**SECURITIES AND EXCHANGE COMMISSION**

**Washington D.C. 20549**

 

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**FORM 10-K**

 
| ý | **ANNUAL REPORT PURSUANT TO SECTION  13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|--------|-------------------------------------------------------------------------------------------|

 

**For the fiscal year ended December 31, 2003**

 

**OR**

 
| o | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|-----------------------------------------------------------------------------------------------|

 

**For the transition periodfrom                 to                 **

 

**Commission File No.: 000-29029**

 

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**FARGO ELECTRONICS, INC.**

(Exactname of registrant as specified in its charter)

 
| **Delaware**                                                     |   | **41-1959505**                         |
|------------------------------------------------------------------|--------|----------------------------------------|
| (State  or other jurisdiction  of incorporation or organization) |   | (I.R.S.  Employer  Identification No.) |
|                                                             |   |                                   |
| **6533 Flying Cloud Drive  Eden Prairie, Minnesota**             |   | **55344**                              |
| (Address  of principal executive offices)                        |   | (Zip  Code)                            |

 

Registrant’stelephone number, including area code: **(952) 941-9470**

 

Securitiesregistered pursuant to Section 12(b) of the Act: **None**

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**Common Stock, $.01 par value**

 

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Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes ý  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of thisForm 10-K or any amendment to this Form 10-K. o

 

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

 

As of March 12, 2004, 12,480,305 shares of the Registrant’s commonstock were outstanding. The aggregate market value of the Registrant’soutstanding common stock as of June 30, 2003, the last business day ofRegistrant’s most recently completed second fiscal quarter (based upon the lastsale price of a share of common stock on that date as reported by the NasdaqNational Market), excluding outstanding shares beneficially owned by directorsand executive officers, was $115,726,788.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Part III of this Annual Report on Form 10-K incorporates byreference information (to the extent specific sections are referred to herein)from the registrant’s Proxy Statement for its 2004 Annual Meeting to be held onMay 4, 2004.

 

 

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**PART I**

 

**Item 1.**                    **BUSINESS**

 

***(a)***           ***General Development of the Business***

 

We are a leading developer, manufacturer andsupplier of card identity systems that personalize plastic identification cards with digital images, text,lamination, and electronically encoded information.  The media used with our systems includes dye sublimation ribbons,overlaminates, thermal resin ribbons, printheads, inkjet cartridges, inkjetcard cartridges and blank cards. The sale of this media provides us with asignificant recurring revenue stream.

 

Our systems are focused on printers andmedia, but have expanded to include software, cameras, tripods and otherrelated components that we offer to our distribution channel as bundledsystems.  We have establishedrelationships with software manufacturers to enhance our offerings and addressnew end user demands for more functionally integrated systems.

 

We market and sell our products exclusivelythrough a distribution channel of system integrators, independent distributorsand resellers in more than 80 countries worldwide. We estimate that as ofDecember 31, 2003, we have manufactured and sold more than 80,000 systems.

 

End-users of our card identity systems createpersonalized cards for a wide variety of applications including:

 

•              Corporate securityand access;

 

•              Drivers’ licenses,government and military identification;

 

•              Studentidentification and access;

 

•              Publictransportation access;

 

•              Loyalty programs;

 

•              Recreation andgaming;

 

•              Healthcare patientidentification; and

 

•              Event badging.

 

Since our inception in 1974, we have used ourengineering expertise and knowledge of printing and data encoding to build areputation for technological leadership in our industry. Historically, we haveleveraged our engineering capabilities to develop systems for multiple markets,including bar code printers, color office printers and card personalizationsystems. In February 1998, we restructured our business and completed arecapitalization of Fargo. As part of the restructuring, we focused ourbusiness exclusively on the card personalization market.

 

On July 31, 2001, we entered into anacquisition agreement pursuant to which we agreed to be acquired by ZebraTechnologies Corporation.  On March 27,2002, Fargo and Zebra agreed to terminate the acquisition agreement due to the mutualconclusion that the FTC would not approve the acquisition. For more informationon the tender offer, see Note 3 to our financial statements beginning on pageF-10.

 

In July, 2002, we completed a secondarypublic offering of 525,000 newly issued shares of common stock, resulting innet proceeds of $3,137,000, which were used to pay down outstanding debt.  At that time, St.Paul Venture CapitalPartners, one of our two original venture capital partners, sold its entireholdings and TA Associates, our other original venture capital partner sold500,000 shares. For more information about the offering, see Note 2 to ourfinancial statements beginning on page F-10. In November 2002, TA Associates disposed of the remainder of itsholdings.

 

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Fargo was originally incorporated in NorthDakota in 1979 and reincorporated as a Minnesota corporation in 1985. Wereincorporated as a Delaware corporation shortly before our initial publicoffering of common stock in February, 2000. Our principal executive offices arelocated at 6533 Flying Cloud Drive, Eden Prairie, Minnesota 55344, and ourtelephone number is (952) 941-9470. Our Web site address is www.fargo.com.Copies of our annual report on Form 10-K, quarterly reports on Form 10-Q,current reports on Form 8-K, and amendments to these reports, are availablefree of charge on our web site as soon as reasonably practicable after suchmaterial is filed with, or furnished to, the Securities and ExchangeCommission.  Such forms are alsoavailable at the Securities and Exchange Commission’s web site at www.sec.gov.

 

***(b)***           ***Financial Information About Segments***

 

Our business is organized, managed andinternally reported as a single segment. Geographical sales information is containedin Note 10 to our financial statements on page F-17 of this report, and isincorporated in this item by reference.

 

***(c)***           ***Narrative Description of theBusiness***

 

**OurIndustry**

 

*Background*

 

The first widely used method of producingidentification cards was to overlay instant photographs and typeset text orlogos on a paper card, then apply a plastic laminate over the card. This methodis commonly known as “cut and paste.” The development of digital imaging anddirect-to-card thermal dye sublimation processes in the late 1980s led to theavailability of systems that could create cards that are more durable than cutand paste cards.  These digital cardshave superior graphic and design capabilities that are more difficult to alteror forge.  A significant trend in the1990s was the replacement of cut and paste systems with digital direct to cardsystems.

 

In the late 1990s, systems incorporatingreverse image printing, such as our High Definition Printing (HDP) process,enabled high quality images to be printed on cards with even or uneven surfacesand of varying size and thickness, such as smart cards and proximity cards.Many high-end governmental applications are using these sophisticatedelectronic cards that are well suited for High Definition Printing.

 

In 2003, we introduced the industry’s firstdesktop ink jet printers designed specifically for printing on plastic cards,the CardJet 410 and Persona CardJet C7. Ink jet is a simple, familiar technology for many entry-levelusers.  We have seen demand by end usersfor simpler, easy to use systems, where many of the components are integratedtogether.  In response, we have bundledour printers with simple badging software, cameras and supplies.

 

*Ongoing Industry Trends*

 

We believe certain social, technological andcommercial factors are increasing the demand for personalized identificationand access cards. Concern for personal safety and property protection hasheightened in the wake of the terrorist attacks of September 11, 2001, ongoingterrorist activities worldwide, as well as other well-publicized securitybreaches and violence at government facilities, businesses, hospitals andschools. Actions in response to these concerns by governments, such as thecreation of the Homeland Security department in the United States, continue togrow.  Personalized identification cardsare increasingly being used as a means of both visual and electronicidentification and access control. In addition, new applications for personalizedcards are being driven by technologies such as magnetic stripes, proximitysensors, biometric technologies, optical data storage cards and small computerchips called “smart chips” that store and process information on cards.

 

We believe that these phenomena—the need forsecurity, governmental activity for identification of citizens and visitors andthe development of new technologies—will foster a growing market for digitalcard printing systems. More specifically, we expect the market for cardprinting systems to continue to grow worldwide due to the following trends:

 

•              New and broadermarkets for personalized IDs and access cards as concern for personal safetyand property protection spreads to regions and markets that have traditionallybeen considered lower risk;

 

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•              Increasingintegration of biometric technologies such as fingerprint reading withpersonalized card systems for added security;

 

•              The increasing useof smart cards in high end applications;

 

•              Governmentinitiatives to establish national ID programs; and

 

•              Continuing migrationamong users from analog, film-based systems to digital systems.

 

We have seen the worldwide recessionaryenvironment impact the demand for printer systems.  The market has become fragmented, with tiers developing in theentry-level, mid-range and high-end. Much of the market has moved toward lower-priced printers as newentrants and more stable printer platforms have been introduced and end usershave chosen less expensive alternatives. In this tier, where the end user does not need advanced securityfeatures but merely wants to print a card, there is greater priceshopping.  In addition, these customershave demanded the bundled systems that we are now producing.  The mid level market, where card security isimportant but not paramount, has become more price sensitive during therecession. High-end customers who require significant integration, highersecurity and more durable cards are now working more with prime contractors andlarge system integrators.

 

We have also seen new channels ofdistribution arising or becoming more important.  The internet has become a more viable method for end users toresearch and purchase printing systems. We have also seen the growth in channels such as the “auto ID” channel,which is primarily a supply chain management distribution system typicallyselling bar code printers and related media. We believe that the changes that we introduced for our distributionsystem in October of 2003 will better position us to compete in this market.

 

**IndustryTechnology**

 

*Central Issue Versus Instant Issue*

 

Two general types of systems characterize thedigital card personalization market: “central issue” and “instant issue”systems. Central issue systems typically involve batch processing, printingand, in the case of credit and debit cards, embossing (raising of certain areasof the card to form letters or numbers) of plastic cards, typically at adifferent location from where the relevant data is collected. Cards are usuallysent or issued to individuals days or weeks after the initial processingbegins, often by mail. Central issue processing is typically used inlarge-scale programs such as processing of credit cards and issuing of driver’slicenses. Central issue systems are generally much larger and substantiallymore expensive than instant issue systems.  However, some central issuance locations network multiple desktopprinting systems rather than a single large central issuance machine.

 

Instant issue systems, which are typicallydesktop systems, are used to print personalized cards on demand for issue tothe cardholder within moments after processing. Instant issue systems reducethe time, costs and likelihood of theft or loss associated with distribution ofcards from centralized systems. In the 1990s, instant issue systems weretypically sold into small and medium scale applications such as corporate foraccess control or employee badging, and universities for studentidentification. These systems have now also been adopted by governmentalagencies for driver’s licenses, national identification programs and militarypersonnel identification that were once the province of central issuanceprinters.

 

*Digital Card Personalization Technologies*

 

Currently, there are two principal digitalcard printing technologies used by instant issue systems to print personalizedcards: *direct-to-card dye-sublimationprinting* and *reverse imageprinting*. We believe that *inkjetprinting* will become another important card printing technology. Withthe shipment of our CardJet 410 and Persona C7 inkjet printers in 2003, webelieve we are the only company in the desktop ID card market that hasdeveloped products that incorporate each of these technologies.

 

Central issuance machines use these three technologies,but also may incorporate technologies such as laser

 

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engraving and inks that requireultra-violet curing.  Another processthat has recently been applied to ID cards is resin transfer, which is aprocess similar to our High Definition Printing except that the colors arecreated by colored resin rather than by dyes.

 

*Direct-to-card printing*is the most common technology used by digital card printers to print imagesdirectly onto the surface of a plastic card. The process involves heating aspecial print ribbon beneath a thermal printhead and applying pressure so thatthe ribbon is in contact with the card and the printhead rests on the top ofthe ribbon, resulting in the transfer of color from the ribbon to a blank card.****Most cardprinters in the market today use this direct-to-card technology.

 

*Reverse image printing*,as used in our High Definition Printers, prints images onto a special film,which is then laminated onto the surface of a blank card through heat andpressure. Because the graphics and text are printed on the underside of thefilm, the image is “sandwiched” between the film and the card.  This process results in exceptional printquality, high durability and the ability to print on a wide variety of cards,including biodegradable cards. Proximity cards and smart cards, which tend to have uneven surfaces dueto embedded wires and smart chips, have more successful printing results usingHigh Definition Printing. We believe that we are one of only two companies thatmanufacture products using this technology. A third competitor uses resin transfer technology that has similartransfer characteristics as our High Definition Printing process.

 

*Inkjet printing*systems, because they are simple to use, quiet and very reliable, have becomethe standard printing technology for desktop computing worldwide. We believethis non-impact printing technology has not previously been used in the cardmarket, because the inks are water-based and traditionally do not readilyadhere to plastic cards.   Using apatented coating on its Teslin® material, PPG Industries worked in cooperationwith us to develop a card that is receptive to inkjet printing. HP, theworldwide leader in inkjet printing, has assisted us in integrating theirinkjet technology into our systems, and by combining these technologies withPPG’s cards, we are now offering what we believe is the first inkjet cardprinting system designed specifically for the card market.

 

*Data Encoding*

 

In addition to printed photographs, text andbar codes, card printing systems can encode personalized data on magneticstripes, smart cards, proximity cards and optical data storage cards.

 

*Magnetic stripe*technology is the oldest and most widely used technology for encodingidentification and storing data on cards. When the cards are swiped through areader, the data is interpreted and the cards can be used for identification,access control, loyalty, records management and more.

 

*Smart cards* commonlyrefer to any plastic card with an embedded integrated circuit microchip or anon-board microprocessor. With “contact” smart cards, data is accessed by directcontact between a smart card reader and a gold plate on the card face.“Contactless” smart cards have an electronic microchip and embedded antennathat allow the card to communicate with an antenna/coupler unit withoutphysical contact.

 

*Proximity cards* haveembedded electronic circuits that store data and can be read by a proximityreading device without the need for the card to make physical contact with thereader. Users can leave their proximity cards inside their wallet or pursewhile the reader processes the code, making the convenience of proximity cardsincreasingly popular for access control applications.

 

*Optical Data Storage Cards* have a laserread-write surface that is created similarly to compact discs.  This technology is being used for high datastorage and government applications such as the Canadian Green Card and theUnited States Visa Program.

 

**OurProducts**

 

*Card Identity Systems*

 

We currently manufacture four differentproduct lines, packaged into two selling lines, with a variety of options in

 

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each product line. We sell ourproducts to distributors and integrators who offer them to end-users as part ofa system they integrate with other companies’ components, or as a bundle thatwe put together including a digital camera and software.  All of our systems are designed to beinteroperable with the hardware, software and other equipment most often usedby our integrators.

 

Our Professional Series offers premiumfeatures and advanced technologies. Professional Series systems are soldthrough a limited number of integrators, value added distributors anddistributors who have agreed to meet certain criteria for carrying theProfessional Series lines. Our Persona Series, targeted to the entry-levelend-user, is distributed without such limitations.

 

The following chart sets forth our productlines, suggested retail price ranges and the markets we believe theyaddress.  We have announced plans tointroduce new products in 2004 that may augment or replace products on thischart.

 
|                    |   | **Professional  Series**                   |   | **Persona  Series**         |   |
|-------------------------|--------|--------------------------------------------|--------|-----------------------------|--------|
|                    |   | **High Definition**                   |   | **Lamination**              |   | **Direct-to-Card** |   | **Inkjet** |   | **Direct-to-Card** |   | **Inkjet** |   |
| **Models:**             |   | **HDP Printers  and HDP  lamination** |   | **Pro-LX  DTC 500-LC** |   | **DTC 500  Series** |   | **CardJet 410** |   | **C25, C16,  C11** |   | **CardJet C7** |   |
|                    |   |                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Suggested Retail Price: |   | $8,400 - $19,400                           |   | $7,500 - $12,300            |   | $3,000 - $9,300 |   | $2,000 -$2,600 |   | $2,000 - $5,595 |   | $1,800  - $2,400 |   |
| **Horizontal Markets**  |   |                                       |   |                        |   |   |   |   |   |   |   |   |   |
| High Security           |   | X                                          |   | X                           |   |   |   |   |   |   |   |   |   |
| Smart Cards             |   | X                                          |   | X                           |   | X |   |   |   |   |   |   |   |
| Access Control          |   | X                                          |   | X                           |   | X |   |   |   | X |   |   |   |
| Cut and Paste ID        |   |                                       |   |                        |   |   |   | X |   | X |   | X |   |
| **Vertical Markets**    |   |                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Corporate ID            |   | X                                          |   | X                           |   | X |   | X |   | X |   | X |   |
| National ID             |   | X                                          |   | X                           |   |   |   |   |   |   |   |   |   |
| Drivers’ Licenses  |   | X                                          |   | X                           |   |   |   |   |   |   |   |   |   |
| Government/Military     |   | X                                          |   | X                           |   | X |   | X |   |   |   |   |   |
| Transportation          |   | X                                          |   | X                           |   |   |   |   |   |   |   |   |   |
| Healthcare              |   | X                                          |   |                        |   | X |   |   |   |   |   |   |   |
| Universities            |   |                                       |   | X                           |   | X |   |   |   | X |   |   |   |
| Corrections             |   |                                       |   | X                           |   | X |   |   |   |   |   |   |   |
| Sports & Leisure    |   |                                       |   | X                           |   | X |   |   |   | X |   |   |   |
| K-12 Schools            |   |                                       |   | X                           |   | X |   | X |   | X |   | X |   |
| Health Clubs            |   |                                       |   |                        |   | X |   | X |   | X |   | X |   |
| Retail & Loyalty    |   |                                       |   |                        |   | X |   | X |   | X |   | X |   |
| Casinos                 |   |                                       |   |                        |   | X |   | X |   | X |   |   |   |
| Manufacturing Plants    |   |                                       |   |                        |   |   |   | X |   |   |   | X |   |
| Libraries               |   |                                       |   |                        |   |   |   | X |   |   |   | X |   |
| Events                  |   |                                       |   |                        |   | X |   | X |   | X |   |   |   |

 

Our HDP systems print images onto a specialfilm, which is then laminated onto the surface of a blank card through heat andpressure.  These systems are typicallyused for high-volume and security applications, especially those integratingsmart cards or proximity cards. With the introduction of the first integratedlamination module on the HDP printers, the HDP820-LC, increased durability andsecurity features are now available.

 

Our Pro-LX and DTC500-LC cardprinter/encoders use direct-to-card printing technology and include either afield upgradeable or an integrated lamination station. The overlaminatesprovide greater durability for the card, and can have unique security features.These systems are typically used for high-volume applications that require thehighest level of card durability or special security features such as driver’slicenses and other government identification applications.

 

Our DTC500 series card identity systems usedirect-to-card technology and offer a variety of printing options includingsingle-sided printing, dual-sided printing, and dual hoppers. These systems aretypically used in moderate-volume applications such as corporateidentification, education and gaming.

 

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Our new CardJet 410 and Persona CardJet C7card identity systems use inkjet technology. We have marketed these products toaddress the needs of low-volume users and end-users who currently use analog“cut and paste” products.

 

Our Persona C25, C16 and C11 card identitysystems use direct-to-card technology. These products are widely distributed,offer single-sided and dual-sided printing and have fewer features than ourDTC500 series printer systems.

 

*Fargo Certified Supplies*

 

A significant portion of our business is inthe sale of consumable supplies, such as ribbons, overlaminates and blankcards. Sales of these products accounted for approximately 60%, 57% and 56% ofour net sales of card personalization products in 2003, 2002 and 2001,respectively. Our consumable supplies business provides us with recurringrevenue because most of our supplies contain proprietary elements that areunique to our systems. We engineer these supplies in cooperation with themanufacturers of these materials. These supplies are designed and manufacturedto produce cards with high-quality images and minimize operator errors. We alsosell replacement parts and extended warranties for our systems.

 

Our media includes:

 

•              *Ribbons.* The dye based ribbons are partitioned by a number of consecutive coloredpanels.  During printing, a printheadcontaining hundreds of thermal elements heats the dyes on the ribbon, whichvaoporize and diffuse into the surface of the card. Each ribbon prints a fixednumber of cards so that an end-user or integrator can calculate the number ofribbons needed to print a certain number of cards.

 

•              *Overlaminates.*  Overlaminates are a second layer applied after the printingprocess to increase the durability of the cards. These overlaminates areavailable in clear material, standard holographic material, and as a customapplication.  End-users may customizethe holograph in the overlaminate in order to enhance the security features.

 

•              *Blank cards.*  We sell the blank cards on which images and text are printed tocreate identification cards. Our UltraCard brand of cards is optically scannedto ensure that they are as clean and defect-free as possible. Blank cards areessentially a commodity item that may be purchased through a variety ofsources.

 

•              *Visual Security Solution cards.*   These blank cards have a generic orcustomized hot stamp hologram to allow for quick identification of valid cardsby visual inspection.

 

•              *Inkjet cartridges.*  We sell the inkjet cartridges that are usedin our CardJet brand of inkjet printer. These cartridges have a radio frequency identification system thatrelays information about the status of the cartridge to the end-user and willprint an exact number of cards.

 

•              *Inkjet card cartridges.*  We also sell card cartridges that containblank inkjet-receptive cards for our CardJet printers. Each cartridge containsa contact smart chip to ensure that the cartridge is properly connected andprovides information on the number of cards remaining in the cartridge.

 

**Researchand Product Development**

 

Our research and development strategy is toidentify and incorporate new technologies, developed by us and others, so thatour products provide end-users with the best card identity systems available.We have adopted a design and development approach that will allow us tointegrate new technologies into our product offering quickly and efficiently.We believe that emerging technologies, such as smart cards and biometrics, willprovide us with new opportunities to differentiate our systems from those of ourcompetitors. We strive to involve our independent integrators to help usdetermine the needs of end-users, assess our systems and better predict marketacceptance of new products.

 

We have begun to work with ImageWare Systems,one of the leading developers of identification badging software, to pursuedevelopment of integrated software and hardware solutions that provideadditional value, ease of use and ease of

 

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integration to our distributionnetwork and end users of our printing systems.

 

We have assembled a highly trained staff ofelectrical, mechanical and chemical engineers, and we devote significantresources to developing new card identity solutions and supplies that containproprietary elements that are unique to our systems, while maintaining highstandards of quality and reliability. We are currently conducting research anddevelopment in the areas of printer design, including potential advances in ourmechanical, electronic and laminating technologies, as well as suppliesdevelopment and encoding development. As of December 31, 2003, we had 41employees engaged in research and development.

 

We invest significant engineering resourcesin product development. Our research and development costs were approximately7.3%, 6.8% and 6.6% of net sales in 2003, 2002 and 2001, respectively.

 

**IntellectualProperty**

 

Portions of our manufacturing processes andthe mechanical and electronic designs of our systems are proprietary. Weattempt to protect our systems and processes through a combination of patents,copyright, trademark and trade secret laws; employee and third-partynondisclosure agreements and similar means. The decision to seek additionalpatents is based on our analysis of various business considerations such as thecost of obtaining a patent, the likely scope of patent protection and thebenefits of patent protection relative to relying on trade secrets and otherprotection.

 

We currently hold 51 United States patentsrelated to our card business. We have also filed applications for approximately80 additional United States patents that are currently pending. Our existingpatents expire during the period between January 2009 and September 2022. Weconsider our most important patents to be those covering our methods fordriving our printheads, our lamination methods and our method of identifyingdye sublimation and thermal transfer ribbons. These methods most directly impact the quality and durability of our systems,areas in which we believe we have a competitive advantage. The patents in theseareas expire between 2013 and 2021.

 

We also rely on our engineering know-how,materials expertise and trade secrets applicable to the manufacture of oursystems. We believe that this knowledge provides us with a competitiveadvantage at least as important as patent protection. We seek to maintain theconfidentiality of this information by requiring employees to signconfidentiality and non-competition agreements and by limiting access byoutside parties to such information.

 

We also file some patents in countriesoutside the United States, again depending on our analysis of various businessconsiderations such as the cost of obtaining a patent, the likely scope ofpatent protection and the benefits of patent protection relative to relying ontrade secrets and other protection. We recognize that some countries in whichwe do business do not offer the same level of protection for intellectualproperty as does the United States.

 

**Manufacturingand Sources of Supply**

 

We outsource assembly of most of thecomponent parts used in our printing systems, such as circuit boards, wireharnessing and cabling to outside manufacturers. These components are thenshipped to our manufacturing facility in Eden Prairie, Minnesota for finalassembly and testing. We also purchase component parts, printheads, inkjetcartridges, inkjet printer assemblies and ribbons from a number of vendorslocated in the United States, China and Japan. The terms of supply contractsare negotiated separately with each vendor. We have entered into an agreementwith Sony Chemical Corporation, a subsidiary of Sony Corporation, pursuant towhich Sony has agreed to provide us with technical assistance, know-how, andexpertise in such areas as manufacturing, smart card, and other electronic andchemical technologies.  Under thisagreement, we have agreed to purchase from Sony, and Sony has agreed to sell tous on an exclusive, worldwide basis, Sony’s dye-sublimation printer ribbons forour products for a multi-year period. Our obligations under this agreement, which include a requirement topurchase $4 million of printer ribbons each year, are subject to Sonyperforming certain obligations under the agreement.  We believe that our present vendors have sufficient capacity tomeet our requirements.  We also believealternate production sources for most components are generally availablewithout undue interruption with the exception of Kyocera, our supplier ofprintheads.

 

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**Inventory**

 

Because most of our systems are built uponorder, we do not maintain a significant inventory of completed systems. Wemaintain only limited inventories of component parts and consumable supplies,although we enter into purchase agreements with certain suppliers that requireus to purchase minimum amounts. We try to produce systems as they are ordered,which causes us to forecast production based on past sales and our estimates offuture demand rather than stocking finished goods. While most components areavailable from multiple vendors, certain components used in our systems areonly available from single or limited sources. In common with most of ourcompetitors, we rely on Kyocera, based in Japan, to supply us with printheadsfor our dye sublimation printers.

 

**Salesand Marketing**

 

*Distribution channel.*  We market and sell our products through adistribution channel of independent distributors and integrators in more than80 countries worldwide.

 

In October 2003, we introduced a new distributionprogram for our United States channel partners.  The new program categorizes distribution partners into fourcomplementary, yet separate, program tracks. Fargo Solution Providers provide retail customers with sales, serviceand integration expertise on Fargo’s full line of Professional and PersonaSeries products and systems.  FargoValue Added Distributors provide in-depth integration expertise and support forFargo Solution Providers and end user customers on Fargo’s full line ofproducts and systems.  FargoDistributors provide product distribution services to Fargo Solution Providersand Persona Series resellers.  FargoManufacturing Resellers are companies that have a core business of developingand manufacturing products where the sale of identification card printers is asecondary portion of its sale.  Eachcategory has the option to work exclusively with Fargo to develop market shareand expertise in the markets they serve. The program continues our two-product line strategy with restricted distributionon our Professional Series products and broad distribution of our Personaproducts.

 

Our international distribution networkincludes integrators and distributors throughout Europe, Asia, Africa, theMiddle East, Latin America, Canada and Australia. Although doing business indeveloping regions involves risks of political and economic instability, we aregenerally able to terminate our arrangements with our internationaldistributors and resellers upon short notice in order to mitigate such risks.Additional information about our international sales is also included inNote 10 to our financial statements on page F-17.

 

Our largest ten distributors and integratorsaccounted for a combined total of 45% of our sales in 2003, with one customer,Wynit, accounting for 12.8% of such sales. We support our distribution networkand end-users through our offices in Eden Prairie, Minnesota. As ofDecember 31, 2003, we directly employed 46 individuals engaged in sales,marketing and support services.

 

Integrators sell a variety of identificationand access control components from different manufacturers and customizesystems for end-user applications as part of their systems integrationbusiness. These sales channels provide, configuration, installation, integrationand support services required by end-users within various market segments. Therelationships our resellers develop and maintain allow us to reach end-usersworldwide in a broad variety of industries. We do not compete with ourdistributors or integrators by selling directly to end-users.

 

*Marketing activities.*  Our marketing operations include customerrelations, product planning and market research functions, marketingcommunications, and technical and training services. Our marketing group worksclosely with our research and development personnel to develop ideas for newproducts and product enhancements to better meet the needs of end-users. Aspart of our strategic planning, we are continually analyzing the market for ourproducts and evaluating our strengths and weaknesses compared with ourcompetition. Our distribution partners have been a valuable source of ideas andinformation and we communicate regularly with our distribution channel tosolicit their input and gather feedback from end-users.

 

We routinely conduct promotional effortstargeted at distributors and integrators, as well as directly to potentialend-users such as corporations, schools, hospitals and others. Our web siteprovides visitors with information about the company and our systems, allowsthem to contact us via e-mail, and also allows special access to our authorizeddistributors and

 

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integrators to obtain detailedproduct specifications, pricing information and technical updates. We alsoactively participate in industry trade shows, both as an exhibitor at largertrade shows and with our distribution partners at smaller, regional tradeshows. Additionally, we sometimes make joint sales calls with our distributorsand integrators. All leads generated by our marketing activities are referredto an authorized distributor or integrator.

 

We provide training and technical support toour distributors and integrators to assist them in marketing and servicing oursystems. Our on-site training workshops, instructional videos and livetelephone support assist our integrators in helping end-users make thepurchasing decision that best suits their particular needs. In addition, weencourage our integrators to become Authorized Service Providers so that theycan provide technical support directly to their customers. As a result, many ofour integrators offer their customers maintenance and support contracts fortheir integrated card personalization solutions.

 

**Competition**

 

Many companies are engaged in the design andmanufacture of card printing systems. Competition in our market is intense, andwe expect it to increase. We compete today, and expect to compete in thefuture, with a number of companies, some of which have greater financial, technicaland marketing resources than we do. Our ability to compete successfully dependson many factors, some of which are outside of our control. Factors affectingour ability to compete include:

 

•              Our ability tointroduce innovative new products and technologies;

 

•              The price, qualityand performance of our systems relative to our competitors;

 

•              Our success indeveloping new systems and the timing of new product introductions;

 

•              The adequacy of ourmanufacturing capacity and supply of components and materials;

 

•              The efficiency ofmanufacturing operations and the cost of manufacturing;

 

•              The effectiveness ofour distribution network;

 

•              Our relationshipswith our suppliers; and

 

•              General market andeconomic conditions.

 

We believe that we compete favorably withrespect to each of these factors. We believe that our Professional Series andPersona Series systems are competitively priced both to the distributionnetwork and to the end users.

 

We believe that the card printing industryincludes between 30 and 35 companies that manufacture digital cardprinters.  These companies include bothdesktop and central issue printing systems. We also compete with manufacturers of “cut-and-paste” card systems, suchas Polaroid Corporation, and we believe our ability to compete in this markethas been enhanced by our new line of inkjet card printers.

 

**Employees**

 

As of February 15, 2004, we employed 198persons, of whom 97 are engaged in manufacturing, 42 in research anddevelopment, 45 in sales, marketing and technical support and the balance inmanagement and administrative positions. None of our employees is representedby a labor union or covered by a collective bargaining agreement. We have notexperienced any work stoppages and consider relations with our employees to begood.

 

All of our employees are required to sign aconfidentiality and non-competition agreement prior to beginning employmentwith us.

 

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***(a)***           ***Financial Information AboutGeographic Areas***

 

See Note 10 on page F-17 of ourfinancial statements for information about export sales.

 

**Item 1A.**                 **CAUTIONARY STATEMENT REGARDING FUTURE RESULTS,FORWARD-LOOKING INFORMATION AND CERTAIN IMPORTANT FACTORS**

 

We make written and oral statements from timeto time regarding our business and prospects, such as projections of futureperformance, statements of management’s plans and objectives, forecasts ofmarket trends, and other matters that are forward-looking statements within themeaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. Statements containing the words orphrases “will likely result,” “are expected to,” “will continue,” “isanticipated,” “estimates,” “projects,” “believes,” “expects,” “anticipates,”“intends,” “target,” “goal,” “plans,” “objective,” “should” or similarexpressions identify forward-looking statements, which may appear in documents,reports, filings with the Securities and Exchange Commission, news releases,written or oral presentations made by officers or other representatives made byus to analysts, stockholders, investors, news organizations and others, anddiscussions with management and other representatives of us. For suchstatements, we claim the protection of the safe harbor for forward-lookingstatements contained in the Private Securities Litigation Reform Act of 1995.

 

Our future results, including results relatedto forward-looking statements, involve a number of risks and uncertainties. Noassurance can be given that the results reflected in any forward-lookingstatements will be achieved. Any forward-looking statement made by or on behalfof us speaks only as of the date on which such statement is made. Ourforward-looking statements are based upon assumptions that are sometimes basedupon estimates, data, communications and other information from suppliers,government agencies and other sources that may be subject to revision. Exceptas required by law, we do not undertake any obligation to update or keepcurrent either (i) any forward-looking statement to reflect events orcircumstances arising after the date of such statement, or (ii) theimportant factors that could cause our future results to differ materially fromhistorical results or trends, results anticipated or planned by us, or whichare reflected from time to time in any forward-looking statement which may bemade by or on behalf of us.

 

In addition to other matters identified ordescribed by us from time to time in filings with the SEC, there are severalimportant factors that could cause our future results to differ materially fromhistorical results or trends, results anticipated or planned by us, or resultsthat are reflected from time to time in any forward-looking statement that maybe made by or on behalf of us. Some of these important factors, but notnecessarily all important factors, include the following:

 

**Ifwe cannot or do not adequately protect or enforce our domestic or internationalintellectual property rights, others may offer products similar to ours whichcould depress our prices and gross profit margins or result in loss of marketshare.**

 

We believe that protecting our proprietarytechnology is important to our success and competitive positioning. In additionto common law intellectual property rights, we currently rely on a combinationof patents, trademarks, license agreements and contractual provisions toestablish and protect our intellectual property rights. Our failure to protector enforce our intellectual property rights could have a material adverseeffect on our business, results of operations and financial condition. Wecannot be certain that the steps we take to protect our intellectual propertywill adequately protect our proprietary rights, that others will notindependently develop or otherwise acquire equivalent or superior technology orthat we can maintain any of our technology as trade secrets.  We have instigated litigation to protect ourintellectual property rights in Korea and China.  The results of this litigation could include the loss of patentrights in those countries, limitation of the protection afforded by our patentsor other adverse results.  In general,intellectual property litigation could result in substantial costs to us andthe diversion of significant time and effort by our executive management, andmay be necessary to enforce our patents and trademarks and to protect our tradesecrets and proprietary technology. We cannot assure you that we will have thefinancial resources necessary to enforce or defend our intellectual propertyrights. We also cannot assure you that we would prevail in any such litigationor that, if we are unsuccessful, we would be able to obtain any necessarylicenses on reasonable terms or at all. The laws of some of the countries inwhich our systems are

 

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or may be sold may not protectour systems and intellectual property to the same extent as the United Statesor at all.

 

**Ourmarkets are highly competitive and many of our competitors have substantialresources. Competition may result in price reductions, lower gross profits andloss of market share.**

 

We face significant competition in developingand selling our systems. Our principal competitors have substantial marketing,financial, development and personnel resources. To remain competitive, webelieve that we must continue to provide:

 

•              technologicallyadvanced systems that satisfy the demands of end-users;

 

•              a dependable andefficient distribution and reseller network;

 

•              superior customerservice; and

 

•              high levels ofquality and reliability.

 

We cannot assure you that we will be able tocompete successfully against our current or future competitors. Zebra has beena significant competitor of ours in the past, and may be a more vigorous competitorin the future.  The security printingsystem market has increased visibility, which may lead to large, well-known,well financed companies entering into this market. Increased competition frommanufacturers of systems or consumable supplies may result in price reductions,lower gross profit margins, increased discounts to distribution and loss ofmarket share and could require increased spending by us on research anddevelopment, sales and marketing and customer support. Some of our competitors maymake strategic acquisitions or establish cooperative relationships withsuppliers or companies that produce complementary products such as cameras,computer equipment, software or biometric applications. If any technology thatis competing with ours becomes more reliable, higher performing, less expensiveor has other advantages over our technology, then the demand for our productscould decrease.

 

**We rely on sole and single-source suppliers,which could cause delays, increases in costs or prevent us from completingcustomer orders, all of which could materially harm our business.**

 

We rely on outside vendors to manufacture ordevelop products and consumable supplies that are used in our systems. Wepurchase critical components for our systems, including printheads, highdefinition printer ribbons, ink jet printer chassis, ink jet ink, ink jet cardsand microprocessors from separate single-source suppliers. Our inability toobtain adequate deliveries or alternative sources of supply could cause delays,loss of sales, increases in costs and lower gross profit margins. Currently,our sole supplier of printheads for dye sublimation printers is Kyocera, basedin Japan, our two suppliers of dye sublimation ribbons are Dai Nippon and SonyChemical Corporation, both also based in Japan, and our supplier of most of themicroprocessors that run our printers is Motorola. Dai Nippon is the soleproducer of high definition printing ribbon and film and may choose not to sellto us. We purchase ink jet printer chassis and ink from HP and purchase ink jetcards from PPG.  If any of thesesuppliers is unable to ship critical components, we would be unable tomanufacture and ship products to our customers. If the price of printheads, ribbonsor microprocessors increases for any reason, or if these suppliers are unableor unwilling to deliver, we may have to find another source, which could resultin interruptions, increased costs, delays, loss of sales and quality controlproblems. War, natural disaster, trade embargoes or economic hardship in Japancould also result in a disruption in shipments from our Japanese suppliers,which could require us and our competitors to develop new sources of thesesupplies or else cause us to be unable to complete and ship orders to ourcustomers.

 

**Ourbusiness success depends wholly on the continued demand for card printingsystems and related supplies.**

 

Because we sell only card printing systemsand related consumable supplies, our business depends on the continued demandfor cards for identification, access control and other purposes. Demand for ourproducts could decline if businesses and organizations use alternativetechnologies for these purposes that do not involve the use of a card. Any suchchanges in the business environment or competition from current and potentialcompetitors could significantly erode the demand for our systems and cause ourbusiness to suffer. If demand on the part of governmental agencies and large

 

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customers are reduced, thiscould significantly impact our revenue.

 

**Ourproducts incorporate technologies that we do not own and we could lose revenueif we are unable to obtain these technologies in the future.**

 

Our products incorporate technologies overwhich we have no control, including thermal printhead technology, dyesublimation technology, software, microprocessors, inkjet technology and inkjet receptive cards. The owners of these technologies are free to sell orlicense these technologies to our competitors, agree to supply thesetechnologies exclusively to a third party or enter the market for our systemsas our competitor. If any of these events occurs, the owners of thesetechnologies could choose not to continue to supply us with vital systemcomponents, which would result in the diversion of our research and developmentresources and could result in lost revenue, inability to ship products and harmto our reputation. Some of these technologies are incorporated into new systemsand if these systems are not shipped, we will see a material adverse impact toour revenues in the foreseeable future.

 

 

**Thecomplex design of our systems could result in manufacturing delays and otherproblems that cause us to fail to meet the demand for our systems on a timelybasis, increase the cost of our systems, or both.**

 

We have experienced manufacturing problemswith some of our systems in the past. Similar problems in the future could leadto production delays that could cause our distribution network to choose tosell competing systems. In addition, manufacturing problems could result inhigher material, labor and other costs, which could increase the total cost ofour systems and could decrease our gross profit margins.

 

**Our systems may have manufacturing or designdefects that we discover after shipment, which could negatively affect ourrevenues, increase our costs and harm our reputation.**

 

Our systems are complex and may containundetected and unexpected defects, errors or failures. If these product defectsare substantial, the result could be product recalls, an increased amount ofproduct returns, loss of market acceptance and damage to our reputation, all ofwhich could increase our costs and cause us to lose sales. We carry generalcommercial liability insurance, including product liability, with a coveragelimit of $2.0 million per occurrence plus an umbrella policy with a$5.0 million limit, however, coverage may not be included on certainrisks. Our insurance may be insufficient to protect us against losses caused bysevere defects in our products.

 

We may not deliver systems that we haveintroduced on a timely basis, which could impact our anticipated revenue, andallow competitors to respond to our product introductions, introduce competingproducts or introduce superior products. These delays, which may occur onfuture product introductions, may allow competition to respond to our plans,which could impact our revenue, or result in the introduction of competingproducts that reduce the innovative value of our products or could betechnologically superior to the product we introduced. Delays in production ofnewly introduced products allow our competitors time to respond to theintroduction, which could reduce revenue from the new products.

 

**Wedo not maintain significant inventories of component parts or finished goodsand our failure to adequately forecast demand could result in shortages anddamage our business.**

 

Because most of our systems are built uponorder, we do not maintain a significant inventory of completed systems. Wemaintain only limited inventories of component parts and consumable supplies,although we enter into purchase agreements with certain suppliers that requireus to purchase minimum amounts. We endeavor to produce systems as they areordered, which causes us to forecast production based on past sales and ourestimates of future demand. In the event that we significantly underestimateour needs or encounter an unexpectedly high level of demand for our systems orour suppliers are unable to deliver our orders of components in a timelymanner, we may be unable to fill our product orders on time which could harmour reputation and result in reduced sales.

 

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**Ourstrategy of providing software and bundled systems may not work.**

 

We have introduced a bundled system thatincludes a printer, low-end software package, camera, tripod, supplies, andcables and we have begun distributing ImageWare ID badging software.  Our distribution system may view these ascompetitive threats to their integration business or no longer perceive us asthe best choice for purchasing ID systems. As a result, ImageWare may choose to terminate our right to distributeits software.  In addition, othercompetitors of ImageWare badging software may no longer continue to integrateFargo printers into their software, may recommend other printing systems or mayreduce their level of cooperation with our distribution network.  We also may be unsuccessful in ourintroductions of bundled systems and may spend engineering, marketing and salesefforts on products that do not generate appreciable revenue.

 

**Technologyin our industry evolves rapidly, potentially causing our products to becomeobsolete, and we must continue to enhance existing systems and develop newsystems or we will lose sales.**

 

Rapid technological advances, rapidlychanging customer requirements and fluctuations in demand characterize thecurrent market for our products. Our existing and development-stage productsmay become obsolete if our competitors introduce newer or more appealingtechnologies. If these technologies are patented or proprietary to ourcompetitors, we may not be able to access these technologies. To be successful,we must constantly enhance our existing systems and develop and introduce newsystems. If we fail to anticipate or respond to technological developments orcustomer requirements, or if we are significantly delayed in developing andintroducing products, our business will suffer lost sales.

 

**Allof our sales are made through independent distributors and resellers, over whomwe have limited control, and if they do not effectively market or sell ourproducts, our sales will decline.**

 

All of our revenue comes from sales throughour distributor and reseller network, and we do not sell our products directlyto end users.  Although certaindistributors and resellers have made certain contractual commitments to us,they are independent businesses that we do not control.  We cannot be certain that companies who havecommitted to exclusively sell our printing systems will remain exclusive orthat our distribution will continue to market or sell our systemseffectively.  Our agreements withdistributors and resellers of our Professional Series line of systems do notcontain requirements that a certain percentage of sales are of our products nordo they restrict the ability of our distribution to choose alternative sourcesfor printing systems.  We havecontractual agreements with certain distributors and resellers to be exclusivepartners, however, these contracts do not place restrictions that limit theexclusive distributors and resellers from changing their exclusive status.  We are dependent upon the continuedviability and financial stability of these distributors and resellers, many ofwhich are small organizations with limited capital. These distributors andresellers may choose to devote their efforts to other products in differentmarkets or reduce or fail to devote the necessary resources to provide effectivesales and marketing support of our product. We believe that our future growth and success will continue to depend inlarge part upon the success of our distributors in operating their ownbusinesses.

 

**Wesell a significant portion of our products internationally and purchaseimportant components from foreign suppliers, which exposes us to currencyfluctuations and other risks.**

 

We sell a significant amount of our productsto customers outside the United States, particularly in Europe and Asia.International sales accounted for 42%, 40%, and 40% of our net sales in 2003,2002, and 2001, respectively. We expect that shipments to internationalcustomers, including customers in Europe and Asia, will continue to account fora significant portion of our net sales. Sales outside the United States involvethe following risks, among others:

 

•              foreign governmentsmay impose tariffs, quotas and taxes;

 

•              political andeconomic instability may reduce demand for our products;

 

•              restrictions on theexport or import of technology may reduce or eliminate our ability to sell incertain markets;

 

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•              potentially limitedintellectual property protection in certain countries may limit our recourseagainst infringing products or cause us to refrain from selling in certainmarkets;

 

•              we may facedifficulties in managing international operations;

 

•              we sell in dollars,not in the currencies of the countries that we export to;

 

•              we may decide toprice our products in foreign currency denominations;

 

•              we do not maintainany overseas warehouses to carry inventory;

 

•              our contracts withforeign distributors and resellers do not fully protect us against politicaland economic instability;

 

•              we may facedifficulties in collecting receivables; and

 

•              we may not be ableto control our international distributors’ efforts on our behalf.

 

Currently, we do not hedge against foreigncurrency fluctuations.  Because wedenominate our international sales in U.S. dollars, currency fluctuations couldalso cause our products to become less affordable or less price competitivethan those of foreign manufacturers. These factors may have a material adverseeffect on our international sales.

 

In addition, we purchase components from anumber of foreign suppliers and outsource certain manufacturing tasks toforeign manufacturers. Currently we purchase all components in US dollars butwe may not be able to do so in the future or we may choose to purchase productsin a foreign currency.

 

**Ifour systems fail to comply with domestic and international governmentregulations, or if these regulations result in a barrier to our business, wecould lose sales.**

 

Our systems must comply with various domesticand international laws, regulations and standards. In the event that we areunable or unwilling to comply with any such laws, regulations or standards, wemay decide not to conduct business in certain markets. Particularly ininternational markets, we may experience difficulty in securing requiredlicenses or permits on commercially reasonable terms, or at all. Failure tocomply with existing or evolving laws or regulations, including export andimport restrictions and barriers, or to obtain timely domestic or foreignregulatory approvals or certificates could result in lost sales.

 

On May 15, 2002, the European UnionCompetition Commission stated that it is reviewing the pricing of printer inkcartridges. Although this investigation is primarily focused on large inkjetprinter manufacturers, if these companies are found to be in violation ofEuropean Union antitrust laws or other similar laws, it is possible that thesame laws may apply to us, which may negatively impact our sales. In December2002, the European Parliament voted to force inkjet printer manufacturers toallow sales of inkjet cartridges filled by third parties. This act becomeseffective in 2006 unless appealed by the inkjet printer manufacturers. If thislaw goes into effect, it could negatively affect our supplies revenue from ourCardJet printers or it could be applied to all printing technologies, includingour direct to card and High Definition Printing products.

 

**Ourquarterly operating results have been volatile as a result of many factors andcontinued volatility may cause our stock price to fluctuate.**

 

We have experienced fluctuations in ourquarterly operating results and we expect those fluctuations to continue due toa variety of factors. Some of the factors that influence our quarterlyoperating results include:

 

•              the number and mixof products sold in the quarter;

 

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•              the timing of majorprojects;

 

•              the availability andcost of components and materials;

 

•              timing, costs andbenefits of new product introductions;

 

•              customer order sizeand shipment timing;

 

•              seasonal factorsaffecting timing of purchase orders;

 

•              promotions byourselves or competitors, and the timing of the promotion; and

 

•              the timing and levelof operating expenses.

 

Because of these factors, our quarterlyoperating results are difficult to predict and are likely to vary in thefuture. If our earnings are below financial analysts’ expectations in anyquarter, our stock price is likely to drop.

 

**Wemay not be able to adequately protect ourselves against infringement claims ofothers, which if successfully brought could require us to redesign or ceasemarketing our products.**

 

We cannot be certain that we have notinfringed the proprietary rights of others. Any such infringement could causethird parties to bring claims against us, resulting in significant costs,possible damages and substantial uncertainty. We could also be forced todevelop a non-infringing alternative, which could be costly and time-consuming.

 

**Ifwe fail to attract and retain highly skilled managerial and technicalpersonnel, we may fail to remain competitive.**

 

Our future success depends, in significantpart, upon the continued service and performance of our senior management andother key personnel, in particular Gary R. Holland, our Chief Executive Officer.Although we have “key man” insurance on Mr. Holland with a death benefitof $3.0 million, losing the services of Mr. Holland could impair ourability to effectively manage our company and to carry out our business plan.  The other members of our management teamalso have significant experience in our industry and the loss of any othermember of our other senior management could likewise impair our ability toeffectively manage our company and carry out our business plan.  We do not carry key man insurance on any ofour senior managers.  In addition,competition for skilled technical employees in our industry is intense. If wecannot attract and retain sufficient qualified technical employees, we may notbe able to effectively develop and deliver competitive products to the market.

 

**Wemay need to raise additional capital to fund our future operations, and anyfailure to obtain additional capital when needed or on satisfactory terms coulddamage our business.**

 

We may need to raise or borrow additional capitalin the future to fund our ongoing operations. Any equity or debt financing, ifavailable at all, may be on terms that are not favorable to us and, in the caseof equity offerings, may result in dilution to our stockholders. Any difficultyin obtaining additional financial resources, including the inability to borrowon satisfactory financial terms, could force us to curtail our operations orprevent us from pursuing our growth strategy or otherwise cause us financialharm.

 

**Item 2.**                    **PROPERTIES**

 

We currently lease approximately 90,240square feet of space for our corporate headquarters and manufacturing facilityin Eden Prairie, Minnesota. Our lease for this facility expires in 2006 and wehave the option of extending this lease for an additional two or five-yearperiod. We consider our present facilities to be sufficient for our currentoperations.

 

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**Item 3.**                    **LEGAL PROCEEDINGS**

 

On December 19, 2003, we filed two separatelawsuits with Seoul Central District Court, Civil Division, claiming thatcertain entities and individuals were selling and manufacturing printer ribbonproducts that infringed upon one or more of our patents.  In the first lawsuit we named KCP Systems,Mr. Sung Jun Park and Mr. Jae Hyun Bae as defendants.  In the second lawsuit we named Mr. Nak Dong Lee doing business as“Intra Korea” and “Intra Worldwide” as defendant.  In both lawsuits we are seeking a permanent injunction barringthe defendants from further activity that infringes our patents.

 

On October 27, 2003, we instituted anadministrative action in the Shenzhen Intellectual Property Office, which is abranch of the Chinese Intellectual Property Office, claiming that ShenzhenKanon Industrial Development Company Ltd. is infringing upon one or more of ourpatents related to our printer ribbon product. We are seeking a permanent injunction, a request for payment of allcosts incurred by us in the case, a public apology and compensation for damagesto our lost sales.

 

We are party to various litigation mattersarising from time to time in the ordinary course of business. We do not believethat any legal matters exist that would have a material adverse effect on ourfinancial position, results of operations or cash flows.

 

**Item 4.**                    **SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

No matter wassubmitted for a vote of our security holders during the fourth quarter of thefiscal year covered by this report.

 

**Item 4A.****                 EXECUTIVEOFFICERS OF FARGO**

 
| **Name**             |   | **Age** |   | **Position**                                                               |   |
|----------------------|--------|---------|--------|----------------------------------------------------------------------------|--------|
| Gary R. Holland      |   | 62      |   | Chairman of  the Board of Directors, President and Chief Executive Officer |   |
| Scott A. Ackerman    |   | 40      |   | Quality and  Management Systems                                            |   |
| Kathleen L. Phillips |   | 39      |   | Marketing  and Distribution                                                |   |
| Thomas C. Platner    |   | 44      |   | Engineering  and Manufacturing                                             |   |
| Paul W.B. Stephenson |   | 49      |   | Chief  Financial Officer                                                   |   |
| Jeffrey D. Upin      |   | 45      |   | Business  Development, General Counsel and Secretary                       |   |

 

*Gary R. Holland* hasserved as our President and Chief Executive Officer since February 1998.From May 1997 to February 1998, Mr. Holland was the generalmanager of Fargo. From 1992 to 1997, Mr. Holland owned and operated twobusiness and strategy consulting firms, Decision Process International ofMinnesota, Inc. and Holland & Associates. From 1982 to 1992, Mr. Hollandwas the President of Datacard Corporation. From 1979 to 1982, he was thePresident and Chief Operating Officer of CPT Corporation. Mr. Holland alsoserves as a member of the board of directors of Delphax Technologies.

 

*Scott A. Ackerman*has been our head of Quality and Management Systems since January 2001. Hewas previously Director of Manufacturing for Fargo, and also served as GeneralManager of Fargo Electronics Jamaica Ltd., a Jamaican corporation locatedin Montego Bay, from 1995 through 1996. From 1993 to 1995, he was an OperationsManager at Piper Capital Management, and held various positions within theAudit Practice at the accounting firm KPMG from 1990 through 1993.

 

*Kathleen L. Phillips*has been our head of Marketing since June 2000.  In December 2003 she assumed additional responsibilities as headof Distribution. She joined Fargo in 1993, and has held various managementpositions at Fargo, including technical support, inside sales, customer serviceand product marketing. Prior to joining Fargo, she held various

 

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positions in research anddevelopment, and technical support and services at Northgate Computer Systemsfrom 1989 to 1992.

 

*Thomas C. Platner*has been our head of Engineering and Manufacturing since November 2000. Hejoined Fargo as Director of Product Development in August 1999. Prior tojoining Fargo, he worked as Engineering Manager and Director of Engineering atRosemount Inc. (a division of Emerson Electric) from 1995 to 1999. He heldvarious engineering positions at McQuay International, from 1985 to 1995, andfor Carrier Corporation (division of United Technologies) as a FieldApplication Engineer from 1981 to 1985.

 

*Paul W.B. Stephenson*rejoined Fargo as Chief Financial Officer in May 2002, having previouslyserved in that position from May 2001 through January 2002.Mr. Stephenson first joined Fargo in February 2001 as an independentconsultant, serving as acting Chief Financial Officer. From January 2002through May 2002, Mr. Stephenson served as Chief Financial Officer ofOppenheimer Wolff & Donnelly LLP, our legal counsel.  From March 1999 to December 2000,Mr. Stephenson served as Vice President and Chief Financial Officer of theMinnesota Orchestral Association. From 1998 to 1999, he served as VicePresident and Chief Financial Officer and from 1992 to 1997, as Vice Presidentof Finance and Administration, of Check Technology Corporation.

 

*Jeffrey D. Upin* hasbeen our head of Business Development since August 2002 and has served asour General Counsel since 1995. Mr. Upin also held operational duties as Director of Supplies.Mr. Upin was appointed as Fargo’s Vice President and Corporate Secretaryin September 2000. Prior to joining Fargo, Mr. Upin served as VicePresident of St. Paul Clothiers, a regional retail operation.

 

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**PART II**

 

**Item 5.**    **                MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.**

 

***(a)***           ***Market Information.***

 

Our common stock is currently traded on theNasdaq National Market under the symbol “FRGO.” The following table sets forth,the high and low sales prices per share as reported by the Nasdaq NationalMarket for each quarter in 2003 and 2002.

 
| **2003**       |   | **High** |   | **Low** |   | **2002**        |   | **High** |   | **Low** |
|----------------|--------|----------|--------|---------|--------|-----------------|--------|----------|--------|---------|
| First Quarter  |   | $10.45   |   | $7.58   |   | First  Quarter  | $7.52  |     | $5.64  |
| Second Quarter |   | 11.93    |   | 9.24    |   | Second  Quarter | 12.47  |     | 7.25   |
| Third Quarter  |   | 13.49    |   | 9.10    |   | Third  Quarter  | 9.48   |     | 6.25   |
| Fourth Quarter |   | 17.10    |   | 11.50   |   | Fourth  Quarter | 13.20  |     | 8.00   |
|                |        |          |        |         |        |                 |        |          |        |         |  |

*** ***

***(b)***           ***Holders.***

 

As of March 12, 2004, we estimate thatthere were over 4,000 beneficial owners of shares of our common stock, whichshares were held by 91 record holders.

 

***(c)***           ***Dividends.***

 

We have not declared or paid any cashdividends on our common stock for the past two fiscal years. Our Board ofDirectors presently intends to retain all earnings to support our operationsand to finance expansion. Under Delaware law, we are permitted to pay dividendsonly out of our surplus or net profits. In addition, the terms of our creditfacility restrict us from paying dividends if an “event of default” as definedby the credit facility agreement has occurred. An “event of default” includes failure to make loan payments on a timelybasis, non-compliance with loan covenants, including the maintenance ofspecified financial ratios, and a change of control.

 

***(d)***           ***Recent Sales of UnregisteredSecurities.***

 

We did not sell any equity securities thatwere not registered under the Securities Act of 1933, as amended, during thefiscal year ended December 31, 2003.

 

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**Item 6.**                    **SELECTED FINANCIAL DATA.**

 

The data presented below as of and for theyears ended December 31, 2003, 2002 and 2001 are derived from our auditedfinancial statements included elsewhere in this report. The financial data asof and for the years ended December 31, 2000 and 1999 are derived from ouraudited financial statements that are not included in this report. Theinformation set forth below should be read in conjunction with “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” inItem 7 of this report and our financial statements and related notes beginningon page F-1 and other financial information included elsewhere in this report.

 

**Summary Statements of Operations Data**

**(in thousands, except per share data)**

 
|                                                            |   | **Year Ended December 31,** |   |
|-----------------------------------------------------------------|--------|-----------------------------|--------|
|                                                            |   | **2003**                    |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Net sales                                                       |   | $                           | 65,491 |   | $ | 66,035 |   | $ | 60,963 |   | $ | 57,845 |   | $ | 54,107 |   |
| Cost of sales                                                   |   | 38,608                      |   | 39,199 |   | 37,497 |   | 34,721 |   | 28,928 |   |
| Gross profit                                                    |   | 26,883                      |   | 26,836 |   | 23,466 |   | 23,124 |   | 25,179 |   |
| Operating expenses:                                             |   |                        |   |   |   |   |   |   |   |   |   |
| Research and development                                        |   | 4,801                       |   | 4,529 |   | 4,053 |   | 4,934 |   | 4,011 |   |
| Selling, general and administrative                             |   | 11,501                      |   | 11,387 |   | 10,341 |   | 10,027 |   | 8,525 |   |
| Terminated acquisition costs (1)                                |   | —                      |   | 552 |   | 1,434 |   | — |   | — |   |
| Total operating expenses                                        |   | 16,302                      |   | 16,468 |   | 15,828 |   | 14,961 |   | 12,536 |   |
| Operating income                                                |   | 10,581                      |   | 10,368 |   | 7,638 |   | 8,163 |   | 12,643 |   |
| Other income (expense):                                         |   |                        |   |   |   |   |   |   |   |   |   |
| Interest expense                                                |   | (29                         | )      | (554 | ) | (1,379 | ) | (2,830 | ) | (5,956 | ) |
| Interest income                                                 |   | 32                          |   | 187 |   | 79 |   | 81 |   | 102 |   |
| Other, net                                                      |   | —                      |   | — |   | (33 | ) | 7 |   | 270 |   |
| Total other income (expense)                                    |   | 3                           |   | (367 | ) | (1,333 | ) | (2,742 | ) | (5,584 | ) |
| Income before provision for income taxes and extraordinary loss |   | 10,584                      |   | 10,001 |   | 6,305 |   | 5,421 |   | 7,059 |   |
| Provision for income taxes                                      |   | 3,344                       |   | 3,265 |   | 2,229 |   | 1,979 |   | 2,575 |   |
| Net income before extraordinary loss                            |   | 7,240                       |   | 6,736 |   | 4,076 |   | 3,442 |   | 4,484 |   |
| Extraordinary loss, net of applicable income taxes              |   | —                      |   | — |   | — |   | (385 | ) | — |   |
| Net income                                                      |   | 7,240                       |   | 6,736 |   | 4,076 |   | 3,057 |   | 4,484 |   |
| Accrued dividends on Series B, 8% redeemable preferred stock    |   | —                      |   | — |   | — |   | (350 | ) | (2,620 | ) |
| Accretion of convertible participating preferred stock          |   | —                      |   | — |   | — |   | — |   | (67,000 | ) |
| Net income (loss) available to common stockholders              |   | $                           | 7,240  |   | $ | 6,736 |   | $ | 4,076 |   | $ | 2,707 |   | $ | (65,136 | ) |
| Net income (loss) per common share:                             |   |                        |   |   |   |   |   |   |   |   |   |
| Basic earnings:                                                 |   |                        |   |   |   |   |   |   |   |   |   |
| Income before extraordinary loss                                |   | $                           | 0.58   |   | $ | 0.56 |   | $ | 0.35 |   | $ | 0.29 |   | $ | (37.56 | ) |
| Extraordinary loss                                              |   | —                      |   | — |   | — |   | (0.04 | ) | — |   |
| Net income (loss)                                               |   | $                           | 0.58   |   | $ | 0.56 |   | $ | 0.35 |   | $ | 0.25 |   | $ | (37.56 | ) |
| Diluted earnings:                                               |   |                        |   |   |   |   |   |   |   |   |   |
| Income (loss) before extraordinary loss                         |   | $                           | 0.57   |   | $ | 0.55 |   | $ | 0.34 |   | $ | 0.27 |   | $ | (37.56 | ) |
| Extraordinary loss                                              |   | —                      |   | — |   | — |   | (0.03 | ) | — |   |
| Net income (loss)                                               |   | $                           | 0.57   |   | $ | 0.55 |   | $ | 0.34 |   | $ | 0.24 |   | $ | (37.56 | ) |
| Weighted average common shares outstanding:                     |   |                        |   |   |   |   |   |   |   |   |   |
| Basic shares outstanding                                        |   | 12,397                      |   | 12,048 |   | 11,760 |   | 10,637 |   | 1,734 |   |
| Diluted shares outstanding                                      |   | 12,799                      |   | 12,331 |   | 11,958 |   | 11,413 |   | 1,734 |   |

 

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(1)           Reflects expenses consisting primarily of legal,professional, and investment banking fees incurred by us in connection with theproposed acquisition of Fargo by Zebra Technologies Corporation, which wasannounced July 31, 2001, and terminated in March 2002.

 

19

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**SummaryBalance Sheet Data**

**(in thousands)**

 
|                                      |   | **As of December 31,** |   |
|-------------------------------------------|--------|------------------------|--------|
|                                      |   | **2003**               |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
| Cash and cash equivalents                 |   | $                      | 13,445 |   | $ | 2,511 |   | $ | 3,586 |   | $ | 1,223 |   | $ | 1,509 |   |
| Working capital                           |   | 22,386                 |   | 12,708 |   | 9,190 |   | 14,850 |   | 7,569 |   |
| Total assets                              |   | 50,807                 |   | 44,009 |   | 46,213 |   | 48,815 |   | 49,094 |   |
| Note payable, stockholder                 |   | —                 |   | — |   | — |   | — |   | 10,000 |   |
| Bank debt                                 |   | —                 |   | — |   | 14,000 |   | 22,900 |   | 50,100 |   |
| Series B, 8% redeemable preferred stock   |   | —                 |   | — |   | — |   | — |   | 34,733 |   |
| Convertible participating preferred stock |   | —                 |   | — |   | — |   | — |   | 75,000 |   |
| Stockholders’ equity (deficiency)    |   | $                      | 44,240 |   | $ | 36,313 |   | $ | 25,638 |   | $ | 21,359 |   | $ | (124,948 | ) |

 

**Item 7.**                    **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS.**

 

Certain statements contained in this reportinclude “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995. All forward-looking statements inthis document are based on information currently available to us as of the dateof this report, and except as required by law, we assume no obligation toupdate any forward-looking statements. Forward-looking statements involve knownand unknown risks, uncertainties and other factors that may cause the actualresults to differ materially from any future results, performance orachievements expressed or implied by such forward-looking statements. Suchfactors may include, among others, those factors listed in Item 1A andelsewhere in this report and our other filings with the Securities and ExchangeCommission. The following discussion should be read in conjunction with ourfinancial statements and related notes appearing elsewhere in this report.

 

**Overview**

 

We are a leading developer, manufacturer andsupplier of printing systems and consumable supplies that personalize plasticidentification cards by printing images and text onto the card.  Our printing systems are capable of encodingdata onto cards that incorporate bar code, magnetic stripe, smart card orproximity card technology.  We believethat our engineering expertise and our ability to offer a broad range ofprinting systems using multiple printing technologies have led to a reputationfor innovation in our industry.

 

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

 

Concern for personal safety and propertyprotection has led to the need for electronic and visual identification andaccess control.  We believe the demandfor our products will increase as governments and corporations worldwideaddress their security needs. We believe the development and implementation ofnew technologies that add security features to plastic cards should foster agrowing market for our systems.

 

We market and sell our products exclusivelythrough a distribution channel of independent distributors and resellers inmore than 80 countries worldwide.  Weestimate that as of December 31, 2003, we have manufactured and sold morethan 80,000 of our printing systems. End-users of our printing systems create personalized cards for a widevariety of applications including corporate security and access; drivers’licenses, government and military identification; student identification andaccess; public transportation access; and recreation and gaming.

 

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We sell both printing systems and consumablesupplies used in those systems.  Weproduce a diverse array of card printing systems that allow us the meet theneeds of end-users, ranging from those who desire a premium system to addresscomplex applications to those focused on lower priced systems with fewerfeatures.  We also sell consumablesupplies that are used with our systems, including dye sublimation ribbons,overlaminates, thermal resin ribbons, printheads, inkjet cartridges, inkjetcard cartridges and blank cards.  Overthe past five years the proportion of our total revenues provided by consumablesupplies has increased to 60% of total revenues in 2003 from 49% in 1999.  Factors affecting our net sales of cardprinting systems each year include the mix of systems sold, declines in averageselling price and the number of major projects we are successful inwinning.  As the number of Fargo systemsinstalled and in use continues to grow, the sale of consumable supplies for usein these systems provides us with a significant recurring, and growing revenuestream.

 

Our markets can be categorized in three broadtiers - entry-level, mid-level and high-level. We have historically been successful in each of these markets.  End users in the entry-level market aretypically using a simple photo identification card.  Users in this market are likely more focused on lower pricedsystems with fewer features. Users in the mid-level tier typically would addfunctionality such as access control or time and attendance recording features.

 

At the high-end of our markets are governmentand government-related projects and corporate security programs withmulti-level requirements, which typically will use a much more sophisticatedand complex identification card and are projects where the end-user is lookingfor the highest levels of functionality and security.  Examples of government and government-related projects includenational identification programs, military programs and drivers’ licenseprograms.  These projects typically spanmultiple years and involve integrating solutions into complex existinginfrastructures.  The printer componentof these projects is typically only a small piece of the overall project.  While the company actively pursues suchproject business, these projects are very competitive and it is very difficultto predict the timing of the bid process, funding and implementation of anysuch projects.  We did not obtain anysignificant new major government project business in 2003.

 

We have experienced and expect to continue toexperience quarterly variations in net sales and gross profit as a result of anumber of factors, including, among other things, the timing and extent ofpromotional pricing; the timing of major projects; the number and mix ofproducts sold in the quarter; the availability and cost of components andmaterials; costs, benefits and timing of new product introductions; customerorder size and shipment timing; and seasonable factors affecting timing ofpurchase orders.

 

In October 2003, we introduced a newdistribution program for our United States channel partners.  The new program categorizes distributionpartners into four complementary, yet separate, program tracks.  Fargo Solution Providers provide retailcustomers with sales, service and integration expertise on Fargo’s full line ofProfessional and Persona Series products and systems.  Fargo Value Added Distributors provide in-depth integrationexpertise and support for Fargo Solution Providers and end user customers on Fargo’sfull line of products and systems. Fargo Distributors provide product distribution services to FargoSolution Providers and Persona Series resellers.  Fargo Manufacturing Resellers are companies that have a corebusiness of developing and manufacturing products where the sale of identificationcard printers is a secondary portion of its sale.  Each category has the option to work exclusively with Fargo todevelop market share and expertise in the markets they serve.  The program continues our two-product linestrategy with restricted distribution on our Professional Series products andbroad distribution of our Persona products. The new program resulted from a review of our existing and futurechannel requirements, our partners’ needs and the products that are underdevelopment by us.  We believe that thisnew distribution structure will be attractive to both current and newdistribution partners.  However, it iscurrently too early to assess the results of the changes or their potentialimpact on our results of operations or financial condition.

 

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**Resultsof Operations**

 

The following table sets forth, for theperiods indicated, certain selected financial data expressed as a percentage ofnet sales:

 
|                                |   | **Years Ended December 31,** |   |
|-------------------------------------|--------|------------------------------|--------|
|                                |   | **2003**                     |   | **2002** |   | **2001** |   |
|                                |   |                         |   |   |   |   |   |
| Net sales                           |   | 100.0                        | %      | 100.0 | % | 100.0 | % |
| Cost of sales                       |   | 59.0                         |   | 59.4 |   | 61.5 |   |
| Gross profit                        |   | 41.0                         |   | 40.6 |   | 38.5 |   |
| Operating expenses:                 |   |                         |   |   |   |   |   |
| Research and development            |   | 7.3                          |   | 6.8 |   | 6.6 |   |
| Selling, general and administrative |   | 17.6                         |   | 17.2 |   | 17.0 |   |
| Terminated acquisition costs        |   | —                       |   | 0.8 |   | 2.4 |   |
| Total operating expenses            |   | 24.9                         |   | 24.8 |   | 26.0 |   |
| Operating income                    |   | 16.1                         | %      | 15.8 | % | 12.5 | % |

 

*Comparison of Years Ended December 31, 2003 and 2002*

 

*Net sales.*  Net sales decreased 0.8% to$65.5 million in 2003 from $66.0 million in 2002. Sales of equipmentdecreased 9.2% to $25.9 million from $28.5 million in 2002, and salesof supplies increased 5.6% to $39.6 million from $37.5 million in2002. The decrease in sales of equipment is mainly due to a decrease inshipments related to major government projects and a decrease in averageselling price, partially offset by an increase in unit volume from non-projectbusiness.  The increase in sales ofsupplies was primarily due to changes in sales mix as well as price increasesin 2003.  The increase is also due to anincrease in sales of supplies for projects.

 

International sales increased 4.5% to$27.6 million in 2003 from $26.4 million in 2002 and accounted for42.1% of net sales in 2003 compared to 39.9% of net sales in 2002. The dollarincrease in international sales was principally attributable to increased salesof supplies in Canada, Mexico, South America, Australia and the Middle East in2003, which is partially offset by a decrease in sales of equipment in Canadaand Australia.

 

*Gross profit.*  Gross profit increased 0.2% to$26.9 million for 2003 from $26.8 million in 2002. Gross profit as apercentage of net sales was 41.0% for 2003 compared to 40.6% in 2002. Grossprofit for 2003 was positively impacted primarily by lower manufacturing costsassociated with improved quality.

 

*Research and development.*  Research and development expenses increased6.0% to $4.8 million in 2003 from $4.5 million in 2002. Research anddevelopment expenses as a percentage of net sales were 7.3% for 2003 comparedto 6.8% for 2002. In 2002, research and development expenses are net ofapproximately $213,000 charged by us to a third party for certain engineeringdevelopment work.  We also experiencedhigher payroll and benefits expenses in 2003.     

 

*Selling, general and administrative.*  Selling, general and administrative expensesincreased 1.0% to $11.5 million in 2003 from $11.4 million in 2002.As a percentage of net sales, selling, general and administrative expenses were17.6% in 2003, compared to 17.2% in 2002. The increase in selling, general andadministrative expenses is due to higher general and administrative expenses,due mainly to higher legal and professional fees, directors’ fees, and healthinsurance costs, partially offset by a decrease in advertising marketingexpenses.  The increase in legal andprofessional fees relates primarily to litigation expenses incurred to enforceour patents in Asia.  Directors’ feesincreased due to the addition of three board members in 2003.  The increase in our health insurance is duemainly to the increase in our major claims experience in the fourth quarter of2003.  The decrease in advertisingmarketing expenses is due to the timing of new product introductions.

 

*Operating income.*Operating income increased 2.1% to $10.6 million in 2003 from$10.4 million in 2002. As a

 

22

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percentage of net sales,operating income was 16.1% in 2003 as compared to 15.8% in 2002.

 

*Interest expense.*Interestexpense totaled $29,000 in 2003 compared to $554,000 in 2002. The interestexpense in 2003 is mainly for non-use fees on our revolving creditfacility.  We had no bank debtoutstanding during 2003.

 

*Interest income*.  Interest income totaled $32,000 in 2003compared to $187,000 in 2002.  In 2002,interest income included $163,000 of interest earned from the repayment in 2002of recourse promissory notes issued in connection with grants of restrictedstock made in 1998 and 1999 to Mr. Holland, our Chief Executive Officer and toan outside director.  There were nopromissory notes outstanding during 2003.

 

*Income tax expense.*  Income tax expense was $3.3 million in2003, which results in an effective tax rate of 31.6%, compared to income taxexpense of $3.3 million and an effective tax rate of 32.6% in 2002. Thelower effective tax rate for 2003 was the result of the recognition ofapproximately $126,000 of additional tax credits related to a prior year, whichwas settled in the third quarter of 2003. Excluding these tax credits, the effective tax rate would have been32.8% for the year ended December 31, 2003. Income tax expense for both 2003 and 2002 includes the currentrecognition of research and experimentation credits in the respective periods.

 

*Comparison of Years Ended December 31, 2002 and 2001*

 

*Net sales.*  Net sales increased 8.3% to$66.0 million in 2002 from $61.0 million in 2001. Sales of equipmentincreased 5.8% to $28.5 million from $27.0 million in 2001, and salesof supplies increased 10.3% to $37.5 million from $34.0 million in2001. In 2002, we experienced an increase in our base printer business andproject equipment sales over the same period of 2001. The increase in shipmentsof equipment is also due to successful new product launches. The increase insales of supplies was mainly the result of increased supplies volume sold in2002 from an increase in project sales.

 

International sales increased 8.4% to$26.4 million in 2002 from $24.3 million in 2001 and accounted for39.9% of net sales in 2002 and 2001. The dollar increase in international saleswas principally attributable to increased sales of equipment and supplies inEurope and Australia in 2002, which is partially offset by a decrease in salesin South America.

 

*Gross profit.*  Gross profit increased 14.4% to$26.8 million for 2002 from $23.5 million in 2001. Gross profit as apercentage of net sales was 40.6% for 2002 compared to 38.5% in 2001. Grossprofit for 2002 was positively impacted by reductions in material costs,increased printer volumes, sales mix, and lower manufacturing costs associatedwith quality issues.

 

*Research and development.*  Research and development expenses increased11.7% to $4.5 million in 2002 from $4.1 million in 2001. Research anddevelopment expenses as a percentage of net sales were 6.8% for 2002 comparedto 6.6% for 2001. The increase is primarily due to higher salary expense as aresult of higher staffing levels.  In2002, research and development expenses are net of approximately $213,000charged by us to a third party for certain engineering development work.

 

*Selling, general and administrative.*  Selling, general and administrative expensesincreased 10.1% to $11.4 million in 2002 from $10.3 million in 2001.As a percentage of net sales, selling, general and administrative expenses were17.2% in 2002, compared to 17.0% in 2001. Increased advertising, tradeshow,business and health insurance and salary expenses were partially offset bylower professional fees. We experienced higher professional fees in 2001 due tofees paid to outside consultants to improve our manufacturing processes. Theincrease in salary expense is mainly due to higher staffing levels in our salesand marketing departments.

 

*Terminated acquisition costs.*  In connection with our proposed acquisitionby another company, which was terminated in March 2002, we incurred legal,professional, and investment banking expenses of $552,000 in 2002, compared to$1.4 million in 2001.

 

*Operating income.*  Operating income increased 35.7% to $10.4 millionin 2002 from $7.6 million in 2001. As a

 

23

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percentage of net sales,operating income was 15.8% in 2002 as compared to 12.5% in 2001.

 

*Interest expense.*  Interest expense totaled $554,000 in 2002 comparedto $1.4 million in 2001. The reduction in our outstanding debt combinedwith reduced interest rates led to the lower interest expense. The weightedaverage interest rate on our outstanding debt for the year endedDecember 31, 2002 was 3.7% as compared to 6.5% in 2001.

 

*Income tax expense.*  Income tax expense was $3.3 million in2002, which results in an effective tax rate of 32.6%, compared to income taxexpense of $2.2 million and an effective tax rate of 35.4% in 2001. Thedecrease in the effective tax rate for 2002 relates to research andexperimentation credits we utilized during 2002.

 

**Liquidityand Capital Resources**

 

We have historically financed our operations,debt service and capital requirements through cash flows generated fromoperations. Working capital was $22.4 million, $12.7 million, and$9.2 million at December 31, 2003, 2002, and 2001, respectively.During 2001, we repaid $8.9 million of bank debt and in 2002, we paid offanother $14.0 million. At December 31, 2002 and throughout 2003, wehad no bank debt outstanding.

 

We believe, based on our current cash levelsas well as the operating cash flows expected in 2004 and the funds available tous under our $5.0 million revolving credit facility, that we will havesufficient funds to finance our current operations and planned capitalexpenditures for at least the next 12 months.

 

We had cash and cash equivalents of$13.4 million at December 31, 2003, an increase of $10.9 millionfrom $2.5 million at December 31, 2002.  This increase is due to positive net cash flows provided by ouroperating activities and to the company being debt-free in 2003, which resultedin a decrease in interest expense from 2002 of $525,000.

 

Cash generated from operating activities in2003 totaled $11.9 million due to net income of $7.2 million and non-cashcharges of $3.6 million primarily for deferred income taxes anddepreciation and amortization. The decrease in accounts receivable of $2.1million also contributed to an increase in cash provided by operating activities.The decrease in accounts receivable is due mainly to the timing of sales andcustomers taking advantage of early payment discounts.  These cash flows were partially offset by adecrease in accounts payable and accrued liabilities of $1.4 million.  The decrease in accounts payable is mainlydue to the timing of purchases and decreased revenue activity in the fourthquarter of 2003, compared to 2002.  Cashused by investing activities was $1.4 million exclusively for the purchaseof equipment and leasehold improvements. The purchase of equipment is largelydependent on the timing of new products. Cash provided by financing activities was $472,000 due to proceedsreceived from the exercise of stock options during 2003.

 

Cash generated from operating activities in2002 totaled $10.3 million due to net income of $6.7 million andnon-cash charges of $4.2 million primarily for deferred income taxes anddepreciation and amortization. Increases in accounts payable and accruedliabilities of $1.1 million also contributed to an increase in cashprovided by operating activities. The increase in accounts payable and accruedliabilities is mainly due to the timing of purchases and increased revenueactivity in the fourth quarter of 2002. These cash flows were partially offsetby an increase in accounts receivable of $1.5 million primarily related tothe timing of sales. Cash used by investing activities was $1.2 millionexclusively for the purchase of equipment and leasehold improvements. Cash usedin financing activities was $10.2 million primarily due to payments on ourcredit facility, partially offset by $3.1 million in net proceeds receivedfrom our secondary public offering.

 

InDecember 2002, we further amended our credit facility, which under theterms of the amendment, was converted to a $5.0 million revolving creditfacility, of which there was no outstanding balance at December 31, 2002or at any point during 2003. The borrowings under the revolving credit facilityare limited to eligible accounts receivable and inventories as defined by theagreement. Under the terms of the amended agreement, we may borrow at the primerate of interest or LIBOR plus a margin of 1.50%. Interest is payable within 30to 180 days, as defined by the agreement. The credit agreement is ineffect through December 2005.

 

The credit facility requires, among otherthings, the maintenance of specified financial ratios including fixed chargecoverage and total debt to EBITDA, as defined in the agreement, andrestrictions on capital expenditures, payment

 

24

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of dividends and operatinglease expenditures.

 

## **Contractual Obligations**

 

The following table summarizes our futurecontractual obligations as of December 31, 2003.

 
|                                                                       |   | **Payments due by period (in thousands)** |   |
|----------------------------------------------------------------------------|--------|-------------------------------------------|--------|
| **Contractual Obligations**                                                |   | **Total**                                 |   | **Less than  1 year** |   | **1 – 3  years** |   | **3 – 5  years** |   | **More  than 5  years** |   |
|                                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| **Long-Term Debt**                                                         |   | —                                    |   | — |   | — |   | — |   | — |   |
| **Capital Lease Obligations**                                              |   | —                                    |   | — |   | — |   | — |   | — |   |
| **Operating Lease**                                                        |   | $                                         | 1,528  |   | $ | 492 |   | $ | 1,036 |   | — |   | — |   |
| **Purchase Obligations**                                                   |   | 44,498                                    |   | 8,498 |   | 8,000 |   | 8,000 |   | 20,000 |   |
| **Other Long-Term Liabilities Reflected on  our Balance Sheet under GAAP** |   | —                                    |   | — |   | — |   | — |   | — |   |
|                                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| **Total**                                                                  |   | $                                         | 46,026 |   | $ | 8,990 |   | $ | 9,036 |   | $ | 8,000 |   | $ | 20,000 |   |
|                                                                            |        |                                           |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

#### *Operating lease.*  We lease ouroffice, warehouse and manufacturing space under an operating lease that expiresin December 2006.  Total rent expensefor this operating lease was $918,000, $940,000, and $727,000 during 2003, 2002and 2001, respectively.

 

*Purchase obligations.*  Purchase obligations are for purchases madein the normal course of business to meet operational requirements.  Of this amount, $1,349,000 relates tounconditional purchase agreements that the Company has entered into withcertain suppliers.  These agreements arereviewed on a semi-annual basis, and, unless terminated by either party,automatically renew for an additional six-month period.  The agreements may be terminated by eitherparty with a 30-day written notice.  Purchase obligations also include anagreement to purchase $4 million a year of materials under a ten-yearagreement with one of our suppliers.  Our obligation to meet thiscommitment is conditional upon the supplier continuing to meet a number ofobligations set out in the agreement.

 

**CriticalAccounting Policies and Estimates**

 

Management’s discussion and analysis of itsfinancial condition and results of operations are based upon our financialstatements, which have been prepared in conformity with accounting principlesgenerally accepted in the United States of America. The preparation offinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets and liabilities and the reported amounts ofrevenues and expenses during the reporting period. We base our estimates onhistorical experience and on various other assumptions that we believe to bereasonable based upon the information available to us, the results of whichform a basis for making judgments about the carrying value of assets andliabilities that are not readily available from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

 

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

 

*Revenue Recognition*—Werecognize revenue when title passes, which generally is at the time ofshipment. We provide for estimated warranty costs and estimated returns in theperiod revenue is recognized. Certain of our customers have arrangements thatinclude stock balancing return provisions. We provide an allowance for stockbalancing based on estimated expected returns. Sales to these customers collectively represented 17.3%, 11.7% and10.2%, respectively, of net sales for the years ended December 31, 2003,2002 and 2001. Under the terms of the stock balancing agreements, we estimatethat the maximum amount of returns is approximately $305,000 atDecember 31, 2003, of which we have recorded an allowance of $133,000 forstock balancing estimated returns. This reserve is included in our allowancefor doubtful accounts and sales returns.

 

25

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*Allowance for doubtful accounts and salesreturns—*We determine the estimate of the allowance fordoubtful accounts and sales returns considering a number of factors, including:(1) historical experience, (2) aging of the accounts receivable,(3) analysis of stock balancing agreements and (4) specificinformation obtained by us on the financial condition and the currentcreditworthiness of our customers. If the financing conditions of our customerswere to deteriorate and reduce the ability of our customers to make payments ontheir accounts, we may be required to increase our allowance by recordingadditional bad debt expense. Likewise, should the financial condition of ourcustomers improve and result in payments or settlements of previously reservedamounts, we may be required to record a reduction in bad debt expense toreverse the recorded allowance. Our allowance for doubtful accounts and salesreturns was $400,000 at December 31, 2003.

 

*Allowance for excess and obsolete inventories*—Wevalue our inventories at the lower of the actual cost to purchase ormanufacture, or the current estimated market value. We regularly review ourinventory quantities on hand and record a provision for excess and obsoleteinventory based primarily on estimated forecasts of product demand andproduction requirements for the subsequent twelve and twenty four months. Wemake every effort to ensure the accuracy of our forecasts of future productdemand, however any significant unanticipated changes in demand ortechnological developments could have a significant impact on the value ofinventories and reported operating results. Our allowance for excess andobsolete inventories at December 31, 2003, was $771,000.

 

*Warranty accrual—*Ourproducts are generally covered by a standard one-year warranty from the date ofsale.  Estimated warranty costs areaccrued in the same period in which the related revenue is recognized, based onanticipated parts and labor costs, utilizing historical experience. Ourwarranty accrual at December 31, 2003, was $525,000.

 

*Deferred tax assets*—Therealization of our deferred tax assets is dependent upon our ability togenerate sufficient future taxable income which we believe is more likely thannot. We anticipate future taxable income sufficient to realize the recordeddeferred tax assets. Historically, we have generated operating income. Futuretaxable income is based on our forecasts of operating results, and there can beno assurance that such results will be achieved.  Our deferred tax assets at December 31, 2003 were $23,142,000.

 

**Inflation**

 

We do not believe that inflation has had a material effect on ourresults of operations in recent years; however, there can be no assurance thatour business will not be adversely affected by inflation in the future.

 

**Recently Issued Accounting Standards**

 

In January 2003, the FASB issued FASB Interpretation No. 46,“Consolidation of Variable Interest Entities” and issued a revisedinterpretation in December 2003 (FIN 46R). FIN 46R requires that if a business enterprise has a controllingfinancial interest in a variable interest entity, the assets, liabilities, andresults of the activities of the variable interest entity must be included inthe consolidated financial statements with those of the business enterprise. FIN46R must be applied for periods ending after March 15, 2004, and was effectiveimmediately for all variable interest entities created after January 31, 2003.The Company does not have ownership in any variable interest entities.  The adoption of this standard did not havean impact on our financial statements.

 

In May 2003, the FASB issued SFAS No. 149, Amendment of Statement 133on Derivative Instruments and Hedging Activities.  This statement amends and clarifies financial accounting andreporting for derivative instruments, including certain derivative instrumentsembedded in other contracts (collectively referred to as derivatives) and forhedging activities under FASB Statement No. 133, Accounting for DerivativeInstruments and Hedging Activities.  SFASNo. 149 is effective for contracts entered into or modified after June 30,2003, and for hedging relationships designated after June 30, 2003.  The adoption of this standard did not havean impact on our financial statements.

 

InMay 2003, the FASB issued SFAS No. 150, Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity.  The statement requires that an issuerclassify financial instruments that are within its scope as a liability.  Many of those instruments were classified asequity under previous guidance.  SFASNo. 150 is effective for all financial instruments entered into or modifiedafter May 31, 2003.  Otherwise, it isgenerally effective on

 

26

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July 1, 2003.  The adoption ofthis standard did not have an impact on our financial statements.

 

## **In May2003, the FASB Emerging Issues Task Force reached a final consensus on EITF00-21, “Accounting for Revenue Arrangements with Multiple Deliverables.”  The EITF addresses how to account formultiple-deliverable revenue arrangements and focuses on when a revenuearrangement should be separated into different revenue-generating deliverablesor “units of accounting” and if so, how the arrangement considerations shouldbe allocated to the different deliverables or units of accounting.  The provisions of EITF 00-21 are effectivefor revenue arrangements entered into at the beginning of the first interimperiod after June 15, 2003.  Theadoption of this standard did not have an impact on our financial statements.**

 

InDecember 2003, the Securities and Exchange Commission issued Staff AccountingBulletin No. 104 (SAB No. 104), “Revenue Recognition”, which codifies, revisesand rescinds certain sections of SAB No. 101, “Revenue Recognition”, in orderto make this interpretive guidance consistent with current authoritativeaccounting and auditing guidance and SEC rules and regulations.  The adoption of this standard did not havean impact on our financial statements.

 

 

**Item7A.****         QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

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

 

**Interest Rate Risk**

 

We are potentially exposed to market risk from interest rate changes inour credit agreement. Under the terms of our credit agreement, we may borrow atthe prime rate of interest or LIBOR plus a margin of 1.50%.  For borrowings under our credit agreement,we typically lock into a fixed interest rate for periods between 30 to90 days.  At December 31, 2002and throughout 2003, we had no borrowings outstanding.

 

**Foreign Currency Risk**

 

Wedenominate all foreign sales in U.S. dollars and do not hedge against currencyfluctuations. We purchase components and supplies from several Japanesesuppliers.  To date, currencyfluctuations have not had a material effect on our results of operations orfinancial condition, but could in the future by causing our products to becomeless affordable or less price competitive than those of foreign manufacturersor by causing the costs of our material supplies to increase. We make all ofour purchases in U.S. dollars and we believe that we have reduced the risks ofincreased purchasing costs that would otherwise occur if the dollar weakensrelative to the yen. We have foregone the opportunity, however, to benefit fromthe full potential cost savings if the dollar strengthens relative to the yen.

 

**Equity Price Risk**

 

We do not generally invest in marketable equity securities. AtDecember 31, 2003, we had approximately $13.4 million in cash andcash equivalents, comprising approximately 26.5% of our total assets.  Given the current low rates of interest, asustained decrease in the rate of interest earned would not have a materialadverse effect on our business.

 

**Item8.****            FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA.**

 

# **Financial Statements**

 

Our financial statements and related notes are contained on pages F-1to F-17 of this report. The index to such items is included in Item 15(a)(i).

 

27

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# **Quarterly Results**

 

The following table sets forth certain unaudited quarterly financialdata for 2003 and 2002. In our opinion, this unaudited information has beenprepared on the same basis as the audited information and includes alladjustments (consisting only of normal recurring adjustments) necessary topresent fairly the information set forth therein. The operating results for anyquarter are not necessarily indicative of results for any future period.

 
|                         |   | **Three  Months Ended** |   |
|------------------------------|--------|-------------------------|--------|
|                         |   | **March 31,  2002**     |   | **June 30,  2002** |   | **September  30, 2002** |   | **December  31, 2002** |   |
| Net sales                    |   | $                       | 15,021 |   | $ | 14,742 |   | $ | 17,817 |   | $ | 18,455 |   |
| Gross profit                 |   | 5,801                   |   | 6,035 |   | 7,622 |   | 7,378 |   |
| Operating expenses           |   | 4,628                   |   | 4,093 |   | 3,905 |   | 3,842 |   |
| Operating income             |   | 1,173                   |   | 1,942 |   | 3,717 |   | 3,536 |   |
| Net income                   |   | $                       | 714    |   | $ | 1,202 |   | $ | 2,426 |   | $ | 2,394 |   |
| Net income per common share: |   |                    |   |   |   |   |   |   |   |
| Basic earnings per share     |   | $                       | 0.06   |   | $ | 0.10 |   | $ | 0.20 |   | $ | 0.19 |   |
| Diluted earnings per share   |   | $                       | 0.06   |   | $ | 0.10 |   | $ | 0.19 |   | $ | 0.19 |   |

 
|                         |   | **Three  Months Ended**                            |   |
|------------------------------|--------|----------------------------------------------------|--------|
|                         |   | **March 31,  2003**                                |   | **June 30,  2003** |   | **September  30, 2003** |   | **December  31, 2003** |   |
|                         |   | **(Amounts  in thousands, except per share data)** |   |
| Net sales                    |   | $                                                  | 15,479 |   | $ | 16,492 |   | $ | 17,059 |   | $ | 16,461 |   |
| Gross profit                 |   | 6,190                                              |   | 6,672 |   | 7,269 |   | 6,752 |   |
| Operating expenses           |   | 4,240                                              |   | 4,039 |   | 3,774 |   | 4,249 |   |
| Operating income             |   | 1,950                                              |   | 2,633 |   | 3,495 |   | 2,503 |   |
| Net income                   |   | $                                                  | 1,315  |   | $ | 1,766 |   | $ | 2,459 |   | $ | 1,700 |   |
| Net income per common share: |   |                                               |   |   |   |   |   |   |   |
| Basic earnings per share     |   | $                                                  | 0.11   |   | $ | 0.14 |   | $ | 0.20 |   | $ | 0.14 |   |
| Diluted earnings per share   |   | $                                                  | 0.10   |   | $ | 0.14 |   | $ | 0.19 |   | $ | 0.13 |   |

 

**Item9.****            CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.**

 

None.

 

**Item9A.****         CONTROLSAND PROCEDURES.**

 

Our disclosure controls and procedures are designed to ensure thatinformation required to be disclosed in reports that we file or submit underthe Securities Exchange Act of 1934 is recorded, processed, summarized andreported within the time periods specified in the rules and forms of theSecurities and Exchange Commission. Our Chief Executive Officer and the ChiefFinancial Officer have reviewed the effectiveness of our “disclosure controlsand procedures” (as defined in the Securities Exchange Act of 1934Rules 13a-14(c) and 15d-14(c)) as of the end of the period covered by thisreport and have concluded that the disclosure controls and procedures areeffective. There were no significant changes in our internal controls or inother factors that could significantly affect these controls subsequent to thelast day they were evaluated by our Chief Executive Officer and Chief FinancialOfficer.

 

28

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**PART III**

 

**Item10.****          DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT.**

 

(a)           *Directorsof the Registrant*.

 

The information under the caption “Election of Directors––InformationAbout Nominees” and “––Other Information About Nominees” in our 2004 ProxyStatement is incorporated herein by reference.

 

(b)           *ExecutiveOfficers of the Registrant*.

 

Information concerning our Executive Officers is included in thisAnnual Report on Form 10-K under Item 4A, “Executive Officers of Fargo.”

 

(c)           *Compliancewith Section 16(a) of the Exchange Act*.

 

The information under the caption “Section 16(a) BeneficialOwnership Reporting Compliance” in our 2004 Proxy Statement is incorporatedherein by reference.

 

*(d)**          Audit CommitteeFinancial Expert.*

 

The information under the caption “Election of Directors-AdditionalInformation About our Board and its Committees” in our 2004 Proxy Statement isincorporated herein by reference.

 

(e)           *Identificationof the Audit Committee.*

 

The information under the caption “Election of Directors-AdditionalInformation About our Board and its Committees” in our 2004 Proxy Statement isincorporated herein by reference.

 

(f)            *Code ofEthics for Senior Financial Officers.*

 

Our principal executive officer, principal financial officer anddirector of finance have signed a Code of Ethics, which we believe meets therequirements of the Securities and Exchange Commission.  We have posted our Code of Ethics for SeniorFinancial Officers on our corporate governance page of our web site.  The corporate governance page can beaccessed on our web site at www.fargo.com. We intend to disclose any amendments to and any waiver from a provisionof our Code of Ethics for Senior Financial Officers on our web site within fivebusiness days following such amendment or waiver.  The information contained or connected to our web site is notincorporated by reference into this Form 10-K and should not be considered partof this or any report that we file with or furnish to the SEC.

 

**Item11.****          EXECUTIVECOMPENSATION.**

 

The information under the caption “Executive Compensation” in our 2004Proxy Statement is incorporated herein by reference.

 

**Item12.****          SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.**

 

The information under the captions “Security Ownership of CertainBeneficial Owners and Management” and “Executive Compensation—SecuritiesAuthorized for Issuance Under Equity Compensation Plans” in our 2004 ProxyStatement is incorporated herein by reference.

 

**Item13.****          CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS.**

 

The information under the caption “Executive Compensation—CertainTransactions” in our 2004 Proxy Statement is incorporated herein by reference.

 

**Item14.****          PRINCIPALACCOUNTANT FEES AND SERVICES.**

 

The information under the caption “Independent Accountants-Fees ofIndependent Auditors” in our 2004 Proxy

 

29

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Statement is incorporated herein by reference.

 

 

**PART IV**

 

**Item15.****          EXHIBITS,FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K**

 

**(a)****           List of documents filedas part of this report:**

 

(1)           *FinancialStatements:*

 

The following financial statements are included in this report on thepages indicated:

 
| Report of Independent Auditors                                                                                | F-1        |
|---------------------------------------------------------------------------------------------------------------|------------|
| Balance  Sheets at December 31, 2003 and 2002                                                            | F-2        |
| Statements of Operations for the years  ended December 31, 2003, 2002 and 2001                           | F-3        |
| Statement  of Changes in Stockholders’ Equity for the years ended December 31,  2003, 2002 and 2001 | F-4        |
| Statements of Cash Flows for  the years ended December 31, 2003, 2002 and 2001                           | F-5        |
| Notes to Financial  Statements                                                                                | F-6 - F-17 |

 

(2)           *FinancialStatement Schedule:*

 

The following financial statement schedule is included herein andshould be read in conjunction with the financial statements referred to above:

 

Report of Independent Auditors on Financial Statement Schedule

 

Schedule II—Valuationand Qualifying Accounts

 

All other schedules are omitted as the required information isinapplicable or the information is presented in the financial statements orrelated notes.

 

30

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**Report of Independent Auditors on**

**Financial Statement Schedule**

 

To the Stockholders and Board of Directors of FargoElectronics, Inc.:

 

Our audits of the financial statements referred to in our report datedFebruary 12, 2004, appearing in the 2003 Annual Report to Stockholders ofFargo Electronics, Inc. (which report and financial statements areincluded in this Annual Report on Form 10-K) also included an audit of thefinancial statement schedule listed in Item 15(a)(2) of this Form 10-K. Inour opinion, this financial statement schedule presents fairly, in all materialrespects, the information set forth therein when read in conjunction with therelated financial statements.

 
| /s/ PRICEWATERHOUSECOOPERS LLP |   |
|--------------------------------|--------|
|                           |
| Minneapolis, Minnesota         |
| February 12, 2004         |

 

31

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**ScheduleII**

**Valuation and Qualifying Accounts**

 
| **Description**                            |   | **Balance at  Beginning of  Period** |      | **Charged to  Costs and  Expenses** |   | **Deductions** |   | **Balance at  End of  Period** |      |
|--------------------------------------------|--------|--------------------------------------|-----------|-----------------------------------------------|--------|----------------|--------|-------------------------------------|-----------|
|                                       |   |                                 |      |                                          |   |           |   |                                |      |
| Valuation account for accounts receivable: |   |                                 |      |                                          |   |           |   |                                |      |
| Year ended December 31, 2003               |   | $                                    | 400,000   |                                          | $      | 724,867        |   | $                                   | 724,867   |   | $ | 400,000 |   |
| Year ended December 31, 2002               |   | $                                    | 300,000   |                                          | $      | 868,165        |   | $                                   | 768,165   |   | $ | 400,000 |   |
| Year ended December 31, 2001               |   | $                                    | 250,000   |                                          | $      | 1,340,035      |   | $                                   | 1,290,035 |   | $ | 300,000 |   |
| Valuation account for inventories:         |   |                                 |      |                                          |   |           |   |                                |      |
| Year ended December 31, 2003               |   | $                                    | 634,372   |                                          | $      | 232,722        |   | $                                   | 96,094    |   | $ | 771,000 |   |
| Year ended December 31, 2002               |   | $                                    | 1,025,000 |                                          | $      | 19,174         |   | $                                   | 409,802   |   | $ | 634,372 |   |
| Year ended December 31, 2001               |   | $                                    | 1,064,922 |                                          | $      | 154,467        |   | $                                   | 194,389   |   | $ | 1,025,000 |   |

 

(3)           *Exhibits*

 

The exhibits to this Annual Report on Form 10-K are listed in theExhibit Index contained on pages E-1 through E-7 of this report.

 

We will furnish a copy of any exhibit to a stockholder who requests acopy in writing. We reserve the right to charge a reasonable fee to cover ourcosts. Requests should be sent to: Paul W.B. Stephenson, Chief FinancialOfficer, Fargo Electronics, Inc, 6533 Flying Cloud Drive, Eden Prairie, MN55344.

 

The following is a list of each management contract or compensatoryplan or arrangement required to be filed as an exhibit to this Annual Report onForm 10-K pursuant to Item 15(c):

 

A.    Amended and Restated 1998 Stock Option and GrantPlan (incorporated by reference to Exhibit 10.2 to Fargo’s Form 10-K forthe fiscal year ended December 31, 2000 (File No. 333-90937)).

 

B.    2001 Employee Stock Purchase Plan (incorporated byreference to Exhibit 10.20 to Fargo’s Form 10-K for the fiscal yearended December 31, 2000 (File No. 333-90937)).

 

C.    Form of Restricted Stock Agreement under theAmended and Restated 1998 Stock Option and Grant Plan (incorporated byreference to Exhibit 10.3 to Fargo’s Registration Statement onForm S-1 (File No. 333-90937)).

 

D.    Form of Incentive Stock Option Agreement under theAmended and Restated 1998 Stock Option and Grant Plan (incorporated byreference to Exhibit 10.5 to Fargo’s Registration Statement onForm S-1 (File No. 333-90937)).

 

E.     Form of Non-qualified Stock Option Agreement underthe Amended and Restated 1998 Stock Option and Grant Plan (incorporated byreference to Exhibit 10.4 to Fargo’s Registration Statement on Form S-1(File No. 333-90937)).

 

F.     Form of Indemnification Agreement for directorsand executive officers of Fargo (incorporated by reference to Exhibit 10.9to Fargo’s Registration Statement on Form S-1 (File No. 333-90937)).

 

G.    2003 Stock Incentive Plan (incorporated byreference to Exhibit 10.1 to Fargo’s Form 10-Q for the quarter ended September30, 2003 (File No. 000-29029)).

 

H.    Form of Non-qualified Stock Option Agreement underthe 2003 Stock Incentive Plan (filed herewith).

** **

**(b)****           Reports onForm 8-K:**

 

On October 21, 2003, we filed a report on Form 8-K furnishing underItem 12 the News Release announcing our earning for the third quarter endedSeptember 30, 2003.

 

32

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**(c)****           Exhibits:**

 

The response to this portion of Item 15 is included as a separatesection of this Annual Report on Form 10-K.

** **

**(d)****           Financial StatementSchedules:**

 

See Item 15, section (a) 2 above for the financial statementschedules filed herewith.

 

33

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has duly caused this Report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 

**FARGOELECTRONICS, INC.**

 

 
|   | By     | /s/ GARY R. HOLLAND                                                           |
|--------|--------|-------------------------------------------------------------------------------|
|   |   | Gary R. Holland                                                               |
|   |   | *Chairman of the Board of Directors,  President  and Chief Executive Officer* |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this Report has been signed below on March 15, 2004 by the following persons onbehalf of the Registrant and in the capacities indicated.

 
| **Signature**            |   | **Title**                                                            |
|--------------------------|--------|----------------------------------------------------------------------|
|                     |   |                                                                 |
| /s/ GARY R. HOLLAND      |   | Chairman of the Board of Directors,                                  |
| Gary R. Holland          |   | President and Chief Executive Officer  (Principal Executive Officer) |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ PAUL W.B. STEPHENSON |   | Chief Financial Officer                                              |
| Paul W.B. Stephenson     |   | (Principal Financial Officer and  Principal Accounting Officer)      |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ EDWARD H. BERSOFF    |   | Director                                                             |
| Edward H. Bersoff        |   |                                                                 |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ EVERETT V. COX       |   | Director                                                             |
| Everett V. Cox           |   |                                                                 |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ WILLIAM H. GIBBS     |   | Director                                                             |
| William H. Gibbs         |   |                                                                 |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ KENT O. LILLEMOE     |   | Director                                                             |
| Kent O. Lillemoe         |   |                                                                 |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ DAVID D. MURPHY      |   | Director                                                             |
| David D. Murphy          |   |                                                                 |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ ELAINE A. PULLEN     |   | Director                                                             |
| Elaine A. Pullen         |   |                                                                 |
|                     |   |                                                                 |
|                     |   |                                                                 |
| /s/ EDWARD J. SMITH      |   | Director                                                             |
| Edward J. Smith          |   |                                                                 |

 

34

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**Fargo Electronics, Inc.**

**Index**

**December 31, 2003 and2002**

 
| **Report of Independent Auditors**                 | F-1        |
|----------------------------------------------------|------------|
|                                               |       |
| **Financial Statements**                           |       |
|                                               |       |
| Balance  Sheets                                    | F-2        |
|                                               |       |
| Statements of Operations                           | F-3        |
|                                               |       |
| Statement of Changes in Stockholders’  Equity | F-4        |
|                                               |       |
| Statements of Cash Flows                           | F-5        |
|                                               |       |
| Notes to Financial Statements                      | F-6 - F-17 |

 

----

 

**Report ofIndependent Auditors**

 

To the Stockholders andBoard of Directors of

Fargo Electronics, Inc.

 

 

In our opinion, theaccompanying balance sheets and the related statements of operations, changesin stockholders’ equity and cash flows present fairly, in all materialrespects, the financial position of Fargo Electronics, Inc. (the “Company”) atDecember 31, 2003 and 2002, and the results of its operations and its cashflows for each of the three years in the period ended December 31, 2003, inconformity with accounting principles generally accepted in the United Statesof America.  These financial statementsare the responsibility of the Company’s management; our responsibility is toexpress an opinion on these financial statements based on our audits.  We conducted our audits of these statementsin accordance with auditing standards generally accepted in the United Statesof America, which require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, and evaluating the overall financialstatement presentation.  We believe thatour audits provide a reasonable basis for our opinion.

 

 

/s/ PRICEWATERHOUSECOOPERSLLP

 

 

Minneapolis Minnesota

February 12, 2004

 

F-1

----

 

**Fargo Electronics, Inc.**

**Balance Sheets**

**December 31, 2003 and2002**

**(in thousands, except per sharedata)**

** **
|                                                                                                                                                  |   | **2003** |   | **2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                                                                                                                  |   |     |   |     |   |
| **Assets**                                                                                                                                            |   |     |   |     |   |
| Current assets                                                                                                                                        |   |     |   |     |   |
| Cash and cash equivalents                                                                                                                             |   | $        | 13,445 |     | $      | 2,511 |   |
| Accounts receivable, net                                                                                                                              |   | 7,015    |   | 9,142    |   |
| Inventories, net                                                                                                                                      |   | 4,848    |   | 5,321    |   |
| Prepaid expenses                                                                                                                                      |   | 233      |   | 252      |   |
| Deferred income taxes                                                                                                                                 |   | 3,412    |   | 3,178    |   |
| Total current assets                                                                                                                                  |   | 28,953   |   | 20,404   |   |
| Equipment and leasehold improvements, net                                                                                                             |   | 2,107    |   | 1,494    |   |
| Deferred income taxes                                                                                                                                 |   | 19,730   |   | 22,068   |   |
| Other                                                                                                                                                 |   | 17       |   | 43       |   |
| Total assets                                                                                                                                          |   | $        | 50,807 |     | $      | 44,009 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                         |   |     |   |     |   |
| Current liabilities                                                                                                                                   |   |     |   |     |   |
| Accounts payable                                                                                                                                      |   | $        | 3,802  |     | $      | 5,109 |   |
| Accrued liabilities                                                                                                                                   |   | 2,765    |   | 2,587    |   |
| Total current liabilities                                                                                                                             |   | 6,567    |   | 7,696    |   |
| Commitments and contingencies                                                                                                                         |   |     |   |     |   |
|                                                                                                                                                  |   |     |   |     |   |
| Stockholders’ equity                                                                                                                             |   |     |   |     |   |
| Common stock, $.01 par value; 50,000 shares  authorized, 12,455 and 12,351 shares issued and outstanding at December 31,  2003 and 2002, respectively |   | 125      |   | 124      |   |
| Additional paid-in capital                                                                                                                            |   | 149,179  |   | 148,509  |   |
| Accumulated deficit                                                                                                                                   |   | (105,064 | )      | (112,304 | )      |
| Deferred compensation                                                                                                                                 |   | —   |   | (16      | )      |
| Total stockholders’ equity                                                                                                                       |   | 44,240   |   | 36,313   |   |
| Total liabilities and stockholders’ equity                                                                                                       |   | $        | 50,807 |     | $      | 44,009 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

F-2

----

 

 

**Fargo Electronics, Inc.**

**Statements of Operations**

**Years Ended December31, 2003, 2002 and 2001**

**(in thousands, except per sharedata)**

 
|                                        |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                        |   |     |   |     |   |     |   |
| Net sales                                   |   | $        | 65,491 |     | $      | 66,035   |   | $ | 60,963 |   |
| Cost of sales                               |   | 38,608   |   | 39,199   |   | 37,497   |   |
| Gross profit                                |   | 26,883   |   | 26,836   |   | 23,466   |   |
|                                        |   |     |   |     |   |     |   |
| Operating expenses                          |   |     |   |     |   |     |   |
| Research and development                    |   | 4,801    |   | 4,529    |   | 4,053    |   |
| Selling, general and administrative         |   | 11,501   |   | 11,387   |   | 10,341   |   |
| Terminated acquisition costs                |   | —   |   | 552      |   | 1,434    |   |
| Total operating expenses                    |   | 16,302   |   | 16,468   |   | 15,828   |   |
| Operating income                            |   | 10,581   |   | 10,368   |   | 7,638    |   |
|                                        |   |     |   |     |   |     |   |
| Other income (expense)                      |   |     |   |     |   |     |   |
| Interest expense                            |   | (29      | )      | (554     | )      | (1,379   | )      |
| Interest income                             |   | 32       |   | 187      |   | 79       |   |
| Other, net                                  |   | —   |   | —   |   | (33      | )      |
| Total other income (expense)                |   | 3        |   | (367     | )      | (1,333   | )      |
| Income before provision for income taxes    |   | 10,584   |   | 10,001   |   | 6,305    |   |
| Provision for income taxes                  |   | 3,344    |   | 3,265    |   | 2,229    |   |
| Net income available to common stockholders |   | $        | 7,240  |     | $      | 6,736    |   | $ | 4,076 |   |
| Net income per common share                 |   |     |   |     |   |     |   |
| Basic earnings per share                    |   | $        | .58    |     | $      | .56      |   | $ | .35 |   |
| Diluted earnings per share                  |   | $        | .57    |     | $      | .55      |   | $ | .34 |   |
|                                        |   |     |   |     |   |     |   |   |   |   |
| Weighted average common shares outstanding  |   |     |   |     |   |     |   |
| Basic                                       |   | 12,397   |   | 12,048   |   | 11,760   |   |
| Diluted                                     |   | 12,799   |   | 12,331   |   | 11,958   |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

F-3

----

 

**Fargo Electronics, Inc.**

**Statement of Changes in Stockholders’ Equity**

**Years Ended December31, 2003, 2002 and 2001**

 
|                                                                     |   | **Common  Stock**     |   | **Additional** |   |                 |   |                     |   | **Stock**                  |     | **Total**                    |   |
|--------------------------------------------------------------------------|--------|-----------------------|--------|----------------|--------|----------------------|--------|--------------------------|--------|----------------------------|----------|------------------------------|--------|
| **(in thousands)**                                                       |   | **Number  of Shares** |   | **Par  Value** |   | **Paid-in  Capital** |   | **Accumulated  Deficit** |   | **Deferred  Compensation** |     | **Subscription  Receivable** |   | **Stockholders’  Equity** |   |
|                                                                     |   |                  |   |           |   |                 |   |                     |   |                       |     |                         |   |   |   |
| **Balances at December 31, 2000**                                        |   | 11,747                |   | $              | 117    |                 | $      | 145,155                  |   | $                          | (123,116 | )                            | $      | (72 | ) | $ | (725 | ) | $ | 21,359 |   |
|                                                                     |   |                  |   |           |   |                 |   |                     |   |                       |     |                         |   |   |   |
| Shares issued from exercise of stock options and stock purchase plan     |   | 50                    |   | 1              |   | 99                   |   | —                   |   | —                     |     | —                       |   | 100 |   |
| Proceeds from stock subscription receivable                              |   | —                |   | —         |   | —               |   | —                   |   | —                     |     | 75                           |   | 75 |   |
| Restricted stock cancellation                                            |   | (16                   | )      | —         |   | (25                  | )      | —                   |   | —                     |     | 25                           |   | — |   |
| Amortization of deferred compensation                                    |   | —                |   | —         |   | —               |   | —                   |   | 28                         |     | —                       |   | 28 |   |
| Net income                                                               |   | —                |   | —         |   | —               |   | 4,076                    |   | —                     |     | —                       |   | 4,076 |   |
| **Balances at December 31, 2001**                                        |   | 11,781                |   | 118            |   | 145,229              |   | (119,040                 | )      | (44                        | )        | (625                         | )      | 25,638 |   |
|                                                                     |   |                  |   |           |   |                 |   |                     |   |                       |     |                         |   |   |   |
| Proceeds from secondary public offering, net of $800 for offering  costs |   | 525                   |   | 5              |   | 3,132                |   | —                   |   | —                     |     | —                       |   | 3,137 |   |
| Shares issued from exercise of stock options and stock purchase plan     |   | 45                    |   | 1              |   | 148                  |   | —                   |   | —                     |     | —                       |   | 149 |   |
| Proceeds from stock subscription receivable                              |   | —                |   | —         |   | —               |   | —                   |   | —                     |     | 625                          |   | 625 |   |
| Amortization of deferred compensation                                    |   | —                |   | —         |   | —               |   | —                   |   | 28                         |     | —                       |   | 28 |   |
| Net income                                                               |   | —                |   | —         |   | —               |   | 6,736                    |   | —                     |     | —                       |   | 6,736 |   |
| **Balances at December 31, 2002**                                        |   | 12,351                |   | 124            |   | 148,509              |   | (112,304                 | )      | (16                        | )        | —                       |   | 36,313 |   |
|                                                                     |   |                  |   |           |   |                 |   |                     |   |                       |     |                         |   |   |   |
| Shares issued from exercise of stock options and stock purchase plan     |   | 104                   |   | 1              |   | 471                  |   | —                   |   | —                     |     | —                       |   | 472 |   |
| Amortization of deferred compensation                                    |   | —                |   | —         |   | —               |   | —                   |   | 16                         |     | —                       |   | 16 |   |
| Tax benefit recognized for stock options                                 |   | —                |   | —         |   | 199                  |   | —                   |   | —                     |     | —                       |   | 199 |   |
| Net income                                                               |   | —                |   | —         |   | —               |   | 7,240                    |   | —                     |     | —                       |   | 7,240 |   |
| **Balances at December 31, 2003**                                        |   | 12,455                |   | $              | 125    |                 | $      | 149,179                  |   | $                          | (105,064 | )                            | $      | — |   | $ | — |   | $ | 44,240 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

F-4

----

 

**Fargo Electronics, Inc.**

**Statements of Cash Flows**

**Years Ended December31, 2003, 2002 and 2001**

**(in thousands)**

 
|                                                                              |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                              |   |     |   |     |   |     |   |
| **Cash flows from operating activities**                                          |   |     |   |     |   |     |   |
| Net income                                                                        |   | $        | 7,240  |     | $      | 6,736    |   | $ | 4,076 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities |   |     |   |     |   |     |   |
| Depreciation and amortization                                                     |   | 1,016    |   | 1,169    |   | 1,372    |   |
| Loss on disposal of equipment                                                     |   | 15       |   | 67       |   | 33       |   |
| Provision for doubtful accounts                                                   |   | 10       |   | 104      |   | 58       |   |
| Provision for excess and obsolete  inventories                                    |   | 233      |   | 19       |   | 154      |   |
| Deferred income taxes                                                             |   | 2,104    |   | 2,793    |   | 2,224    |   |
| Deferred compensation                                                             |   | 16       |   | 28       |   | 28       |   |
| Tax benefit recognized for stock options                                          |   | 199      |   | —   |   | —   |   |
| Changes in operating assets and liabilities                                       |   |     |   |     |   |     |   |
| Accounts receivable                                                               |   | 2,117    |   | (1,533   | )      | (1,017   | )      |
| Inventories                                                                       |   | 240      |   | (96      | )      | 2,720    |   |
| Prepaid expenses and other assets                                                 |   | 44       |   | (106     | )      | 71       |   |
| Accounts payable                                                                  |   | (1,537   | )      | 794      |   | 1,483    |   |
| Accrued liabilities                                                               |   | 178      |   | 327      |   | 536      |   |
| Net cash provided by operating activities                                         |   | 11,875   |   | 10,302   |   | 11,738   |   |
| **Cash flows from investing activities**                                          |   |     |   |     |   |     |   |
| Purchases of equipment and leasehold  improvements                                |   | (1,413   | )      | (1,169   | )      | (650     | )      |
| Net cash used in investing activities                                             |   | (1,413   | )      | (1,169   | )      | (650     | )      |
| **Cash flows from financing activities**                                          |   |     |   |     |   |     |   |
| Proceeds from secondary public offering,  net of $800 for offering costs          |   | —   |   | 3,137    |   | —   |   |
| Payments on notes payable, bank                                                   |   | —   |   | (14,000  | )      | (5,000   | )      |
| Proceeds from revolving credit facility                                           |   | —   |   | 2,000    |   | —   |   |
| Payments on revolving credit facility                                             |   | —   |   | (2,000   | )      | (3,900   | )      |
| Payments of deferred financing costs                                              |   | —   |   | (119     | )      | —   |   |
| Proceeds from exercise of stock options                                           |   | 472      |   | 149      |   | 100      |   |
| Proceeds from stock subscription receivable                                       |   | —   |   | 625      |   | 75       |   |
| Net cash provided by (used in) financing  activities                              |   | 472      |   | (10,208  | )      | (8,725   | )      |
| Net increase (decrease) in cash and cash  equivalents                             |   | 10,934   |   | (1,075   | )      | 2,363    |   |
|                                                                              |   |     |   |     |   |     |   |
| **Cash and cash equivalents**                                                     |   |     |   |     |   |     |   |
| Beginning of period                                                               |   | 2,511    |   | 3,586    |   | 1,223    |   |
| End of period                                                                     |   | $        | 13,445 |     | $      | 2,511    |   | $ | 3,586 |   |
| **Cash paid during the period for**                                               |   |     |   |     |   |     |   |
| Interest                                                                          |   | $        | 19     |     | $      | 347      |   | $ | 1,752 |   |
| Income taxes                                                                      |   | 797      |   | 480      |   | —   |   |
|                                                                              |   |     |   |     |   |     |   |
| **Noncash transactions**                                                          |   |     |   |     |   |     |   |
| Restricted stock cancellations                                                    |   | —   |   | —   |   | (25      | )      |
| Purchase of equipment included in accounts  payable                               |   | 230      |   | —   |   | —   |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

F-5

----

 

**Fargo Electronics, Inc.**

**Notes to Financial Statements**

**December 31, 2003 and2002**

 

**1.**                          **Nature of Business andSummary of Significant Accounting Policies**

 

**Nature ofBusiness**

Fargo Electronics, Inc.(“Fargo” or the “Company”) develops, manufactures and supplies printing systemsand consumable supplies that personalize plastic identification cards byprinting images and text onto the card. The Company sells its products exclusively through independentdistributors and resellers in more than 80 countries worldwide.

 

**Cash andCash Equivalents**

All highly liquidinvestments with original maturities of three months or less are consideredcash equivalents.  Substantially all ofthe Company’s cash and cash equivalents are held by two financial institutions.

 

**Inventories**

Inventories, which consistprimarily of raw materials, are stated at the lower of cost or market, withcost being determined by the first-in, first-out (“FIFO”) method.  Allowances for write-downs to the lower ofcost or market are recorded for estimated excess and obsolete inventories basedprimarily on forecasts of product demand and estimated production requirements.

 

**Equipmentand Leasehold Improvements**

Equipment and leaseholdimprovements are stated at cost. Depreciation is recorded over the estimated useful lives of the assets(three to five years) generally using accelerated methods.  Leasehold improvements are amortized overthe shorter of estimated useful lives or the terms of the related leases.

 

Major renewals orbetterments are capitalized, while repair and maintenance expenditures arecharged to operations as incurred.  Thecost and accumulated depreciation or amortization of equipment and leaseholdimprovements disposed of or sold are eliminated from their respective accounts,and the resulting gain or loss is recorded in operations.

 

**Valuationof Long-Lived Assets**

The Company periodicallyanalyzes its long-lived assets for potential impairment, assessing theappropriateness of lives and recoverability of unamortized balances throughmeasurement of undiscounted operating cash flows.

 

**Warranties**

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

 
| **(in thousands)**                                        |   | **2003** |   | **2002** |   |
|-----------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                      |   |     |   |     |   |
| Accrued warranties                                        |   |     |   |     |   |
| Beginning of year                                         |   | $        | 557    |     | $      | 505 |   |
| Settlements made                                          |   | (529     | )      | (731     | )      |
| Change in liability related to product  warranties issued |   | 497      |   | 783      |   |
| End of year                                               |   | $        | 525    |     | $      | 557 |   |

 

F-6

----

 

**RevenueRecognition**

Revenue is recognized whentitle passes, which is generally at the time of shipment.  The Company provides for estimated warrantycosts and estimated returns in the period revenue is recognized.  Certain of the Company’s customers havearrangements which include limited stock balancing return provisions.  The Company provides an allowance for stockbalancing based on estimated expected returns. Sales to these customers represented 17.3%, 11.7% and 10.2%,respectively, of net sales for the years ended December 31, 2003, 2002 and2001.  Under the terms of the stockbalancing agreements, the maximum amount of returns is approximately $305,000at December 31, 2003, of which the Company has recorded an allowance of$133,000 for estimated returns.

 

**Researchand Development**

Research and developmentcosts are charged to expense as incurred.

 

**IncomeTaxes**

Deferred income taxes arecomputed using the asset and liability method, such that deferred tax assetsand liabilities are recognized for the expected future tax consequences oftemporary differences between financial reporting amounts and the tax basis ofexisting assets and liabilities based on currently enacted tax laws and taxrates in effect for the periods in which the differences are expected toreverse.  Income tax expense is the taxpayable for the period plus the change during the period in deferred incometaxes.  Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount expectedto be realized.

 

**Fair Valueof Financial Instruments**

The Company considers thatthe carrying amount of financial instruments, including accounts receivable,accounts payable and accrued liabilities, approximates fair value due to theirshort maturities.

 

**SegmentInformation**

The Company’s business isorganized, managed and internally reported as a single segment.

 

**Stock-BasedCompensation**

The Company measurescompensation expense for its stock-based compensation plan using the intrinsicvalue method.  Accordingly, compensationcost for stock options granted to employees is measured as the excess, if any,of the value of the Company’s stock at the date of the grant over the amount anemployee must pay to acquire the stock. The Company provides disclosure of the effect on net income as if thefair value-based method had been applied in measuring compensation expense.

 

F-7

----

 

Had compensation cost forthe plan been determined based on the fair value of options at the date ofgrant, the Company’s net income available to common stockholders and basic anddiluted net income per share would have been reduced to the following pro formaamounts:

 
| **(in thousands)**                                                                                                             |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                                                                                           |   |     |   |     |   |     |   |
| Net income available to common stockholders                                                                                    |   |     |   |     |   |     |   |
| As reported                                                                                                                    |   | $        | 7,240  |     | $      | 6,736    |   | $ | 4,076 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method, net of related  tax effects |   | (1,705   | )      | (1,447   | )      | (1,175   | )      |
| Pro forma                                                                                                                      |   | $        | 5,535  |     | $      | 5,289    |   | $ | 2,901 |   |
|                                                                                                                           |   |     |   |     |   |     |   |   |   |   |
| Basic earnings per common share                                                                                                |   |     |   |     |   |     |   |
| As reported                                                                                                                    |   | $        | .58    |     | $      | .56      |   | $ | .35 |   |
| Pro forma                                                                                                                      |   | $        | .45    |     | $      | .44      |   | $ | .25 |   |
|                                                                                                                           |   |     |   |     |   |     |   |   |   |   |
| Diluted earnings per common share                                                                                              |   |     |   |     |   |     |   |
| As reported                                                                                                                    |   | $        | .57    |     | $      | .55      |   | $ | .34 |   |
| Pro forma                                                                                                                      |   | $        | .43    |     | $      | .43      |   | $ | .24 |   |

 

**Earningsper Share**

Basic earnings per share iscomputed by dividing net income available to common stockholders by theweighted average number of common shares outstanding.  Diluted earnings per share is computed by dividing net incomeavailable to common stockholders by the weighted average number of outstandingcommon shares and potentially dilutive shares relating to stock options.

 

The following provides areconciliation of shares used in the computation of basic and diluted earningsper share:

 
| **(in thousands)**                         |   | **2003** |   | **2002** |   | **2001** |   |
|--------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                       |   |     |   |     |   |     |   |
| Weighted average common shares outstanding |   |     |   |     |   |     |   |
| Basic                                      |   | 12,397   |   | 12,048   |   | 11,760   |   |
| Effect of dilutive stock options           |   | 402      |   | 283      |   | 198      |   |
| Diluted                                    |   | 12,799   |   | 12,331   |   | 11,958   |   |

 

Options to purchase 45,000,362,000 and 404,000 shares of common stock were outstanding at December 31,2003, 2002 and 2001, respectively, but were not included in the computations ofdiluted earnings per share because the exercise prices were greater than theaverage market prices of the common shares for the periods.

 

**Use ofEstimates**

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities as of the date ofthe financial statements and disclosure of contingent assets and liabilities atthe date of the financial statements. Estimates also affect the reported amounts of revenues and expensesduring the periods reported.  Actualresults could differ from those estimates.

 

F-8

----

 

**RecentlyIssued Accounting Standards**

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No.46, *Consolidation of Variable InterestEntities*, and issued a revised interpretation in December 2003 (FIN46R).  FIN 46R requires that if abusiness enterprise has a controlling financial interest in a variable interestentity, the assets, liabilities, and results of the activities of the variableinterest entity must be included in the consolidated financial statements withthose of the business enterprise.  FIN46R must be applied for periods ending after March 15, 2004, and was effectiveimmediately for all variable interest entities created after January 31,2003.  The Company does not haveownership in any variable interest entities. The adoption of this standard did not impact the Company’s financialstatements.

 

In May 2003, the FASB issuedStatement of Financial Accounting Standards (“SFAS”) No. 149, *Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities*.  Thisstatement amends and clarifies financial accounting and reporting for derivativeinstruments, including certain derivative instruments embedded in othercontracts (collectively referred to as derivatives) and for hedging activitiesunder SFAS No. 133, *Accounting forDerivative Instruments and Hedging Activities*.  SFAS No. 149 is effective for contractsentered into or modified after June 30, 2003, and for hedging relationshipsdesignated after June 30, 2003.  Theadoption of this standard did not impact the Company’s financial statements.

 

In May 2003, the FASB issuedSFAS No. 150, *Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity*.  The statement requires that an issuerclassify financial instruments that are within its scope as a liability.  Many of those instruments were classified asequity under previous guidance.  SFASNo. 150 is effective for all financial instruments entered into or modifiedafter May 31, 2003.  Otherwise, it isgenerally effective on July 1, 2003. The adoption of this standard did not impact the Company’s financialstatements.

 

In May 2003, the FASBEmerging Issues Task Force reached a final consensus on EITF 00-21, *Accounting for Revenue Arrangements with MultipleDeliverables*.  The EITFaddresses how to account for multiple-deliverable revenue arrangements andfocuses on when a revenue arrangement should be separated into differentrevenue-generating deliverables or “units of accounting” and if so, how thearrangement considerations should be allocated to the different deliverables orunits of accounting.  The provisions ofEITF 00-21 are effective for revenue arrangements entered into at the beginningof the first interim period after June 15, 2003.  The adoption of this standard did not impact the Company’sfinancial statements.

 

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

 

F-9

----

 

**2.**                          **Public Offerings**

 

In July 2002, the Companyand certain selling stockholders completed a secondary public offering of2,587,500 shares of common stock at $7.50 per share.  The Company’s two principal stockholders at that time sold2,062,500 previously issued and outstanding shares, and the Company sold525,000 newly issued shares.  Theaggregate offering price of the shares sold by the Company was $3,937,500.  The proceeds to the Company from theoffering were approximately $3,137,000 after deducting the underwritingdiscounts and commissions of approximately $236,500 and other direct offeringcosts of approximately $564,000.  TheCompany used the net proceeds from the offering to pay down its outstandingdebt.

 

**3.**                          **Tender Offer**

 

On March 27, 2002, theCompany and Zebra Technologies Corporation (“Zebra”) announced that thecompanies mutually agreed to terminate the acquisition agreement whereby Zebrawould acquire all outstanding shares of the Company’s common stock for $7.25per share in cash.  The transaction hadbeen under Hart-Scott-Rodino antitrust review by the Federal Trade Commission(“FTC”).  Based on discussion withrepresentatives of the FTC, the companies believed it was unlikely that the FTCwould have approved the proposed transaction. Accordingly, the companies agreed to a mutual termination of theiracquisition agreement.  Neither partypaid a break-up fee.  During 2002 and2001, acquisition related costs of $552,000 and $1,434,000, respectively, wereexpensed as incurred.

 

The acquisition wasannounced on July 31, 2001.  A tenderoffer for all outstanding shares of the Company’s stock commenced on August 3,2001, and was terminated on March 27, 2002. None of the Company’s shares tendered in the tender offer were acceptedfor payment and paid for, and Zebra returned all shares of the Company’s commonstock tendered and not withdrawn in the tender offer.

 

**4.**                          **Selected Financial StatementInformation**

 

**AccountsReceivable, Net**

 
| **(in thousands)**                                       |   | **2003** |   | **2002** |   |
|----------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                     |   |     |   |     |   |
| Trade accounts receivable                                |   | $        | 7,415  |     | $      | 9,542 |   |
| Less: Allowance for doubtful accounts and  sales returns |   | (400     | )      | (400     | )      |
|                                                     |   | $        | 7,015  |     | $      | 9,142 |   |

 

For the years ended December31, 2003, 2002 and 2001, one customer accounted for approximately 12.8%, 9.3%and 8.3% of net sales, respectively.

 

The Company’s ten largestdistributors and resellers accounted for a combined total of 44.7%, 42.8% and43.1% of net sales in 2003, 2002 and 2001, respectively.  These distributors accounted for 47.8% and45.5% of trade accounts receivable at December 31, 2003 and 2002, respectively.

 

F-10

----

 

**Inventories, Net**

 
| **(in thousands)**                                   |   | **2003** |   | **2002** |   |
|------------------------------------------------------|--------|----------|--------|----------|--------|
|                                                 |   |     |   |     |   |
| Raw materials and purchased parts                    |   | $        | 3,630  |     | $      | 4,269 |   |
| Work in process                                      |   | —   |   | 119      |   |
| Finished goods                                       |   | 1,989    |   | 1,567    |   |
|                                                 |   | 5,619    |   | 5,955    |   |
| Less: Allowance for excess and obsolete  inventories |   | (771     | )      | (634     | )      |
|                                                 |   | $        | 4,848  |     | $      | 5,321 |   |

 

**Equipment and Leasehold Improvements, Net**

 
| **(in thousands)**                               |   | **2003** |   | **2002** |   |
|--------------------------------------------------|--------|----------|--------|----------|--------|
|                                             |   |     |   |     |   |
| Tooling and manufacturing equipment              |   | $        | 5,844  |     | $      | 5,219 |   |
| Office and other equipment                       |   | 4,645    |   | 3,642    |   |
| Leasehold improvements                           |   | 488      |   | 488      |   |
|                                             |   | 10,977   |   | 9,349    |   |
| Less: Accumulated depreciation and  amortization |   | (8,870   | )      | (7,855   | )      |
|                                             |   | $        | 2,107  |     | $      | 1,494 |   |

 

**Accrued Liabilities**

 
| **(in thousands)**   |   | **2003** |   | **2002** |   |
|----------------------|--------|----------|--------|----------|--------|
|                 |   |     |   |     |   |
| Accrued warranties   |   | $        | 525    |     | $      | 557 |   |
| Accrued compensation |   | 393      |   | 711      |   |
| Accrued vacation     |   | 450      |   | 400      |   |
| Customer advances    |   | 362      |   | 175      |   |
| Income taxes payable |   | 541      |   | 337      |   |
| Other                |   | 494      |   | 407      |   |
|                 |   | $        | 2,765  |     | $      | 2,587 |   |

 

**5.**                          **Financing Arrangements**

 

In December 2002, theCompany amended its credit agreement to a $5,000,000 revolving creditfacility.  There were no borrowingsduring 2003, and there was no outstanding balance at December 31, 2003.  Under the terms of the amended agreement,the amount available may be limited based on eligible accounts receivable andinventories, as defined.  The Companymay borrow at the prime rate of interest or LIBOR plus a margin of 1.50%.  Interest is payable within 30 to 180 days,as defined by the agreement.  The creditfacility requires, among other things, the maintenance of specified financialratios including fixed charge coverage and total debt to EBITDA, as defined inthe agreement, and restrictions on capital expenditures, payment of dividendsand operating lease expenditures.  Thecredit agreement is in effect through December 2005.

 

F-11

----

 

In February 2002 and April2001, the Company amended its credit facility. Under the terms of the April 2001 amendment, the credit facility wasconverted to a $19,000,000 term loan, of which $14,000,000 was outstanding atDecember 31, 2001, and a $5,000,000 revolving credit facility, of which therewas no outstanding balance at December 31, 2001.  During 2002, the Company repaid the balance of the term loan.

 

**6.**                          **Stock Options**

 

In May 2003, the Board ofDirectors and stockholders adopted the Fargo Electronics, Inc. 2003 StockIncentive Plan (the “2003 Plan”) which authorizes and reserves a maximum of1,000,000 shares of common stock available for issuance.  The 2003 Plan is administered by theCompensation Committee of the Board of Directors and provides for the grant of:(a) incentive stock options; (b) nonqualified stock options; and (c) restrictedstock awards to employees, officers, directors and others, subject to certainlimitations, as defined by the 2003 Plan. Stock options issued under the 2003 Plan generally have an exerciseprice equal to the fair market value on the date of grant, vest and becomeexercisable ratably over four years, and expire no later than ten years fromthe date of grant.  If a change incontrol occurs, as defined by the 2003 Plan, the Board of Directors, or acommittee thereof, at its sole discretion, may determine that all stock optionsthat have been outstanding for at least six months will become immediatelyexercisable in full for the remainder of their terms and all restricted stockawards that have been outstanding for at least six months will becomeimmediately 100% vested.  Unlessterminated earlier, the 2003 Plan will terminate on April 30, 2013.

 

In February 1998, the Boardof Directors and stockholders adopted the Fargo Electronics, Inc. 1998 StockOption and Grant Plan (the “1998 Plan”) which, as amended, authorized andreserved a maximum number of shares for issuance equal to 15% of the outstandingcommon stock.  The 1998 Plan wasterminated, and no new awards were issued thereunder, following approval of the2003 Plan in May 2003.

 

Shares of restricted stockwere awarded to certain directors and employees in 1998 and 1999 at an exerciseprice which was equal to the fair market value on the date of grant.  Sales of the restricted stock were paid forby means of recourse promissory notes with payment terms of five years.  The restricted stock had a weighted averageexercise price of $1.60.  At December31, 2002, all restricted shares were vested or cancelled, and the promissorynotes were repaid.  There were norestricted shares outstanding at December 31, 2003 or 2002.

 

F-12

----

 

Stock option and restrictedstock activity for 2003, 2002 and 2001 was as follows:

 
| **(in thousands, except per share  data)**              |   | **Shares  Available  for Grant** |   | **Options  Outstanding** |   | **Restricted  Stock  Outstanding** |   | **Weighted  Average  Exercise Price  Per Share  of Options** |   |
|---------------------------------------------------------|--------|----------------------------------|--------|--------------------------|--------|------------------------------------|--------|--------------------------------------------------------------|--------|
|                                                    |   |                             |   |                     |   |                               |   |                                                         |   |
| Balances at December 31, 2000                           |   | 113                              |   | 799                      |   | 453                                |   | $                                                            | 6.58   |   |
|                                                    |   |                             |   |                     |   |                               |   |                                                         |   |
| Plan amendment                                          |   | 357                              |   | —                   |   | —                             |   | —                                                       |   |
| Granted                                                 |   | (71                              | )      | 71                       |   | —                             |   | 4.02                                                         |   |
| Cancelled                                               |   | 82                               |   | (66                      | )      | (16                                | )      | 7.18                                                         |   |
| Exercised                                               |   | —                           |   | (23                      | )      | (47                                | )      | 1.60                                                         |   |
| Balances at December 31, 2001                           |   | 481                              |   | 781                      |   | 390                                |   | 6.42                                                         |   |
|                                                    |   |                             |   |                     |   |                               |   |                                                         |   |
| Increase in shares available due to  secondary offering |   | 86                               |   | —                   |   | —                             |   | —                                                       |   |
| Granted                                                 |   | (373                             | )      | 373                      |   | —                             |   | 7.55                                                         |   |
| Cancelled                                               |   | 58                               |   | (58                      | )      | —                             |   | 5.18                                                         |   |
| Exercised                                               |   | —                           |   | (31                      | )      | (390                               | )      | 1.88                                                         |   |
| Balances at December 31, 2002                           |   | 252                              |   | 1,065                    |   | —                             |   | 7.01                                                         |   |
|                                                    |   |                             |   |                     |   |                               |   |                                                         |   |
| Termination of the 1998 Plan                            |   | (271                             | )      | —                   |   | —                             |   | —                                                       |   |
| Adoption of the 2003 Plan                               |   | 1,000                            |   | —                   |   | —                             |   | —                                                       |   |
| Granted                                                 |   | (74                              | )      | 74                       |   | —                             |   | 12.83                                                        |   |
| Cancelled                                               |   | 48                               |   | (48                      | )      | —                             |   | 7.44                                                         |   |
| Exercised                                               |   | —                           |   | (91                      | )      | —                             |   | 4.20                                                         |   |
| Balances at December 31, 2003                           |   | 955                              |   | 1,000                    |   | —                             |   | $                                                            | 7.68   |   |

 

Information related to stockoptions outstanding and exercisable at December 31, 2003, is as follows:

 

**Options Outstanding**

 
| **Range of  Exercise Prices** |   | **Number  Outstanding** |   | **Weighted  Average  Remaining  Contractual  Life** |   | **Weighted  Average  Exercise  Price** |   |
|-------------------------------|--------|-------------------------|--------|-----------------------------------------------------|--------|----------------------------------------|--------|
|                          |   | **(in thousands)**      |   |                                                |   |                                   |   |
|                          |   |                    |   |                                                |   |                                   |   |
| $1.60-$2.40                   |   | 53                      |   | 2.4 years                                           |   | $                                      | 1.60   |   |
| $2.75-$4.13                   |   | 182                     |   | 6.2 years                                           |   | 2.91                                   |   |
| $4.81-$7.22                   |   | 62                      |   | 5.7 years                                           |   | 6.08                                   |   |
| $7.30-$10.95                  |   | 381                     |   | 6.0 years                                           |   | 7.79                                   |   |
| $11.00-$15.41                 |   | 322                     |   | 4.2 years                                           |   | 11.54                                  |   |
|                          |   | 1,000                   |   |                                                |   | $                                      | 7.68   |   |

 

F-13

----

 

**Options Exercisable**

 
| **Range of  Exercise Prices** |   | **Number  Exercisable** |   | **Weighted  Average  Exercise  Price** |   |
|-------------------------------|--------|-------------------------|--------|----------------------------------------|--------|
|                          |   | **(in  thousands)**     |   |                                   |   |
|                          |   |                    |   |                                   |   |
| $1.60-$2.40                   |   | 53                      |   | $                                      | 1.60   |   |
| $2.75-$4.13                   |   | 107                     |   | 2.89                                   |   |
| $4.81-$7.22                   |   | 57                      |   | 6.17                                   |   |
| $7.30-$10.95                  |   | 86                      |   | 7.80                                   |   |
| $11.00-$15.41                 |   | 209                     |   | 11.00                                  |   |
|                          |   | 512                     |   | $                                      | 7.25   |   |

 

For the years ended December31, 2003, 2002 and 2001, the Company recorded deferred compensation expense of$16,000, $28,000 and $28,000 per year, respectively, for 8,750 options grantedin 1999 at a discount from the estimated fair market value of the Company’scommon stock.

 

The weighted averagegrant-date fair value of options granted during 2003, 2002 and 2001 was $6.18,$5.30 and $3.00, respectively, which was determined using the Black-Scholesmethod and the following key assumptions:

 
| **Assumptions**          |   | **2003**       |   | **2002**       |   | **2001**       |   |
|--------------------------|--------|----------------|--------|----------------|--------|----------------|--------|
|                     |   |           |   |           |   |           |   |
| Volatility               |   | 70.29%         |   | 77.35%         |   | 85.23%         |   |
| Risk-free interest rates |   | 3.03% to 3.48% |   | 4.02% to 4.92% |   | 4.93% to 5.21% |   |
| Expected life            |   | Five years     |   | Six years      |   | Six years      |   |
| Expected dividends       |   | None           |   | None           |   | None           |   |

 

**EmployeeStock Purchase Plan**

In January 2001, theCompany’s Board of Directors adopted a noncompensatory Employee Stock PurchasePlan (“Purchase Plan”).  Under thePurchase Plan, participating employees are granted options to purchase commonstock at a 15% discount from the lower of the fair market value on the firstday or last day of each calendar quarter. The Purchase Plan permits an enrolled employee to make contributions topurchase shares of common stock through payroll deductions between 1% and 15%of compensation.  The number of sharesthat may be purchased by any single employee during a calendar quarter islimited to 250 shares and total shares with a maximum fair market value of$25,000 in each calendar year.  TheCompensation Committee of the Board of Directors administers the PurchasePlan.  The total number of shares ofcommon stock that may be issued pursuant to options granted under the PurchasePlan is 250,000 shares of common stock.  At December 31, 2003, approximately 56,000 shares of common stockhave been issued under the Purchase Plan.

 

F-14

----

 

**7.**                          **Benefit Plan**

 

The Company has a 401(k)retirement savings plan whereby eligible employees may contribute up to 15% oftheir earnings either before taxes (subject to Internal Revenue Servicelimitation) or after tax, not to exceed annual amounts allowed under theInternal Revenue Code (“IRC”).  In addition,the Company may also make discretionary matching contributions.  Company matching contributions for the yearsended December 31, 2003, 2002 and 2001, were $169,000, $164,000 and $164,000,respectively.

 

**8.**                          **Income Taxes**

 

The components of theprovision for income taxes are as follows:

 
| **(in thousands)**         |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------|--------|----------|--------|----------|--------|----------|--------|
|                       |   |     |   |     |   |     |   |
| Current                    |   |     |   |     |   |     |   |
| Federal                    |   | $        | 1,235  |     | $      | 467      |   | $ | — |   |
| State                      |   | 5        |   | 5        |   | 5        |   |
|                       |   | 1,240    |   | 472      |   | 5        |   |
| Deferred                   |   |     |   |     |   |     |   |
| Federal                    |   | 1,977    |   | 2,664    |   | 2,098    |   |
| State                      |   | 127      |   | 129      |   | 126      |   |
|                       |   | 2,104    |   | 2,793    |   | 2,224    |   |
| Provision for income taxes |   | $        | 3,344  |     | $      | 3,265    |   | $ | 2,229 |   |

 

Temporary differencescomprising the net deferred tax assets recognized in the accompanying balancesheets at December 31, 2003 and 2002, are as follows:

 
| **(in thousands)**                                 |   | **2003** |   | **2002** |   |
|----------------------------------------------------|--------|----------|--------|----------|--------|
|                                               |   |     |   |     |   |
| Tax goodwill, current portion                      |   | $        | 2,372  |     | $      | 2,388 |   |
| Accrued liabilities, including accrued  warranties |   | 346      |   | 415      |   |
| Inventories                                        |   | 312      |   | 259      |   |
| Other                                              |   | 382      |   | 116      |   |
| Current deferred income taxes                      |   | 3,412    |   | 3,178    |   |
| Tax goodwill, net of current portion               |   | 19,297   |   | 21,684   |   |
| Depreciation and amortization                      |   | 205      |   | 232      |   |
| Other                                              |   | 228      |   | 152      |   |
| Long-term deferred income taxes                    |   | 19,730   |   | 22,068   |   |
| Total deferred income taxes                        |   | $        | 23,142 |     | $      | 25,246 |   |

 

F-15

----

 

A reconciliation between theCompany’s effective tax and the federal statutory tax is as follows:

 
| **(in thousands)**                                    |   | **2003** |   | **2002** |   | **2001** |   |
|-------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                  |   |     |   |     |   |     |   |
| Provision for federal income taxes at  statutory rate |   | $        | 3,599  |     | $      | 3,400    |   | $ | 2,144 |   |
| State income taxes, net of federal benefit            |   | 184      |   | 177      |   | 129      |   |
| Research and experimentation credits                  |   | (456     | )      | (300     | )      | (75      | )      |
| Other                                                 |   | 17       |   | (12      | )      | 31       |   |
|                                                  |   | $        | 3,344  |     | $      | 3,265    |   | $ | 2,229 |   |

 

Historically, the Companyhas generated operating income.  Therealization of the deferred tax assets is dependent upon the Company’s ability togenerate sufficient future taxable income which management believes is morelikely than not.  The Companyanticipates future taxable income sufficient to realize the recorded deferredtax assets.  Future taxable income isbased on management’s forecasts of the operating results of the Company, andthere can be no assurance that such results will be achieved.

 

**9.**                          **Commitments andContingencies**

 

The Company leases office,warehouse and manufacturing space under an operating lease that expires inDecember 2006.  Future minimum leasepayments at December 31, 2003, consist of the following:

 
| **(in thousands)**           |   |   |   |
|------------------------------|--------|--------|--------|
|                         |   |   |   |
| 2004                         |   | $      | 492    |   |
| 2005                         |   | 518    |   |
| 2006                         |   | 518    |   |
| Total minimum lease payments |   | $      | 1,528  |   |

 

Total rent expense for theyears ended December 31, 2003, 2002 and 2001, was $918,000, $940,000 and$727,000, respectively.

 

The Company has entered intounconditional purchase agreements with certain suppliers which may require theCompany to purchase up to $1,349,000 of inventories.  The agreements are reviewed on a semi-annual basis, and unlessterminated by either party, automatically renew for an additional six-monthperiod.  The agreements may beterminated by either party with a 30-day written notice.

 

In June 2001, the Companyentered into a management and employment agreement with its Chief ExecutiveOfficer (“CEO”), which provides certain benefits to the CEO upon termination,as defined in the agreement.  Theagreement had an initial term expiring in December 2003, and provides forautomatic renewal thereafter unless either party decides not to renew it andgives the other party notice of nonrenewal. The agreement was automatically renewed in December 2003 for anadditional year.  Under the agreement,upon termination without cause, certain events defined as good cause for theCEO to terminate or a change in control, the CEO will be entitled to receive alump sum cash payment up to 250% of base salary plus accrued bonus payments andfull vesting of any restricted stock or stock options held, group health, dentaland life insurance benefits and a monthly cash allowance of $1,000 for a periodof 30 months.

 

F-16

----

 

In December 2003, theCompany extended the management agreements, originally executed in April 2001and May 2002, with several of its officers and employees.  These agreements provide certain benefits tothese individuals if they are terminated, as defined in the managementagreements, in connection with a change in control of the Company.  The agreements have a one-year term.  Under the agreements, these individuals willbe entitled to receive a lump sum cash payment up to 150% of their base salaryplus full vesting of any restricted stock or stock options held.

 

The Company is party tovarious litigation matters arising from time to time in the ordinary course ofbusiness.  Management does not believethat any legal matters exist that would have a material adverse effect on theCompany’s financial position, results of operations, or cash flows.

 

**10.****                  ****Export Sales**

 

Export sales were asfollows:

 
| **(in thousands)**                                      |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
|                                                    |   |     |   |     |   |     |   |
| Europe                                                  |   | $        | 9,304  |     | $      | 9,669    |   | $ | 8,670 |   |
| Asia and Australia                                      |   | 6,547    |   | 6,715    |   | 5,495    |   |
| North and South America (other than the  United States) |   | 7,733    |   | 6,998    |   | 7,322    |   |
| Other                                                   |   | 3,976    |   | 2,981    |   | 2,832    |   |
|                                                    |   | $        | 27,560 |     | $      | 26,363   |   | $ | 24,319 |   |

 

Export sales are generallybased on contractual shipment destinations by customer, as determined by theirdistributor agreement.

 

**11.****                  ****Significant Vendor**

 

The Company buys asignificant portion of its ribbons, an important component of its revenue, fromone supplier.  In 2002, the Companyadded a second ribbon supplier that provides similar ribbons on comparableterms.  Management believes a change insuppliers would not adversely affect operating results.

 

In addition, the Companybuys printheads for its dye sublimation printers from one supplier.

 

F-17

----

** **

**FARGO ELECTRONICS, INC.**

**Exhibit Index to Annual Report**

**on Form 10-K**

**For the fiscal year ended December 31,2003**

 
| **Item No.** |   | **Description**                                                                                                                                    |   | **Method of  Filing**                                                                                                                      |   |
|--------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|--------|
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 2.2          |   | Certificate  of Ownership and Merger between Fargo Electronics, Inc., a Minnesota  corporation and Fargo Electronics, Inc., a Delaware corporation |   | Incorporated  by reference to Exhibit 2.2 to Fargo’s Form 10-K for the fiscal year ended  December 31, 1999 (File No. 333-90937) |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 2.3          |   | Articles of  Merger                                                                                                                                |   | Incorporated  by reference to Exhibit 2.3 to Fargo’s Form 10-K for the fiscal year ended  December 31, 1999 (File No. 333-90937) |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 2.4          |   | Agreement  and Plan of Merger, between Fargo Electronics, Inc., a Minnesota corporation  and Fargo Electronics, Inc., a Delaware corporation       |   | Incorporated  by reference to Exhibit 2.4 to Fargo’s Form 10-K for the fiscal year ended  December 31, 1999 (File No. 333-90937) |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 3.1          |   | Amended and  Restated Certificate of Incorporation                                                                                                 |   | Incorporated  by reference to Exhibit 3.1 to Fargo’s Form 10-K for the fiscal year ended  December 31, 1999 (File No. 333-90937) |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 3.2          |   | Bylaws, as  amended on August 3, 2000                                                                                                              |   | Incorporated  by reference to Exhibit 3.1 to Fargo’s 10-Q for the quarter ended  September 30, 2000 (File No. 333-90937).   |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 4.1          |   | Stockholder  Rights Agreement                                                                                                                      |   | Incorporated  by reference to Exhibit 4.1 to Fargo’s Form 10-K for the fiscal year ended  December 31, 1999 (File No. 333-90937) |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 4.2          |   | Amended and  Restated Certificate of Incorporation                                                                                                 |   | Incorporated  by reference to Exhibit 3.1 to Fargo’s Form 10-K for the fiscal year ended  December 31, 1999 (File No. 333-90937) |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 4.3          |   | Bylaws, as  amended on August 3, 2000                                                                                                              |   | Incorporated  by reference to Exhibit 3.1 to Fargo’s 10-Q for the quarter ended  September 30, 2000 (File No. 333-90937).   |   |
|         |   |                                                                                                                                               |   |                                                                                                                                       |   |
| 10.1         |   | Office/Warehouse  Lease, dated June 15, 1996, between Fargo Electronics, Inc. and Opus  Northwest L.L.C., as amended                               |   | Incorporated  by reference to Exhibit 10.1 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).                  |   |

 

E-1

----

 
| **Item No.** |   | **Description**                                                                                                                            |   | **Method of  Filing**                                                                                                            |   |
|--------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------|--------|
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.2         |   | Amended and  Restated 1998 Stock Option and Grant Plan, as amended                                                                         |   | Incorporated  by reference to Appendix C to Fargo’s 2001 Proxy Statement.                                                   |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.3         |   | Form of  Restricted Stock Agreement under the Amended and Restated 1998 Stock Option  and Grant Plan                                       |   | Incorporated  by reference to Exhibit 10.3 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).        |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.4         |   | Form of  Non-qualified Stock Option Agreement under the Amended and Restated 1998  Stock Option and Grant Plan                             |   | Incorporated  by reference to Exhibit 10.4 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).        |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.5         |   | Form of  Incentive Stock Option Agreement under the Amended and Restated 1998 Stock  Option and Grant Plan                                 |   | Incorporated  by reference to Exhibit 10.5 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).        |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.6         |   | Technology  and Trademark License Agreement, dated February 17, 1998, between Fargo  Electronics, Inc. and Primera Technology, Inc.        |   | Incorporated  by reference to Exhibit 10.6 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).        |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.7         |   | Form of  Indemnification Agreement for directors and executive officers of Fargo  Electronics, Inc.                                        |   | Incorporated  by reference to Exhibit 10.9 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).        |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.8         |   | Stockholders’  Agreement, dated February 18, 1998, between Fargo Electronics, Inc., Robert  Cummins and certain Investors, as amended |   | Incorporated  by reference to Exhibit 10.10 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).       |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.9         |   | Non-Compete  Agreement dated Feb. 18, 1998 between Fargo Electronics, Inc., Robert Cummins  and Primera Technology, Inc.                   |   | Incorporated  by reference to Exhibit 10.17 to Fargo’s Registration Statement on Form S-1  (File No. 333-90937).       |   |
|         |   |                                                                                                                                       |   |                                                                                                                             |   |
| 10.10        |   | Amended and  Restated Consulting Agreement, dated February 18, 1998, between Fargo  Electronics, Inc. and Primera Technology, Inc.         |   | Incorporated  by reference to Exhibit 10.18 to Fargo’s Registration Statement on Form S-1  (File No.  333-90937). |   |

 

E-2

----

 
| **Item No.** |   | **Description**                                                                                                                                                                                                                                               |   | **Method of  Filing**                                                                                                                          |   |
|--------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.11        |   | 2001  Employee Stock Purchase Plan                                                                                                                                                                                                                            |   | Incorporated  by reference to Exhibit 10.20 to Fargo’s Form 10-K for the fiscal year ended  December 31, 2000 (File No. 333-90937).  |   |
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.12        |   | Amended and  Restated Employment Agreement dated June 19, 2001 between Fargo Electronics,  Inc. and Gary R. Holland, as amended                                                                                                                               |   | Incorporated  by reference to Exhibit 99(e)(6) of Fargo’s Schedule 14D-9 filed on  August 3, 2001 (File No. 005-59663).    |   |
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.13        |   | Control  Agreement with a Securities Intermediary among Fargo Electronics, Inc.,  LaSalle Bank, NA and Wells Fargo Brokerage Services, LLC                                                                                                                    |   | Incorporated  by reference to Exhibit 10.2 to Fargo’s 10-Q for the quarter ended  June 30, 2001 (File No. 333-90937)       |   |
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.14        |   | Control  Agreement (Deposit Account), dated as of June 8, 2001, among Fargo  Electronics, Inc., LaSalle Bank National Association, as agent for the banks  party to that certain Credit Agreement dated as of September 15, 2000, and  Wells Fargo Bank, N.A. |   | Incorporated  by reference to Exhibit 10.3 to Fargo’s 10-Q for the quarter ended  June 30, 2001 (File No. 333-90937).      |   |
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.15        |   | Lease, dated  February 28, 2001, between Fargo Electronics, Inc. and AETNA Life Insurance  Company                                                                                                                                                            |   | Incorporated  by reference to Exhibit 10.1 to Fargo’s 10-Q for the quarter ended  September 30, 2001 (File No. 333-90937). |   |
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.16        |   | Acquisition  Agreement dated as of July 31, 2001 among Zebra Technologies Corporation,  Rushmore Acquisition Corp. and Fargo Electronics, Inc.                                                                                                                |   | Incorporated  by reference to Exhibit 2.1 of Fargo’s Form 8-K filed on  August 1, 2001 (File No. 333-90937).               |   |
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.17        |   | Form of  Stockholder Agreement dated as of July 31, 2001 between Zebra Technologies  Corporation and each of the Entities Affiliated with TA Associates, Inc. and  St. Paul Venture Capital, Inc.                                                             |   | Incorporated  by reference to Exhibit 99.2 of Fargo’s Form 8-K filed on  August 1, 2001 (File No. 333-90937)).             |   |
|         |   |                                                                                                                                                                                                                                                          |   |                                                                                                                                           |   |
| 10.18        |   | Form of  Stockholder Agreement dated as of July 31, 2001 between Zebra Technologies  Corporation and each of Fargo’s Directors and Executive Officers                                                                                                    |   | Incorporated  by reference to Exhibit 99.3 of Fargo’s Form 8-K filed on  August 1, 2001 (File No. 333-90937)).             |   |

 

E-3

----

 
| **Item No.** |   | **Description**                                                                                                                                                   |   | **Method of  Filing**                                                                                                                                            |   |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|         |   |                                                                                                                                                              |   |                                                                                                                                                             |   |
| 10.19        |   | Amendment  No. 1, dated August 30, 2001, to Acquisition Agreement among Zebra  Technologies Corporation, Rushmore Acquisition Corp. and Fargo Electronics,  Inc.  |   | Incorporated  by reference to Exhibit 99.1(d)(6) to Amendment No. 3 to Fargo’s Schedule TO  filed on August 30, 2001 (File No. 005-59663).   |   |
|         |   |                                                                                                                                                              |   |                                                                                                                                                             |   |
| 10.20        |   | Amendment  No. 2, dated October 11, 2001, to Acquisition Agreement among Zebra  Technologies Corporation, Rushmore Acquisition Corp. and Fargo Electronics,  Inc. |   | Incorporated  by reference to Exhibit 99.1(d)(7) to Amendment No. 6 to Fargo’s Schedule TO  filed on October 12, 2001 (File No. 005-59663).  |   |
|         |   |                                                                                                                                                              |   |                                                                                                                                                             |   |
| 10.21        |   | Amendment  No. 3, dated February 5, 2002, to Acquisition Agreement among Zebra  Technologies Corporation, Rushmore Acquisition Corp. and Fargo Electronics,  Inc. |   | Incorporated  by reference to Exhibit 99.1(d)(8) to Amendment No. 14 to Fargo’s Schedule TO  filed on February 6, 2002 (File No. 005-59663). |   |
|         |   |                                                                                                                                                              |   |                                                                                                                                                             |   |
| 10.23        |   | Termination  Agreement, dated March 27, 2002, among Zebra Technologies Corporation,  Rushmore Acquisition Corp. and Fargo Electronics, Inc.                  |   | Incorporated  by reference to Exhibit 99.1(d)(9) to Amendment No. 19 to Fargo’s Schedule TO  filed on March 27, 2002 (File No. 005-59663).   |   |
|         |   |                                                                                                                                                              |   |                                                                                                                                                             |   |
| 10.24        |   | Conditional  Release from Pledge Agreement, dated August 27, 2002, between Fargo  Electronics, Inc. and William H. Gibbs                                          |   | Incorporated  by reference to Exhibit 10.1 to Fargo’s 10-Q for the quarter ended  September 30, 2002 (File No. 333-90937)                    |   |
|         |   |                                                                                                                                                              |   |                                                                                                                                                             |   |
| 10.25        |   | Conditional  Release from Pledge Agreement, dated October 28, 2002, between Fargo  Electronics, Inc. and Gary R. Holland                                          |   | Incorporated  by reference to Exhibit 10.2 to Fargo’s 10-Q for the quarter ended  September 30, 2002 (File No. 333-90937)                    |   |
|         |   |                                                                                                                                                              |   |                                                                                                                                                             |   |
| 10.26        |   | Amended and  Restated Credit Agreement, dated December 18, 2002, between Fargo  Electronics, Inc. and LaSalle Bank National Association                           |   | Incorporated  by reference to Exhibit 10.37 to Fargo’s Form 10-K for the fiscal year ended  December 31, 2002 (File No. 333-90937).                    |   |

 

E-4

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| **Item No.** |   | **Description**                                                                                                                                                                     |   | **Method of  Filing**                                                                                                                         |   |
|--------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 10.27        |   | Amended and  Restated Security Agreement, dated December 18, 2002, between Fargo  Electronics, Inc. and LaSalle Bank National Association                                           |   | Incorporated  by reference to Exhibit 10.38 to Fargo’s Form 10-K for the fiscal year ended  December 31, 2002 (File No. 333-90937). |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 10.28        |   | Note, dated  December 18, 2002, payable to LaSalle Bank National Association                                                                                                        |   | Incorporated  by reference to Exhibit 10.39 to Fargo’s Form 10-K for the fiscal year ended  December 31, 2002 (File No. 333-90937). |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 10.29        |   | 2003 Stock  Incentive Plan                                                                                                                                                          |   | Incorporated  by reference to Exhibit 10.1 to Fargo’s Form 10-Q for the quarter ended  September 30, 2003 (File No. 000-29029).     |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 10.30        |   | Form of  Non-qualified Stock Option agreement under the 2003 Stock Incentive Plan                                                                                                   |   | Filed electronically  herewith.                                                                                                               |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 10.31        |   | Form of  Direct Reports Agreement dated December 15, 2003 between Fargo Electronics,  Inc. and each of Scott Ackerman, Kathleen L. Phillips, Thomas C. Platner and  Jeffrey D. Upin |   | Filed  electronically herewith.                                                                                                               |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 10.32        |   | Form of  Direct Reports Agreement dated December 15, 2003 between Fargo Electronics,  Inc. and Paul W.B. Stephenson                                                                 |   | Filed  electronically herewith.                                                                                                               |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 23.1         |   | Consent of  PricewaterhouseCoopers LLP                                                                                                                                              |   | Filed  electronically herewith.                                                                                                               |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 31.1         |   | Certification  of Gary R. Holland Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                         |   | Filed  electronically herewith.                                                                                                               |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 31.2         |   | Certification  of Paul W.B. Stephenson Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                                                                   |   | Filed  electronically herewith.                                                                                                               |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 32.1         |   | Certification  of Gary R. Holland Pursuant to 18 U.S.C Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                         |   | Filed  electronically herewith.                                                                                                               |   |
|         |   |                                                                                                                                                                                |   |                                                                                                                                          |   |
| 32.2         |   | Certification  of Paul W.B. Stephenson Pursuant to 18 U.S.C Section 1350, as Adopted  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                    |   | Filed  electronically herewith.                                                                                                               |   |

 

E-5

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