514   |       |
| Less accumulated depreciation and  amortization |       | (34,234  | )          | (38,395  | )          |
| Net property, plant and equipment               |       | $        | 29,999     |     | $          | 34,119 |   |

 

The entire amount of assets available forsale was sold on January 28, 2005. We sold 546.65 acres of land located in Beeand Karnes Counties, Texas, plus improvements and personal property, whichresulted in a gain of $.3 million.  See “Note14 - Related Party Transactions” and “Note 15 – Subsequent Event” to these Notesto Consolidated Financial Statements for additional information.

 

Net intangibles and other assets consist of the following (amounts inthousands):

 
| ** **                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------|------------|----------|------------|----------|------------|
| Patents                             |       | $        | 3,848      |     | $          | 3,779 |   |
| Accumulated amortization of patents |       | (774     | )          | (1,148   | )          |
| Net intangibles                     |       | 3,074    |       | 2,631    |       |
| Deposits                            |       | 112      |       | 166      |       |
| Net intangibles and other assets    |       | $        | 3,186      |     | $          | 2,797 |   |

 

F-24

----

 

Accrued expenses consist of the following (amounts in thousands):

 
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Payroll and related expenses          |       | $        | 4,159      |     | $          | 1,747 |   |
| Commissions                           |       | 328      |       | 314      |       |
| Health and workers’ compensation |       | 303      |       | 502      |       |
| Property taxes                        |       | 226      |       | 286      |       |
| Interest                              |       | 189      |       | 703      |       |
| Warranty                              |       | 1,257    |       | 586      |       |
| Other taxes                           |       | 505      |       | 139      |       |
| Investigation fees                    |       | —   |       | 702      |       |
| Other accrued expenses                |       | 1,062    |       | 1,985    |       |
|                                  |       | $        | 8,029      |     | $          | 6,964 |   |

 

Other operating (income) expenses consist of the following (amounts inthousands):

 
| ** **                                              | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| (Gain) loss on sale and disposal of assets              |       | ($57       | )          | $          | 279        |       | ($4        | ) |
| Impairment of investment in consolidated  joint venture |       | —     |       | 853        |       | —     |       |
| Impairment of intangible assets                         |       | 229        |       | 188        |       | —     |       |
|                                                    |       | $          | 172        |       | $          | 1,320      |       | ($4 | ) |
|                                                         |            |            |            |            |            |            |            |  |  |

 

Other income (expenses) consist of the following (amounts inthousands):

 
| **(amounts in thousands)** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------|------------|----------|------------|----------|------------|----------|------------|
| Interest income            |       | $        | 11         |     | $          | —   |       | $ | 47 |   |
| Bank charges               |       | (415     | )a         | (155     | )          | (91      | )          |
| Royalties income - net     |       | 138      |       | 78       |       | 44       |       |
| Exchange gains (losses)    |       | (13      | )          | (59      | )          | 502      |       |
| Miscellaneous              |       | 193      |       | 159      |       | 143      |       |
| Total                      |       | $        | (86        | )        | $          | 23       |       | $ | 645 |   |

 

----

(a) Bank Charges includes $0.3 million of of bank facility closingcosts in 2004.

 

**10.          Product Warranties**

 

We generally warrant our products againstcertain manufacturing and other defects.  These product warranties areprovided for specific periods of time from the date of sale.  We haveaccrued for estimated product warranty claims of $1.3 million and $0.6 millionas of December 31, 2004 and 2003, respectively.  The accrued productwarranty costs are based primarily on actual warranty claims as well as currentinformation on repair costs.  Warranty claims expense for each of theyears 2004, 2003 and 2002 was $0.5 million, $0.8 million and $0.2 million,respectively.

 

F-25

----

 

Accrued warranty liability consists of the following (amounts inthousands):

 
| ** **                                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------|------------|----------|------------|----------|------------|
| Beginning Balance                                            |       | $        | 586        |     | $          | 526 |   |
| Liabilities accrued for warranties issued  during the period |       | 1,122    |       | 735      |       |
| Warranty claims paid during the period                       |       | (451     | )          | (675     | )          |
| Ending Balance                                               |       | $        | 1,257      |     | $          | 586 |   |

 

**11.          Commitments andContingencies**

 

**Leases**

 

Our leases are primarily for manufacturing,warehouse and office facilities, and to a lesser extent, for equipment. At December 31, 2004, future minimum lease payments required under allnoncancelable operating leases are as follows

 

(amounts in thousands):

 
| 2005                         |   | $   | 885    |   |
|------------------------------|--------|-----|--------|--------|
| 2006                         |   | 749 |   |
| 2007                         |   | 496 |   |
| 2008                         |   | 329 |   |
| 2009                         |   | 92  |   |
| Total minimum lease payments |   | $   | 2,551  |   |

 

Total rental expense was $1.3 million, $1.2 million and $1.0 million in2004, 2003 and 2002, respectively.

 

We have been party to agreements to providewarehousing space and services for certain of its customers. Rental incomerelated to the warehousing agreements totaled approximately $0, $0 and $0.2million in 2004, 2003 and 2002, respectively. These agreements were terminatedin 2002.

 

**Other Guarantees**

 

During 2003, Lancer FBD Partnership, Ltd., of which we own 50%,obtained a $1.5 million revolving credit facility from a bank.  The creditfacility expires March 31, 2005. We entered into a Continuing GuaranteeAgreement with the lender pursuant to which we guaranteed the repayment of thepartnership’s debt, which expires annually.  In accordance with FASBInterpretation (“FIN”) No. 45, we have recorded a liability of $22,500, whichrepresents the estimated value of the guaranty.  As of December 31, 2004,there were no amounts outstanding under the credit facility.

 

On March 5, 2003, Moo Technologies, LLC, a limited liability company inwhich we own 50% of the outstanding equity, obtained a $0.75 million revolvingcredit facility from a bank.  We enteredinto a Commercial Guarantee with the lender pursuant to which we guaranteed therepayment of the Moo Technologies, LLC debt. We recorded a liability of $11,250 in 2003, which represents theestimated value of the guaranty.  As ofDecember 31, 2004, the balance of the credit facility was $0.75 million.  Moo Technologies, LLC is a developmentalstage company that reported no operating revenue in 2003 and 2004.  Moo Technologies, LLC incurred net losses of($0.6 million), ($0.3 million) and ($0.2 million) in 2004, 2003 and 2002,respectively.  We have invested $0.8million in Moo Technologies, LLC since its inception, including $0.3 millionduring 2004, bringing our net investment in the company to $0.3 million as ofDecember 31, 2004.  During the firstquarter of 2005, we invested an additional $0.5 million in Moo Technologies tofund operations and the retirement of its debt. Moo Technologies’ lender subsequently released us from our guaranty ofthe debt.  We expect Moo Technologies tobe unprofitable through at least 2005.

 

**Litigation**

 

In August 2003, the US Attorney’s Office informed us that it wasconducting an investigation arising from allegations raised in a lawsuitagainst The Coca-Cola Company by a former Coca-Cola employee, Matthew Whitley,and requested certain information, which we supplied. On January 13, 2004, wereceived written notice that the Securities and Exchange Commission had issueda formal order of investigation, dated December 2, 2003, that appeared toconcern matters which were the subject of our prior Audit Committeeinvestigation (which concluded in January 2004) including certain allegations 

 

F-26

----

 

relating to us that were contained in the Whitley lawsuit against TheCoca-Cola Company. We are unable at this point to predict the scope or outcomeof the Securities and Exchange Commission or US Attorney’s Officeinvestigations. We have cooperated, and intend to continue to cooperate, withboth the US Attorney’s Office and the Securities and Exchange Commissioninvestigations.  We have not hadsubstantive contact relating to these investigations with either the USAttorney’s Office or the Securities and Exchange Commission since July2004.  There has been no change in thestatus of the investigations between December 31, 2004 and the date of thefiling of this report.

 

**12.          Quarterly FinancialInformation (Unaudited)**

 

The third quarter of 2004 includes $7.0million paid to us pursuant to the settlement agreement, the write-off ofcertain tooling and related deferred licensing and maintenance fees, write-offof tooling related to another project and gain related to insurance proceedsfrom a claim that occurred in 2003.  Thefourth quarter of 2003 includes an impairment of $1.2 million of inventoryrelated to a specific product line, and impairment of the investment in a jointventure and certain assets of $1.2 million. The following table reflects the quarterly results for 2004 and 2003(amounts in thousands, except share data):

 
| ** **          | ** ** | **Three Months Ended** | ** ** |
|---------------------|------------|------------------------|------------|
| **2004**            | ** ** | **March  31**          | ** ** | **June  30** | ** ** | **September  30** | ** ** | **December  31** | ** ** |
| Net Sales           |       | $                      | 29,507     |   | $ | 31,696 |   | $ | 31,264 |   | $ | 31,782 |   |
| Gross Profit        |       | 8,601                  |       | 10,197 |   | 8,896 |   | 9,037 |   |
| Net earnings        |       | 945                    |       | 1,422 |   | 5,826 |   | 1,907 |   |
|                |       |                   |       |   |   |   |   |   |   |
| Earnings per share: |       |                   |       |   |   |   |   |   |   |
| Basic               |       | $                      | 0.10       |   | $ | 0.15 |   | $ | 0.62 |   | $ | 0.21 |   |
| Diluted             |       | $                      | 0.10       |   | $ | 0.15 |   | $ | 0.61 |   | $ | 0.20 |   |

 
| ** **          |       | **Three Months Ended** |       |
|---------------------|------------|------------------------|------------|
| **2003**            | ** ** | **March  31**          | ** ** | **June  30** | ** ** | **September  30** | ** ** | **December  31** | ** ** |
| Net Sales           |       | $                      | 26,874     |   | $ | 29,370 |   | $ | 30,237 |   | $ | 27,019 |   |
| Gross Profit        |       | 5,794                  |       | 7,690 |   | 8,382 |   | 7,233 |   |
| Net (loss) earnings |       | (317                   | )          | 230 |   | 574 |   | (1,254 | ) |
|                |       |                   |       |   |   |   |   |   |   |
| Earnings per share: |       |                   |       |   |   |   |   |   |   |
| Basic               |       | $                      | (0.03      | ) | $ | 0.02 |   | $ | 0.06 |   | $ | (0.14 | ) |
| Diluted             |       | $                      | (0.03      | ) | $ | 0.02 |   | $ | 0.06 |   | $ | (0.14 | ) |

 

F-27

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**13.          Segment andGeographic Information**

 

We are engaged in themanufacture and distribution of beverage dispensing equipment and related partsand components.  We manage our operations geographically.  Sales areattributed to a region based on the ordering location of the customer.

 
| **Amounts in thousands**                    | ** ** | **North  America** | ** ** | **Latin  America** | ** ** | **Asia /  Pacific** | ** ** | **Europe** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|--------------------|------------|--------------------|------------|---------------------|------------|------------|------------|---------------|------------|-----------|------------|
|                                        |       |               |       |               |       |                |       |       |       |          |       |      |       |
| Year ended December 31, 2004           |       |               |       |               |       |                |       |       |       |          |       |      |       |
| Total revenues                              |       | $                  | 79,528     |               | $          | 5,814               |       | $          | 27,969     |          | $          | 10,938    |       | — |   | $ |  124,249 |   |
| Depreciation and Amortization               |       | 3,751              |       | 33                 |       | 412                 |       | 45         |       |          |       | 4,241     |       |
| Operating income                            |       | 18,002             |       | 92                 |       | 2,803               |       | 1,089      |       | (14,377       | )          | 7,609     |       |
| Long-lived assets at December 31, 2004 |       | 29,846             |       | 3,818              |       | 3,631               |       | 157        |       | —        |       | 37,452    |       |
| Impairment of long-lived assets             |       | 229                |       | 50                 |       | —              |       | —     |       | —        |       | 279       |       |
| Goodwill (net)                              |       | —             |       | —             |       | 1,879               |       | —     |       | —        |       | 1,879     |       |
| Capital expenditures                        |       | 1,280              |       | 216                |       | 337                 |       | 50         |       | —        |       | 1,883     |       |
|                                        |       |               |       |               |       |                |       |       |       |          |       |      |       |
| Year ended December 31, 2003           |       |               |       |               |       |                |       |       |       |          |       |      |       |
| Total revenues                              |       | $                  | 75,924     |               | $          | 7,690               |       | $          | 21,645     |          | $          | 8,241     |       | — |   | $ | 113,500 |   |
| Depreciation and Amortization               |       | 4,928              |       | 28                 |       | 304                 |       | 68         |       |          |       | 5,328     |       |
| Operating income                            |       | 9,385              |       | 117                |       | 3,660               |       | 27         |       | (13,835       | )          | (646      | )          |
| Long-lived assets at December 31, 2003 |       | 32,735             |       | 4,270              |       | 3,674               |       | 177        |       | —        |       | 40,856    |       |
| Impairment of long-lived assets             |       | 188                |       | —             |       | —              |       | —     |       | —        |       | 188       |       |
| Goodwill (net)                              |       | —             |       | 50                 |       | 1,879               |       | —     |       | —        |       | 1,929     |       |
| Capital expenditures                        |       | 2,679              |       | 989                |       | 409                 |       | 68         |       | —        |       | 4,145     |       |
|                                        |       |               |       |               |       |                |       |       |       |          |       |      |       |
| Year ended December 31, 2002           |       |               |       |               |       |                |       |       |       |          |       |      |       |
| Total revenues                              |       | $                  | 97,575     |               | $          | 13,351              |       | $          | 18,555     |          | $          | 9,534     |       | — |   | $ |  139,015 |   |
| Depreciation and Amortization               |       | 4,525              |       | 164                |       | 222                 |       | 48         |       |          |       | 4,959     |       |
| Operating income                            |       | 17,434             |       | 1,979              |       | 1,785               |       | 1,360      |       | (12,999       | )          | 9,559     |       |
| Long-lived assets at December 31, 2002 |       | 35,657             |       | 3,389              |       | 3,352               |       | 147        |       | —        |       | 42,545    |       |
| Impairment of long-lived assets             |       | —             |       | —             |       | —              |       | —     |       | —        |       | 0         |       |
| Goodwill (net)                              |       | —             |       | 50                 |       | 1,879               |       | —     |       | —        |       | 1,929     |       |
| Capital expenditures                        |       | 2,591              |       | 487                |       | 535                 |       | 45         |       | —        |       | 3,658     |       |

 

All intercompany revenues are eliminated in computing revenues andoperating income.  The corporate component of operating income representscorporate general and administrative expenses.  Long-lived assets arethose assets identified with the operations in each geographic area.  Therevenues and operating income from Brazil have been included in discontinuedoperations.  During 2002, we placed the Asia region and the Pacific regionunder common management.  The two regions are now combined for segmentreporting purposes.

 

Substantially all revenues result from thesales of products and services associated with beverage dispensing.  Theproducts can be divided into four major categories: (i) fountain soft drink andcitrus dispensers; (ii) post-mix dispensing valves; (iii) beer dispensing systems;and (iv) other products and services as follows (Amounts in thousands):

 
| ** **                                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                               |       |     |       |     |       |     |       |
| Soft drink, citrus and frozen beverage  dispensers |       | $        | 44,280     |     | $          | 42,135   |       | $ | 62,470 |   |
| Post mix dispensing valves                         |       | 16,673   |       | 12,394   |       | 13,452   |       |
| Beer dispensing systems                            |       | 14,746   |       | 11,364   |       | 8,757    |       |
| Other                                              |       | 48,550   |       | 47,607   |       | 54,336   |       |
|                                               |       |     |       |     |       |     |       |
| Total revenue                                      |       | $        | 124,249    |     | $          | 113,500  |       | $ | 139,015 |   |

 

F-28

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The following provides information regarding net sales to majorcustomers, domestically and internationally (Amounts in thousands):

 
| ** **                | ** ** | **2004** | ** ** | **Percent of  Net Sales** | ** ** | **2003** | ** ** | **Percent of  Net Sales** | ** ** | **2002** | ** ** | **Percent of  Net Sales** | ** ** |
|---------------------------|------------|----------|------------|---------------------------|------------|----------|------------|---------------------------|------------|----------|------------|---------------------------|------------|
|                      |       |     |       |                      |       |     |       |                      |       |     |       |                      |       |
| United States:            |       |     |       |                      |       |     |       |                      |       |     |       |                      |       |
| The Coca-Cola Company     |       | $        | 28,127     |                      | 23         | %        | $          | 31,318                    |       | 28       | %          | $                         | 49,241     |   | 35 | % |
| Other                     |       | 47,713   |       | 38                        | %          | 40,725   |       | 36                        | %          | 45,998   |       | 33                        | %          |
|                      |       | 75,840   |       | 61                        | %          | 72,043   |       | 63                        | %          | 95,239   |       | 69                        | %          |
| Outside of United States: |       |     |       |                      |       |     |       |                      |       |     |       |                      |       |
| Other                     |       | 48,409   |       | 39                        | %          | 41,457   |       | 37                        | %          | 43,776   |       | 31                        | %          |
|                      |       |     |       |                      |       |     |       |                      |       |     |       |                      |       |
|                      |       | $        | 124,249    |                      | 100        | %        | $          | 113,500                   |       | 100      | %          | $                         | 139,015    |   | 100 | % |

 

In addition to sales made directly to The Coca-Cola Company,substantially all sales to other entities are significantly influenced by TheCoca-Cola Company.  Any disruption or change in the relationship with TheCoca-Cola Company could have a material adverse effect on our results ofoperations.

 

We had accounts receivable outstanding from The Coca-Cola Company of$1.2 million and $0.6 million at December 31, 2004 and 2003, respectively.

 

**14.          Related Party Transactions**

 

*Leases*

 

Prior to July 31, 2004, we rented a building, in which portions of ourmanufacturing facilities were located, under an operating lease from apartnership controlled by certain shareholders.  The month-to-monthagreement provided for monthly rental payments of $7,400 and the payment ofreal estate taxes, insurance and maintenance expenses.  In July 2004, we vacated the property andhave no further rental obligations there. Rental payments made under the lease were $52 thousand, $89 thousand and$89 thousand at December 31, 2004, 2003 and 2002, respectively.

 

*Joint Venture Transactions*

 

As outlined in Note-3 Investment in JointVentures, we have sales, purchases and commission transactions between us andLancer FBD Partnership. Ltd.

 

*Subsequent Event – Sale of Ranch Assets*

 

On January 28, 2005, we completed the sale of546.65 acres of land and improvements, located in Bee and Karnes Counties,Texas, to Schroeder Land and Cattle Company, Incorporated.  See “Note 15 – Subsequent Event” to these Notesto Consolidated Financial Statements for additional information.

 

**15.****                               SubsequentEvent**

 

On January 28, 2005, we completed the sale of546.65 acres of land and improvements, located in Bee and Karnes Counties,Texas, to Schroeder Land and Cattle Company, Incorporated (SLCC). The purchaseprice of $0.7 million approximates the average of two independent third partyappraisals on the property.  SLCC isowned by the children of Alfred A. Schroeder and George F. Schroeder.  Both Alfred A. Schroeder and George F.Schroeder are our employees, members of our Board, and significant shareholdersof our stock.  Lance M. Schroeder, son ofAlfred A. Schroeder, is our Vice President of Corporate Development and is a25% owner of SLCC.  We had used theproperty, commonly known as the Monteola Ranch, for entertaining customers andother business associates.  We expect torealize a gain of $257 thousand on the transaction in the first quarter of2005.

 

F-29

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**16.****                               OtherMatters**

 

In June 2003, our Audit Committee beganconducting an internal investigation. The investigation was related toallegations raised by a lawsuit against The Coca-Cola Company by a formerCoca-Cola employee, Matthew Whitley. Although we were not a defendant to thelawsuit, certain allegations contained in the lawsuit specifically involved us.The investigation was later expanded to include allegations raised in certainpress articles.

 

Our former independent auditor advised that,until the Audit Committee investigation was complete, it would not be able tocomplete its review of our consolidated financial statements for the second andthird quarters of 2003. Therefore, we were unable to file our quarterly reportsfor the second and third quarters of 2003 with the Securities and ExchangeCommission. On December 5, 2003, we provided financial information for thesecond and third quarters of 2003 in exhibits to a Form 8-K, in order toprovide information to the investing public while the investigation continued.

 

Our inability to file our quarterly reportfor the second quarter of 2003 with the SEC on a timely basis violated theAmerican Stock Exchange (AMEX) continued listing standards, specificallySection 1003(d) of the AMEX Company Guide. We submitted a formal action plan toregain compliance with AMEX on September 30, 2003 and AMEX accepted the plan onOctober 8, 2003. After the initial acceptance, we revised the plan with theapproval of AMEX in order to accommodate new developments, including our inabilityto file our annual report on Form 10-K for 2003 and our quarterly report onForm 10-Q for the first quarter 2004.

 

In August 2003, the US Attorney’s Officeinformed us that it was conducting an investigation arising from allegationsraised in a lawsuit against The Coca-Cola Company by a former Coca-Colaemployee, Matthew Whitley and requested certain information, which we supplied.On January 13, 2004, we received written notice that the Securities andExchange Commission had issued a formal order of investigation, dated December2, 2003, that appeared to concern matters which were the subject of our priorAudit Committee investigation (which concluded in January, 2004) includingcertain allegations relating to us that were contained in the Whitley lawsuitagainst The Coca-Cola Company. We have cooperated, and intend to continue tocooperate, with both the US Attorney’s Office and the Securities and ExchangeCommission investigations.  We have nothad substantive contact relating to these investigations with either the USAttorney’s Office or the Securities and Exchange Commission since July2004.  Although we are unable at thispoint to predict the scope or outcome of the Securities and Exchange Commissionand US Attorney’s Office investigations, it is possible that the investigationscould result in the institution of administrative, civil injunctive or criminalproceedings, the imposition of fines and penalties, and/or other remedies andsanctions.  The conduct of theseproceedings could adversely affect our business. In addition, we expect tocontinue to incur expenses associated with responding to these agencies,regardless of the outcome, and the efforts and attention of our management teammay be diverted from normal business operations. This could adversely affectour business, financial condition, operating results, and cash flow.

 

On January 30, 2004, we announced that theAudit Committee investigation had concluded and the Audit Committee hadreleased a general summary of the investigation findings. On February 2, 2004,our former auditor resigned from its position and subsequently withdrew itsaudit reports for the periods ended December 31, 2002, 2001 and 2000, advisingus that the financial statements and related audit reports should no longer berelied upon. The former auditor stated in a letter to us that it had determinedthat likely “illegal acts”, which had been the subject of the Audit Committeeinvestigation, had come to its attention and that these illegal acts would havea material effect on our financial statements. Additionally, our former auditorindicated that information had come to its attention that caused it to concludethat our accounting for revenue recognition in connection with sales ofequipment to Coca-Cola North America Fountain in the years ended December 31,2001 and 2002 is “not correct” and had raised concerns that the accounting isnot correct in each of the three quarters of fiscal year 2003. We have filedthe letters from our former auditors which outline these assertions and haveresponded to them in an 8-K, filed with the Securities and Exchange Commissionon February 10, 2004, and two subsequent amendments to that Form 8-K, filedwith the Securities and Exchange Commission on February 24, 2004 and March 10,2004.

 

On March 1, 2004, the Audit Committee engagedBDO Seidman as our new independent auditor to audit our financial informationfor 2003, as well as for prior periods for which the former auditor hadwithdrawn its audit reports, and to review financial information for priorquarterly periods. This process of audit and review was completed by BDOSeidman on June 16, 2004, which enabled us to file all past due and currentperiodic reports with the Securities and Exchange Commission on July 1, 2004and to regain compliance with Section 1003(d) of the AMEX Company Guide. Thereaudit did not result in any adjustment to our previously disclosed financialstatements for the prior periods.

 

Prior to June 30, 2004, we were a party tothe Seventh Amendment and Restated Credit Agreement that provided for termloans in the aggregate amount of $14.8 million, and a $25 million revolvingloan amount, which we refer to as our former credit facility. Effective June30, 2004, our former lenders agreed to amend our former credit facility becausewe were in default on certain of our credit agreement terms. The amendment toour former credit facility provided for, among other 

 

F-30

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things, waivers for our past defaults andpotential defaults and amended terms of the former credit agreement toaccommodate events surrounding these past defaults.

 

On September 13, 2004, we entered into an agreement, which we refer toas the settlement agreement, with The Coca-Cola Company relating to the jointdevelopment of the iFountain line of dispensers.  Pursuant to the settlement agreement, TheCoca-Cola Company paid us a total of $7.0 million in consideration of (i) ourengineering, research and development and other costs incurred by us on theproject,  (ii) our inventory related tothe project that could not be used as intended and did not have feasiblealternate uses, and (iii) certain covenants and releases relating to theproject.  We had previously written-off$1.2 million of inventory associated with the project during the fourth quarterof 2003.  We recorded the $7.0 millionpayment as other income when we received the payment in the third quarter of2004.

 

On December 17, 2004, we entered into a new credit facility, which werefer to as our new credit facility.  Thenew credit facility consists of a total of $15.0 million revolving loan amount,and allows us to borrow, repay, and reborrow, on a secured basis and from timeto time until December 30, 2007, up to the $15.0 million total.

 

F-31

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SCHEDULE II

 

Valuation and Qualifying Accounts

 

Amounts Reported in Thousands

 
| **Description**                 | ** ** | **Balance at  Beginning of  Year** | ** ** | **Additions  Charged to  Expense** | ** ** | **Deductions  from  Account** | ** ** | **Balance at  End of Year** | ** ** |
|---------------------------------|------------|------------------------------------|------------|------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
|                            |       |                               |       |                               |       |                          |       |                        |       |
| Allowance for doubtful accounts |       |                               |       |                               |       |                          |       |                        |       |
| December 31, 2004          |       | $                                  | 745        |                               | $          | 37                            |       | $                           | 362        |   | $ | 420 |   |
| December 31, 2003          |       | $                                  | 979        |                               | $          | 258                           |       | $                           | 492        |   | $ | 745 |   |
| December 31, 2002          |       | $                                  | 467        |                               | $          | 622                           |       | $                           | 110        |   | $ | 979 |   |
| Inventory reserve account       |       |                               |       |                               |       |                          |       |                        |       |
| December 31, 2004          |       | $                                  | 3,627      |                               | $          | 2,195                         |       | $                           | 3,755      |   | $ | 2,067 |   |
| December 31, 2003          |       | $                                  | 3,752      |                               | $          | 2,316                         |       | $                           | 2,441      |   | $ | 3,627 |   |
| December 31, 2002          |       | $                                  | 1,478      |                               | $          | 3,916                         |       | $                           | 1,642      |   | $ | 3,752 |   |

 

F-32

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