**SECURITIESAND EXCHANGE COMMISSION**

**Washington, DC 20549**

**FORM 10-Q**

x          **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934**

**For the quarterly period ended June 30, 2006**

**OR**

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

**For the transition period from               to               **

**Commission File Number 1-14227**

**AMERICANBANK NOTE HOLOGRAPHICS, INC.**

**(Exact name of Registrant as specified in itscharter)**
| **Delaware**                                                    | ** ** | **13-3317668**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**2 Applegate Drive**

**Robbinsville, New Jersey 08691**

(Address ofprincipal executive offices, including zip code)

**(609) 632-0800**

(Registrant’s telephone number, including area code)

**Not applicable**

(Former name, former address and former fiscal year,if changed since last report)

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports) and (2) has been subject to such filing for thepast 90 days.

x  Yes o  No

Indicate bycheckmark whether the registrant is a large accelerated filer, an acceleratedfiler or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act..(Check one):

Large acceleratedfiler o     Acceleratedfiler o    Non-accelerated filer x

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

o  Yes x  No

The aggregatenumber of shares of common stock, $.01 par value, outstanding on August 4, 2006was 18,905,580.

 

 

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**AMERICAN BANK NOTE HOLOGRAPHICS, INC.**

**FORM 10-Q**

## **INDEX**

|                                                                                                     | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                          | ** ** |
| PART  I - FINANCIAL INFORMATION                                                                     |       |
|                                                                                                |       |
| Item  1. Financial Statements                                                                       |       |
|                                                                                                |       |
| Balance  Sheets — Unaudited as of June 30, 2006 and December 31, 2005                          |       |
|                                                                                                |       |
| Statements of Operations - Unaudited For the Three and  Six Months Ended June 30, 2006 and 2005     |       |
|                                                                                                |       |
| Statements of Cash Flows - Unaudited For the Six  Months Ended June 30, 2006 and 2005               |       |
|                                                                                                |       |
| Condensed Notes to Unaudited Financial Statements                                                   |       |
|                                                                                                |       |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |       |
|                                                                                                |       |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 |       |
|                                                                                                |       |
| Item 4. Controls and Procedures                                                                     |       |
|                                                                                                |       |
| PART  II - OTHER INFORMATION                                                                        |       |
|                                                                                                |       |
| Item 1A. Risk Factors                                                                               |       |
|                                                                                                |       |
| Item 6. Exhibits                                                                                    |       |

 

 

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PART I —FINANCIAL INFORMATION

ITEM I.FINANCIAL STATEMENTS

AMERICAN BANK NOTEHOLOGRAPHICS, INC.

BALANCE SHEETS — UNAUDITED

(In thousands,except share data)
| ** **                                                                                                                             | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                             | ** ** | **(Unaudited)**         | ** ** | **(Note A)**           | ** ** |
| **ASSETS**                                                                                                                             |       |                    |       |                        |       |
| CURRENT ASSETS:                                                                                                                        |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                             |       | $                       | 13,413     |                        | $          | 9,114 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $500 and $500                                                          |       | 4,732                   |       | 6,019                       |       |
| Inventories, net                                                                                                                       |       | 2,258                   |       | 2,940                       |       |
| Deferred income  taxes, net                                                                                                            |       | 2,756                   |       | 2,968                       |       |
| Prepaid expenses  and other                                                                                                            |       | 110                     |       | 331                         |       |
| Income tax  receivable                                                                                                                 |       | 329                     |       | 401                         |       |
| Total current  assets                                                                                                                  |       | 23,958                  |       | 21,773                      |       |
| MACHINERY, EQUIPMENT  AND LEASEHOLD IMPROVEMENTS—Net of accumulated depreciation and amortization  of $9,240 and $8,852           |       | 6,489                   |       | 7,224                       |       |
| DEFERRED INCOME TAXES,  NET                                                                                                            |       | —                  |       | 411                         |       |
| OTHER ASSETS                                                                                                                           |       | 66                      |       | 76                          |       |
| TOTAL ASSETS                                                                                                                           |       | $                       | 30,153     |                        | $          | 29,484 |   |
|                                                                                                                                   |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| CURRENT LIABILITIES:                                                                                                                   |       |                    |       |                        |       |
| Accounts payable                                                                                                                       |       | $                       | 2,908      |                        | $          | 3,820 |   |
| Accrued expenses                                                                                                                       |       | 3,291                   |       | 3,834                       |       |
| Customer  advances                                                                                                                     |       | 325                     |       | 204                         |       |
| Income taxes  payable                                                                                                                  |       | —                  |       | 359                         |       |
| Total current  liabilities                                                                                                             |       | 6,524                   |       | 8,217                       |       |
| LONG-TERM LIABILITIES                                                                                                                  |       | 1,646                   |       | 1,957                       |       |
| Total  liabilities                                                                                                                     |       | 8,170                   |       | 10,174                      |       |
|                                                                                                                                   |       |                    |       |                        |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                         |       |                    |       |                        |       |
| STOCKHOLDERS’ EQUITY:                                                                                                             |       |                    |       |                        |       |
| Preferred stock,  authorized 5,000,000 shares; no shares issued or outstanding                                                         |       | —                  |       | —                      |       |
| Common stock,  par value $.01 per share, authorized 40,000,000 shares; issued and  outstanding 18,905,580 shares and 18,715,469 shares |       | 189                     |       | 187                         |       |
| Additional  paid-in capital                                                                                                            |       | 25,303                  |       | 24,729                      |       |
| Unearned  compensation                                                                                                                 |       | —                  |       | (96                         | )          |
| Accumulated  deficit                                                                                                                   |       | (3,509                  | )          | (5,510                      | )          |
| Total  Stockholders’ Equity                                                                                                       |       | 21,983                  |       | 19,310                      |       |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                       |       | $                       | 30,153     |                        | $          | 29,484 |   |
|                                                                                                                                   |       |                    |       |                        |       |

 

See Condensed Notes to Unaudited Financial Statements.

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AMERICAN BANK NOTEHOLOGRAPHICS, INC.

STATEMENTS OFOPERATIONS — UNAUDITED

(In thousands,except per share data)
| ** **                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenue:                                                    |       |                                            |       |                                          |       |   |   |   |   |
| Sales                                                       |       | $                                               | 8,370      |                                          | $          | 6,857 |   | $ | 18,358 |   | $ | 13,257 |   |
| Royalty income                                              |       | —                                          |       | —                                        |       | — |   | 10 |   |
|                                                        |       | 8,370                                           |       | 6,857                                         |       | 18,358 |   | 13,267 |   |
| Costs and  expenses:                                        |       |                                            |       |                                          |       |   |   |   |   |
| Cost of goods sold, excluding depreciation and amortization |       | 3,759                                           |       | 3,161                                         |       | 8,595 |   | 5,960 |   |
| Selling and administrative                                  |       | 2,366                                           |       | 2,213                                         |       | 5,131 |   | 4,131 |   |
| Research and development                                    |       | 479                                             |       | 308                                           |       | 936 |   | 581 |   |
| Depreciation and amortization                               |       | 224                                             |       | 277                                           |       | 451 |   | 628 |   |
| Facility consolidation                                      |       | 74                                              |       | 215                                           |       | 114 |   | 322 |   |
|                                                        |       | 6,902                                           |       | 6,174                                         |       | 15,227 |   | 11,622 |   |
|                                                        |       |                                            |       |                                          |       |   |   |   |   |
| Operating income                                            |       | 1,468                                           |       | 683                                           |       | 3,131 |   | 1,645 |   |
|                                                        |       |                                            |       |                                          |       |   |   |   |   |
| Other income:                                               |       |                                            |       |                                          |       |   |   |   |   |
| Interest income                                             |       | 117                                             |       | 68                                            |       | 204 |   | 122 |   |
|                                                        |       | 117                                             |       | 68                                            |       | 204 |   | 122 |   |
|                                                        |       |                                            |       |                                          |       |   |   |   |   |
| INCOME BEFORE  PROVISION FOR INCOME TAXES                   |       | 1,585                                           |       | 751                                           |       | 3,335 |   | 1,767 |   |
| PROVISION FOR  INCOME TAXES                                 |       | 634                                             |       | 301                                           |       | 1,334 |   | 707 |   |
|                                                        |       |                                            |       |                                          |       |   |   |   |   |
| NET INCOME                                                  |       | $                                               | 951        |                                          | $          | 450 |   | $ | 2,001 |   | $ | 1,060 |   |
|                                                        |       |                                            |       |                                          |       |   |   |   |   |
| NET INCOME PER  SHARE:                                      |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                       |       | $                                               | 0.05       |                                          | $          | 0.02 |   | $ | 0.11 |   | $ | 0.06 |   |
| Diluted                                                     |       | $                                               | 0.05       |                                          | $          | 0.02 |   | $ | 0.10 |   | $ | 0.06 |   |
|                                                        |       |                                            |       |                                          |       |   |   |   |   |
| WEIGHTED AVERAGE  NUMBER OF SHARES:                         |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                                       |       | 18,889                                          |       | 18,550                                        |       | 18,858 |   | 18,533 |   |
| Diluted                                                     |       | 19,359                                          |       | 19,402                                        |       | 19,636 |   | 19,255 |   |

 

See Condensed Notes to Unaudited Financial Statements.

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AMERICAN BANK NOTEHOLOGRAPHICS, INC.

STATEMENTS OF CASHFLOWS—UNAUDITED

(In thousands)
| ** **                                                                         | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| ** **                                                                         | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                             | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net income                                                                         |       | $                                             | 2,001      |   | $ | 1,060 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                                          |       |   |   |
| Depreciation and amortization                                                      |       | 451                                           |       | 628 |   |
| Write-off of fixed assets                                                          |       | 254                                           |       | — |   |
| Deferred income taxes, net                                                         |       | 711                                           |       | (85 | ) |
| Compensation costs related to share-based payment  arrangements                    |       | 518                                           |       | — |   |
| Increase in allowance for doubtful accounts                                        |       | —                                        |       | 10 |   |
| Increase in provision for inventories                                              |       | 77                                            |       | 143 |   |
| Non-cash settlement of accounts payable                                            |       | (958                                          | )          | — |   |
| Excess tax benefits from share-based payment  arrangements                         |       | (1                                            | )          | — |   |
| Changes in operating assets and liabilities:                                       |       |                                          |       |   |   |
| Accounts receivable                                                                |       | 1,287                                         |       | (532 | ) |
| Inventories                                                                        |       | 605                                           |       | (2,362 | ) |
| Prepaid expenses and other                                                         |       | 229                                           |       | 157 |   |
| Income tax receivable                                                              |       | 72                                            |       | — |   |
| Accounts payable                                                                   |       | (38                                           | )          | 1,031 |   |
| Accrued expenses                                                                   |       | (543                                          | )          | 265 |   |
| Customer advances                                                                  |       | 121                                           |       | 177 |   |
| Income taxes payable                                                               |       | (359                                          | )          | (200 | ) |
| Long-term liabilities                                                              |       | (399                                          | )          | 148 |   |
| Net cash  provided by operating activities                                         |       | 4,028                                         |       | 440 |   |
|                                                                               |       |                                          |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                             |       |                                          |       |   |   |
| Decrease in short-term investments                                                 |       | —                                        |       | 1,989 |   |
| Capital refunds (expenditures)                                                     |       | 116                                           |       | (2,330 | ) |
| Net cash provided  by (used in) investing activities                               |       | 116                                           |       | (341 | ) |
|                                                                               |       |                                          |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                             |       |                                          |       |   |   |
| Proceeds from exercise of stock options                                            |       | 154                                           |       | 149 |   |
| Excess tax benefits from share-based payment  arrangements                         |       | 1                                             |       | — |   |
| Net cash provided by financing activities                                          |       | 155                                           |       | 149 |   |
|                                                                               |       |                                          |       |   |   |
| INCREASE IN CASH  AND CASH EQUIVALENTS                                             |       | 4,299                                         |       | 248 |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF YEAR                                      |       | 9,114                                         |       | 11,357 |   |
|                                                                               |       |                                          |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                          |       | $                                             | 13,413     |   | $ | 11,605 |   |
|                                                                               |       |                                          |       |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                               |       |                                          |       |   |   |
| Taxes paid                                                                         |       | $                                             | 843        |   | $ | 990 |   |
| Capital expenditures included in accounts payable                                  |       | $                                             | 84         |   | $ | 732 |   |
| Non-cash  settlement of accounts payable                                           |       | $                                             | 958        |   | $ | — |   |

 

See Condensed Notes to Unaudited Financial Statements.

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AMERICAN BANK NOTEHOLOGRAPHICS, INC.

CONDENSEDNOTES TO UNAUDITED FINANCIAL STATEMENTS

NOTE A- BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

AmericanBank Note Holographics, Inc. (“ÁBNH” or the “Company”) originates, produces,markets and sells secure holograms and products incorporating secure holograms.The Company’s products are used primarily in security applications includingauthentication of transaction cards, identity documents, value documents andvarious consumer products.  Our abilityto create distinctive, secure optically variable devices, to reproduce themwith high quality and to distribute them securely has enabled us to become amarket leader in security holography. Our products are sold to over 200companies worldwide, including MasterCard, VISA, American Express, Discover,Diners Club, Sears, Nordstrom, Quaker State, Nike, Janssen-Cilag and Gennoma,as well as agencies of the United States government and certain foreigngovernments. We also produce non-secure holograms for design and promotionalapplications.  The Company operates inone reportable industry segment.

Thepreparation of our financial statements in conformity with accountingprinciples generally accepted in the United States of America requiresmanagement to make use of estimates and assumptions that impact the reportedamounts of assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reporting period.  On an ongoing basis, we evaluate our estimates,including those related to bad debts, stock-based compensation, inventories andintangible assets.  These estimates andassumptions are based on historical results and trends as well as our forecastsas to how these might change in the future. In addition, these estimates and assumptions have been influenced by ourcurrent knowledge of the potential impact of the VISA Decision as defined andmore fully described under “Business Information” on the following page.

Theaccompanying unaudited financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete financial statements. In the opinion of management, alladjustments that are normal and recurring and are considered necessary for afair statement have been included. Operating results for the three and sixmonths ended June 30, 2006 are not necessarily indicative of the results thatmay be expected for the year ending December 31, 2006.

Thebalance sheet at December 31, 2005 has been derived from the audited financialstatements at that date but does not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates of America for complete financial statements.

Forfurther information, refer to the financial statements and footnotes theretoincluded in the Company’s annual report on Form 10-K for the year endedDecember 31, 2005, as filed with the United States Securities and ExchangeCommission (“SEC”).

REVENUERECOGNITION

Ourproducts are sold on a fixed price basis under purchase orders and contractswith customers. Sales and the related cost of goods sold are generallyrecognized at the latter of the time of shipment or when title passes tocustomers. In some situations, the Company has shipped product where the saleis contingent upon the customers’ use of the product. In these situations, theCompany does not recognize sales upon product shipment, but rather when thebuyer of the product informs the Company that the product has been used.Additionally, pursuant to the request of and agreement with a certain customer,completed items are stored on behalf of this customer at the Company’s on-sitesecured facility, and in that instance, sales are recognized when all of thefollowing have occurred: the customer has ordered the goods pursuant to a fixedprice purchase order, the manufacturing process is complete, the goods havebeen transferred to the on-site secured facility and are ready for shipment,the risk of ownership has passed to the customer, the customer has been billedfor the order and collection of the invoice is considered reasonably assured.In certain cases the Company has agreed to maintain an inventory of productsfor a customer to ensure quick turn around of deliveries.  The Company only accepts returns of productsold to customers when the product is determined to not be in conformance withthe specifications previously agreed upon with such customers in accordancewith the terms of its warranty policy (within 180 days of such sale) and generallyreplaces the product.

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Customeradvances represent payments received from customers for products which have notyet been shipped.  These customeradvances are classified as current liabilities on the accompanying balancesheets.

Shippingand handling amounts billed to customers are included in sales and amounted to$207,000 and $152,000 for the three months ended June 30, 2006 and 2005,respectively. Shipping and handling amounts billed to customers in the sixmonths ended June 30, 2006 and 2005 amounted to $557,000 and $263,000,respectively. Shipping and handling costs are included in selling andadministrative expenses.

BASIC AND DILUTEDNET INCOME PER SHARE

Basic and dilutedearnings per share are calculated in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 128, “Earnings Per Share.”

The followingtable sets forth the reconciliation of basic weighted average sharesoutstanding and diluted weighted average shares outstanding:
| **(Amounts in thousands)**                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                    |       |                                            |       |                                          |       |   |   |   |   |
| Basic weighted  average shares outstanding              |       | 18,889                                          |       | 18,550                                        |       | 18,858 |   | 18,533 |   |
|                                                    |       |                                            |       |                                          |       |   |   |   |   |
| Dilutive effect  of stock options and restricted shares |       | 470                                             |       | 852                                           |       | 778 |   | 722 |   |
|                                                    |       |                                            |       |                                          |       |   |   |   |   |
| Diluted weighted  average shares outstanding            |       | 19,359                                          |       | 19,402                                        |       | 19,636 |   | 19,255 |   |

 

Thediluted earnings per share calculations exclude the effect of stock optionswhen the options’ exercise prices exceed the average market price of the commonshares during the period. For the three and six-month periods ended June 30,2006, the numbers of stock options not included in the computations were738,000 and 543,000, respectively. For the three and six-month periods endedJune 30, 2005, the numbers of stock options not included in the computationswere 131,000 and 125,000, respectively. These stock options were outstanding atthe end of each of the respective periods.

BUSINESSINFORMATION

Sales to MasterCard wereapproximately 34% and 37% of sales for the three months ended June 30, 2006 and2005, respectively and were approximately 34% and 35% of sales for the sixmonths ended June 30, 2006 and 2005, respectively. The Company has an agreementwith MasterCard, as amended, in which MasterCard has retained the Company asits exclusive supplier of MasterCard holograms as well as holographic magneticstripe (HoloMagTM) through February 28, 2013, subject to automatic renewal ifnot terminated by either party.  At June30, 2006 and December 31, 2005, accounts receivable from this customer totaled$1.9 million and $1.5 million, respectively.

If we were to lose asubstantial portion of our business with MasterCard without replacing it withnew product sales, our business, operating results and financial conditionwould be materially and adversely affected. In addition, if we fail to obtainanticipated orders from MasterCard or if we experience delays or cancellationsof orders from MasterCard, our business, operating results and financialperformance will be materially and adversely affected.

Sales of VISA holograms(which includes HoloMag starting in the three month period ended September 30,2005) to manufacturers of VISA transaction cards were approximately 31% and 24%of sales for the three months ended June 30, 2006 and 2005, respectively andwere approximately 36% and 24% of sales for the six months ended June 30, 2006and 2005, respectively. Currently we are one of two companies authorized tomanufacture and sell the VISA Dove hot stamp hologram to manufacturers of VISAbrand transaction cards.****On March 15,2005, VISA announced its intention to phase out the Dove hot stamp hologramthat we supply for the front of the VISA card, and to replace it with anintegrated holographic magnetic stripe. On April 8, 2005, we entered into anAgreement with VISA, pursuant to which we were authorized to supply HoloMag toVISA-approved card manufacturers. On March 14, 2006, we were informed by VISAthat, as a result of a small number of incidents in which certain cardterminals had been affected by electro-static discharge (“ESD”) from staticelectricity carried on cards incorporating

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HoloMag, VISA isinforming its member financial institutions and authorized card manufacturersthat (i) VISA will no longer approve VISA card designs which incorporate thecurrent version of HoloMag, (ii) VISA strongly recommends that theirmembers attempt to avoid further issuance of cards incorporating the currentversion of HoloMag and (iii) VISA recommends that their members follow analternate card design incorporating a conventional magnetic stripe and Dove hotstamp hologram and VISA provided notice to us that it was revoking our right toproduce HoloMag under its agreement (the “VISA Decision”).  In its correspondence to us relating toHoloMag, VISA also stated its view that “a remediation program for impactedstakeholders may be necessary” and that VISA would seek indemnification from usfor such costs and/or claims. VISA has recommended to its members that cardsbearing the HoloMag product already in the market be replaced as soon aspractical. There can be no assurance that VISA authorized card maufacturerswill continue to purchase the Dove hot stamp hologram from us in the future. Weare continuing to evaluate VISA’s actions and claims.We believe that we are incompliance with our agreement with VISA and that the HoloMag product complieswith all standards and specifications contained in our agreement. Accountsreceivable from manufacturers of VISA transaction cards approximated $2.7million and $3.4 million at June 30, 2006 and December 31, 2005, respectively.

We have invented a technologyand methods of significantly reducing ESD and we have filed patent applicationson these inventions. We have incorporated our invention into our HoloMagproduct and our testing shows that our second generation HoloMag productgenerally exhibits no more ESD than a standard black magnetic stripe. We arecurrently offering to customers a second generation version of HoloMag andexpect to begin shipping the product in limited quantities later this year.

We purchase certain keymaterials used in the manufacture of our products, and subcontract certainproduction functions or products from third parties some of which are solesuppliers.   In some cases, we do nothave supply contracts with our suppliers, and operate on a purchase orderbasis. In the case of HoloMag, we have a single supplier, CFC International,Inc., with whom we have a supply contract which was amended on July 26, 2006.  Also at that time we negotiated a settlementwith CFC International, Inc. that resulted in a reduction of our payable to themof approximately $1.0 million. We may not be able to find alternativesources in a timely manner if our suppliers or subcontractors become unwillingor unable to supply us, or if they increase their prices. Our inability toobtain key product components or to have certain processes performed on ourbehalf could cause delays or reduce product shipments, which could cause ourrelationship with customers to suffer and materially and adversely affect ourfinancial condition, results of operations and cash flows.

STOCK-BASEDCOMPENSATION PLANS

In December 2004, the Financial Accounting StandardsBoard issued Statement No. 123(R) (FAS 123R), Share-Based Payment, revising FAS123 and requiring that all share-based payments to employees be recognized inthe financial statements. We adopted the new statement effective January 1,2006, using the modified-prospective transition method described in thestatement. Under this method, we are required to recognize compensation expensefor all awards granted after the adoption based on the grant date fair valueestimated in accordance with FAS 123 (R) and for the unvested portion ofpreviously granted options that remain outstanding as of the adoption datebased on the grant date fair value in accordance with the original provisionsof FAS 123. In the three and six months ended June 30, 2006, operating incomewas reduced by $285,000 and $518,000, respectively, for stock-based paymentcompensation expense for both stock options and restricted stock. Stock-basedcompensation in the second quarter affected cost of goods sold by $123,000,selling, general and administrative expenses by $126,000 and research anddevelopment expenses by $36,000. Stock-based compensation for the six monthsended June 30, 2006 affected cost of goods sold by $124,000, selling, generaland administrative expenses by $331,000 and research and development expensesby $63,000. Stock-based compensation expense reduced our quarterly and sixmonth net income by $171,000 and $311,000, respectively, and our basic andfully diluted earnings per share by $0.01and $0.02, respectively, for the threeand six month periods ended June 30, 2006. Prior periods have not beenadjusted. Unearned compensation on restricted shares has been reclassified toadditional paid in capital beginning January 1, 2006.

Prior to adoptingFAS 123R, we applied the intrinsic value-based method of accounting prescribedin APB Opinion No. 25 and, accordingly, did not recognize compensation expensefor stock option grants made at an exercise price equal to or in excess of thefair market value of the stock at the date of grant.

Thefollowing table details the effect on the Company’s net income and basic anddiluted net income per share had compensation expense for stock-based awardsbeen recorded in the three and six months ended June 30, 2005 based on thefair-value method under SFAS 123.

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| **(In thousands, except per share amounts)**                                                     | ** ** | **Three Months Ended  June 30, 2005** | ** ** | **Six Months Ended  June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| Net income, as reported                                                                                                   |       | $                                                         | 450        |                                                    | $          | 1,060 |   |
| Add: Stock-based employee compensation, as reported                                                                       |       | —                                                    |       | —                                                  |       |
| Deduct: Stock-based employee compensation  expense determined under fair value based  method for all awards, net of taxes |       | 62                                                        |       | 103                                                     |       |
| Pro forma net income                                                                                                      |       | $                                                         | 388        |                                                    | $          | 957 |   |
|                                                                                                                      |       |                                                      |       |                                                    |       |
| Basic and diluted net income per share, as reported                                                                       |       | $                                                         | 0.02       |                                                    | $          | 0.06 |   |
| Basic and  diluted net income per share, pro forma                                                                        |       | $                                                         | 0.02       |                                                    | $          | 0.05 |   |

 

We usethe Black-Scholes option pricing model to calculate the fair value of options.The key assumptions for this valuation method include the expected term of theoption, stock price volatility, risk-free interest rate, dividend yield,exercise price, and forfeiture rate. Many of these assumptions are judgmentaland highly sensitive in the determination of compensation expense. Under theassumptions, indicated below, the weighted average fair value of the stock optiongrants in the six months ended June 30, 2006 and 2005 were $4.70 and $2.60,respectively. The table below indicates the key assumptions used in thevaluation calculations for options granted in the six months ended June 30,2006 and 2005 and a discussion of our methodology for developing each of theassumptions used in the valuation model:

 
| ** **               | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| ** **               | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Term                     |       | 4.9  years                                    |       | 7.5  years |   |
| Volatility               |       | 105.0%                                        |       | 63.0% |   |
| Dividend yield           |       | 0.0%                                          |       | 0.0% |   |
| Risk-free  interest rate |       | 4.72%  - 5.19%                                |       | 4.07%  - 4.60% |   |
| Forfeiture rate          |       | 5.8%                                          |       | — |   |

 

Term —This is the period of time over which the options granted are expected toremain outstanding. Options granted have a maximum term of ten (10) years. Anincrease in the expected term will increase compensation expense.

Volatility— This is the measure of the amount by which a stock price has fluctuated or isexpected to fluctuate. Volatilities are based on historical volatility of ABNH’sshares, and other factors such as expected volatility arising from plannedchanges in our business operations. An increase in the expected volatility willincrease compensation expense.

Risk-freeinterest rate — This is the U.S. Treasury rate for the week of the grant havinga term equal to the expected term of the options granted. An increase in therisk-free interest rate will increase compensation expense.

Dividendyield — We did not make any dividend payments during the last five years and wehave no plans to make any dividend payments in the foreseeable future. Anincrease in the dividend yield will decrease compensation expense.

ForfeitureRate — This is the estimated percentage of options granted that are expected tobe forfeited or canceled before becoming vested. An increase in the forfeiturerate will decrease compensation expense. The forfeiture rate was first estimated as of January 1, 2006 inconjunction with our adoption of FAS 123 (R).

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Thefollowing table summarizes information about our stock incentive plans for thesix months ended June 30, 2006.
| ** **                          | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining Contractual  Life** | ** ** | **Aggregate  Intrinsic Value  (in 000’s)** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Balance,  December 31, 2005         |       | 2,971,938                   |       | $                                          | 2.41       |                                                    |       |                                                      |       |   |
| Options granted                     |       | 223,000                     |       | $                                          | 6.00       |                                                    |       |                                                      |       |   |
| Options  exercised                  |       | (57,111                     | )          | $                                          | 1.56       |                                                    |       |                                                      |       |   |
| Options  forfeited                  |       | (64,898                     | )          | $                                          | 5.35       |                                                    |       |                                                      |       |   |
| Options  outstanding, June 30, 2006 |       | 3,072,929                   |       | $                                          | 2.62       |                                                    | 5.32 years |                                                      | $          | 3,494 |   |
| Options exercisable,  June 30, 2006 |       | 2,456,420                   |       | $                                          | 2.26       |                                                    | 4.46 years |                                                      | $          | 3,184 |   |

 

As of June 30,2006 there was $1,769,000 of total unrecognized compensation cost, net ofestimated forfeitures, related to stock options. These costs are expected to berecognized over a weighted average period of 1.04 years.

The totalintrinsic value of stock options exercised during the six months ended June 30,2006 was $170,000.

Cash received fromstock option exercises in the six months ended June 30, 2006 was $89,000. Theincome tax benefit from stock based arrangements totaled $68,000 all of whichwas attributable to stock option exercises, of which $67,000 was credited toadditional paid in capital.

The followingtable summarizes information about restricted stock awards for the six monthsended June 30, 2006:
| ** **                               | ** ** | **Shares** | ** ** | **Weighted Average  Grant-Date  Fair Value** | ** ** | **Fair Value of  Shares Vested** | ** ** |
|------------------------------------------|------------|------------|------------|--------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                               | ** ** | ** ** | ** ** | ** **                                             | ** ** | ** **                                      | ** ** |
| Non-vested  balance at December 31, 2005 |       | 15,000     |       | $                                                      | 5.65       |                                            |       |   |
| Granted                                  |       | 139,000    |       | $                                                      | 6.00       |                                            |       |   |
| Vested                                   |       | (5,000     | )          | $                                                      | 6.00       |                                            | $          | 2.72 |   |
| Forfeited                                |       | (6,000     | )          | $                                                      | 6.00       |                                            |       |   |
| Non-vested balance at  June 30, 2006     |       | 143,000    |       | $                                                      | 5.97       |                                            |       |   |
|                                          |            |            |            |                                                        |            |                                                 |            |  |  |

 

Restrictedstock awards were made under the 2005 Stock Incentive Plan and generally vest100% three years from the grant date.

As ofJune 30, 2006 there was $741,000 of unrecognized compensation costs, net ofestimated forfeitures, related to restricted stock awards. These costs areexpected to be recognized over a weighted average period of 2.5 years.

As ofJune 30, 2006 an aggregate of 1,318,211 shares remained available for futuregrants and awards under our stock incentive plans, which cover stock optionsand restricted stock awards. We issue shares to satisfy stock option exercisesand restricted stock awards.

COMPREHENSIVEINCOME

Comprehensiveincome is equal to net income in all periods.

WARRANTY COSTS

The Company provides forwarranty costs in amounts it estimates will be needed to cover future warrantyobligations for products sold.  Estimatesof warranty costs are based on historical experience and are periodicallyreviewed and adjusted, when necessary. The Company’s product warranty provision is included in accrued expensesin the accompanying balance sheets. Changes in the Company’s warranty provisionare as follows:

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| ** **                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                     | ** ** | **(In thousands)**                         | ** ** | **(In thousands)**                       | ** ** |
| ** **                     | ** ** | ** **                                      | ** ** | ** **                                    | ** ** |
| Balance at beginning of period |       | $                                               | 900        |                                          | $          | 505 |   | $ | 1,140 |   | $ | 510 |   |
| Warranty provisions            |       | 60                                              |       | 60                                            |       | 120 |   | 120 |   |
| Settlement of warranty         |       | (175                                            | )          | (17                                           | )          | (475 | ) | (82 | ) |
| Balance at June  30            |       | $                                               | 785        |                                          | $          | 548 |   | $ | 785 |   | $ | 548 |   |

 

RECLASSIFICATIONS —Certain prior year amounts have been reclassified to conform with the currentyear’s presentation.

IMPACT OF RECENTLYISSUED ACCOUNTING STANDARDS — In July 2006, the Financial Accounting StandardsBoard issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes— an interpretation of SFAS no. 109” (“FIN 48”). FIN 48 clarifies theaccounting for uncertainty in income tax positions that the Company has takenor expects to take with respect to a tax refund. The pronouncement prescribes amore-likely-than-not threshold for recognition as well as measurement criteriafor changes in such tax positions for financial statement purposes. Inaddition, FIN 48 also requires additional qualitative and quantitativedisclosures on unrecognized tax benefits to be included in the notes to thefinancial statements.  The Company will berequired to adopt the provisions of FIN 48 beginning in fiscal year 2007. TheCompany is currently assessing the impact of the adoption of FIN 48 on itsConsolidated Financial Statements.

In December 2004,the Financial Accounting Standards Board issued Statement No. 123(R) (FAS123R), Share-Based Payment, revising FAS 123 and requiring that all share-basedpayments to employees be recognized in the financial statements. Generally, theapproach to accounting for share-based payments in FAS 123R is similar to theapproach described in FAS 123, however, pro forma footnote disclosure will nolonger be an alternative to financial statement recognition. This statement, asamended, becomes effective in the first annual period beginning after June 15,2005. We adopted the new statement effective January 1, 2006, using themodified-prospective transition method described in the statement. The adoptionof FAS123R primarily resulted in a change in our method of measuring andrecognizing fair value of our share-based grants, estimating forfeitures forall unvested awards, and accounting for awards to retirement eligibleemployees.

In November 2004,the Financial Accounting Standards Board issued Statement No. 151 (FAS 151),Inventory costs, an amendment of ARB No. 43, Chapter 4. FAS 151 clarifies thatabnormal amounts of idle facility expense, freight, handling costs and wastedmaterials should be recognized as current period charges. In addition, FAS 151requires that allocation of fixed production overhead to inventory be based onthe normal capacity of the production facilities. FAS 151 is effective forinventory costs incurred during fiscal years beginning after June 15, 2005. Weadopted FAS 151 effective January 1, 2006. The adoption of FAS 151 did not havea material impact on our financial statements.

InMarch 2005, the Financial Accounting Standards Board (“FASB”) issuedinterpretation No. 47, *Accounting for ConditionalAsset Retirement Obligations*, an interpretation of SFAS No. 143.This interpretation clarifies that the term of *conditionalasset retirement obligation* refers to a legal obligation to performan asset retirement activity in which the timing and/or method of settlementare conditional on a future event that may or may not be within the control ofthe entity. The obligation to perform the asset retirement activity isunconditional even though uncertainty exists about the timing and/or method ofsettlement. Accordingly, an entity is required to recognize a liability for thefair value of a conditional asset retirement obligation if the fair value ofthe liability can be reasonably estimated. The provisions of Interpretation 47are effective for fiscal years ending after December 15, 2005. We adoptedInterpretation 47 effective January 1, 2006. The adoption of this statement hadno impact on our financial statement presentation since there have been noconditional asset retirement obligations.

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 154, *Accounting Changes and Error Corrections*, a replacement ofAPB Opinion No. 20 and SFAS No. 3. This statement changes the requirements forthe accounting and reporting of a change in accounting principle. Thisstatement requires retrospective application to prior period financialstatements of changes in accounting principle, unless it is impracticable todetermine either the period-specific effects of the 

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cumulativeeffect of the change. Indirect effects of a change in accounting principleshould be recognized in the period of the accounting change. The provisions ofSFAS No. 154 are effective for fiscal years beginning after December 15,2005.We adopted this Statement beginning January 1, 2006.

NOTE B —INVENTORIES, NET

Inventoriesconsist of the following:
| ** **                                   | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                   | ** ** | **(Unaudited)**         | ** ** | **(Note A)**           | ** ** |
| ** **                                   | ** ** | **(In thousands)** | ** ** |
|                                         |       |                    |       |                        |       |
| Finished goods                               |       | $                       | 4,852      |                        | $          | 5,802 |   |
| Finished goods on consignment with customers |       | 226                     |       | 158                         |       |
| Work in process                              |       | 896                     |       | 644                         |       |
| Raw materials                                |       | 641                     |       | 616                         |       |
| Subtotal                                     |       | 6,615                   |       | 7,220                       |       |
| Less: Inventory reserves                     |       | 4,357                   |       | 4,280                       |       |
| Net inventory                                |       | $                       | 2,258      |                        | $          | 2,940 |   |

 

NOTE C — OTHER LONG-TERM LIABILITIES

Other long-termliabilities at both June 30, 2006 and December 31, 2005 include a $718,000reserve for potential tax liabilities. Also included in other long-termliabilities at June 30, 2006 and December 31, 2005 are $463,000 and $876,000,respectively, of long-term rent on our abandoned facility in Elmsford, New Yorkand $377,000 and $363,000, respectively, of deferred rent on our Robbinsville,New Jersey facility. The balance of $88,000 in other long-term liabilities atJune 30, 2006 is comprised of long-term deferred tax liabilities.

NOTE D — FACILITYCONSOLIDATION

On December 14, 2004, weentered into agreements to lease a 134,000 square foot modern manufacturing andoffice building in Robbinsville, New Jersey, which is the site of our primaryoperations following the closure, relocation and consolidation of our prioroperations in Elmsford, New York and Huntingdon Valley, Pennsylvania into theRobbinsville facility. We completed the relocation and consolidation of ouroperations during 2005.We have re-opened the Huntingdon Valley facility forcertain manufacturing operations and secure storage that was previously performedat a contract facility in Dalton, Massachusetts which will no longer be leasedafter the expiration of the lease on the facility in October 2006.

The base rent onthe lease for the Robbinsville, New Jersey facility is $555,000 per year,increasing by 1.9% per year, and the first seven months of the lease wererent-free. We recorded deferred rent of $0.4 million in 2005. The term of thelease for the Robbinsville facility extends through May 31, 2017, and at theexpiration of the term, we have options to renew the lease for threeconsecutive five year periods at the then fair market value and also have anoption to purchase the building after the end of the original lease term forthe adjusted fair market value as defined in the lease agreement. The base renton the lease in Huntingdon Valley, Pennsylvania is $144,000 per year. The leaseon this facility expires on June 30, 2007. The base rent on the lease in Elmsford, New York is $746,000 per year.The lease on this facility expires on December 31, 2007. As this facility wasabandoned as part of our move and consolidation in 2005 the remaining rent, netof estimated sublease income, through the end of the lease term was charged toFacility Consolidation Expense in 2005.

The following table illustrates the liability balanceand activity related to the relocation and consolidation in the three and sixmonths ended June 30, 2006 and 2005.

 

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| ** **                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **(In thousands)**                         | ** ** | **(In thousands)**                       | ** ** |
| Balance at beginning of  period |       | $                                               | 1,491      |                                          | $          | 101 |   | $ | 1,683 |   | $ | 15 |   |
| Cash payments:                  |       |                                            |       |                                          |       |   |   |   |   |
| Rent on  abandoned facility     |       | (222                                            | )          | —                                        |       | (451 | ) | — |   |
| Severance  payments             |       | (11                                             | )          | (39                                           | )          | (17 | ) | (40 | ) |
| Additions to liability:         |       |                                            |       |                                          |       |   |   |   |   |
| Accretion on  rent              |       | 35                                              |       | —                                        |       | 70 |   | — |   |
| Accrued  severance              |       | —                                          |       | 38                                            |       | 8 |   | 125 |   |
| Balance at June 30              |       | $                                               | 1,293      |                                          | $          | 100 |   | $ | 1,293 |   | $ | 100 |   |
|                            |       |                                            |       |                                          |       |   |   |   |   |
| Expensed as incurred:           |       |                                            |       |                                          |       |   |   |   |   |
| Employee relocation             |       | $                                               | 39         |                                          | $          | 30 |   | $ | 44 |   | $ | 48 |   |
| Facility moving  costs          |       | —                                          |       | 147                                           |       | — |   | 148 |   |
| Other costs                     |       | 35                                              |       | —                                        |       | 70 |   | 1 |   |
| Total                           |       | $                                               | 74         |                                          | $          | 177 |   | $ | 114 |   | $ | 197 |   |

 

NOTE E- COMMITMENTS AND CONTINGENCIES

TheCompany from time to time is involved in litigation (as both plaintiff anddefendant) incidental to the conduct of its business; however, the Company isnot a party to any lawsuit or proceeding which, in the opinion of management ofthe Company, could have a material impact on the Company’s financial position,results of operations or cash flows.

SeeNote A - Business Information for a description of issues relating to the VISADecision.

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

Thefollowing discussion and analysis should be read in conjunction with theCompany’s unaudited financial statements, including the notes thereto,appearing elsewhere in this report.

OVERVIEW

AmericanBank Note Holographics, Inc. (the “Company”) originates, produces, markets andsells secure holograms and products incorporating secure holograms. The Company’sproducts are used primarily in security applications including authenticationof transaction cards, identity documents, value documents and various consumerproducts.  The Company operates in onereportable industry segment. Our ability to create distinctive, secureoptically variable devices, to reproduce them with high quality and todistribute them securely has enabled us to become a market leader in security holography.Our products are sold to over 200 companies worldwide, including MasterCard,VISA, American Express, Discover, Diners Club, Sears, Nordstrom, Quaker State,Nike, Janssen-Cilag and Gennoma, as well as agencies of the United Statesgovernment and certain foreign governments. We also produce non-secureholograms for design and promotional applications.

A significant portion ofthe Company’s business is derived from orders placed by certain transactioncard companies, including MasterCard and manufacturers of VISA brandtransaction cards, and variations in the timing of such orders can causesignificant fluctuations in the Company’s sales.  Several thousand banks worldwide issue VISAand MasterCard branded cards that incorporate the Company’s holograms.

Sales to MasterCard wereapproximately 34% and 37% of sales for the three months ended June 30, 2006 and2005, respectively and were approximately 34% and 35% of sales for the sixmonths ended June 30, 2006 and 2005, respectively. The Company has an agreementwith MasterCard, as amended, pursuant to which the Company is the exclusivesupplier of MasterCard holograms and holographic magnetic stripes,HoloMag.  In the quarter ended September30, 2005, MasterCard advised its member financial institutions around the worldthat it will allow them 

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to choose among carddesigns that incorporate either the traditional hot stamp hologram or HoloMag,both of which are supplied by the Company. The agreement with MasterCard was amended on August 24, 2005, and expireson February 28, 2013, subject to automatic renewal thereafter. If we were tolose a substantial portion of our business with MasterCard without replacing itwith new product sales, our business, operating results and financial conditionwould be materially and adversely affected. In addition, if we fail to obtainanticipated orders from MasterCard or if we experience delays or cancellationsof orders from MasterCard, our business, operating results and financialperformance will be materially and adversely affected.

Sales of VISA holograms(which includes HoloMag starting in the three month period ended September 30,2005) to manufacturers of VISA transaction cards were approximately 31% and 24%of sales for the three months ended June 30, 2006 and 2005, respectively andwere approximately 36% and 24% of sales for the six months ended June 30, 2006and 2005, respectively. Currently we are one of two companies authorized tomanufacture and sell the VISA Dove hot stamp holograms to manufacturers of VISAbrand transaction cards.****On March 15,2005, VISA announced its intention to phase out the Dove hot stamp hologramthat we supply for the front of the VISA card, and to replace it with anintegrated holographic magnetic stripe. On April 8, 2005, we entered into anAgreement with VISA, pursuant to which we were authorized to supply HoloMag toVISA-approved card manufacturers. On March 14, 2006, we were informed by VISAthat, as a result of a small number of incidents in which certain cardterminals had been affected by electro-static discharge (“ESD”) from staticelectricity carried on cards incorporating HoloMag, VISA is informing itsmember financial institutions and authorized card manufacturers that(i) VISA will no longer approve VISA card designs which incorporate thecurrent version of HoloMag, (ii) VISA strongly recommends that theirmembers attempt to avoid further issuance of cards incorporating the currentversion of HoloMag and (iii) VISA recommends that their members follow analternate card design incorporating a conventional magnetic stripe and Dove hotstamp hologram and VISA provided notice to us that it was revoking our right toproduce HoloMag under its agreement (the “VISA Decision”).  In its correspondence to us relating toHoloMag, VISA also stated its view that “a remediation program for impactedstakeholders may be necessary” and that VISA would seek indemnification from usfor such costs and/or claims. VISA has recommended to its members that cardsbearing the HoloMag product already in the market be replaced as soon aspractical. There can be no assurance that our customers will continue topurchase the Dove hot stamp hologram from us in the future. We are continuingto evaluate VISA’s actions and claims.We believe that we are in compliance withour agreement with VISA and that the HoloMag product complies with allstandards and specifications contained in our agreement.

We have invented atechnology and methods of significantly reducing ESD and we have filed patentapplications on these inventions. We have incorporated our invention into ourHoloMag product and our testing shows that our second generation HoloMagproduct generally exhibits no more ESD than a standard black magnetic stripe.We are currently offering to customers a second generation version of HoloMagand expect to begin shipping the product in limited quantities later this year.

Ourproducts are sold on a fixed price basis under purchase orders and contractswith customers. Sales and the related cost of goods sold are generallyrecognized at the latter of the time of shipment or when title passes tocustomers. In some situations, the Company has shipped product where the saleis contingent upon the customers’ use of the product. In these situations, theCompany does not recognize sales upon product shipment, but rather when thebuyer of the product informs the Company that the product has been used.Additionally, pursuant to the request of and agreement with a certain customer,completed items are stored on behalf of this customer at the Company’s on-sitesecured facility, and in that instance, sales are recognized when all of thefollowing have occurred: the customer has ordered the goods pursuant to a fixedprice purchase order, the manufacturing process is complete, the goods havebeen transferred to the on-site secured facility and are ready for shipment,the risk of ownership has passed to the customer, the customer has been billedfor the order and collection of the invoice is considered reasonablyassured.  In certain cases the Companyhas agreed to maintain an inventory of products for a customer to ensure quickturn around of deliveries.  The Companyonly accepts returns of product sold to customers when the product isdetermined to not be in conformance with the specifications previously agreedupon with such customers in accordance with the terms of its warranty policyand generally replaces the product. The Company generally provides replacementproduct for up to 180 days from original shipment as a warranty for defectiveproduct. Shipping and handling amounts billed to customers are included insales and amounted to $207,000 and $152,000 for the three months ended June 30,2006 and 2005, respectively.  Shippingand handling amounts billed to customers in the six months ended June 30, 2006and 2005 amounted to $557,000 and $263,000 respectively. Shipping and handlingcosts are included in selling and administrative expenses.

We purchase certain keymaterials used in the manufacture of our products, and subcontract certainproduction functions or products from third parties some of which are solesuppliers.   In some cases, we do nothave supply 

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contracts with oursuppliers, and operate on a purchase order basis. In the case of HoloMag, wehave a single supplier, CFC International, Inc., with whom we have a supplycontract which was amended on July 26, 2006. Also at that time we negotiated asettlement with CFC International, Inc. that resulted in a reduction of ourpayable to them of approximately $1.0 million. We may not be able to findalternative sources in a timely manner if our suppliers or subcontractorsbecome unwilling or unable to supply us, or if they increase their prices. Ourinability to obtain key product components or to have certain processesperformed on our behalf could cause delays or reduce product shipments, whichcould cause our relationship with customers to suffer and materially andadversely affect our financial condition, results of operations and cash flows.

Sales may fluctuate fromquarter to quarter due to changes in customers’ ordering patterns. Customers donot typically provide us with precise forecasts of future order quantities.Quarterly demand for our products may be materially influenced by customers’promotions, inventory replenishment, card expiration patterns, deliveryschedules and other factors, such as the VISA Decision, which may be difficultfor us to anticipate.

Costof goods sold includes raw materials such as nickel, foils, films andadhesives; labor costs; manufacturing overhead; and hologram origination costs(which represent costs of a unique master hologram that is made to customerspecifications and is an integral part of the production process). Cost ofgoods sold also includes the cost of certain processes that the Companyoutsources to third parties. As a result, costs of goods sold are affected byproduct mix, manufacturing yields, supplier prices and changes in the cost ofraw materials and labor.

Sellingand administrative expenses primarily consist of salaries, benefits andcommissions for the Company’s corporate, sales, customer service, marketing andadministrative personnel, marketing and promotion expenses, legal andaccounting expenses and expenses associated with being a public company. TheCompany also includes the cost of shipping and handling product deliveries thatare billed to customers in selling and administrative expenses. The cost ofshipping and handling is included in selling and administrative expenses andamounted to $200,000 and $183,000 for the three months ended June 30, 2006 and2005, respectively, and $614,000 and $313,000 for the six months ended June 30,2006 and 2005, respectively.

Stock-based compensation expense

Beginning in the first quarter of 2006, we wererequired to record the expense of share-based payment transactions pursuant toStatement of Financial Accounting Standards No. 123 (R) (“FAS 123R”). Under themodified prospective method, we were not required to restate the prior yearfinancial statements or include in the current year any expenses related tostock option grants vested as of December 31, 2005.

We use the Black-Scholes option pricing model tocalculate the fair value of options. The key assumptions for this valuationmethod include the expected term of the option, stock price volatility,risk-free interest rate, dividend yield, exercise price, and forfeiture rate.Many of these assumptions are judgmental and highly sensitive in thedetermination of compensation expense. In the first quarter of 2006 we modifiedour assumption of the expected term from that used under FAS 123 to reflect anestimated reduction in the amount of time that options granted will remainoutstanding as a result of our historical trends. We increased our expectedvolatility based on recent events which resulted in significantly highervolatility than in previous periods. Under FAS 123 (R) we are required toestimate forfeitures rather than recording forfeitures when they occur aspreviously permitted. Our estimated forfeiture rate was determined by reviewinghistorical trends. We will continue to review our Black-Scholes assumptions andmodify them as needed in the future. Changes in these assumptions may lead tovariations in the compensation expense that we record in future periods.

In the three and six months ended June 30, 2006,operating income was reduced by $285,000 and $518,000, respectively, forstock-based payment compensation expense. Stock-based compensation in thesecond quarter affected cost of goods sold by $123,000, selling, general andadministrative expenses by $126,000 and research and development expenses by$36,000. Stock-based compensation for the six months ended June 30, 2006affected cost of goods sold by $124,000, selling, general and administrativeexpenses by $331,000 and research and development expenses by $63,000.Stock-based compensation expense reduced our quarterly and six month net incomeby $171,000 and $310,000, respectively, and our basic and fully dilutedearnings per share by $0.01 and $0.02 for the three and six month periods endedJune 30, 2006. Prior periods have not been adjusted. Unearned compensation onrestricted shares has been reclassified to additional paid in capital beginningJanuary 1, 2006.

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Impact of the VISA Decision

In the quarter ended December 31, 2005, as a result ofthe VISA Decision, we recorded a pre-tax charge amounting to approximately $5.0 millionof which $4.8 million was recorded in cost of goods sold and was principallyrelated to the carrying value of our HoloMag inventory. Also included in thecharge were increases in our provisions for accounts receivable and potentialnon-ESD related warranty claims. During the three months ended June 30, 2006 weevaluated these provisions and determined that the amounts previously recordedfor potential non-ESD related warranty claims and the allowance for doubtfulaccounts were still appropriate. We will continue to review the valuation ofthese accounts on an ongoing basis as a part of our closing process and makeappropriate changes to our reserve levels based upon the facts at the time.Certain shipments of HoloMag that were completed and invoiced during thequarter ended March 31, 2006 were not recognized as revenue as the collectionof these amounts was not considered probable as a result of the VISA Decision.Subsequent to completing and filing our financial statements for the threemonths ended March 31, 2006 approximately $0.9 million was collected andaccordingly the revenue was recorded in the quarter ended June 30, 2006.Approximately $1.4 million remains uncollected at June 30, 2006. Revenue willbe recognized in the future in the event that additional amounts are collected.Additionally, as a result of the VISA Decision, in the quarter ended June 30,2006 we wrote-off approximately $0.8 million of overhead costs that werenot absorbed into inventory and approximately $0.3 million of costs thatwere on the balance sheet relating to a terminated manufacturing project.

COMPARISON OF THREEMONTHS ENDED JUNE 30, 2006 TO THREE MONTHS ENDED

JUNE30, 2005

*Sales.*  Sales increased by $1.5 million, or 22.1%,from $6.9 million for the three months ended June 30, 2005 to $8.4 million forthe three months ended June 30, 2006. The increase was primarily due to higher sales of our HoloMagTMintegrated holographic magnetic security stripe product to customers in thetransaction card market, including $0.9 million of revenue recognized on VISAHoloMag shipments made in the quarter ended March 31, 2006 that was notrecognized as revenue at that time due to the VISA Decision as described above.We also experienced growth of other products for the transaction card market aswell as in the product authentication market which was partially offset by adecline in sales to the identity document market as a result of the timing ofchanges in customer programs. As a result of the VISA Decision we currentlyexpect that sales in the quarter ending September 30, 2006 will besubstantially less than sales in the comparable prior year period.

*Cost ofGoods Sold, excluding depreciation and amortization.*  Cost of goods sold increased by $0.6 million,from $3.2 million for the three months ended June 30, 2005 to $3.8 million forthe three months ended June 30, 2006 primarily as a result of the volumeincrease (excluding sales of VISA HoloMag that were recognized in the quarteras the cost of that revenue was recorded upon shipment in the quarter endedMarch 31, 2006), the write-off of approximately $0.8 million of additionaloverhead costs that were not absorbed into inventory and the write-off ofapproximately $0.3 million of costs that were recorded on the balancesheet which related to a terminated manufacturing project partially offset bythe reduction of approximately $1.0 million of costs relating to anegotiated settlement with a vendor and lower fixed costs resulting from theconsolidation of facilities in Robbinsville. Also included in the three monthsended June 30, 2006 was approximately $0.1 million of stock-basedcompensation expense. As a percentage of sales, cost of goods sold decreasedfrom 46.1% for the three months ended June 30, 2005 to 44.9% for the threemonths ended June 30, 2006.

*Sellingand Administrative.* Selling and administrative expenses increased $0.2 million from $2.2million for the three months ended June 30, 2005 to $2.4 million for the threemonths ended June 30, 2006. As a percentage of sales, selling andadministrative expenses decreased from 32.3% for the three months ended June30, 2005 to 28.3% for the same period in 2006. The increase in expenses was primarily due to higher shipping chargeswhich increased due to higher product shipments, higher salaries and wages andhigher costs associated with being a public company. Also included in the threemonths ended June 30, 2006 was approximately $0.1 million of stock-basedcompensation expense. The decrease in percentage of sales was primarily due tothe volume increase in sales, partially offset by higher general andadministrative costs.

*Researchand Development. *Researchand development expenses increased $0.2 million from $0.3 million forthe three months ended June 30, 2005 to $0.5 million for the same periodin 2006 primarily as a result of higher research and development costsassociated with the invention to reduce ESD and development of the secondgeneration HoloMag 

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productas well as higher salaries and wages due to manpower additions. Also includedin the three months ended June 30, 2006 was approximately $36,000 ofstock-based compensation expense.

*Depreciationand Amortization.* Depreciation and amortization decreased $0.1 million from $0.3 millionfor the three months ended June 30, 2005 to $0.2 million for the sameperiod in 2006. The decrease was primarily due to the acceleration ofdepreciation of certain assets used at the Elmsford, New York facility prior toits closure in connection with the consolidation of the Company’s operationsinto its new facility in Robbinsville, New Jersey as well as the elimination ofdepreciation expense on certain high value assets which became fullydepreciated during 2005.

*FacilityConsolidation Expenses.*Facility consolidation expenses, inthe three months ended June 30, 2006 and June 30, 2005 amounted to $0.1 millionand $0.2 million, respectively. Expenses in the three months ended June 30,2006 related to employee relocations and additional expenses incurred on theabandoned facility rent while the costs incurred in the prior year period wereprimarily for employee severance, employee relocation and moving of equipmentto the Company’s new facility in Robbinsville, New Jersey.

*InterestIncome*.  Interestincome increased $49,000 from $68,000 for the three months ended June 30, 2005to $117,000 for the three months ended June 30, 2006 due to higher averagebalances of cash and cash equivalents and higher interest rates in effectduring the current period.

COMPARISON OF SIX MONTHSENDED JUNE 30, 2006 TO SIX MONTHS ENDED

JUNE 30, 2005

*Sales*.  Sales increased by $5.1 million, or 38.5%,from $13.3 million for the six months ended June 30, 2005 to $18.4 million forthe six months ended June 30, 2006.  Theincrease was primarily due to higher sales of our HoloMagTM integratedholographic magnetic security stripe product to customers in the transactioncard market, including $3.1 million of VISA HoloMag sales recognized in thequarter ended March 31, 2006 prior to the VISA Decision and $0.9 million ofrevenue recognized in the quarter ended June 30, 2006 relating to amountscollected in that quarter on VISA HoloMag shipments made in the quarter endedMarch 31, 2006 that was not recognized as revenue at that time due to the VISADecision as described above. We also experienced growth of other products forthe transaction card market as well as in the product authentication marketwhich was partially offset by a decline in sales to the identity documentmarket generally as a result of the timing of changes in customer programs.

*Cost ofGoods Sold, excluding depreciation and amortization*. Cost ofgoods sold increased by $2.6 million, from $6.0 million for the six monthsended June 30, 2005 to $8.6 million for the six months ended June 30, 2006primarily as a result of the volume increase, additional inventory charges as aresult of the VISA Decision, additional overhead costs that were not absorbedinto inventory partially offset by lower fixed costs resulting from theconsolidation of facilities in Robbinsville and the reduction of costs relatingto a negotiated settlement with a vendor. Also included in the six-months endedJune 30, 2006 was approximately $0.1 million of stock-based compensationexpense. As a percentage of sales, cost of goods sold increased from 45.0% forthe six months ended June 30, 2005 to 46.8% for the six months ended June 30,2006.

*Sellingand Administrative*. Selling and administrative expenses increased $1.0 million from $4.1million for the six months ended June 30, 2005 to $5.1 million for the six monthsended June 30, 2006. As a percentage of sales, selling and administrativeexpenses decreased from 31.2% for the six months ended June 30, 2005 to 28.0%for the six months ended June 30, 2006. The increase in expenses was primarilydue to higher legal costs, higher shipping costs due to higher volume andhigher salaries and wages partially offset by lower commissions due to thetiming of certain customer programs and lower travel expenses. Also included inthe six-months ended June 30, 2006 was approximately $0.3 million ofstock-based compensation expense.

*Researchand Development*.* *Research and development expensesincreased $0.3 million from $0.6 million for the six months ended June 30, 2005to $0.9 million for the same period in 2006 primarily as a result of higherresearch and development costs associated with the invention to reduce ESD anddevelopment of the second generation HoloMag product as well as higher salariesand wages due to manpower additions. Also included in the six-months ended June30, 2006 was approximately $0.1 million of stock-based compensationexpense.

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*Depreciationand Amortiza*tion. Depreciation and amortization decreased $0.2 million from $0.6 millionfor the six months ended June 30, 2005 to $0.4 million for the same period in2006. The decrease was primarily due to the write-off of certain assets used atthe Elmsford, New York facility prior to its closure in connection with theconsolidation of the Company’s operations into its new facility inRobbinsville, New Jersey as well as the elimination of depreciation expense oncertain high value assets which became fully depreciated during 2005.

*FacilityConsolidation Expenses.*Facility consolidation expensesdecreased $0.2 million from $0.3 million for the six months ended June 30, 2005to $0.1 million for the same period in 2006. Expenses in 2006 related primarilyto employee relocations and additional expenses incurred on the abandonedfacility rent while the expenses in 2005 were principally for moving ofmachinery and equipment, employee relocation and severance as a result of theconsolidation of facilities into Robbinsville, New Jersey.

*InterestIncome*.  Interestincome increased $0.1 million from $0.1 million for the six monthsended June 30, 2005 to $0.2 million for the six months ended June 30, 2006due to higher average balances of cash and cash equivalents and higher interestrates in effect during 2006.

LIQUIDITY ANDCAPITAL RESOURCES

AtJune 30, 2006, the Company had $13.4 million in cash and cash equivalents andworking capital of $17.4 million.

The Company’s operatingactivities provided cash of $4.0 million for the six months ended June 30,2006, compared to $0.4 million for the six months ended June 30, 2005. Theincrease in cash in 2006 was primarily due to net income of $2.0 millionadjusted for non-cash costs of $1.1 million as well as decreases in accountsreceivable, inventories, and pre-paid expenses, a tax receivable as a result ofoverpaying estimated income taxes in 2005 and decreased accounts payable. Forthe six months ended June 30, 2005 cash increased primarily as a result of netincome adjusted for non-cash costs of $1.8 million and higher accounts payablepartially offset by higher inventories and accounts receivable. Investingactivities for the six months ended June 30, 2006 provided cash of $0.1 millionprimarily as a result of the return of progress payments made to themanufacturer of a special machine that was not accepted by the Companypartially offset by capital expenditures in the six-month period. Investingactivities in the six months ended June 30, 2005 amounted to a use of $0.3million of cash as a result of capital expenditures of $2.3 million partiallyoffset by the sale of short-term investments of $2.0 million. Financingactivities for the six months ended June 30, 2006 and 2005 provided cash of$0.1 million due to the exercise of stock options.

On December 14, 2004, weentered into agreements to lease a 134,000 square foot modern manufacturing andoffice building in Robbinsville, New Jersey, which is the site of our primaryoperations following the closure, relocation and consolidation of our prioroperations in Elmsford, New York and Huntingdon Valley, Pennsylvania into theRobbinsville facility. We completed the relocation and consolidation of ouroperations during 2005. We have re-opened the Huntingdon Valley facility forcertain manufacturing operations and secure storage that was previouslyperformed at a contract facility in Dalton, Massachusetts which will no longerbe leased after the expiration of the lease on the Dalton facility in October2006.

The base rent on thelease for the Robbinsville, New Jersey facility is $555,000 per year,increasing by 1.9% per year, and the first seven months of the lease wererent-free. We recorded deferred rent of $0.4 million in 2005. The term of thelease for the Robbinsville facility extends through May 31, 2017, and at theexpiration of the term, we have options to renew the lease for threeconsecutive five year periods at the then fair market value and also have anoption to purchase the building after the end of the original lease term forthe adjusted fair market value as defined in the lease agreement. The base renton the lease in Huntingdon Valley, Pennsylvania is $144,000 per year. The leaseon this facility expires on June 30, 2007. The base rent on the lease in Elmsford, New York is $746,000 per year.The lease on this facility expires on December 31, 2007. As this facility wasabandoned as part of our move and consolidation in 2005 the remaining rent, netof estimated sublease income, through the end of the lease term was charged toFacility Consolidation Expense in 2005.

We completed the move andconsolidation of our operations into the Robbinsville, New Jersey facility in2005. We recorded costs totaling $3.0 million in 2004 and 2005 relating to theconsolidation and expect to record additional costs amounting to $0.3 millionin 2006 ($0.1 million was recorded in the six months ended June 30, 2006) and 2007,respectively. Of the costs recorded to-date we expect to pay approximately $2.1in cash ratably from the first quarter of 2006 through the fourth quarter of2007. Expenses incurred for the consolidation were primarily 

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associated with theElmsford lease, vacating the facility, relocating and terminating certainemployees, moving equipment and other related expenses.

The Company believes thatcash flows from operations and its cash balances will be sufficient to meetworking capital needs and fund capital expenditures for the foreseeable futureafter considering the potential impact of the VISA Decision.

SPECIALNOTE REGARDING FORWARD - LOOKING STATEMENTS

Certainstatements in this Form 10-Q, including without limitation, statementscontaining the words “believes,” “intends,” “expects,” “anticipates,” and wordsof similar import, constitute “forward-looking statements” within the meaningof the private securities litigation reform act of 1995.  Such forward-looking statements are based oncurrent management expectations. Numerous factors, including those disclosedherein, those related to transaction card industry trends and those detailed inour filings with the Securities and Exchange Commission (as set forth underItem 1A. “Risk Factors” in our Annual Report on Form 10-K for the year endedDecember 31, 2005), may cause results to differ materially from thoseanticipated in the forward-looking statements. Many of the factors that will determine our future results are beyondour capability to control or predict. These statements are subject to risks anduncertainties and therefore actual results may differ materially. Readersshould not place undue reliance on such forward-looking statements whichreflect management’s view only as of the date hereof. We undertake noobligation to revise or update any forward-looking statements, or to make anyother forward-looking statements, whether as a result of new information,future events or otherwise.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

TheCompany does not engage in significant activity with respect to market risksensitive instruments. Accordingly, our risk with respect to market risksensitive instruments is immaterial.

ITEM 4. CONTROLS AND PROCEDURES

**The Company carried out an evaluation, under thesupervision and with the participation of management, including the Company’sChief Executive Officer and Chief Financial Officer, of the effectiveness ofthe design and operation of the Company’s disclosure controls and procedures asof the end of the period covered by this report pursuant to Exchange Act Rule13a-15.  Based upon that evaluation, theChief Executive Officer and Chief Financial Officer concluded that the Company’sdisclosure controls and procedures were effective in timely alerting them tomaterial information relating to the Company required to be included in theCompany’s periodic Securities and Exchange Commission filings.  There were no changes in the Company’sinternal control over financial reporting that occurred during the Company’smost recent fiscal quarter that would have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.**

PART II — OTHERINFORMATION

ITEM 1A. RISK FACTORS

In addition to the other information set forth in thisreport, you should carefully consider the factors discussed in Part I,Item 1A. “Risk Factors” in the Company’s Annual Report on Form 10-K for theyear ended December 31, 2005, which could materially affect our business, financialposition and results of operations. There are no material changes from the riskfactors set forth in Part I, Item 1A, “Risk Factors,” of the Company’s AnnualReport on Form 10-K for the year ended December 31, 2005.

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ITEM6.  EXHIBITS

| 10.1   | Amendment No. 2,  dated July 26, 2006, to the Development, Supply and Subcontracting Agreement  dated as of May 30, 2001 by and between American Bank Note Holographics, Inc.  and CFC International, Inc.* |
|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                        |
| 31.1   | Certification of  Kenneth H. Traub pursuant to Exchange Act Rules 13a-14 and 15d-14, as adopted  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|   |                                                                                                                                                                                                        |
| 31.2   | Certification of Mark J. Bonney pursuant to Exchange  Act Rules 13a-14 and 15d-14, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                   |
|   |                                                                                                                                                                                                        |
| 32.1   | Certification of Kenneth H. Traub 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 Mark J. Bonney pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                 |
|   |                                                                                                                                                                                                        |

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* Portions havebeen omitted pursuant to a request for confidential treatment.

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Company has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|   | AMERICAN BANK NOTE |
|--------|--------------------|
|   | HOLOGRAPHICS, INC. |
|   |               |   |
|   | By:                | /s/ Kenneth H. Traub |
|   |               | Kenneth H. Traub |
|   |               | President and Chief Executive Officer |
|   |               |   |
|   | By:                | /s/ Mark J. Bonney |
|   |               | Mark J. Bonney |
|   |               | Executive Vice President, |
|   |               | Chief Financial Officer and |
|   |               | Chief Accounting Officer |

 

Date: August 11,2006

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