** **

**SECURITIESAND 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, 2005**                                                                                                                                                                                                 |
| ** **                                                                                                                                                                                                                                            | ** ** | ** **                                                                                               |
| **OR**                                                                                                                                                                                                                                                |
| ** **                                                                                                                                                                                                                                            | ** ** | ** **                                                                                               |
| **o**                                                                                                                                                                                                                                                 | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
| ** **                                                                                                                                                                                                                                            | ** ** | ** **                                                                                               |
| **For the transition period from                     to                  ** |

** **

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

** **

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**FARGOELECTRONICS, 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’s telephone number, including area code:**(952) 941-9470

** **

**Securities registered pursuant to Section 12(b) ofthe Act:**None

** **

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

**Common Stock, $.01 parvalue**

** **

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Indicateby check mark if the registrant is a well-known seasoned issuer, as defined inRule 405 of the Securities Act. Yes  o   No  ý

 

Indicateby check mark if the registrant is not required to file reports pursuant toSection 13 or Section 15(d) of the Act. Yes  o   No  ý

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.    Yes  ý   No  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. ý

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act. Largeaccelerated filer  o Accelerated filer  ý  Non-acceleratedfiler  o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of the Act.    Yes  o   No  ý

 

Asof February 23, 2006, 12,788,781 shares of the Registrant’s common stock wereoutstanding. The aggregate market value of the Registrant’s outstanding commonstock as of June 30, 2005, the last business day of Registrant’s mostrecently completed second fiscal quarter (based upon the last sale price of ashare of common stock on that date as reported by the Nasdaq National Market),excluding outstanding shares beneficially owned by directors and executiveofficers, was $249,325,570.

 

**DOCUMENTSINCORPORATED 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 2006 Annual Meeting to be held onMay 2, 2006.**

 

 

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**PART I**

** **

**Item1.**         BUSINESS

** **

***(a)****** ******GeneralDevelopment of the Business***

 

We are a global leaderin the development of secure technologies for identity card issuance systems,including secure card printer/encoders, materials and software. Our cardissuance systems help reduce vulnerabilities and potential for loss of time,money and lives by focusing on improving the security of identity credentials.

 

We manufacture threecard printing technologies to meet the unique card and security needs of ourusers. These are:

 

1.      HDP (High Definition Printing), reverseimage technology for high-level security and large applications especially whena card with electronics, either Radio Frequency Identification (RFID) proximityor integrated circuit chips, is used;

 

2.      DTC (Direct-to-Card), dye-sublimationtechnology for low to mid-level security and large applications which is themost commonly used technology in identification card printing; and

 

3.      Inkjet printing, which is a familiarinkjet technology for low-level security and entry-level applications.

 

We market and sell ourproducts exclusively through a distribution channel of system integrators andindependent distributors in more than 80 countries worldwide. As ofDecember 31, 2005, we estimate we have manufactured and sold more than 120,000systems.

 

End users of our cardidentity systems create personalized cards for a wide variety of applicationsincluding:

 

•  **Government: **national and military identification;employee identification; access control; driver’s licenses; social servicesidentification and stored value; inmate and corrections staff identification.

 

•  **Corporate:**  access control; time and attendance tracking;employee identification; parking passes; visitor management.

 

•  **Education: **faculty and student identification,stored value for bookstores and cafeterias; library cards; dorm and equipmentaccess.

 

•  **Transportation: **bus and train passes; airport security;employee identification.

 

•  **Trade and professionalassociations**:  membershipidentification, loyalty and discount cards.

 

Since our inception in1974, we have used our engineering expertise and knowledge of printing and dataencoding to build a reputation for technological leadership in our industry.Historically, we have leveraged our engineering capabilities to develop systemsfor multiple markets, including bar code printers, color office printers andcard personalization systems.

 

We own or have rights tocertain trademarks that we use in connection with the sale of our products,including, but not limited to, the following: Fargo®, Persona®, HDP®,UltraCard®, DTC®, Build-a-Badge®, SmartGuard®, SmartShield®, CardJet®, FargoCertified Supplies®, Fargo Certified Software®, SecureMark®, C11®, Pro-LTM,Pro-LXTM, TM, CardJet Printing TechnologyTM, HolomarkTM, VerimarkTM, PolyGuardTM,RibbonTraqTM, Visual Security SolutionsTM, C16TM, Print Security ManagerTM, PrintSecurity SuiteTM, C30TM and High Definition PrintingTM.

 

We are a Delawarecorporation. Our principal executive offices are located at 6533 Flying CloudDrive, Eden Prairie, Minnesota 55344, and our telephone number is(952) 941-9470. Our web site address is *www.fargo.com*.Copies of our annual report on Form 10-K, quarterly reports onForm 10-Q, current reports on Form 8-K and amendments to thesereports are available free of charge on our web site as soon as reasonablypracticable after such material is filed with, or furnished to, the Securitiesand Exchange Commission. Such forms are also available at the Securities andExchange Commission’s web site at *www.sec.gov.*

 

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***(b)****** ******FinancialInformation About Segments***

 

Our business isorganized in one business unit and is managed and internally reported as a singlesegment. Financial information regarding our business segment is contained inour financial statements beginning on Page F-1 of this report.

 

***(c)****** ******NarrativeDescription of the Business***

 

**OurIndustry**

** **

*Background*

* *

The first widely usedmethod of producing identification cards was to overlay instant photographs andtypeset text or logos on a paper card, then apply a plastic laminate over thecard. This method is commonly known as “cut-and-paste.” The development ofdigital imaging and direct-to-card thermal dye sublimation processes in thelate 1980’s led to the availability of systems that could create cards moredurable than cut-and-paste cards. These digital cards have superior graphic anddesign capabilities that are more difficult to alter or forge. These cards canalso include electronic data and security features such as RFID antennae,computer chips and holographic overlaminates. A significant trend in the 1990’swas the replacement of cut-and-paste systems with digital direct-to-cardsystems.

 

In the late 1990’s,systems incorporating reverse image printing, such as our HDP process, enabledhigh quality images to be printed on cards with even or uneven surfaces and ofvarying size and thickness. This technology is especially suited to cards suchas ‘smart’ cards with computer chips and proximity cards with RFID antennae.Many high-end government and transit applications are using these sophisticatedelectronic cards that are well suited for HDP.

 

In 2002, we introducedthe industry’s first desktop inkjet printers designed specifically for printingon plastic cards, the CardJet 410 and CardJet C7. Inkjet is a simple, familiartechnology for many entry-level users.

 

In 2004, we added newprinters in both our HDP and DTC product lines, and introduced Print SecuritySuite, user-friendly software that provides up to five applications to helpcontrol the issuance and help ensure the authenticity of ID cards. Thissoftware introduction signaled a broadening of our strategy from that of beingan ID card printer manufacturer to a company focused on the needs of customersin reducing vulnerabilities in their organizations by making their cardissuance programs more secure.

 

In 2005, we added newprinters to our DTC and entry-level Persona product lines and continued ourdevelopment of software products and tools designed to improve card issuancesecurity.

 

*OngoingIndustry Trends*

* *

We believe certainsocial, technological and commercial factors are increasing the demand forpersonalized identification and access cards. Concern for personal safety andproperty protection has heightened since the terrorist attacks ofSeptember 11, 2001, ongoing terrorist activities worldwide, as well asother well-publicized security breaches and violence at government facilities,businesses, hospitals and schools. Actions in response to these concerns bygovernments, such as the creation of the Department of Homeland Security in theUnited States and national ID programs overseas, continue to grow. Personalizedidentification cards are increasingly being used as a means of visual andelectronic identification and access control. Concern over the fraudulentproduction of these important credentials is increasing. In addition, newapplications for personalized cards are being driven by technologies such asmagnetic stripes, proximity sensors, biometric technologies, optical datastorage cards and smart cards. These applications include more secure forms ofidentification and authentication of an individual, electronic purse programsthat allow financial transactions via the card, single sign-on to computers andnetworks that increase security by eliminating multiple passwords, encryptede-mail and increased government usage of sophisticated identification cardswith higher levels of protection against forgery.

 

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We believe that threelong term global trends are currently driving our business. These trends are:

 

•      The increased desire for security whichis driven by terrorist threats and concerns about crime.

 

•      The growth in the adoption of electronicsmart card technology as advances in the capabilities, cost and ease of use of thetechnology make it easier for organizations to use this technology in theiridentity credential programs. We are seeing biometric technology for highersecurity being incorporated into these smart cards.

 

•      The convergence between the desire forphysical security and information security. Historically in our industry,physical security has been paramount and companies providing physical securityhave not been involved in information security. Although this trend isrelatively recent, we believe the desire for information security coupled withphysical access is accelerating as organizations seek to detect and preventunauthorized access to their information.

 

We believe that themarket for identification card printers has become fragmented, with tiersdeveloping in the entry-level, integration and project markets. Much of themarket, which we define as entry-level has moved toward lower-priced printers,as new entrants and more stable printer platforms have been introduced and endusers have become comfortable with installing simple card printing systemswithout any help. In this tier, where the end user does not need advancedsecurity features but merely wants to print a card, price is generally the mostimportant determinant. The integration market, where card security is moreimportant and often multiple applications are being placed onto one card, hasalso become more price sensitive but end users still need the expertise of anintegrator to put together the system that meets all of their needs. Growingintegration applications include time and attendance, access control, andincreased visual security where the end user still needs assistance from aknowledgeable integration resource. The project market, usually governments orlarge corporations, often requires unique features, significant integration,higher security and more durable cards. Many times these end users work withprime contractors and large system integrators, with the printers being a smallpart of the overall project scope.

 

We have also seen newchannels of distribution arising or becoming more important. The internet hasbecome a more viable method for end users to research and purchase cardissuance systems. We have also seen the growth in channels such as the “auto ID”channel, which is primarily a supply chain management distribution systemtypically selling bar code printers and related media.

 

**IndustryTechnology**

** **

*CentralIssue Versus Decentralized Issue*

* *

Two general types ofsystems characterize the digital card personalization market: “central issue”and “decentralized issue” systems. Central issue systems typically involvebatch processing, printing and, in the case of credit and debit cards,embossing (raising of certain areas of the card to form letters or numbers)plastic cards. Typically, these processes take place at a different locationfrom where the relevant cardholder’s data is collected. Cards are usually sentor issued to individuals days or weeks after the initial processing begins,often by mail. Central issue processing is typically used in large-scaleprograms such as processing private label credit cards and issuing driver’slicenses. Central issue systems are generally much larger and substantiallymore expensive than decentralized issue systems. However, some central issuancelocations network multiple desktop printing systems rather than a single largecentral issuance machine.

 

Decentralized issuesystems, which are typically desktop systems, are used to print personalizedcards on demand for issue to the cardholder within moments after processing. Webelieve that decentralized issue systems reduce the time, costs and likelihoodof theft or loss associated with distribution of cards from centralized systemsand that decentralized issuance generally reduces printing down time, withbackup or multiple printers available to continue processing cards if onesystem requires maintenance. In the 1990’s, decentralized issue systems weretypically sold into small and medium scale applications such as corporationsfor access control or employee badging, and universities for studentidentification. These systems have now also been adopted by

 

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some governmentalagencies for driver’s licenses, national identification programs and militarypersonnel identification which were once the province of central issuanceprinters.

 

*DigitalCard Personalization Technologies*

* *

Currently, there are twoprincipal digital card printing technologies used by decentralized issuesystems to print personalized cards: direct-to-carddye-sublimation printing and reverseimage printing. We believe that inkjetprinting will become another important card printing technology. Webelieve we are the only company in the desktop ID card market that hasdeveloped products that incorporate each of these technologies.

 

Central issuancemachines primarily use direct-to-card printing, but also may incorporatetechnologies such as laser engraving and inks that require ultra-violet curing.Another process that has recently been applied to ID cards is resin transfer,which is a process similar to our High Definition Printing except that thecolors are created by colored resin rather than by dyes.

 

*Direct-to-cardprinting*is the most common technology used by digital card printersto print images directly onto the surface of a plastic card. The processinvolves heating a special print ribbon beneath a thermal printhead andapplying pressure so that the ribbon is in contact with the card and theprinthead rests on the top of the ribbon, resulting in the transfer of colorfrom the ribbon to a blank card.****Mostcard printers in the market today use direct-to-card technology.

 

*Reverseimage printing,*as used in our High Definition Printers,prints images onto a special film, which is then laminated onto the surface ofa blank card through heat and pressure. Because the graphics and text are printedon the underside of the film, the image is “sandwiched” between the film andthe card. This process produces one of the most physically secure cardconstructions available in combination with dye-sublimation printing. Itproduces exceptional print quality, high durability and greater flexibility toprint on a variety of card constructions. The sandwiched image also produces amore secure card, reducing the possibility of image tampering. Proximity cards,optical data storage cards and smart cards, which tend to have uneven surfacesdue to embedded wires, a laser read-write area or smart chips, have moresuccessful printing results using High Definition Printing. We believe that weare one of only two companies that manufacture products using this technology.A third competitor uses resin transfer technology that has transfercharacteristics similar to our High Definition Printing process.

 

*Inkjetprinting**systems*, becausethey are simple to use, quiet and very reliable, have become the standardprinting technology for desktop computing worldwide. We believe this non-impactprinting technology has not previously been used in the card market, becausethe inks are water-based and traditionally do not readily adhere to plasticcards. We now offer a pair of inkjet receptive cards that produce glossy andmatte finishes that work with our CardJet printer. Non-impact printing is alsobeneficial for use on proximity cards that are designed with embeddedelectronics. Together with AccessID, a leading provider of custom secure cardsolutions for the electronic identification market, we are now marketing astandard 26-bit proximity card with HID electronics inside. We believe thiscard may open up new market opportunities with access control dealers searchingfor reliable, easy-to-use solutions for print personalizing proximity cards.

 

*DataEncoding*

* *

In addition to printedphotographs, text and bar codes, card printing systems can encode personalizeddata on magnetic stripes, smart cards, proximity cards and optical data storagecards.

 

*Magneticstripe* technology is the oldest and most widely used technologyfor encoding identification and storing data on cards. When the cards areswiped through a reader, the data is interpreted and the cards can be used foridentification, access control, time and attendance, loyalty programs, recordsmanagement and more.

 

*Smartcards* commonly refer to any plastic card with an embeddedintegrated circuit microchip or an on-board microprocessor. The microprocessorprovides controlled access to the data on the card using a pin code orencryption key. This makes it ideal for security applications including singlesign-on, on-board biometrics, encrypted email, and financial applicationsincluding EMV (Europay Mastercard Visa, an international standard) andelectronic purse. With “contact” smart cards, data is accessed by directcontact between a smart card reader

 

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and a gold plate on thecard face. “Contactless” smart cards have an electronic microchip and embeddedantenna that allow the card to communicate with an antenna/coupler unit withoutphysical contact.

 

*Proximitycards* have embedded electronic circuits that store data and canbe read by a proximity reading device without the need for the card to makephysical contact with the reader. Users can leave their proximity cards insidetheir wallet or purse while the reader processes the code, making theconvenience of proximity cards increasingly popular for access controlapplications.

 

*Optical Data Storage Cards* have alaser read-write surface that is created similarly to compact discs. Thistechnology is being used for high data storage and government applications suchas in the Italian and Saudi Arabian national identification programs.

 

**OurProducts**

** **

*FargoSecure Card Identity Systems*

* *

We currently manufacturefour different product platforms, packaged into two selling lines, with avariety of options in each product line. We sell our products to distributorsand integrators, who offer them to end users as part of a system they integratewith other companies’ components. All of our systems are designed to beinteroperable with the hardware, software and other equipment most often usedby our integrators. Our newest printers now incorporate security features thatwe have developed internally and are being sold as SecureMark softwareproducts.

 

Our Fargo ProfessionalSeries offers premium features and advanced technologies. Fargo ProfessionalSeries systems are sold through a limited number of integrators, valueadded distributors and distributors who have agreed to meet certain criteriafor carrying the Fargo Professional Series lines. Our Persona by Fargo Series,targeted to the entry-level end user, is distributed without such limitations.

 

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The following chart setsforth our product lines, suggested retail price ranges and the markets webelieve they address:

 
| ** **                    | ** ** | **Fargo Professional Series**                                                                | ** ** | **Persona by Fargo**                                                  | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| **Models:**                   | ** ** | **High Definition  Printing:  HDP 600 and  HDP 800  Printers/Encoder/  Laminator** | ** ** | **Lamination  Printing:  DTC500 and  DTC550  Printer/Encoder/  Laminator** | ** ** | **Direct-to-Card  Printing:  DTC400  Printer/Encoder** | ** ** | **Inkjet Printing:  CardJet 410  Printer** | ** ** | **Direct-to-Card  Printing:  C30  Printer** | ** ** | **Inkjet Printing:  CardJet C7  Printer** | ** ** |
| Suggested Retail  Price:      |       | $6,995–$18,995                                                                                    |       | $3,095–$10,995                                                             |       | $2,895–$5,995 |   | $1,495–$2,095 |   | $2,295–$4,595 |   | $1,195–$1,595 |   |
| **Applications**              |       |                                                                                                   |       |                                                                            |       |   |   |   |   |   |   |   |   |
| SmartCards/  Technology Cards |       | X                                                                                                      |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Visual  Identification        |       | X                                                                                                      |       | X                                                                               |       | X |   | X |   | X |   | X |   |
| Time and  Attendance          |       | X                                                                                                      |       | X                                                                               |       | X |   | X |   | X |   | X |   |
| Access Control                |       | X                                                                                                      |       | X                                                                               |       | X |   | X |   | X |   | X |   |
| Loyalty                       |       | X                                                                                                      |       | X                                                                               |       |   |   |   |   |   |   |   |   |
| **Vertical  Markets**         |       |                                                                                                   |       |                                                                            |       |   |   |   |   |   |   |   |   |
| Corporate ID                  |       | X                                                                                                      |       | X                                                                               |       | X |   | X |   | X |   | X |   |
| National ID                   |       | X                                                                                                      |       | X                                                                               |       |   |   |   |   |   |   |   |   |
| Driver’s  Licenses       |       | X                                                                                                      |       | X                                                                               |       |   |   |   |   |   |   |   |   |
| Government/  Military         |       | X                                                                                                      |       | X                                                                               |       |   |   |   |   |   |   |   |   |
| Transportation                |       | X                                                                                                      |       | X                                                                               |       | X |   |   |   |   |   |   |   |
| Healthcare                    |       | X                                                                                                      |       | X                                                                               |       | X |   |   |   |   |   |   |   |
| Universities                  |       | X                                                                                                      |       | X                                                                               |       | X |   |   |   |   |   |   |   |
| Corrections                   |       |                                                                                                   |       | X                                                                               |       | X |   |   |   |   |   |   |   |
| Sports &  Leisure    |       |                                                                                                   |       | X                                                                               |       | X |   | X |   | X |   | X |   |
| K-12 Schools                  |       |                                                                                                   |       | X                                                                               |       | X |   | X |   | X |   | X |   |
| Health Clubs                  |       |                                                                                                   |       |                                                                            |       | X |   | X |   | X |   | X |   |
| Retail &  Loyalty    |       |                                                                                                   |       |                                                                            |       |   |   |   |   | X |   | X |   |
| Casinos                       |       |                                                                                                   |       |                                                                            |       | X |   |   |   | X |   |   |   |
| Manufacturing  Plants         |       |                                                                                                   |       |                                                                            |       | X |   | X |   | X |   | X |   |
| Libraries                     |       |                                                                                                   |       |                                                                            |       | X |   | X |   | X |   | X |   |
| Events                        |       | X                                                                                                      |       | X                                                                               |       |   |   |   |   |   |   |   |   |

 

Our HDP600 is adual-sided, full-color printer/encoder that uses our patented High DefinitionPrinting technology. It features a compact design that is 50% smaller andlighter than previous HDP models. It has been designed with simplifiedelectronics for improved reliability and data communication. In addition, userconveniences such as drop-in, color-coded consumables make set up faster andeasier. A card lamination module is available as a factory-built orfield-installable option. The lamination module applies our PolyGuardoverlaminate to one or both sides of the printed card for extended card lifeand added security and durability.

 

Our DTC500 series cardidentity systems use direct-to-card technology and offer a variety of printingoptions including single-sided printing, dual-sided printing, dual hoppers anda field-upgradeable lamination station. These systems are typically used inmoderate-volume applications such as corporate identification, education andgaming.

 

Launched in September,2005, our DTC550 card identity systems use direct-to-card technology and arethe successor to the DTC500 series. The DTC550 features enhanced reliability,quieter operation, more images per ribbon roll and an optional Ethernetinterface with built-in print server. In addition, user conveniences such asdrop-in, color-coded consumables make set up faster and easier. Other optionsinclude single-side printing, dual-side printing, dual hoppers and afield-upgradeable lamination station. The DTC550 also offers Fargo’s new PrintSecurity Software as an upgradeable feature.

 

Introduced and shippedin late 2004, our DTC400 series card identity systems use direct-to-cardtechnology and are designed for ease of use and security in ID card issuance.Its convenience features include: a print ribbon cartridge that installs in oneeasy step; an integrated cleaning roller in every cartridge that eliminates theneed for

 

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separate card cleaning;and an LCD panel that communicates prompts and commands. Encoding anddual-sided printing modules can be added to the DTC400 as security needs grow.The DTC400 also offers our new Print Security Software as an upgradeablefeature.

 

Our Persona C30 is asingle- or dual-sided, full-color printer using direct-to-card technology andis designed for entry-level end users requiring ease of use and reliability. Itsconvenience features include: a print ribbon cartridge that installs in oneeasy step; an integrated cleaning roller in every cartridge that eliminates theneed for separate card cleaning; and bi-directional communication to the PCthat communicates prompts and status messages. A magnetic stripe encoder can beadded to the C30 as a customer’s needs change.

 

Our Fargo CardJet 410and Persona CardJet C7 card identity systems use inkjet technology. We havemarketed these products to address the needs of low-volume users and end userswho currently use analog cut-and-paste products.

 

*FargoSecure Materials*

* *

A significant portion ofour business is in the sale of secure printer materials including ribbons, holographicoverlaminates and a portfolio of blank cards that include optional visualsecurity features. Our materials business strategy supports the design andincorporation of proprietary elements and logical RFID security that are uniqueto our systems and add value to our customers’ badging solutions. We engineerthese materials in close cooperation with the manufacturers of these materials.Our materials strategy is designed to support our overall mission of reducingsecurity vulnerabilities and increasing profits.

 

Our Secure Materialsinclude:

 

•  *Ribbon and Inks.  *Thedye-based ribbons used by our printer/encoders are partitioned into consecutivecolor panels that generate rich, full-color images. During printing, aprinthead containing hundreds of thermal elements heats the dyes on the ribbon,which vaporize and diffuse into the surface of the card. Inks for use inCardJet are dye-based and generate robust photo image quality. All of ourribbons and inks are protected through patents, and we are designing ribbonsthat feature RFID that ensure security within the printer and avoidance ofcustomer error. These ribbons and inks have historically provided a recurringrevenue stream for us.

 

•  *Overlaminate and Films.  *Overlaminates and films, especially custom holographic applications, are agrowing portion of our business as end users seek enhanced durability andhigher security for their identification cards. For use in our laminatingprinter/encoders and HDP printers respectively, overlaminates and films areavailable in clear and custom designs. In 2005, we introduced a new High Securecustom overlaminate and holographic HDP film for high security applications. Incombination, visual security on overlaminates and films reinforce our missionof reducing security vulnerabilities and also provide a recurring revenuestream.

 

•  *Blank cards.  *We sell aportfolio of branded blank cards on which images and text are printed to createidentification cards. The production of our UltraCard brand of cards include aprocess that optically scans each card to ensure that they are as clean anddefect-free as possible. Blank cards are essentially a commodity item that maybe purchased through a variety of sources. We introduced a new HID co-brandedproximity card for use in our CardJet printer platform that we believe willincrease our exposure to the access control dealer channel.

 

•  *Secure Foil cards.  *To supportend users’ demands for more secure cards, we offer customized secure foil cardsmanufactured in-house. Using a hot stamp foil process, we offer customizedsolutions for small and large organizations alike that allow for quickidentification of valid cards by visual inspection.

 

Our continued focus onmaterials innovation in 2004 led us to introduce a series of new visualsecurity products for use in combination with our printer/encoders. Theseinclude a six-panel fluorescing color ribbon for use in direct-to-cardprinters; holographic reverse transfer film for use in HDP printers; a newsecure custom overlaminate for use in laminating printer modules, and securefoil cards for use in direct-to-card printers.

 

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*FargoSecure Software*

* *

Throughout 2005 we havecontinued our development of software products and tools designed to improvecard issuance security.  Our first product was Print Security Suite, whichbecame available to our distribution channel in early 2005.  This productis a suite of security tools that improve card authentication and secure thecard issuance process.  At the end of 2005, we added Ethernet networkconnectivity to our printer products.  Complementing that offering, weintroduced Print Security Manager, a network based printer management tooldesigned to securely manage multiple networked printers from a centrallocation.

 

**Researchand Product Development**

** **

Our research anddevelopment strategy is to identify and incorporate new technologies, developedby us and others, so that our products provide end users with the most securecard identity systems available. We have adopted a design and developmentapproach that will allow us to integrate new technologies into our product offeringquickly and efficiently. We believe that emerging technologies, such astechnology cards and biometrics, will provide us with new opportunities todifferentiate our systems from those of our competitors. We strive to involveour system integrators to help us determine the needs of end users, assess oursystems and better predict market acceptance of new products.

 

We have assembled ahighly trained staff of electrical, mechanical, chemical and softwareengineers, and we devote significant resources to developing new card identitysolutions and materials that contain proprietary elements that are unique toour systems, while maintaining high standards of quality and reliability. Weare currently conducting research and development in the areas of printerdesign, including potential advances in our mechanical, electronic andlaminating technologies, supplies development encoding development, and morerecently software applications development. As of December 31, 2005, wehad 48 employees engaged in research and development.

 

We invest significantengineering resources in product development. Our research and developmentcosts were approximately 7.1%, 7.2% and 7.3% of net sales in 2005, 2004 and2003, respectively.

 

**IntellectualProperty**

** **

Portions of our manufacturingprocesses and the mechanical and electronic designs of our systems areproprietary. We attempt to protect our systems and processes through acombination of patents, copyright, trademark and trade secret laws; employeeand third-party nondisclosure agreements and similar means. The decision toseek additional patents is based 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 currently hold 67United States patents related to our card business. A number of these patentshave also issued internationally. We have also filed applications forapproximately 50 additional United States patents that are currently pending.Our existing patents expire during the period between January 2009 andSeptember 2023. We consider our most important patents to be thosecovering our methods for driving our printheads, our lamination methods and ourmethods of identifying dye sublimation and thermal transfer ribbons. Thesemethods most directly impact the quality and durability of our systems, areasin which we believe we have a competitive advantage. The patents in these areasexpire between 2013 and 2024.

 

We also rely on ourengineering know-how, materials expertise and trade secrets applicable to themanufacture of our systems. We believe that this knowledge provides us with acompetitive advantage at least as important as patent protection. We seek tomaintain the confidentiality of this information by requiring employees to signconfidentiality and non-competition agreements and by limiting access byoutside parties to such information.

 

We also file somepatents in countries outside the United States, again depending on our analysisof various business considerations such as the cost of obtaining a patent, thelikely scope of patent protection and the benefits of patent protectionrelative to relying on trade secrets and other protection. We recognize thatsome

 

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countries in which we dobusiness do not offer the same level of protection for intellectual property asdoes the United States.

 

**Manufacturingand Sources of Supply**

** **

We outsource assembly ofmost of the component parts used in our printing systems, such as circuitboards, wire harnessing and cabling to outside manufacturers, both domesticallyand internationally. These components are then shipped to our manufacturingfacility in Eden Prairie, Minnesota for final assembly and testing. We maychoose to assemble products in other locations than our Minnesota facility. Wealso purchase component parts, print heads, inkjet cartridges, inkjet printerassemblies and ribbons from a number of vendors located in the United States,China and Japan. The terms of supply contracts are negotiated separately witheach vendor. In 2002 we entered into an agreement with Sony ChemicalCorporation, a subsidiary of Sony Corporation, which supplements our long termrelationship with Dai Nippon Printing, for color dye sublimation ribbons. Underthis agreement, we have agreed to purchase from Sony, and Sony has agreed tosell to us on an exclusive, worldwide basis, Sony’s dye-sublimation printerribbons for our products for a ten-year period. Our obligations under thisagreement, which include a requirement to purchase $4 million of printerribbons each year, are subject to Sony performing certain obligations under theagreement. We believe that our present vendors have sufficient capacity to meetour requirements. We also believe alternate production sources for mostcomponents are generally available without undue interruption with theexception of Kyocera Corporation, our supplier of print heads.

 

**Inventory**

** **

Because most of oursystems are built upon order, we do not maintain a significant inventory ofcompleted systems. We maintain only limited inventories of component parts andmaterials, although we enter into purchase agreements with certain suppliersthat require us to purchase minimum amounts. We try to produce systems as theyare ordered, which causes us to forecast production based on past sales and ourestimates of future demand rather than stocking finished goods. While mostcomponents are available from multiple vendors, certain components used in oursystems are only available from single or limited sources. In common with mostof our competitors, we rely on Kyocera Corporation, based in Japan, to supplyus with print heads for our dye sublimation and reverse image printers.

 

**Salesand Marketing**

** **

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

 

In the United States,our distribution program categorizes our distribution channel into four programtracks. Fargo Solution Providers provide retail customers with sales, serviceand integration expertise on Fargo’s full line of Professional and PersonaSeries products and systems. Fargo Value Added Distributors providein-depth integration expertise and support for Fargo Solution Providers and enduser customers on Fargo’s full line of products and systems. Fargo Distributorsprovide product distribution services to Fargo Solution Providers. FargoManufacturing Resellers provide a core business strategy of developing andmanufacturing products where the sale of identification card printers is asecondary portion of its sales. We continue to implement our two-product linestrategy with restricted distribution on our Professional Series productsand broad distribution of our Persona Series

 

Internationally, ourdistribution program categorizes our distribution into three program tracks. ImportSuppliers act as a master distributor in a country. International Dealers sellto retail customers. International Distributors provide product distribution. Althoughdoing business in developing regions involves risks of political and economicinstability, we are generally able to terminate our arrangements with ourinternational distributors and integrators upon short notice in order tomitigate such risks. Additional information about our international sales isalso included in Note 8 to our financial statements on page F-17.

 

From time to time, weadjust selected parts of our distribution system to address changingrequirements. In the second half of 2005, we made some changes, primarily inthe areas of harmonizing discounts world-wide,

 

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eliminating someexclusivity options for certain of our distribution and increasing the requirementsnecessary to purchase directly from us.

 

Our ten largestdistributors and integrators accounted for a combined total of 48.9% of oursales in 2005, with one customer, Wynit Inc., accounting for 14.9% of suchsales in 2005 and 10.6% in 2004. We support our distribution network and endusers through our offices in Eden Prairie, Minnesota. As of December 31,2005, we directly employed 57 individuals engaged in sales, marketing andtechnical support services.

 

Our integrators sell avariety of identification, access control, time and attendance and visitormanagement components from different manufacturers to customize systems forend-user applications. These integrators provide configuration, installation,training and support services required by end users within various marketsegments. The relationships our integrators develop and maintain allow us toreach end users worldwide in a broad variety of industries. We do not competewith our distributors or integrators by selling directly to end users.

 

*Marketingactivities.  *Our marketing operations include customerand technical support, product management, market research, marketingcommunications, and repair services and training. 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 continually analyze the market for ourproducts and evaluate 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.

 

Our marketingcommunications activities build our brand and generate sales leads. All leadsgenerated by our marketing activities are referred to an authorized distributoror integrator. These marketing activities include:

 

•  We routinely conduct promotions targetedat distributors and integrators, as well as directly to potential end userssuch as corporations, schools, hospitals and others.

 

•  Our web site provides visitors withinformation about the company and our systems, with referrals to ourintegrators for follow-up consultations. A second, proprietary web site allowsspecial access to our authorized distributors and integrators to obtaindetailed product specifications, market information, pricing and technicalupdates.

 

•  We actively participate in industry tradeshows in the United States and internationally, both as an exhibitor at largertrade shows and with our distribution partners at smaller, regional tradeshows.

 

•  We regularly advertise in online andprint publications in the security, government, and education markets.

 

•  Our public relations efforts generate editorialplacements and speaking engagements for our staff.

 

We provide training andtechnical support to our distributors and integrators to assist them inmarketing and servicing our systems. Our training workshops, instructionalvideos and live telephone support assist our integrators in helping end usersmake the purchasing decision that best suits their particular needs. Inaddition, we encourage our integrators to become Authorized Service Providersso that they can provide technical support directly to their customers. As aresult, many of our integrators offer their customers maintenance and supportcontracts for their integrated card personalization solutions.

 

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**Competition**

** **

Many companies are engagedin the design and manufacture of card printing systems. Competition in ourmarket is intense, and we expect it to increase. We compete today, and expectto compete in the future, with a number of companies, some of which havegreater financial, technical and marketing resources than we do. Significantcompetitors include Zebra Technologies Corporation and DataCard Corporation.Our ability to compete successfully depends on many factors, some of which areoutside of our control. Factors affecting our ability to compete include:

 

•  Our ability to introduce innovative newproducts and technologies;

 

•  The effectiveness of our distributionnetwork;

 

•  The price, quality and performance of oursystems relative to our competitors;

 

•  The competition with aftermarket ribbonmanufacturers;

 

•  Our success in developing new systems andthe timing of new product introductions;

 

•  The adequacy of our manufacturingcapacity and supply of components and materials;

 

•  The efficiency of manufacturingoperations and the cost of manufacturing;

 

•  Our relationships with our suppliers; and

 

•  General market and economic conditions.

 

We believe we competefavorably with respect to each of these factors. We believe our ProfessionalSeries and Persona Series systems are competitively priced both tothe distribution network and to the end users.

 

We believe the cardprinting industry includes approximately 30 to 35 companies that manufacturedigital card printers. We also compete with manufacturers of central issuancesystems such as DataCard and NBS as well as cut-and-paste card systems, such asPolaroid Corporation.

 

**GovernmentRegulation**

** **

Certain of our operations involve the use ofsubstances regulated under various federal, state and internationalenvironmental laws. It is our policy to apply strict standards forenvironmental protection to sites inside and outside the United States, even ifnot subject to regulations imposed by local governments.

 

The European Parliament has enacted the Restriction onUse of Hazardous Substances Directive, or RoHS Directive, which restricts thesale of new electrical and electronic equipment containing certain hazardoussubstances. We are working to modify our manufacturing processes as required bythe RoHS Directive. This may require additional capital expenditures. Inaddition, the costs associated with compliance may negatively impact ourresults of operations and competitive position. Based upon current informationavailable to us, we believe that we will be able to comply with the RoHS Directivewithin the applicable time period. However, if we do not comply with thisDirective, we may suffer a loss of revenue, be unable to sell in certainmarkets or countries and suffer competitive disadvantage.

 

The European Parliament has also recently finalizedthe Waste Electrical and Electronic Equipment Directive, or WEEE Directive,which makes producers of electrical and electronic equipment financiallyresponsible for specified collection, recycling, treatment and disposal of pastand future covered products. We may incur financial responsibility for thecollection, recycling, treatment or disposal of products covered under the WEEEDirective. Because the EU member states have not fully implemented the WEEEDirective, the nature and extent of the costs to comply and fees or penaltiesassociated with non-compliance are unknown at this time. Costs to comply withthe WEEE Directive and similar future legislation, if applicable, may alsoinclude legal and regulatory costs and insurance costs. We may also be requiredto take reserves for costs associated with compliance with these regulations.

 

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**Employees**

** **

As of February 15,2006, we employed 226 persons, of whom 100 are engaged in manufacturing, 49 inresearch and development, 61 in sales, marketing and technical support, and thebalance in management and administrative positions. None of our employees isrepresented by a labor union or covered by a collective bargaining agreement.We have not experienced any work stoppages and consider relations with ouremployees to be good.

 

All of our employees arerequired to sign a confidentiality and non-competition agreement prior tobeginning employment with us.

 

***(d)****** ******FinancialInformation About Geographic Areas***

 

Geographical salesinformation is contained in Note 8 to our financial statements on page F-17of this report, and is incorporated in this item by reference.

 

**Item1A.**      RISK FACTORS

** **

The following factors areimportant and should be considered carefully in connection with any evaluationof our business, financial condition, results of operations, prospects and aninvestment in our common stock. Additionally, the following factors could causeour actual results to materially differ from those reflected in any forward-lookingstatements.

 

In this report we make,and from time to time we otherwise make, written and oral statements regardingour business and prospects, such as projections of future performance,statements of management’s plans and objectives, forecasts of market trends,and other matters that are forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934. Statements containing the words or phrases “willlikely result,” “are expected to,” “will continue,” “is anticipated,” “estimates,”“projects,” “believes,” “expects,” “anticipates,” “intends,” “target,” “goal,” “plans,”“objective,” “should” or similar expressions identify forward-lookingstatements, which may appear in documents, reports, filings with the Securitiesand Exchange Commission, news releases, written or oral presentations made byofficers or other representatives made by us to analysts, stockholders,investors, news organizations and others, and discussions with management andother representatives of us. For such statements, we claim the protection ofthe safe harbor for forward-looking statements contained in the PrivateSecurities Litigation Reform Act of 1995.

 

Our future results,including results related to forward-looking statements, involve a number ofrisks and uncertainties. No assurance can be given that the results reflectedin any forward-looking statements will be achieved. Any forward-lookingstatement 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.

 

**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 thatprotecting our proprietary technology is important to our success andcompetitive positioning. In addition to common law intellectual propertyrights, we currently rely on a combination of patents, trademarks, licenseagreements and contractual provisions to establish and protect our intellectualproperty rights. Our failure to protect or enforce our intellectual propertyrights could have a material adverse effect on our business, results ofoperations and financial condition. We cannot be certain that the steps we take

 

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to protect ourintellectual property will adequately protect our proprietary rights, thatothers will not independently develop or otherwise acquire equivalent orsuperior technology or that we can maintain any of our technology as tradesecrets.

 

We have instigatedlitigation to protect our intellectual property rights in the United States,Korea and China. Moreover, we recently received an adverse partial summaryjudgment ruling in our litigation with Iris Ltd., Inc, which we plan toappeal. The results of any 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 couldresult in substantial costs to us and the diversion of significant time andeffort by our executive management, and may be necessary to enforce our patentsand trademarks and to protect our trade secrets and proprietary technology. Wecannot assure you that we will have the financial resources necessary toenforce or defend our intellectual property rights. We also cannot assure youthat we would prevail in any such litigation or that, if we are unsuccessful,we would be able to obtain any necessary licenses on reasonable terms or atall. The laws of some of the countries in which our systems are or may be soldmay not protect our systems and intellectual property to the same extent as theUnited States or at all.

 

**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 certainthat we have not infringed the proprietary rights of others. Any suchinfringement could cause third parties to bring claims against us, resulting insignificant costs, possible damages and substantial uncertainty. We could alsobe forced to develop a non-infringing alternative, which could be costly andtime-consuming.

 

**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 significantcompetition in developing and selling our systems. Our principal competitorshave substantial marketing, financial, development and personnel resources. Toremain competitive, we believe that we must continue to provide:

 

•  technologically advanced and innovativesystems that satisfy the demands of end users;

 

•  a dependable and efficient distributionand integrator network;

 

•  superior customer service; and

 

•  high levels of quality and reliability.

 

We cannot assure youthat we will be able to compete successfully against our current or futurecompetitors. The security printing system market has increased visibility,which may lead to large, well-known, well financed companies entering into thismarket. Increased competition from manufacturers of systems or consumable materialsmay result in price reductions, lower gross profit margins, increased discountsto distribution and loss of market share and could require increased spendingby us on research and development, sales and marketing and customer support.Some of our competitors may make strategic acquisitions or establishcooperative relationships with suppliers or companies that producecomplementary products such as cameras, computer equipment, software orbiometric applications. If any technology that is competing with ours becomesmore reliable, higher performing, less expensive or has other advantages overour technology, then the demand for our products could decrease.

 

**Werely on sole and single-source suppliers, which could cause delays, increasesin costs or prevent us from completing customer orders, all of which couldmaterially harm our business.**

** **

We rely on outsidevendors to manufacture or develop products and consumable materials that areused in our systems. We purchase critical components for our systems, includingprint heads, High Definition Printer ribbons, inkjet printer chassis, inkjetink, inkjet cards and microprocessors from separate single-source suppliers.Our inability to obtain adequate deliveries or alternative sources of supplycould cause delays, loss of sales,

 

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increases in costs andlower gross profit margins. Currently, our sole supplier of print heads for dyesublimation printers is Kyocera Corporation, based in Japan; our two suppliersof dye sublimation ribbons are Dai Nippon and Sony Chemical Corporation, bothalso based in Japan; and our supplier of most of the microprocessors that runour printers is Motorola. Dai Nippon is the sole producer of High DefinitionPrinting ribbon and film and may choose not to sell to us. We purchase inkjetprinter chassis and ink from Hewlett-Packard and purchase inkjet proximitycards from AccessID. If any of these suppliers is unable to ship criticalcomponents, we would be unable to manufacture and ship products to ourcustomers. If the price of print heads, ribbons or microprocessors increasesfor any reason, or if these suppliers are unable or unwilling to deliver, wemay have to find another source, which could result in interruptions, increasedcosts, delays, loss of sales and quality control problems. War, naturaldisaster, trade embargoes or economic hardship in Japan could also result in adisruption in shipments from our Japanese suppliers, which could require us andour competitors to develop new sources of these supplies or else cause us to beunable to complete and ship orders to our customers.

 

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

** **

Because we sell cardissuance systems which incorporate printers, materials and software, ourbusiness depends on the continued demand for cards for identification, accesscontrol and other purposes. Demand for our products could decline if businessesand organizations use alternative technologies for these purposes that do notinvolve the use of a card such as biometrics. Several identification programs,such as the US-VISIT program, incorporate biometrics without the use of a card.Any such changes in the business environment or competition from current andpotential competitors could significantly erode the demand for our systems andcause our business to suffer. If demand on the part of governmental agenciesand large customers are reduced, this could 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 incorporatetechnologies over which we have no control, including thermal print headtechnology, dye sublimation technology, software, microprocessors, inkjettechnology and inkjet receptive cards. The owners of these technologies arefree to sell or license these technologies to our competitors, agree to supplythese technologies exclusively to a third party or enter the market for oursystems as our competitor. If any of these events occurs, the owners of these technologiescould choose not to continue to supply us with vital system components, whichwould result in the diversion of our research and development resources andcould result in lost revenue, inability to ship products and harm to ourreputation. Some of these technologies are incorporated into new systems and ifthese systems are not shipped, we will see a material adverse impact to ourrevenues in the foreseeable future.

 

**Thedesign of our systems or where they are manufactured could result in manufacturingdelays and other problems that cause us to fail to meet the demand for oursystems on a timely basis, increase the cost of our systems, or both.**

** **

We have experiencedmanufacturing problems with some of our systems in the past. Similar problemsin the future could lead to production delays that could cause our distributionnetwork to choose to sell competing systems. In addition, manufacturingproblems could result in higher material, labor and other costs, which couldincrease the total cost of our systems and could decrease our gross profitmargins.

 

We may choose tomanufacture products in other locations than our Minnesota facility, whichcould require higher tooling expenses, more inventory, management time to setup such production and supply chain management requirements as well as otherunforeseen problems. We may be subject to delays in shipping and the loss ofcontrol of our designs and intellectual property. The risk of war anddisruption in an international location could be higher. We may be impacted bythe choice of location of manufacture by our competitors who may be able toreduce costs at a faster rate due to manufacturing in lower cost regions of theworld.

 

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**Oursystems may have manufacturing or design defects that we discover aftershipment, which could negatively affect our revenues, increase our costs andharm our reputation.**

** **

Oursystems are complex and may contain undetected and unexpected defects, errorsor failures. If these product defects are substantial, the result could beproduct recalls, an increased amount of product returns, loss of marketacceptance and damage to our reputation, all of which could increase our costsand cause us to lose sales. We carry general commercial liability insurance,including product liability, with a coverage limit of two million dollars peroccurrence plus an umbrella policy with a five million dollar limit,however, coverage may not be included on certain risks. Our insurance may be insufficientto protect us against losses caused by severe defects in our products. Thedesign flaws may be exacerbated by the location where the product ismanufactured.

 

Wemay not deliver systems that we have introduced on a timely basis, which couldimpact our anticipated revenue, and allow competitors to respond to our productintroductions, introduce competing products or introduce superior products.These delays, which may occur on future product introductions, may allowcompetition to respond to our plans, which could impact our revenue, or resultin the introduction of competing products that reduce the innovative value ofour products or could be technologically superior to the product we introduced.

 

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

** **

Becausemost of our systems are built upon order, we do not maintain a significantinventory of completed systems. We maintain only limited inventories ofcomponent parts and consumable supplies, although we enter into purchaseagreements with certain suppliers that require us to purchase minimum amounts.We endeavor to produce systems as they are ordered, which causes us to forecastproduction based on past sales and our estimates of future demand. In the eventthat we significantly underestimate our needs or encounter an unexpectedly highlevel of demand for our systems or our suppliers are unable to deliver ourorders of components in a timely manner, we may be unable to fill our productorders on time which could harm our reputation and result in reduced sales.

 

Weare in the process of implementing a new enterprise resource planning system. Themigration from our old system to this new system could lead to the inability toprocess customer orders, meet demand or forecast the appropriate inventorylevels.

 

**Ourstrategy of providing secure issuance solutions may not be successful.**

** **

We have been developingsecure issuance solutions, which include card printer/encoders, materials andsoftware, for identification card printing. Our distribution system may viewthese as competitive threats to their integration business or no longerperceive us as the best choice for purchasing ID systems. We may spendengineering, marketing and sales efforts on products that do not generateappreciable 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 technologicaladvances, rapidly changing customer requirements and fluctuations in demandcharacterize the current market for our products. Our existing anddevelopment-stage products may become obsolete if our competitors introducenewer or more appealing technologies. If these technologies are patented orproprietary to our competitors, we may not be able to access thesetechnologies. To be successful, we must constantly enhance our existing systemsand develop and introduce new systems. If we fail to anticipate or respond totechnological developments or customer requirements, or if we are significantlydelayed in developing and introducing products, our business will suffer lostsales.

 

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

** **

All of our revenue comesfrom sales through our distributor and integrator network, and we do not sellour products directly to end users. Although certain distributors andintegrators have made certain contractual commitments to us, they areindependent businesses that we do not control and these contractual commitmentsmay be terminated with limited notice and without a particular reason fortermination. We cannot be certain that companies who have committed toexclusively sell our printing systems will remain exclusive or that ourdistribution will continue to market or sell our systems effectively. Ouragreements with distributors and integrators of our ProfessionalSeries line of systems do not contain requirements that a certainpercentage of sales are of our products nor do they restrict the ability of ourdistribution to choose alternative sources for printing systems. We have madechanges to our distribution system, and may do so again in the future, both inthe United States and internationally, and these changes could adversely affectour relationships with distribution and our sales. We have contractualagreements with certain integrators to be exclusive partners, however, thesecontracts do not place restrictions that limit the exclusive integrators fromchanging their exclusive status. We are dependent upon the continued viabilityand financial stability of our distribution, many of which are smallorganizations with limited capital. These distributors and integrators maychoose to devote their efforts to other products in different markets or reduceor fail to devote the necessary resources to provide effective sales andmarketing support of our product. We believe that our future growth and successwill continue to depend in large part upon the success of our distributors inoperating their own businesses.

 

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**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 significantamount of our products to customers outside the United States. Internationalsales accounted for 45%, 44% and 42% of our net sales in 2005, 2004 and 2003,respectively. We expect that shipments to international customers will continueto account for a significant portion of our net sales. Sales outside the UnitedStates involve the following risks, among others:

 

•  foreign governments may impose tariffs,quotas and taxes;

 

•  political and economic instability mayreduce demand for our products;

 

•  restrictions on the export or import oftechnology may reduce or eliminate our ability to sell in certain markets;

 

•  potentially limited intellectual propertyprotection in certain countries may limit our recourse against infringingproducts or cause us to refrain from selling in certain markets;

 

•  certain countries may have legalrequirements that impact our ability to change our distribution withouteconomic impact;

 

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

 

•  we may decide to price our products inforeign currency denominations;

 

•  we do not maintain any overseaswarehouses to carry inventory;

 

•  we may add overseas warehouses ormanufacturing that could increase our inventories and increase our reliance onshipments from a foreign country;

 

•  our contracts with foreign distributorsand integrators do not fully protect us against political and economicinstability;

 

•  we may face difficulties in collectingreceivables; and

 

•  we may not be able to control ourinternational distributors’ efforts on our behalf.

 

Currently, we do nothedge against foreign currency fluctuations. Because we denominate ourinternational sales in U.S. dollars, currency fluctuations could also cause ourproducts to become less affordable or less price competitive than those offoreign manufacturers. These factors may have a material adverse effect on ourinternational sales.

 

In addition, we purchasecomponents from a number of foreign suppliers and outsource certainmanufacturing tasks to foreign manufacturers. Currently, we purchaser allcomponents in U.S. dollars but we may not be able to do so in the future, wemay have to renegotiate prices due to currency fluctuations or we may choose topurchase products in 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 complywith various domestic and international laws, regulations and standards. In theevent that we are unable or unwilling to comply with any such laws, regulationsor standards, we may decide not to conduct business in certain markets.Particularly in international markets, we may experience difficulty in securingrequired licenses or permits on commercially reasonable terms, or at all.Failure to comply with existing or evolving laws or regulations, includingexport and import restrictions and barriers, or to obtain timely domestic orforeign regulatory approvals or certificates could result in lost sales.

 

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**Internationalenvironmental regulations, such as the Reduction of Hazardous Substances (RoHS)and Waste of Electrical and Electronic Equipment (WEEE), could increase costsor limit our ability to sell products.**

** **

Many governmentsare increasing enforcement of environmental requirements for manufacturers ofelectronic equipment. In the European Union, the WEEE directive and RoHSdirective require significant changes to the manufacture and recycling ofelectronic equipment, including many of our products. We may have to set uprecycling groups, redesign products, change suppliers and increase testing inorder to comply with these directives. Any or all of these could increase costsof manufacturing and sales and marketing costs. If we do not comply with thesegovernmental regulations, we may not be able to ship products into a market,which could adversely affect our sales.

 

The WEEE directivealso could affect our consumable sales, as the recyclability of ink jetcartridges has been discussed as part of the WEEE directive. This could alsoaffect the sale of dye sublimation ribbons, laminates and cards, all of whichare products that we sell.

 

We anticipate thatthe regulation of these issues will increase, in the European Union, in othercountries world-wide and in the United States.

 

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

** **

We have experiencedfluctuations in our quarterly operating results and we expect thosefluctuations to continue due to a variety of factors. Some of the factors thatinfluence our quarterly operating results include:

 

•  the number and mix of products sold inthe quarter;

 

•  the timing of major projects;

 

•  the availability and cost of componentsand materials;

 

•  timing, costs and benefits of new productintroductions;

 

•  customer order size and shipment timing;

 

•  changes in distribution;

 

•  seasonal factors affecting timing ofpurchase orders;

 

•  promotions by ourselves or competitors,and the timing of the promotion; and

 

•  the timing and level of operatingexpenses.

 

Because of thesefactors, our quarterly operating results are difficult to predict and arelikely to vary in the future. If our earnings are below financial analysts’expectations in any quarter, our stock price is likely to drop.

 

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

** **

Our future successdepends, in significant part, upon the continued service and performance of oursenior management and other key personnel, in particular Gary R. Holland, ourChief Executive Officer. Losing the services of Mr. Holland could impairour ability to effectively manage our company and to carry out our businessplan. The other members of our management team also have significant experiencein our industry and the loss of any other member of our other senior managementcould likewise impair our ability to effectively manage our company and carryout our business plan. We do not carry key man insurance on any of our seniormanagers. In addition, competition for skilled technical employees in ourindustry is intense. If we cannot attract and retain sufficient qualifiedtechnical employees, we may not be able to effectively develop and delivercompetitive products to the market.

 

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**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 orborrow additional capital in the future to fund our ongoing operations. Anyequity or debt financing, if available at all, may be on terms that are notfavorable to us and, in the case of equity offerings, may result in dilution toour stockholders. Any difficulty in obtaining additional financial resources,including the inability to borrow on satisfactory financial terms, could forceus to curtail our operations or prevent us from pursuing our growth strategy orotherwise cause us financial harm.

 

**Compliancewith changing regulation of corporate governance and public disclosure mayresult in additional expenses.**

** **

Changing laws,regulations and standards relating to corporate governance and publicdisclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations andNASDAQ National Market rules, are creating uncertainty for companies such asours. These new or changed laws, regulations and standards are subject tovarying interpretations in many cases due to their lack of specificity, and asa result, their application in practice may evolve over time as new guidance isprovided by regulatory and governing bodies, which could result in continuinguncertainty regarding compliance matters and higher costs necessitated byongoing revisions to disclosure and governance practices. We are committed tomaintaining high standards of corporate governance and public disclosure. As aresult, our efforts to comply with evolving laws, regulations and standardshave resulted in, and are likely to continue to result in, increased generaland administrative expenses and a diversion of management time and attentionfrom revenue-generating activities to compliance activities. In particular, ourefforts to comply with Section 404 of the Sarbanes-Oxley Act of 2002 andthe related regulations regarding our required assessment of our internalcontrols over financial reporting and our external auditors’ audit of thatassessment has required the commitment of significant financial and managerialresources. We expect these efforts to require the continued commitment ofsignificant resources. Further, our board members, chief executive officer andchief financial officer could face an increased risk of personal liability inconnection with the performance of their duties. As a result, we may havedifficulty attracting and retaining qualified board members and executive officers,which could harm our business. If our efforts to comply with new or changedlaws, regulations and standards differ from the activities intended byregulatory or governing bodies due to ambiguities related to practice, ourreputation may be harmed.

 

**Item1B.**      UNRESOLVED STAFF COMMENTS

** **

**None.**

** **

**Item2.**         PROPERTIES

** **

We currently leaseapproximately 90,240 square feet of space for our corporate headquarters andmanufacturing facility in Eden Prairie, Minnesota. Our lease for this facilityexpires in December 2006. In 2005, our lease for this facility was amended toextend the term of the lease from January 2007 to December 2016. Theeffectiveness of the lease amendment is subject to the approval of certaingovernmental organizations for additional parking as well as a build-out ofadditional office space. We consider our present facilities to be sufficientfor our current operations.

 

**Item3.**         LEGALPROCEEDINGS

** **

*Iris Ltd. Litigation*

* *

We filed a patentinfringement complaint against Iris Ltd., Inc. on February 24, 2004in Federal District Court in the State of Minnesota and served this complainton Iris Ltd., Inc. on March 26, 2004. Our complaint allegesinfringement of one or more of our patents relating to our printer ribbonproduct. We are seeking injunctive relief, damages and legal fees. In opencourt on September 8, 2004, Iris agreed to cease selling its infringingribbons. In early 2005, Iris announced another ribbon core and began solicitingorders for this ribbon. We believe this product infringes upon our patents andmay violate the cessation of sales agreed to in open court. On November 30,2005, the court granted partial summary judgment for IRIS on claims related tothe 5,755,519

 

19

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patent based on atechnical legal reading of the patent and invalidated some of the claimscontained in the patent. The lawsuit is continuing on the claims related to the6,152,625 patent and other non-patent related claims, including trademarkinfringement. We have stated that we anticipate appealing the ruling once theFederal District Court has issued a final determination of all issues in thelawsuit.

 

*Chinese Patent Litigation*

* *

OnOctober 27, 2003, we instituted an administrative action in the ShenzhenIntellectual Property Office, which is a branch of the Chinese IntellectualProperty Office, claiming that Shenzhen Kanon Industrial Development CompanyLtd. is infringing upon one or more of our patents related to our printerribbon products. We are seeking a permanent injunction, a request for paymentof all costs incurred by us in the case, a public apology and compensation fordamages resulting from our lost sales. On November 17, 2004, the ShenzhenMunicipal Intellectual Property Office issued an opinion that Shenzhen KanonIndustrial Development Company is infringing upon our patents and has orderedShenzhen Kanon to cease such infringement. If Shenzhen Kanon does not cease itsactivities, criminal charges may be filed against Shenzhen Kanon. As late asMay 2005, Shenzhen Kanon reiterated its offers to sell products that infringeupon the ribbon patents. We are evaluating our options but anticipate thislawsuit continuing.

 

*Other Litigation*

* *

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

 

**Item4.**         SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

** **

No matter was submittedfor a vote of our security holders during the fourth quarter of the fiscal yearcovered by this report.

 

**Item4A.**      EXECUTIVE OFFICERS OF FARGO

 
| **Name**              | ** ** | **Age** | ** ** | **Position**                                                               |
|-----------------------|------------|---------|------------|----------------------------------------------------------------------------|
| Gary  R. Holland      |       | 64      |       | Chairman  of the Board of Directors, President and Chief Executive Officer |
| Kathleen  L. Phillips |       | 41      |       | Marketing  and Distribution                                                |
| Thomas  C. Platner    |       | 46      |       | Engineering  and Manufacturing                                             |
| Paul  W.B. Stephenson |       | 51      |       | Chief  Financial Officer                                                   |
| Jeffrey  D. Upin      |       | 47      |       | Business  Development, General Counsel and Secretary                       |

 

*GaryR. Holland* has served as our President and ChiefExecutive Officer since February 1998. From May 1997 toFebruary 1998, Mr. Holland was the general manager of Fargo. From1992 to 1997, Mr. Holland owned and operated two business and strategyconsulting firms, Decision Process International of Minnesota, Inc. andHolland & Associates. From 1982 to 1992, Mr. Holland was thePresident of DataCard Corporation. From 1979 to 1982, he was the President andChief Operating Officer of CPT Corporation. Mr. Holland also serves as amember of the board of directors of Delphax Technologies, Inc.

 

*KathleenL. Phillips* has been our head of Marketing sinceJune 2000. In December 2003, she assumed additional responsibilitiesas head of Distribution. She joined Fargo in 1993, and has held variousmanagement positions at Fargo, including technical support, inside sales,customer service and product marketing. Prior to joining Fargo, she heldvarious positions in research and development, and technical support andservices at Northgate Computer Systems from 1989 to 1992.

 

*ThomasC. Platner* has been our head of Engineering andManufacturing since November 2000. He joined Fargo as Director of ProductDevelopment in August 1999. Prior to joining Fargo, he worked asEngineering Manager and Director of Engineering at Rosemount Inc. (adivision of Emerson Electric) from 1995 to 1999. He

 

20

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held various engineeringpositions at McQuay International from 1985 to 1995, and for CarrierCorporation (division of United Technologies) as a Field Application Engineerfrom 1981 to 1985.

 

*PaulW.B. Stephenson* rejoined Fargo as Chief FinancialOfficer in May 2002, having previously served in that position fromMay 2001 through January 2002. Mr. Stephenson first joined Fargoin February 2001 as an independent consultant, serving as acting ChiefFinancial Officer. From January 2002 through May 2002,Mr. Stephenson served as Chief Financial Officer of OppenheimerWolff & Donnelly LLP, our legal counsel. From March 1999 toDecember 2000, Mr. Stephenson served as Vice President and ChiefFinancial Officer of the Minnesota Orchestral Association. From 1998 to 1999,he served as Vice President and Chief Financial Officer and from 1992 to 1997,as Vice President of Finance and Administration, of Check TechnologyCorporation.

 

*JeffreyD. Upin* has been our head of Business Development sinceAugust 2002 and has served as our 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.

 

21

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**PART II**

** **

**Item5.**         MARKET FORREGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

** **

***(a)****** ******MarketInformation.***

 

Our common stock iscurrently traded on the Nasdaq National Market under the symbol “FRGO.” Thefollowing table sets forth, the high and low sales prices per share as reportedby the Nasdaq National Market for each quarter in 2005 and 2004.

 
| **2005**       | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $        | 15.25      |    | $          | 12.12 |   |
| Second Quarter |       | 20.46    |       | 12.76   |       |
| Third Quarter  |       | 22.52    |       | 16.12   |       |
| Fourth Quarter |       | 21.90    |       | 16.66   |       |
|                |            |          |            |         |            |  |  |

 
| **2004**       | ** ** | **High** | ** ** | **Low** | ** ** |
|----------------|------------|----------|------------|---------|------------|
| First Quarter  |       | $        | 13.58      |    | $          | 9.75 |   |
| Second Quarter |       | 11.93    |       | 8.74    |       |
| Third Quarter  |       | 11.50    |       | 7.93    |       |
| Fourth Quarter |       | 15.83    |       | 9.71    |       |
|                |            |          |            |         |            |  |  |

 

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

 

As of March 10,2006, we estimate that there were approximately 8,000 beneficial owners ofshares of our common stock, which shares were held by 95 record holders.

 

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

 

We have not declared orpaid any cash dividends on our common stock for the past four fiscal years. OurBoard of Directors presently intends to retain all earnings to support ouroperations and to finance expansion. The terms of our credit facility restrictus from paying dividends if an “event of default”, as defined by the creditfacility agreement, has occurred. An “event of default” includes failure tomake loan payments on a timely basis, non-compliance with loan covenants,including the maintenance of specified financial ratios, and a change ofcontrol.

 

***(d)****** ******RecentSales of Unregistered Securities.***

 

We did not sell anyequity securities that were not registered under the Securities Act of 1933, asamended, during the fiscal year ended December 31, 2005.

 

***(e)****** ******RecentStock Purchases.***

 

None.

 

22

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**Item6.**         SELECTEDFINANCIAL DATA.

** **

The data presented belowfor the years ended December 31, 2005, 2004 and 2003 and as ofDecember 31, 2005 and 2004 are derived from our audited financialstatements included elsewhere in this report. The financial data for the yearsended December 31, 2002 and 2001 and as of December 31, 2003, 2002 and 2001are derived from our audited financial statements that are not included in thisreport. The information 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 thisreport.

 

**SummaryStatements of Operations Data**(in thousands, except per share data)

 
| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net sales                                    |       | $                                          | 81,028     |   | $ | 72,393 |   | $ | 65,491 |   | $ | 66,035 |   | $ | 60,963 |   |
| Cost of sales                                |       | 45,795                                     |       | 43,319 |   | 38,608 |   | 39,199 |   | 37,497 |   |
| Gross profit                                 |       | 35,233                                     |       | 29,074 |   | 26,883 |   | 26,836 |   | 23,466 |   |
| Operating  expenses:                         |       |                                       |       |   |   |   |   |   |   |   |   |
| Research and  development                    |       | 5,724                                      |       | 5,151 |   | 4,801 |   | 4,529 |   | 4,053 |   |
| Selling, general  and administrative         |       | 15,739                                     |       | 13,060 |   | 11,501 |   | 11,387 |   | 10,341 |   |
| Terminated  acquisition costs(1)             |       | —                                     |       | — |   | — |   | 552 |   | 1,434 |   |
| Total operating  expenses                    |       | 21,463                                     |       | 18,211 |   | 16,302 |   | 16,468 |   | 15,828 |   |
| Operating income                             |       | 13,770                                     |       | 10,863 |   | 10,581 |   | 10,368 |   | 7,638 |   |
| Other income:                                |       |                                       |       |   |   |   |   |   |   |   |   |
| Interest expense                             |       | —                                     |       | (7 | ) | (29 | ) | (554 | ) | (1,379 | ) |
| Interest income                              |       | 884                                        |       | 200 |   | 32 |   | 187 |   | 79 |   |
| Other, net                                   |       | 386                                        |       | (2 | ) | — |   | — |   | (33 | ) |
| Total other  income (expense)                |       | 1,270                                      |       | 191 |   | 3 |   | (367 | ) | (1,333 | ) |
| Income before  provision for income taxes    |       | 15,040                                     |       | 11,054 |   | 10,584 |   | 10,001 |   | 6,305 |   |
| Provision for  income taxes                  |       | 4,943                                      |       | 3,338 |   | 3,344 |   | 3,265 |   | 2,229 |   |
| Net income  available to common stockholders |       | $                                          | 10,097     |   | $ | 7,716 |   | $ | 7,240 |   | $ | 6,736 |   | $ | 4,076 |   |
| Net income per  common share:                |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic earnings  per share                    |       | $                                          | 0.79       |   | $ | 0.62 |   | $ | 0.58 |   | $ | 0.56 |   | $ | 0.35 |   |
| Diluted earnings  per share                  |       | $                                          | 0.77       |   | $ | 0.60 |   | $ | 0.57 |   | $ | 0.55 |   | $ | 0.34 |   |
| Weighted average  common shares outstanding: |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic                                        |       | 12,704                                     |       | 12,515 |   | 12,397 |   | 12,048 |   | 11,760 |   |
| Diluted                                      |       | 13,072                                     |       | 12,869 |   | 12,799 |   | 12,331 |   | 11,958 |   |

 

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(1)    Reflects expenses consisting primarily oflegal, professional and investment banking fees incurred by us in connectionwith the proposed acquisition of Fargo by Zebra Technologies Corporation, whichwas announced July 31, 2001, and terminated on March 27, 2002.

 

**SummaryBalance Sheet Data(in thousands)**

 
| ** **                | ** ** | **As of December 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| Cash and cash equivalents |       | $                                     | 36,475     |   | $ | 23,435 |   | $ | 13,445 |   | $ | 2,511 |   | $ | 3,586 |   |
| Working capital           |       | 46,931                                |       | 34,062 |   | 22,386 |   | 12,708 |   | 9,190 |   |
| Total assets              |       | 74,837                                |       | 61,905 |   | 50,807 |   | 44,009 |   | 46,213 |   |
| Bank debt                 |       | —                                |       | — |   | — |   | — |   | 14,000 |   |
| Stockholders’ equity |       | $                                     | 64,946     |   | $ | 53,081 |   | $ | 44,240 |   | $ | 36,313 |   | $ | 25,638 |   |

 

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**Item7.**         MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

Certain statementscontained in this report include “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995. Allforward-looking statements in this document are based on information currentlyavailable to us as of the date of this report, and except as required by law,we assume no obligation to update any forward-looking statements.Forward-looking statements involve known and unknown risks, uncertainties andother factors that may cause the actual results to differ materially from anyfuture results, performance or achievements expressed or implied by suchforward-looking statements. Such factors may include, among others, thosefactors listed in Item 1A and elsewhere in this report and our other filingswith the Securities and Exchange Commission. The following discussion should beread in conjunction with our financial statements and related notes appearingelsewhere in this report.

 

**Overview**

** **

We are a leadingdeveloper, manufacturer and supplier of printing systems and consumable materialsthat personalize plastic identification cards by printing images and text ontothe card. Our printing systems are capable of encoding data onto cards thatincorporate bar code, magnetic stripe, smart card or proximity card technology.We believe that our engineering expertise and our ability to offer a broadrange of printing systems using multiple printing technologies have led to areputation for innovation in our industry.

 

We believe that we arethe only manufacturer in our industry to offer three distinct technologies inprinting systems—High Definition Printing (reverse image), traditionalDirect-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 35companies manufacturing digital card printers. The great majority of these areoffering direct-to-card dye-sublimation printers. We believe our HighDefinition Printing platform currently has two competitors and we are not awareof any other company offering an inkjet solution for printing plasticidentification cards.

 

Concern for personalsafety and property protection has led to the need for electronic and visualidentification and access control. We believe the demand for our products willincrease as governments and corporations worldwide address their securityneeds. We believe the development and implementation of new technologies thatadd security features to plastic cards should foster a growing market for oursystems.

 

We market and sell ourproducts exclusively through a distribution channel of system integrators andindependent distributors in more than 80 countries worldwide. We estimate thatas of December 31, 2005, we have manufactured and sold more than 120,000of our printing systems. End users of our printing systems create personalizedcards for a wide variety of applications including corporate security and access;driver’s licenses, government and military identification; studentidentification and access; public transportation access; and recreation andgaming.

 

We sell both printingsystems and consumable materials used in those systems. We produce a diversearray of card printing systems that allow us to meet the needs of end users,ranging from those who desire a premium system to address complex applicationsto those focused on lower priced systems with fewer features. We also sellconsumable materials that are used with our systems, including dye sublimationribbons, overlaminates, thermal resin ribbons, printheads, inkjet cartridges,inkjet card cartridges and blank cards. Over the past seven years, theproportion of our total revenues provided by consumable materials has increasedto 61% of total revenues in 2005 from 49% in 1999. Factors affecting our netsales of card printing systems each year include the mix of systems sold,changes in average selling price and the number of major projects we are successfulin winning. As the number of Fargo systems installed and in use continues togrow, it is our belief that the sale of consumable materials for use in thesesystems will provide us with a significant recurring, and growing revenuestream.

 

Our markets can be categorized in three broadtiers—entry-level, integration and projects. We have historically beensuccessful in each of these markets. End users in the entry-level market aretypically using a simple photo identification card. Users in this market arelikely more focused on lower priced systems with fewer

 

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features. Users in the integration tier typically would addfunctionality such as access control or time and attendance recording features.At the project level, these customers are typically government andgovernment-related projects and corporate security programs with multi-levelrequirements, which typically will use a much more sophisticated and complexidentification card and are projects where the end user is looking for thehighest levels of functionality and security. Examples of government andgovernment-related projects include national identification programs, militaryprograms and driver’s license programs. These projects typically span multipleyears and involve integrating solutions into complex existing infrastructures.The printer component of these projects is typically only a small piece of theoverall project. While the company actively pursues such project business,these projects are very competitive and it is very difficult to predict thetiming of the bid process, funding and implementation of any such projects.

 

We have experienced andexpect to continue to experience quarterly variations in net sales and grossprofit as a result of a number of factors, including, among other things, thetiming and extent of promotional pricing; the timing of major projects; changesin average selling prices; the number and mix of products sold in the quarter;the availability and cost of components and materials; costs, benefits andtiming of new product introductions; customer order size and shipment timing;and seasonal factors affecting timing of purchase orders.

 

In the United States,our distribution program categorizes our distribution channel into four programtracks. Fargo Solution Providers provide retail customers with sales, serviceand integration expertise on Fargo’s full line of Professional and PersonaSeries products and systems. Fargo Value Added Distributors providein-depth integration expertise and support for Fargo Solution Providers and enduser customers on Fargo’s full line of products and systems. Fargo Distributorsprovide product distribution services to Fargo Solution Providers. FargoManufacturing Resellers provide a core business strategy of developing andmanufacturing products where the sale of identification card printers is asecondary portion of its sales. Internationally, our distribution programcategorizes our distribution into three program tracks. Import Suppliers act asa master distributor in a country. International Dealers sell to retailcustomers. International Distributors provide product distribution. We continueto implement our two-product line strategy with restricted distribution on ourProfessional Series products and broad distribution of our Persona Series.From time to time, we adjust selected parts of our distribution system toaddress changing requirements. In the second half of 2005, we made somechanges, primarily in the areas of harmonizing discounts world-wide,eliminating some exclusivity options for certain of our distribution andincreasing the requirements necessary to purchase directly from us.

 

Since the second half of2004, we have been making additional investments in the infrastructure of ourbusiness, resulting in an increase in operating expenses. The purpose of theseinvestments is to position ourselves better to capitalize on anticipated marketopportunities for our products and to grow our revenue in the future. It is ourintention to continue to make these investments. We also anticipate continuedlegal expenses in connection with patent litigation we have initiated. Wecurrently expect our future operating expenses to increase at a faster ratethan the increases we have experienced in the past. We believe theseexpenditures will enhance the future growth of the company for ourshareholders; however, the anticipated growth cannot be assured and ouroperating income may be negatively affected.

 

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**Results ofOperations**

 

The following table setsforth, for the periods indicated, certain selected financial data expressed asa percentage of net sales:

 
| ** **                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                           |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
| Cost of  sales                      |       | 56.5                                        |       | 59.8 |   | 59.0 |   |
| Gross profit                        |       | 43.5                                        |       | 40.2 |   | 41.0 |   |
| Operating  expenses:                |       |                                        |       |   |   |   |   |
| Research and development            |       | 7.1                                         |       | 7.2 |   | 7.3 |   |
| Selling, general and administrative |       | 19.4                                        |       | 18.0 |   | 17.6 |   |
| Total operating expenses            |       | 26.5                                        |       | 25.2 |   | 24.9 |   |
| Operating  income                   |       | 17.0                                        | %          | 15.0 | % | 16.1 | % |

 

Sales to customers bygeographic region, for the periods indicated, were as follows (in thousands):

 
| ** **                                     | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Europe                                         |       | $                                           | 10,869     |   | $ | 9,751 |   | $ | 9,408 |   |
| Middle East  and Africa                        |       | 8,661                                       |       | 6,005 |   | 4,002 |   |
| Asia and  Australia                            |       | 8,213                                       |       | 7,881 |   | 6,569 |   |
| North and  South America (other than the U.S.) |       | 8,773                                       |       | 8,212 |   | 7,795 |   |
| Total international sales                      |       | 36,516                                      |       | 31,849 |   | 27,774 |   |
| U.S.                                           |       | 44,512                                      |       | 40,544 |   | 37,717 |   |
| Total sales                                    |       | $                                           | 81,028     |   | $ | 72,393 |   | $ | 65,491 |   |

* *

*Comparison of Years Ended December 31, 2005 and2004*

* *

*Net sales. *Net sales increased 11.9% to $81.0 million in 2005 from $72.4 millionin 2004. Sales of printers/encoders increased 9.4% to $31.7 million from $28.9million in 2004. The increase in sales of printers/encoders was due to anincrease in unit volume, partially offset by a decrease in average sellingprice.  The decrease in average sellingprice was primarily due to changes in unit mix. Sales of secure materials increased 13.6% to $49.3 million from $43.5million in 2004. Sales of secure materials increased approximately $5.9 milliondue to unit volume, changes in unit mix and increases in average selling pricesas a result of price increases effective in the first quarter of 2005. The balanceis mainly due to decreased sales of software and other supplies such as cards,overlaminates and printheads.

 

International salesincreased 14.7% to $36.5 million in 2005 from $31.8 million in 2004 andaccounted for 45.1% of net sales in 2005 compared to 44.0% in 2004.International sales increased $4.7 million primarily due to a $1.1 millionincrease in sales in Europe and a $2.7 million increase in the Middle East andAfrica region. The balance is related to increases in the Asia and Australia regionand North and South America (other than the United States). We believe thegrowth in international sales is a result of our new product introductions thatmeet a broader array of user needs and our increased sales and marketinginitiatives.

* *

*Grossprofit. *Gross profit increased 21.2% to $35.2 millionfor 2005 from $29.1 million in 2004. Gross profit as a percentage of net saleswas 43.5% for 2005 compared to 40.2% in 2004. The gross profit percentagebenefited from increased volume, product mix and cost improvements.  Gross profit for 2004 benefited from a$360,000 reduction of cost of sales related to the settlement of prior years’duty drawback claims.

* *

*Researchand development. *Research and development expenses increased11.1% to $5.7 million in 2005 from $5.2 million in 2004. Research anddevelopment expenses as a percentage of net sales were 7.1% for 2005

 

26

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and 7.2% for 2004. The increase in research and development expenses ismainly due to higher payroll expenses in 2005 as a result of annual salaryincreases and additional compensation expense due to growth.

* *

*Selling,general and administrative. *Selling, general and administrative expensesincreased 20.5% to $15.7 million in 2005 from $13.1 million in 2004.As a percentage of net sales, selling, general and administrative expenses were19.4% in 2005, compared to 18.0% in 2004. The increase in selling, general andadministrative expenses is due to higher sales and marketing expenses of approximately$1.4 million and increased general and administrative expenses of approximately$1.3 million. The increase in sales and marketing expenses is mainly due toadditional advertising and promotional expenses of approximately $0.6 millionand increased salary expense of approximately $0.6 million. The increase inadvertising and promotional expense is primarily due to the launch of newproducts in 2005. The increase in salary expense is primarily due to anincrease in the number of employees engaged in sales, marketing and supportservices and other compensation expense due to growth.  The increase in general and administrativeexpenses is due to an increase in legal and professional fees of approximately$0.4 million, increased compensation of $0.3 million, health insurance costs ofapproximately $0.1 million and information technology related costs ofapproximately $0.3 million. The increase in legal and professional fees is dueto on-going patent litigation expense. Compensation expenses increased due to growth and information technologycosts increased due to expenses relating to a new enterprise resource planningsystem, which the company is currently in the process of implementing.

* *

*Operatingincome. *Operating income increased 26.8% to$13.8 million in 2005 from $10.9 million in 2004. As a percentage ofnet sales, operating income was 17.0% in 2005 as compared to 15.0% in 2004.

* *

*Otherincome*.  Other income was $1.3 million in 2005compared to $0.2 million in 2004.  Theincrease was primarily due to increased interest income mainly as a result of alarger cash balance.  Interest incometotaled $0.9 million in 2005 compared to $0.2 million in 2004.  Other income in 2005 also included $0.4million as a result of a patent litigation settlement received in the secondquarter of 2005.

* *

*Income taxexpense. *Income tax expense was $4.9 million in2005, which represents an effective tax rate of 32.9%, compared to income taxexpense of $3.3 million and an effective tax rate of 30.2% in 2004. Thechange in the effective tax rate is mainly due to the timing of the recognitionof research and experimentation credits.

* *

*Comparisonof Years Ended December 31, 2004 and 2003*

* *

*Net sales. *Net sales increased 10.5% to $72.4 million in 2004 from $65.5 millionin 2003. Sales of printers/encoders increased 11.6% to $28.9 million from $25.9million in 2003. The increase in printer/encoder sales is due to an increase of$1.1 million in major government project business. Printer/encoder sales werealso higher due to an increase in non-major government project related unitvolume, partially offset by a decrease in average selling price and unit mix.Sales of secure materials increased 9.8% to $43.5 million from $39.6 million in2003. The increase in sales of secure materials is due to an increase of $1.4million in major government project business and an increase of $1.2 millionrelated to higher average selling prices and sales mix of ribbons. The balanceis mainly due to increased sales of software and other materials such as cards,overlaminates and printheads.

 

International salesincreased 14.7% to $31.8 million in 2004 from $27.8 million in 2003 andaccounted for 44.0% of net sales in 2004 compared to 42.4% of net sales in2003. International sales increased $4.0 million primarily due to a $1.3million increase in sales in the Asia and Australia region and a $2.0 millionincrease in the Middle East and Africa region. The balance is related toincreases in Europe and North and South America (other than the United States).The increase in sales in Asia and Australia region is primarily related to anincrease in materials for a major government project. The increase in sales inthe Middle East is due to enhanced distribution efforts in this geographicalarea.

* *

*Grossprofit. *Gross profit increased 8.2% to $29.1 millionfor 2004 from $26.9 million in 2003. Gross profit as a percentage of net saleswas 40.2% for 2004 compared to 41.0% in 2003. The gross profit percentage wasadversely impacted by lower average selling prices on printers and unit mixwithin printers and materials,

 

27

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partially offset by reduced warranty expenses of approximately $250,000and a $360,000 reduction of cost of sales related to the settlement of prioryears’ duty drawback claims.

* *

*Researchand developme. *Research and development expenses increased7.3% to $5.2 million in 2004 from $4.8 million in 2003. Research anddevelopment expenses as a percentage of net sales were 7.2% for 2004 comparedto 7.3% for 2003. The increase in research and development expenses is mainlydue to higher payroll expenses in 2004 as a result of annual salary increasesand market adjustments.

* *

*Selling,general and administrative. *Selling, general and administrative expensesincreased 13.6% to $13.1 million in 2004 from $11.5 million in 2003.As a percentage of net sales, selling, general and administrative expenses were18.0% in 2004, compared to 17.6% in 2003. The increase in selling, general andadministrative expenses is due to higher sales and marketing expenses ofapproximately $1.0 million and increased general and administrative expenses ofapproximately $0.55 million. The increase in sales and marketing expenses ismainly due to additional advertising and promotional expenses of approximately$0.6 million and increased salary expense of approximately $0.3 million. Theincrease in advertising and promotional expense is primarily due to the launchof new products in 2004. The increase in salary expense is primarily due to anincrease in the number of employees engaged in sales, marketing and supportservices. The increase in general and administrative expenses is due to anincrease in professional fees of approximately $0.3 million and increasedcompensation and health insurance costs. The increase in legal and professionalfees is due to on-going patent litigation expense, as well as professional feesrelating to implementing Sarbanes-Oxley Section 404.

* *

*Operatingincome. *Operating income increased 2.7% to$10.9 million in 2004 from $10.6 million in 2003. As a percentage ofnet sales, operating income was 15.0% in 2004 as compared to 16.1% in 2003.

* *

*Otherincome*.   Other income was $191,000 in 2004 compared$3,000 in 2003.  The increase wasprimarily due to increased interest income mainly as a result of a larger cashbalance.  Interest income totaled$200,000 in 2004 compared to $32,000 in 2003.

* *

*Income taxexpense. *Income tax expense was $3.3 million in2004, which represents an effective tax rate of 30.2%, compared to income tax expenseof $3.3 million and an effective tax rate of 31.6% in 2003. In 2004, werecognized approximately $200,000 of additional tax credits related to a prioryear, which was settled in the third quarter of 2004. In 2003, we recognizedapproximately $126,000 of additional tax credits related to a prior year, whichwas settled in the third quarter of 2003. Excluding these tax credits, theeffective tax rate would have been 32.0% in 2004 and 32.8% in 2003. Income taxexpense for both 2004 and 2003 includes the current recognition of research andexperimentation credits in the respective periods.

** **

**Liquidityand Capital Resources**

 

We have historicallyfinanced our operations, debt service and capital requirements through cashflows generated from operations. Working capital was $46.9 million,$34.1 million and $22.4 million at December 31, 2005, 2004, and2003, respectively.  At December 31,2005 and throughout 2005, 2004 and 2003, we had no bank debt outstanding.

 

We believe, based on ourcurrent cash levels as well as the operating cash flows expected in 2006 andthe funds available to us under our $5.0 million revolving credit facility,that we will have sufficient funds to finance our current operations andplanned capital expenditures for at least the next 12 months.

 

We had cash and cashequivalents of $36.5 million at December 31, 2005, an increase of$13.1 million from $23.4 million at December 31, 2004. Thisincrease is mainly due to positive net cash flows provided by our operatingactivities in 2005.

 

Cash generated fromoperating activities in 2005 totaled $13.9 million due to net income of $10.1million, non-cash charges of $4.3 million and changes in operating assets andliabilities of $(0.5) million. The non-cash charges are primarily for deferredincome taxes and depreciation and amortization. The changes in operating assetsand liabilities relate primarily to an increase in accounts receivable of $0.6million, an increase in inventory of $0.3 million, a decrease of accountspayable of $0.3 million and an increase other current assets of $0.2 million,offset by an increase in accrued liabilities of $0.9 million. Accountsreceivable increased due to

 

28

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increased sales in the fourth quarter compared to the fourth quarter of2004. The increase in inventory is primarily due to the introduction of newproducts. The decrease in accounts payable is due to the timing of purchases.The increase in other current assets is due to increased interest receivable.  The increase in accrued liabilities isprimarily due to an increase in employee benefits.  Cash used by investing activities was $2.2million primarily due to expenditures related to the purchase of a newenterprise resource planning system, which the company is currently in theprocess of implementing, and other equipment expenditures, primarily tooling.Cash provided by financing activities was $1.4 million due to proceeds receivedfrom the exercise of stock options during 2005.

 

Cash generated fromoperating activities in 2004 totaled $10.1 million due to net income of $7.7million, non-cash charges of $4.4 million and changes in operating assets andliabilities of $(2.0) million. The non-cash charges are primarily for deferredincome taxes and depreciation and amortization. The changes in operating assetsand liabilities relate primarily to an increase in accounts receivable of $2.7million, an increase in inventory of $1.5 million, offset by an increase inaccounts payable and accrued liabilities of $2.2 million. Accounts receivableincreased due to the increase in sales in the fourth quarter compared to 2003and a reduction in customer prepayments. The increase in inventory is primarilydue to the introduction of new products. The increase in accounts payable isdue to increased revenue activity in the fourth quarter of 2004 compared to2003 and the timing of purchases. Cash used by investing activities was $0.9million exclusively for the purchase of equipment and leasehold improvements.Cash provided by financing activities was $0.9 million due to proceeds receivedfrom the exercise of stock options during 2004.

 

Under our revolving creditfacility, there was no outstanding balance at December 31, 2005 or at any pointduring 2005 and 2004. The credit facility expires March 31, 2006.  At that time, the credit facility will renew,provided each party executes an amendment documenting such renewal.  Borrowings under the revolving creditfacility are limited to eligible accounts receivable and inventories, as definedby the agreement. Under the terms of the credit facility, we may borrow at theprime rate of interest or LIBOR plus a margin of 1.5%.

 

The credit facilityrequires, among other things, the maintenance of a minimum EBITDA and restrictsour ability to pay dividends or incur new operating lease expenditures, asdefined in the agreement.

** **

**ContractualObligations**

 

The following tablesummarizes our future contractual obligations as of December 31, 2005.

 
| ** **                                                                 | ** ** | **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**                                                       |       | $                                                                  | 5,690      |   | $ | 518 |   | $ | 962 |   | $ | 962 |   | $ | 3,248 |   |
| **Purchase  Obligations**                                                  |       | 37,691                                                             |       | 13,691 |   | 8,000 |   | 8,000 |   | 8,000 |   |
| **Other Long-Term Liabilities Reflected on  our Balance Sheet under GAAP** |       | —                                                             |       | — |   | — |   | — |   | — |   |
| **Total**                                                                  |       | $                                                                  | 43,381     |   | $ | 14,209 |   | $ | 8,962 |   | $ | 8,962 |   | $ | 11,248 |   |

 

*Operatinglease.* We lease our office, warehouse and manufacturingspace under an operating lease expiring in December 2006.  In December 2005, the operating lease wasamended to extend the term of the lease from January 2007 to December2016.  The effectiveness of the leaseamendment is subject to the approval of certain governmental organizations foradditional parking as well as a build-out of additional office space.  Total rent expense for this operating leasewas $909,000, $857,000 and $918,000 during 2005, 2004 and 2003, respectively.

* *

*Purchaseobligations. *Purchase obligations are for purchases madein the normal course of business to meet operational requirements. Of thisamount, $1,728,000 relates to unconditional purchase agreements that we haveentered into with certain suppliers. These agreements are reviewed on asemi-annual basis, and, unless

 

29

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terminated by either party,automatically renew for an additional six-month period. The agreements may beterminated by either party with a 30-day written notice. Purchaseobligations also include an agreement to purchase $4 million a year ofmaterials under a ten-year agreement with one of our suppliers which expires in2012. Our obligation to meet this commitment is conditional upon the suppliercontinuing to meet a number of obligations set out in the agreement.

 

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**Inflation**

 

We do not believe thatinflation has had a material effect on our results of operations in recentyears; however, there can be no assurance that our business will not beadversely affected by inflation in the future.

** **

**CriticalAccounting Policies and Estimates**

 

Management’s discussion andanalysis of its financial condition and results of operations are based uponour financial statements, which have been prepared in conformity withaccounting principles generally accepted in the United States of America. Thepreparation of financial statements requires us to make estimates andassumptions that affect the reported amounts of assets and liabilities and thereported amounts of revenues and expenses during the reporting period. We baseour estimates on historical experience and on various other assumptions that webelieve to be reasonable based upon the information available to us, theresults of which form a basis for making judgments about the carryingvalue of assets and liabilities that are not readily available from othersources. Actual results may differ from these estimates under differentassumptions or conditions.

 

The following critical policiesrelate to the more significant judgments and estimates used in the preparationof the financial statements:

* *

*RevenueRecognition*—Revenueis recognized when product has been shipped, risk of loss has passed to thepurchaser and we have fulfilled all of our obligations. We provide forpromotional discounts, estimated early payment discounts, estimated warrantycosts and estimated returns in the period the related revenue is recognized.Certain of our customers have arrangements which include limited stockbalancing return provisions. We provide an allowance for stock balance returnsbased on estimated expected returns. Sales to these customers represented18.8%, 14.0% and 17.3% of net sales for the years ended December 31, 2005,2004 and 2003, respectively. Under the terms of the stock balancing agreements,the maximum amount of returns is approximately $309,000 at December 31,2005, of which we have recorded an allowance of $268,000 for estimated returns.This reserve is included in our allowance for doubtful accounts and salesreturns.

 

We make marketingdevelopment funds available to our resellers to support demand generationactivity by the resellers. We treat payment of these funds as marketing costsup to the fair value of the benefit received where we receive an identifiablebenefit and can reasonably estimate the fair value of the benefit received inaccordance with the requirements of EITF 01-9, *Accountingfor Consideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)*. Any payments to resellers that do not meet theserequirements, including any promotional discounts for the purchase of product,are recorded as reductions to revenue.

* *

*Allowancefor doubtful accounts and sales returns—*We determine the estimate of the allowancefor doubtful accounts and sales returns considering a number of factors,including: (1) historical experience, (2) aging of the accountsreceivable, (3) analysis of stock balancing agreements and(4) specific information obtained by us on the financial condition and thecurrent creditworthiness of our customers. If the financing conditions of ourcustomers were to deteriorate and reduce the ability of our customers to makepayments on their accounts, we may be required to increase our allowance byrecording additional bad debt expense. Likewise, should the financial conditionof our customers improve and result in payments or settlements of previouslyreserved amounts, we may be required to record a reduction in bad debt expenseto reverse the recorded allowance. Our allowance for doubtful accounts andsales returns, which includes the allowance for stock balance returns,was $610,000 at December 31, 2005.

* *

*Allowancefor excess and obsolete inventories*—We value our inventories at the lower of the actual cost to purchaseor manufacture, 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 and productionrequirements for the subsequent twelve and twenty-four month periods. We makeevery effort to ensure the accuracy of our forecasts of future product demand,however, any significant unanticipated changes in demand or technologicaldevelopments could have a significant impact on the value of inventories andreported operating results. Our allowance for excess and obsolete inventoriesat December 31, 2005, was $615,000.

 

31

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*Warrantyaccrual—*Our products aregenerally covered by either a one-year or two-year standard warranty from thedate of sale. Estimated warranty costs are accrued in the same period in whichthe related revenue is recognized, based on anticipated parts and labor costs,utilizing historical experience. Our warranty accrual at December 31,2005, was $220,000.

* *

*Deferredtax assets*—Therealization of our deferred tax assets is dependent upon our ability togenerate sufficient future taxable income which we believe is more likely thannot. Historically, we have generated operating income and we anticipate futuretaxable income sufficient to realize the recorded deferred tax assets. 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 atDecember 31, 2005, were $17,783,000.

** **

**RecentlyIssued Accounting Standards**

 

In December 2004, theFinancial Accounting Standards Board (FASB) issued SFAS No. 123 (revised2004), *Share-Based Payment* (SFAS 123R). SFAS 123R requires that allshare-based payments to employees, including grants of stock options, berecognized in the financial statements based on their fair value beginning withthe first interim or annual reporting period that begins after June 15,2005. In March 2005, the SEC issued *StaffAccounting Bulletin No. 107* (SAB 107) regarding the SEC Staff’sinterpretation of SFAS 123R and provides the Staff’s views regardinginteractions between SFAS 123R and certain SEC rules and regulations and providesinterpretations of the valuation of share-based payments for public companies.In April 2005, the SEC amended Regulation S-X to amend the date for compliancewith SFAS 123R so that each registrant (that is not a small business issuer)will be required to prepare financial statements in accordance with SFAS 123Rbeginning with the first interim reporting period for the registrant’s firstfiscal year beginning on or after June 15, 2005. The Company plans toadopt SFAS 123R beginning in the first quarter of 2006. The Company believesits stock compensation expense for the first quarter of 2006 will beapproximately one cent per diluted share after tax.

 

In June 2005, the FASBissued FASB Staff Position FSP No. 143-1, *Accountingfor Electronic Equipment Waste Obligations*, and the related FIN 47, *Accounting for Conditional Asset RetirementObligations* which provides requirements for the accounting forobligations associated with electronic equipment disposal for both commercialusers and producers of electronic equipment. FASB FSP No. 143-1 is effectivethe later of July 31, 2005 or the date of the adoption of the law by theapplicable member country of the European Union. The adoption of FASB FSP No.143-1 did not have any material effect on our financial statements in 2005.

 

In December 2004, theFASB issued FSP FAS 109-1, *Application ofFASB No. 109, Accounting for Income Taxes, to the Tax Deduction onQualified Production Activities Provided by the American Jobs Creation Act of2004.* FSP FAS No. 109-1 clarifies SFAS No. 109’s guidancethat applies to the new tax deduction for qualified domestic productionactivities. FSP No. 109-1 became effective upon issuance and we believethat this pronouncement has had an insignificant impact on our effective taxrate in 2005.

 

**Item 7A.****     ****QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.**

 

Market risk is the risk ofloss to future earnings, to fair values or to future cash flows that may resultfrom changes in the price of a financial instrument. The value of a financialinstrument may change as a result of changes in interest rates, exchange rates,commodity prices, equity prices and other market changes. Market risk isattributed to all market sensitive financial instruments, including long-termdebt.

** **

**Interest RateRisk**

 

We are potentially exposedto market risk from interest rate changes in our credit agreement. Under theterms of our credit agreement, we may borrow at the prime rate of interest orLIBOR plus a margin of 1.50%. At December 31, 2005 and throughout 2005,2004 and 2003, we had no bank debt outstanding.

 

32

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**ForeignCurrency Risk**

 

We denominate all foreignsales in U.S. dollars and do not hedge against currency fluctuations. Wepurchase components and supplies from several Japanese suppliers. To date,currency fluctuations have not had a material effect on our results ofoperations or financial condition, but could in the future by causing ourproducts to become less affordable or less price competitive than those offoreign manufacturers or by causing the costs of our material supplies toincrease. We make all of our purchases in U.S. dollars and we believe that wehave reduced the risks of increased purchasing costs that would otherwise occurif the dollar weakens relative to the yen. We have foregone the opportunity,however, to benefit from the full potential cost savings if the dollarstrengthens relative to the yen.

** **

**Item 8.****        ****FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.**

** **

**FinancialStatements**

 

Our financial statements andrelated notes are contained on pages F-1 to F-18 of this report. The indexto such items is included in Item 15(a)(i).

** **

**Item 9.****        ****CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTINGAND FINANCIAL DISCLOSURE.**

 

None.

** **

**Item 9A****      ****Controls and Procedures**

* *

*Evaluationof Disclosure Controls and Procedures. *Based on their evaluation as of the end ofthe period covered by this Annual Report on Form 10-K, our ChiefExecutive Officer and Chief Financial Officer have concluded that the disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) ofthe Securities Exchange Act of 1934) are effective to ensure that informationrequired to be disclosed by us in reports that we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commissionrules and forms. Additionally, our disclosure controls and procedures werealso effective in ensuring that information required to be disclosed in ourExchange Act reports is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer to allowtimely decisions regarding required disclosures

* *

*Management’sReport on Internal Control over Financial Reporting*.  Ourmanagement is responsible for establishing and maintaining internal controlover financial reporting as defined in Rule 13a-15(f) of theSecurities Exchange Act of 1934. Our internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Ourinternal control over financial reporting includes those policies andprocedures that (i) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of our assets; (ii) provide reasonable assurance that transactionsare recorded as necessary to permit preparation of financial statements inaccordance with generally accepted accounting principles, and that our receiptsand expenditures are being made only in accordance with authorizations of ourmanagement and directors; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof our assets that could have a material effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

Management has assessed ourinternal control over financial reporting based on criteria described in *Internal Control—Integrated Framework*,issued by the Committee of Sponsoring Organizations of the Treadway

 

33

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Commission. Based on this assessment using those criteria, we concludedthat, as of December 31, 2005, our internal control over financialreporting was effective.

 

Our management’s assessmentof the effectiveness of our internal control over financial reporting as ofDecember 31, 2005 has been audited by PricewaterhouseCoopers LLP, anindependent registered public accounting firm, as stated in their report whichappears on page F-2 of this Annual Report on Form 10-K.

* *

*Changes inInternal Control over Financial Reporting. *There was nochange in our internal control over financial reporting that occurred duringthe fourth quarter of fiscal 2005 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

** **

**Item 9B.****     ****OTHER INFORMATION.**

 

None.

 

34

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**PART III**

** **

**Item 10.****     ****DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.**

 

(a)*   **Directors of the Registrant.*

 

The information under thecaption “Election of Directors—Directors Nominated For Election”and ”—Directors Continuing in Office” in our 2006 Proxy Statement isincorporated herein by reference.

 

(b)*   **Executive Officers of the Registrant.*

 

Information concerning ourExecutive Officers is included in this Annual Report on Form 10-K underItem 4A, “Executive Officers of Fargo.”

 

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

 

The information under thecaption “Section 16(a) Beneficial Ownership Reporting Compliance” inour 2006 Proxy Statement is incorporated herein by reference.

 

(d)*   **Audit Committee Financial Expert.*

 

The information under thecaption “Election of Directors—Additional Information About our Board and itsCommittees” in our 2006 Proxy Statement is incorporated herein by reference.

 

(e)*   **Identification of the Audit Committee.*

 

The information under thecaption “Election of Directors—Additional Information About our Board and itsCommittees” in our 2006 Proxy Statement is incorporated herein by reference.

 

(f)*    **Code of Ethics for Senior Financial Officers.*

 

We have adopted a Code ofEthics that applies to our principal executive officer, principal financialofficer and director of finance. We have posted our Code of Ethics for SeniorFinancial Officers on our investor relations page of our web site. Thecorporate governance page can be accessed on our web site at *www.fargo.com.*

** **

**Item 11.****     ****EXECUTIVE COMPENSATION.**

 

The information under thecaption “Executive Compensation” in our 2006 Proxy Statement is incorporatedherein by reference.

** **

**Item 12.****     ****SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT.**

 

The information under thecaptions “Security Ownership of Certain Beneficial Owners and Management” and“Executive Compensation—Securities Authorized for Issuance Under EquityCompensation Plans” in our 2006 Proxy Statement is incorporated herein byreference.

** **

**Item 13.****     ****CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.**

 

The information under thecaption “Executive Compensation—Certain Transactions” in our 2006 ProxyStatement is incorporated herein by reference.

** **

**Item 14.****     ****PRINCIPAL ACCOUNTANT FEES AND SERVICES.**

 

The information under thecaption “Independent Accountants—Fees of Independent Auditors” in our 2006Proxy Statement is incorporated herein by reference.

 

35

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**PART IV**

** **

**Item 15.****     ****EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ONFORM 8-K**

** **

**(a)List ofdocuments filed as part of this report:**

 

(1)*   **Financial Statements:*

 

The following financialstatements are included in this report on the pages indicated:

 
| Report of  Independent Registered Public Accounting Firm                                                           |   |
|--------------------------------------------------------------------------------------------------------------------|--------|
| Balance Sheets at December 31,  2005 and 2004                                                                 |   |
| Statements of Operations for  the years ended December 31, 2005, 2004 and 2003                                |   |
| Statement of  Changes in Stockholders’ Equity for the years ended December 31, 2005,  2004 and 2003 |   |
| Statements of Cash Flows for  the years ended December 31, 2005, 2004 and 2003                                |   |
| Notes to Financial Statements                                                                                      |   |

 

(2)*   **Financial Statement Schedule:*

 

The following financialstatement schedule is included herein and should be read in conjunction withthe financial statements referred to above:

 
| Report of Independent Registered Public Accounting Firm on Financial  Statement Schedule |                                                    |   |   |   |
|------------------------------------------------------------------------------------------|---------------------------------------------------------|--------|--------|--------|
|                                                                                     | Schedule II—Valuation and Qualifying Accounts |   |   |   |
|                                                                                          |                                                         |        |        |        |  |  |  |  |

 

All other schedules areomitted as the required information is inapplicable or the information ispresented in the financial statements or related notes.

 

36

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**Report ofRegistered Public Accounting Firm onFinancial Statement Schedule**

 

To****the Stockholders andBoard of Directors of Fargo Electronics, Inc.:

 

Ouraudits of the financial statements, of management’s assessment of theeffectiveness of internal control over financial reporting and of theeffectiveness of internal control over financial reporting referred to in ourreport dated March 14, 2006****appearingin the 2005 Annual Report to Shareholders of Fargo Electronics, Inc. (whichreport, financial statements and assessment are incorporated by reference inthis Annual Report on Form 10-K) also included an audit of the financialstatement schedule listed in Item 15(a)(2) of this Form 10-K.  In our opinion, this financial statementschedule presents fairly, in all material respects, the information set forththerein when read in conjunction with the related financial statements.

 

 
| /s/ PRICEWATERHOUSECOOPERS LLP |   |
|--------------------------------|--------|
|                           |
| Minneapolis, Minnesota         |
| March 14, 2006            |

 

37

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**Schedule IIValuation 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, 2005(1)        |       | $                                              | 350,000    |                                                | $          | 1,213,101      |       | $                                        | 953,101    |   | $ | 610,000 |   |
| Year ended December 31, 2004(1)        |       | $                                              | 400,000    |                                                | $          | 612,668        |       | $                                        | 662,668    |   | $ | 350,000 |   |
| Year ended December 31, 2003(1)        |       | $                                              | 400,000    |                                                | $          | 724,867        |       | $                                        | 724,867    |   | $ | 400,000 |   |
| Valuation  account for inventories:         |       |                                           |       |                                                |       |           |       |                                     |       |
| Year ended December 31, 2005           |       | $                                              | 414,000    |                                                | $          | 332,845        |       | $                                        | 131,845    |   | $ | 615,000 |   |
| Year ended December 31, 2004           |       | $                                              | 771,000    |                                                | $          | 106,505        |       | $                                        | 463,505    |   | $ | 414,000 |   |
| Year ended December 31, 2003           |       | $                                              | 634,372    |                                                | $          | 232,722        |       | $                                        | 96,094     |   | $ | 771,000 |   |

 

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(1)    Amounts charged to costs and expenses includestock balancing returns, sales returns and sales credits which are recorded asan adjustment to revenue and bad debt expense which is charged to costs andexpenses.

 

38

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(3)    *Exhibits*

 

The exhibits to this AnnualReport on Form 10-K are listed in the Exhibit Index containedon pages E-1 through E-4 of this report.

 

We will furnish a copy ofany exhibit to a stockholder who requests a copy in writing. We reserve theright to charge a reasonable fee to cover our costs. Requests should be sentto: Paul W.B. Stephenson, Chief Financial Officer, Fargo Electronics, Inc, 6533Flying Cloud Drive, Eden Prairie, MN 55344.

 

The following is a list ofeach management contract or compensatory plan or arrangement required to befiled as an exhibit to this Annual Report on Form 10-K pursuant toItem 15(c):

 
| A.     |   | Amended and Restated 1998 Stock Option and Grant Plan (incorporated  by reference to Exhibit 10.2 to Fargo’s Form 10-K for the  fiscal year ended December 31, 2000 (File No. 333-90937)).                                                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                        |
| B.     |   | 2001 Employee Stock Purchase Plan, as amended (filed herewith).                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                        |
| C.     |   | 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)).                                              |
|   |   |                                                                                                                                                                                                                                                                                        |
| D.     |   | 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)).                                        |
|   |   |                                                                                                                                                                                                                                                                                        |
| E.     |   | 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)).                                    |
|   |   |                                                                                                                                                                                                                                                                                        |
| F.     |   | Form of Indemnification Agreement for directors and executive  officers of Fargo (incorporated by reference to Exhibit 10.9 to Fargo’s  Registration Statement on Form S-1 (File No. 333-90937)).                                                                  |
|   |   |                                                                                                                                                                                                                                                                                        |
| G.     |   | 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)).                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                        |
| H.     |   | Form of Non-qualified Stock Option Agreement under the 2003  Stock Incentive Plan (incorporated by reference to Exhibit 10.30 to  Fargo’s Form 10-K for the fiscal year ended December 31, 2003  (File No. 000-29029)).                                  |
|   |   |                                                                                                                                                                                                                                                                                        |
| I.     |   | Form of Officers Agreement dated December 8, 2004, as  amended (incorporated by reference to Exhibit 10.1 of Fargo’s  Form 8-K filed on December 13, 2005  (File No. 000-29029)).                                                              |
|   |   |                                                                                                                                                                                                                                                                                        |
| J.     |   | 2006 Non-Employee Director Compensation (incorporated by reference to  Exhibit 10.3 of Fargo’s Form 8-K filed on  March 2, 2006 (File No. 000-29029)).                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                        |
| K.     |   | 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)). |
|   |   |                                                                                                                                                                                                                                                                                        |
| L.     |   | 2006 Compensation Arrangements for Named Executive Officers  (incorporated by reference to Exhibit 10.2 of Fargo’s Form 8-K  filed on March 2, 2006 (File No. 000-29029)).                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                        |
| M.     |   | Description of 2006 Success Sharing Bonus Plan (incorporated by  reference to Exhibit 10.1 of Fargo’s Form 8-K filed on March  2, 2006 (File No. 000-29029)).                                                                                                      |

 

**(b)****   ****Exhibits:**

 

The response to this portionof Item 15 is included as a separate section of this Annual Report onForm 10-K.

 

39

----

 

**(c)****   ****Financial Statement Schedules:**

 

See Item 15,section (a) (2) above for the financial statement schedule filedherewith.

 

40

----

 

**SIGNATURES**

 

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

 
| ** ** | **FARGO ELECTRONICS, INC.** |
|------------|----------------------------------|
| ** ** | ** **                       |
|       | By                               | /s/ GARY R. HOLLAND |   |
|       |                             | Gary R. Holland |
| * *   | * *                         | *Chairman of the Board of Directors, President and*

*Chief  Executive Officer* |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this Report has been signed below onMarch 15, 2006 by the following persons on behalf of the Registrant and inthe 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/ 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          |       |                                                                |

 

41

----

 

**FargoElectronics, Inc.IndexDecember 31, 2005 and 2004**

 
| Report of  Independent Registered Public Accounting Firm |       |
|----------------------------------------------------------|------------|
| **Financial Statements**                                 | ** ** |
| Balance Sheets                                           |       |
| Statements of Operations                                 |       |
| Statement of  Changes in Stockholders’ Equity       |       |
| Statements of Cash Flows                                 |       |
| Notes to Financial  Statements                           |       |

 

F-1

----

 

**Report of Independent Registered Public Accounting Firm**

 

To****the Stockholders andBoard of Directors of Fargo Electronics, Inc.:

 

We have completed integrated audits of Fargo Electronics, Inc.’s 2005and 2004 financial statements and of its internal control over financialreporting as of December 31, 2005, and an audit of its 2003 financialstatements in accordance with the standards of the Public Company AccountingOversight Board (United States).  Ouropinions, based on our audits, are presented below.

 

Financial statements

 

In our opinion, the accompanying balance sheets and the relatedstatements of operations, of changes in stockholders’ equity and of cash flowspresent fairly, in all material respects, the financial position of FargoElectronics, Inc. at December 31, 2005 and 2004, and the results of itsoperations and its cash flows for each of the three years in the period endedDecember 31, 2005 in conformity with accounting principles generally acceptedin the United States of America.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.  We conducted our audits of these statementsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit of financial statements 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.

 

Internalcontrol over financial reporting

 

Also,in our opinion, management’s assessment, included in Management’s Report onInternal Control over Financial Reporting appearing in Item 9a, that theCompany maintained effective internal control over financial reporting as ofDecember 31, 2005 based on criteria established in *Internal Control - Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), isfairly stated, in all material respects, based on those criteria. Furthermore,in our opinion, the Company maintained, in all material respects, effectiveinternal control over financial reporting as of December 31, 2005, based oncriteria established in *Internal Control -Integrated Framework* issued by the COSO.  The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financialreporting.  Our responsibility is toexpress opinions on management’s assessment and on the effectiveness ofthe Company’s internal control over financial reporting based on our audit. Weconducted our audit of internal control over financial reporting in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates).  Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects.  An audit of internalcontrol over financial reporting includes obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we consider necessary in thecircumstances.  We believe that our auditprovides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles.  A company’s internal control over financialreporting

 

F-2

----

 

includes those policies and procedures that (i) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company;(ii) provide reasonable assurance that transactions are recorded asnecessary to permit preparation of financial statements in accordance with generallyaccepted accounting principles, and that receipts and expenditures of thecompany are being made only in accordance with authorizations of management anddirectors of the company; and (iii) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition, use, or dispositionof the company’s assets that could have a material effect on the financialstatements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 
| **/s/ PRICEWATERHOUSECOOPERS LLP** |   |
|------------------------------------|--------|
|                               |
| Minneapolis, Minnesota             |
| March 14. 2006                |

 

F-3

----

 

**Fargo Electronics, Inc.Balance SheetsDecember 31, 2005 and 2004(in thousands, except per share data)**

 
| ** **                                                                                                                                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| **Assets**                                                                                                                                                 |       |     |       |     |       |
| Current  assets                                                                                                                                            |       |     |       |     |       |
| Cash and cash equivalents                                                                                                                                  |       | $        | 36,475     |     | $          | 23,435 |   |
| Accounts receivable, net                                                                                                                                   |       | 10,286   |       | 9,702    |       |
| Inventories, net                                                                                                                                           |       | 6,178    |       | 6,219    |       |
| Other current assets                                                                                                                                       |       | 460      |       | 271      |       |
| Deferred income taxes                                                                                                                                      |       | 3,423    |       | 3,259    |       |
| Total current assets                                                                                                                                       |       | 56,822   |       | 42,886   |       |
| Equipment  and leasehold improvements, net                                                                                                                 |       | 3,636    |       | 2,026    |       |
| Deferred  income taxes                                                                                                                                     |       | 14,360   |       | 16,966   |       |
| Other                                                                                                                                                      |       | 19       |       | 27       |       |
| Total assets                                                                                                                                               |       | $        | 74,837     |     | $          | 61,905 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                              |       |     |       |     |       |
| Current  liabilities                                                                                                                                       |       |     |       |     |       |
| Accounts payable                                                                                                                                           |       | $        | 6,225      |     | $          | 6,018 |   |
| Accrued liabilities                                                                                                                                        |       | 3,666    |       | 2,806    |       |
| Total current liabilities                                                                                                                                  |       | 9,891    |       | 8,824    |       |
|                                                                                                                                                       |       |     |       |     |       |
| Commitments  and contingencies                                                                                                                             |       | —   |       | —   |       |
|                                                                                                                                                       |       |     |       |     |       |
| Stockholders’  equity                                                                                                                                 |       |     |       |     |       |
| Common stock, $.01 par value; 50,000 shares  authorized, 12,784 and 12,603 shares issued and outstanding at  December 31, 2005 and 2004, respectively |       | 128      |       | 126      |       |
| Additional paid-in capital                                                                                                                                 |       | 152,069  |       | 150,303  |       |
| Accumulated deficit                                                                                                                                        |       | (87,251  | )          | (97,348  | )          |
| Total stockholders’ equity                                                                                                                            |       | 64,946   |       | 53,081   |       |
| Total liabilities and stockholders’ equity                                                                                                            |       | $        | 74,837     |     | $          | 61,905 |   |

 

The accompanying notes arean integral part of these financial statements.

 

F-4

----

 

**Fargo Electronics, Inc.Statements of OperationsYears Ended December 31, 2005, 2004 and 2003(in thousands, except per share data)**

 
| ** **                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net sales                                    |       | $        | 81,028     |     | $          | 72,393   |       | $ | 65,491 |   |
| Cost of  sales                               |       | 45,795   |       | 43,319   |       | 38,608   |       |
| Gross profit                                 |       | 35,233   |       | 29,074   |       | 26,883   |       |
| Operating  expenses                          |       |     |       |     |       |     |       |
| Research and development                     |       | 5,724    |       | 5,151    |       | 4,801    |       |
| Selling, general and administrative          |       | 15,739   |       | 13,060   |       | 11,501   |       |
| Total operating expenses                     |       | 21,463   |       | 18,211   |       | 16,302   |       |
| Operating  income                            |       | 13,770   |       | 10,863   |       | 10,581   |       |
|                                         |       |     |       |     |       |     |       |
| Other income  (expense)                      |       |     |       |     |       |     |       |
| Interest expense                             |       | —   |       | (7       | )          | (29      | )          |
| Interest income                              |       | 884      |       | 200      |       | 32       |       |
| Other, net                                   |       | 386      |       | (2       | )          | —   |       |
| Total other income                           |       | 1,270    |       | 191      |       | 3        |       |
| Income  before provision for income taxes    |       | 15,040   |       | 11,054   |       | 10,584   |       |
| Provision  for income taxes                  |       | 4,943    |       | 3,338    |       | 3,344    |       |
| Net income  available to common stockholders |       | $        | 10,097     |     | $          | 7,716    |       | $ | 7,240 |   |
| Net income  per common share                 |       |     |       |     |       |     |       |
| Basic earnings per share                     |       | $        | .79        |     | $          | .62      |       | $ | .58 |   |
| Diluted earnings per share                   |       | $        | .77        |     | $          | .60      |       | $ | .57 |   |
| Weighted  average common shares outstanding  |       |     |       |     |       |     |       |
| Basic                                        |       | 12,704   |       | 12,515   |       | 12,397   |       |
| Diluted                                      |       | 13,072   |       | 12,869   |       | 12,799   |       |

 

The accompanying notes arean integral part of these financial statements.

 

F-5

----

 

**Fargo Electronics, Inc.Statement of Changes inStockholders’ EquityYears Ended December 31, 2005, 2004 and 2003(in thousands)**

 
| ** **                                                            | ** ** | **Common Stock**      | ** ** | **Additional** | ** ** | ** **           | ** ** | ** **               | ** ** | **Total**                  | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|----------------|------------|----------------------|------------|--------------------------|------------|----------------------------|------------|
| ** **                                                            | ** ** | **Number of  Shares** | ** ** | **Par  Value** | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Deferred  Compensation** | ** ** | **Stockholders’  Equity** | ** ** |
| **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 |   |
| Shares issued from exercise of stock  options and stock purchase plan |       | 148                        |       | 1              |       | 865                  |       | —                   |       | —                     |       | 866 |   |
| Tax benefit recognized for stock options                              |       | —                     |       | —         |       | 259                  |       | —                   |       | —                     |       | 259 |   |
| Net income                                                            |       | —                     |       | —         |       | —               |       | 7,716                    |       | —                     |       | 7,716 |   |
| **Balances at December 31, 2004**                                |       | 12,603                     |       | 126            |       | 150,303              |       | (97,348                  | )          | —                     |       | 53,081 |   |
| Shares issued from exercise of stock  options and stock purchase plan |       | 181                        |       | 2              |       | 1,392                |       | —                   |       | —                     |       | 1,394 |   |
| Tax benefit recognized for stock options                              |       | —                     |       | —         |       | 374                  |       | —                   |       | —                     |       | 374 |   |
| Net income                                                            |       | —                     |       | —         |       | —               |       | 10,097                   |       | —                     |       | 10,097 |   |
| **Balances at December 31, 2005**                                |       | 12,784                     |       | $              | 128        |                 | $          | 152,069                  |       | $                          | (87,251    | ) | $ | — |   | $ | 64,946 |   |

 

The accompanying notes arean integral part of these financial statements.

 

F-6

----

 

**Fargo Electronics, Inc.Statements of Cash FlowsYears Ended December 31, 2005, 2004 and 2003(in thousands)**

 
| ** **                                                                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Cash  flows from operating activities**                                         |       |     |       |     |       |     |       |
| Net income                                                                        |       | $        | 10,097     |     | $          | 7,716    |       | $ | 7,240 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities |       |     |       |     |       |     |       |
| Depreciation and amortization                                                     |       | 1,146    |       | 1,092    |       | 1,016    |       |
| Loss on disposal of equipment                                                     |       | 16       |       | 2        |       | 15       |       |
| Provision for doubtful accounts                                                   |       | —   |       | —   |       | 10       |       |
| Provision for excess and obsolete  inventories                                    |       | 333      |       | 107      |       | 233      |       |
| Deferred income taxes                                                             |       | 2,442    |       | 2,917    |       | 2,104    |       |
| Deferred compensation                                                             |       | —   |       | —   |       | 16       |       |
| Tax benefit recognized for stock options                                          |       | 374      |       | 259      |       | 199      |       |
| Changes in operating assets and liabilities                                       |       |     |       |     |       |     |       |
| Accounts receivable                                                               |       | (584     | )          | (2,687   | )          | 2,117    |       |
| Inventories                                                                       |       | (292     | )          | (1,478   | )          | 240      |       |
| Prepaid expenses and other assets                                                 |       | (189     | )          | (53      | )          | 44       |       |
| Accounts payable                                                                  |       | (317     | )          | 2,156    |       | (1,537   | )          |
| Accrued liabilities                                                               |       | 860      |       | 41       |       | 178      |       |
| Net cash provided by operating activities                                         |       | 13,886   |       | 10,072   |       | 11,875   |       |
| **Cash flows from investing activities**                                          |       |     |       |     |       |     |       |
| Purchases of equipment and leasehold  improvements                                |       | (2,240   | )          | (948     | )          | (1,413   | )          |
| Net cash used in investing activities                                             |       | (2,240   | )          | (948     | )          | (1,413   | )          |
| **Cash flows from financing activities**                                          |       |     |       |     |       |     |       |
| Proceeds from exercise of stock options                                           |       | 1,394    |       | 866      |       | 472      |       |
| Net cash provided by financing activities                                         |       | 1,394    |       | 866      |       | 472      |       |
| Net increase in cash and cash equivalents                                         |       | 13,040   |       | 9,990    |       | 10,934   |       |
| **Cash and cash equivalents**                                                     |       |     |       |     |       |     |       |
| Beginning of period                                                               |       | 23,435   |       | 13,445   |       | 2,511    |       |
| End of period                                                                     |       | $        | 36,475     |     | $          | 23,435   |       | $ | 13,445 |   |
| **Cash paid during the period for**                                               |       |     |       |     |       |     |       |
| Income taxes                                                                      |       | $        | 1,769      |     | $          | 466      |       | $ | 797 |   |
| Interest                                                                          |       | —   |       | 7        |       | 19       |       |
| **Significant noncash financing and investing  activities**                       |       |     |       |     |       |     |       |
| Purchase of equipment included in accounts  payable                               |       | 524      |       | 60       |       | 230      |       |

 

The accompanying notes arean integral part of these financial staements.

 

F-7

----

 

**Fargo Electronics, Inc.Notes to Financial StatementsDecember 31, 2005 and 2004**

** **

**1.   Nature ofBusiness and Summary of Significant Accounting Policies**

** **

**Nature of Business**

 

Fargo Electronics, Inc. (“Fargo” or the“Company”) develops, manufactures and supplies secure technologies for identitycard issuance systems, including secure card printer/encoders, materials andsoftware. The Company sells its products exclusively through a distributionchannel of system integrators, independent distributors and integrators in morethan 80 countries worldwide.

** **

**Cash and CashEquivalents**

 

All highly liquid investments with originalmaturities of three months or less are considered cash equivalents. Substantiallyall of the Company’s cash and cash equivalents are held by two financialinstitutions.

** **

**Inventories**

 

Inventories, which consist primarily of rawmaterials, are stated at the lower of cost or market, with cost beingdetermined by the first-in, first-out (“FIFO”) method. Allowances forwrite-downs to the lower of cost or market are recorded for estimated excessand obsolete inventories based primarily on forecasts of product demand andestimated production requirements.

** **

**Equipment and Leasehold Improvements**

 

Equipment and leasehold improvements are statedat cost. Equipment is depreciated over the estimated useful lives of the assets(three to seven years) generally using accelerated methods. Leaseholdimprovements are amortized over the shorter of estimated useful lives or theterms of the related leases. Software and capitalized web site development,included in office equipment and other, is depreciated using the straight-linemethod over the estimated useful lives of the assets.

 

Major renewals or betterments are capitalized,while repair and maintenance expenditures are charged to operations asincurred. The cost and accumulated depreciation or amortization of equipmentand leasehold improvements disposed of or sold are eliminated from their respectiveaccounts, and the resulting gain or loss is recorded in operations.

** **

**Valuation of Long-LivedAssets**

 

The Company reviews long-lived assets for impairment whenever events orcircumstances indicate that the carrying value of such assets may not be fullyrecoverable.  An impairment is evaluatedbased on the sum of undiscounted estimated future cash flows expected to resultfrom use of the asset compared to its carrying value.  If an impairment is indicated, the carryingvalue of the impaired asset is reduced to its fair value, based on discountedfuture cash flows.  At December 31, 2005,the Company’s management believes that none of its long-lived assets wereimpaired.

 

F-8

----

** **

**Warranties**

 

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

 
| ** **                                                                    | ** ** | **2005**                | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                                                    | ** ** | **(in thousands)** | ** ** |
| Accrued  warranties                                                           |       |                    |       |     |       |
| Beginning of year                                                             |       | $                       | 392        |     | $          | 525 |   |
| Settlements made                                                              |       | (347                    | )          | (278     | )          |
| Accruals related to pre-existing warranties  (including changes in estimates) |       | (115                    | )          | (114     | )          |
| Accruals for warranties issued                                                |       | 290                     |       | 259      |       |
| End of year                                                                   |       | $                       | 220        |     | $          | 392 |   |

 

**RevenueRecognition**

 

Revenue is recognized whenproduct has been shipped, risk of loss has passed to the purchaser and Fargohas fulfilled all of its obligations. The Company provides for promotionaldiscounts, estimated early payment discounts, estimated warranty costs andestimated returns in the period the related revenue is recognized. Certain ofthe Company’s customers have arrangements, which include limited stockbalancing return provisions. The Company provides an allowance for stockbalancing based on estimated expected returns. Sales to these customersrepresented 18.8%, 14.0% and 17.3% of net sales for the years endedDecember 31, 2005, 2004 and 2003, respectively. Under the terms of thestock balancing agreements, the maximum amount of returns is approximately$309,000 at December 31, 2005, of which the Company has recorded anallowance of $268,000 for estimated returns. This reserve is included in our allowancefor doubtful accounts and sales returns.

 

Fargo makes marketingdevelopment funds available to its resellers to support demand generationactivity by the resellers. Fargo treats payment of these funds as marketingcosts up to the fair value of the benefit received where it receives anidentifiable benefit and can reasonably estimate the fair value of the benefitreceived in accordance with the requirements of EITF 01-9, *Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products)*. Anypayments to resellers that do not meet these requirements, including anypromotional discounts for the purchase of product, are recorded as reductionsto revenue.

** **

**Allowancefor Doubtful Accounts and Sales Returns**

 

The Company determines theestimate of the allowance for doubtful accounts and sales returns considering anumber of factors, including: (1) historical experience, (2) aging ofthe accounts receivable, (3) analysis of stock balancing agreements and(4) specific information obtained by the Company on the financialcondition and the current creditworthiness of the Company’s customers. Theallowance for doubtful accounts and sales returns, which includes the allowancefor stock balance returns, was $610,000 at December 31, 2005.

** **

**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 tax payable for the period plus the changeduring the period in deferred income taxes. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount expectedto be realized.

 

F-9

----

 

**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, compensation cost for stock options granted toemployees is measured as the excess, if any, of the value of the Company’sstock at the date of the grant over the amount an employee must pay to acquirethe stock. The Company provides disclosure of the effect on net income as ifthe fair value-based method had been applied in measuring compensation expense.

 

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:

 
| ** **                                                                                                                          | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                                                          | ** ** | **(in thousands)** | ** ** |
| Net income  available to common stockholders                                                                                        |       |                    |       |     |       |     |       |
| As reported                                                                                                                         |       | $                       | 10,097     |     | $          | 7,716    |       | $ | 7,240 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value based method, net of related  tax effects |       | (560                    | )          | (606     | )          | (1,705   | )          |
| Pro forma                                                                                                                           |       | $                       | 9,537      |     | $          | 7,110    |       | $ | 5,535 |   |
|                                                                                                                                |       |                    |       |     |       |     |       |
| Basic earnings per common share                                                                                                     |       |                    |       |     |       |     |       |
| As reported                                                                                                                         |       | $                       | .79        |     | $          | .62      |       | $ | .58 |   |
| Pro forma                                                                                                                           |       | $                       | .75        |     | $          | .57      |       | $ | .45 |   |
|                                                                                                                                |       |                    |       |     |       |     |       |
| Diluted earnings per common share                                                                                                   |       |                    |       |     |       |     |       |
| As reported                                                                                                                         |       | $                       | .77        |     | $          | .60      |       | $ | .57 |   |
| Pro forma                                                                                                                           |       | $                       | .73        |     | $          | .55      |       | $ | .43 |   |

 

**Earnings perShare**

 

Basic earnings per share iscomputed by dividing net income available to common stockholders by theweighted average number of common shares outstanding. Diluted earnings pershare is computed by dividing net income available to common stockholders bythe weighted average number of outstanding common shares and potentiallydilutive shares relating to stock options.

 

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

 
| ** **                                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                  | ** ** | **(in thousands)** | ** ** |
| Weighted  average common shares outstanding |       |                    |       |     |       |     |       |
| Basic                                       |       | 12,704                  |       | 12,515   |       | 12,397   |       |
| Effect of dilutive stock options            |       | 368                     |       | 354      |       | 402      |       |
| Diluted                                     |       | 13,072                  |       | 12,869   |       | 12,799   |       |

 

Options to purchase 45,000and 45,000 shares of common stock were outstanding at December 31, 2004and 2003, respectively, but were not included in the computations of dilutedearnings per share because the exercise

 

F-10

----

 

prices were greater than the average market prices of the common sharesfor the periods.  At December 31, 2005,there were no options to purchase shares of common stock outstanding withexercise prices greater than the average market price of common shares.

 

**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 reportedamounts of revenues and expenses during the periods reported. Actual resultscould differ from those estimates.

** **

**RecentlyIssued Accounting Standards**

 

In December 2004, theFinancial Accounting Standards Board (FASB) issued SFAS No. 123 (revised2004), *Share-Based Payment* (SFAS 123R). SFAS 123R requires that allshare-based payments to employees, including grants of stock options, berecognized in the financial statements based on their fair value beginning withthe first interim or annual reporting period that begins after June 15,2005. In March 2005, the SEC issued *StaffAccounting Bulletin No. 107* (SAB 107) regarding the SEC Staff’sinterpretation of SFAS 123R and provides the Staff’s views regardinginteractions between SFAS 123R and certain SEC rules and regulations andprovides interpretations of the valuation of share-based payments for publiccompanies. In April 2005, the SEC amended Regulation S-X to amend the date forcompliance with SFAS 123R so that each registrant (that is not a small businessissuer) will be required to prepare financial statements in accordance withSFAS 123R beginning with the first interim reporting period for theregistrant’s first fiscal year beginning on or after June 15, 2005. TheCompany plans to adopt SFAS 123R beginning in the first quarter of 2006. TheCompany believes its stock compensation expense for the first quarter of 2006will be approximately one cent per diluted share after tax.

 

In June 2005, the FASBissued FASB Staff Position FSP No. 143-1, *Accountingfor Electronic Equipment Waste Obligations*, and the related FIN 47, *Accounting for Conditional Asset Retirement Obligations*which provide requirements for the accounting for obligations associated withelectronic equipment disposal for both commercial users and producers ofelectronic equipment. FASB FSP No. 143-1 is effective the later of July 31,2005 or the date of the adoption of the law by the applicable member country ofthe European Union. The adoption of FASB FSP No. 143-1 did not have anymaterial effect on the Company’s financial statements in 2005.

 

In December 2004, theFASB issued FSP FAS 109-1, *Application ofFASB No. 109, Accounting for Income Taxes, to the Tax Deduction onQualified Production Activities Provided by the American Jobs Creation Act of2004.* FSP FAS No. 109-1 clarifies SFAS No. 109’s guidancethat applies to the new tax deduction for qualified domestic productionactivities. FSP No. 109-1 became effective upon issuance and the Companybelieves that this pronouncement has had an insignificant impact on itseffective tax rate in 2005.

 

**2.      SelectedFinancial Statement Information**

 

**AccountsReceivable, Net**

 
| ** **                                               | ** ** | **2005**                | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                               | ** ** | **(in thousands)** | ** ** |
| Trade  accounts receivable                               |       | $                       | 10,896     |     | $          | 10,052 |   |
| Less:  Allowance for doubtful accounts and sales returns |       | (610                    | )          | (350     | )          |
|                                                     |       | $                       | 10,286     |     | $          | 9,702 |   |

 

For the years endedDecember 31, 2005, 2004 and 2003, one customer accounted for approximately14.9%, 10.6% and 12.8% of net sales, respectively.

 

F-11

----

 

The Company’s ten largestdistributors and resellers accounted for a combined total of 48.9%, 48.5% and44.7% of net sales in 2005, 2004 and 2003, respectively. These distributorsaccounted for 53.9% and 50.8% of trade accounts receivable at December 31,2005 and 2004, respectively.

 

**Inventories,Net**

 
| ** **                                           | ** ** | **2005**                | ** ** | **2004** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                           | ** ** | **(in thousands)** | ** ** |
| Raw  materials and purchased parts                   |       | $                       | 3,988      |     | $          | 4,597 |   |
| Finished  goods                                      |       | 2,805                   |       | 2,036    |       |
|                                                 |       | 6,793                   |       | 6,633    |       |
| Less:  Allowance for excess and obsolete inventories |       | (615                    | )          | (414     | )          |
|                                                 |       | $                       | 6,178      |     | $          | 6,219 |   |

 

The Company buys itsribbons, an important component of its revenue, from two suppliers. In addition,the Company buys printheads for its dye sublimation printers from one supplier.

** **

**Equipmentand Leasehold Improvements, Net**

 
| ** **                                       | ** ** | **2005**                | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                       | ** ** | **(in thousands)** | ** ** |
| Tooling and  manufacturing equipment             |       | $                       | 8,635      |     | $          | 6,535 |   |
| Office  equipment and other                      |       | 5,487                   |       | 4,960    |       |
| Leasehold  improvements                          |       | 488                     |       | 488      |       |
|                                             |       | 14,610                  |       | 11,983   |       |
| Less:  Accumulated depreciation and amortization |       | (10,974                 | )          | (9,957   | )          |
|                                             |       | $                       | 3,636      |     | $          | 2,026 |   |

** **

**AccruedLiabilities**

** **
| ** **            | ** ** | **2005**                | ** ** | **2004** | ** ** |
|-----------------------|------------|-------------------------|------------|----------|------------|
| ** **            | ** ** | **(in thousands)** | ** ** |
| Accrued  warranties   |       | $                       | 220        |     | $          | 392 |   |
| Accrued  compensation |       | 1,270                   |       | 682      |       |
| Accrued  vacation     |       | 563                     |       | 442      |       |
| Customer  advances    |       | 176                     |       | 312      |       |
| Income taxes  payable |       | 590                     |       | 263      |       |
| Other                 |       | 847                     |       | 715      |       |
|                  |       | $                       | 3,666      |     | $          | 2,806 |   |

 

**3.      FinancingArrangements**

 

The Company has a $5.0million revolving credit facility, on which there was no outstanding balance atDecember 31, 2005 or at any point during 2005, 2004 and 2003. The creditfacility expires March 31, 2006.  At thattime, the credit facility will renew, provided each party executes an amendmentdocumenting such renewal.  Borrowingsunder the revolving credit facility are limited to eligible accounts receivableand inventories, as defined by the agreement. Under the terms of the creditfacility, we may borrow at the prime rate of interest or LIBOR plus a margin of1.5%.

 

The credit facilityrequires, among other things, the maintenance of a minimum EBITDA and restrictsour ability to pay dividends or incur new operating lease expenditures, asdefined in the agreement.

 

F-12

----

 

**4.****    ****Stock Options**

 

In May 2003, the Boardof Directors and stockholders adopted the Fargo Electronics, Inc. 2003Stock Incentive Plan (the “2003 Plan”), which authorizes and reserves a maximumof 1,000,000 shares of common stock available for issuance. The 2003 Plan isadministered by the Compensation Committee of the Board of Directors andprovides for the grant of: (a) incentive stock options;(b) nonqualified stock options; and (c) restricted stock awards toemployees, officers, directors and others, subject to certain limitations, asdefined by the 2003 Plan. Stock options issued under the 2003 Plan generallyhave an exercise price equal to the fair market value on the date of grant,vest and become exercisable ratably over four years, and expire no later thanten years from the date of grant. If a change in control occurs, as defined bythe 2003 Plan, the Board of Directors, or a committee thereof, at its solediscretion, may determine that all stock options that have been outstanding forat least six months will become immediately exercisable in full for theremainder of their terms and all restricted stock awards that have beenoutstanding for at least six months will become immediately 100% vested. Unlessterminated earlier, the 2003 Plan will terminate on April 30, 2013.

 

In February 1998, theBoard of Directors and stockholders adopted the Fargo Electronics, Inc.1998 Stock Option and Grant Plan (the “1998 Plan”) which, as amended,authorized and reserved a maximum number of shares for issuance equal to 15% ofthe outstanding common stock. The 1998 Plan was terminated, and no new awardswere issued thereunder, following approval of the 2003 Plan in May 2003.

 

Stock option and restrictedstock activity for 2005, 2004 and 2003 was as follows:

 
| ** **                     | ** ** | **Shares  Available  for Grant**     | ** ** | **Options  Outstanding** | ** ** | **Weighted  Average  Exercise Price  Per Share  of Options** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|--------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **(in thousands, except per share data)** | ** ** |
| 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                                                                        |       |
| Granted                        |       | (30                                       | )          | 30                       |       | 9.84                                                                        |       |
| Cancelled                      |       | —                                    |       | (60                      | )          | 7.96                                                                        |       |
| Exercised                      |       | —                                    |       | (131                     | )          | 5.44                                                                        |       |
| Balances at  December 31, 2004 |       | 925                                       |       | 839                      |       | 8.08                                                                        |       |
| Granted                        |       | (30                                       | )          | 30                       |       | 14.48                                                                       |       |
| Cancelled                      |       | —                                    |       | (42                      | )          | 10.06                                                                       |       |
| Exercised                      |       | —                                    |       | (173                     | )          | 7.37                                                                        |       |
| Balances at  December 31, 2005 |       | 895                                       |       | 654                      |       | $                                                                           | 8.44       |   |

 

F-13

----

 

Information related to stockoptions outstanding and exercisable at December 31, 2005, is as follows:

** **

**OptionsOutstanding**

** **
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** | ** **                                          | ** ** | ** **                             | ** ** |
| $ 1.60-$ 2.40                 |       | 6                       |       | 2.7 years                                           |       | $                                      | 1.60       |   |
| $ 2.75-$ 4.13                 |       | 112                     |       | 4.2 years                                           |       | 2.91                                   |       |
| $ 4.81-$ 7.22                 |       | 49                      |       | 3.4 years                                           |       | 6.33                                   |       |
| $ 7.30-$10.95                      |       | 266                     |       | 4.5 years                                           |       | 8.13                                   |       |
| $11.00-$15.41                           |       | 221                     |       | 3.7 years                                           |       | 12.26                                  |       |
|                                    |       | 654                     |       |                                                |       | $                                      | 8.44       |   |

 

**OptionsExercisable**

 
| **Range of  Exercise Prices** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
| ** **                              | ** ** | **(in thousands)** | ** ** | ** **                             | ** ** |
| $ 1.60-$ 2.40                 |       | 6                       |       | $                                      | 1.60       |   |
| $ 2.75-$ 4.13                 | 112        |                    | 2.91       |                                   |
| $ 4.81-$ 7.22                 |       | 49                      |       | 6.33                                   |       |
| $ 7.30-$10.95                      |       | 165                     |       | 8.03                                   |       |
| $11.00-$15.41                           | 169        |                    | 11.51      |                                   |
|                                    |       | 501                     |       | $                                      | 7.82       |   |

 

For the year endedDecember 31, 2003, the Company recorded deferred compensation expenseof  $16,000 for 8,750 options granted in1999 at a discount from the estimated fair market value of the Company’s commonstock. For the years ended December 31, 2005 and 2004, there was no deferredcompensation expense recorded.

 

The weighted averagegrant-date fair value of options granted during 2005, 2004 and 2003 was $7.47,$5.86 and $6.18, respectively, which was determined using the Black-Scholesmethod and the following key assumptions:

 
| **Assumptions**           | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**     | ** ** |
|---------------------------|------------|------------|------------|------------|------------|--------------|------------|
| Volatility                |       | 63.69      | %          | 68.05      | %          | 70.29        | %          |
| Risk-free  interest rates |       | 3.85       | %          | 3.82       | %          | 3.03 to 3.48 | %          |
| Expected  life            |       | Four years |       | Five years |       | Five 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 the Purchase Plan, participating employees aregranted options to purchase common stock at a 15% discount from the lower ofthe fair market value on the first day 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 10%of compensation. The number of shares that may be purchased by any singleemployee during a calendar quarter is limited to 250 shares and total shareswith a maximum fair market value of $25,000 in each calendar year. TheCompensation and Human Resources Committee of the Board of Directorsadministers the Purchase Plan.

 

F-14

----

 

In December 2005, thePurchase Plan was amended, with an effective date of January 1, 2006. Under theamended Purchase Plan, participating employees are granted options to purchasecommon stock at a 5% discount from the fair market value on the last day ofeach calendar quarter. The amended Purchase Plan permits an enrolled employeeto make contributions to purchase shares of common stock through payrolldeductions between 1% and 10% of compensation. The number of shares that may bepurchased by any single employee during a calendar quarter is limited to 250shares and total shares with a maximum fair market value of $25,000 in eachcalendar year.

 

The total number of sharesof common stock that may be issued pursuant to options granted under theamended Purchase Plan is 250,000 shares of common stock.  At December 31, 2005, approximately81,000 shares of common stock have been issued under the Purchase Plan.

** **

**5.      Benefit Plan**

 

The Company has a401(k) retirement savings plan whereby eligible employees may contributeup to 15% of their earnings either before taxes (subject to Internal RevenueService limitation) or after tax, not to exceed annual amounts allowed underthe Internal Revenue Code (“IRC”). In addition, the Company may also makediscretionary matching contributions. Company matching contributions for theyears ended December 31, 2005, 2004 and 2003, were $207,000, $176,000 and$169,000, respectively.

** **

**6.      Income Taxes**

 

The components of theprovision for income taxes are as follows:

 
| ** **                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                  | ** ** | **(in thousands)** | ** ** |
| Current                     |       |                    |       |     |       |     |       |
| Federal                     |       | $                       | 2,496      |     | $          | 416      |       | $ | 1,235 |   |
| State                       |       | 5                       |       | 5        |       | 5        |       |
|                        |       | 2,501                   |       | 421      |       | 1,240    |       |
| Deferred                    |       |                    |       |     |       |     |       |
| Federal                     |       | 2,322                   |       | 2,776    |       | 1,977    |       |
| State                       |       | 120                     |       | 141      |       | 127      |       |
|                        |       | 2,442                   |       | 2,917    |       | 2,104    |       |
| Provision  for income taxes |       | $                       | 4,943      |     | $          | 3,338    |       | $ | 3,344 |   |

 

Temporary differencescomprising the net deferred tax assets recognized in the accompanying balancesheets at December 31, 2005 and 2004, are as follows:

 
| ** **                                         | ** ** | **2005**                | ** ** | **2004** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                         | ** ** | **(in thousands)** | ** ** |
| Tax goodwill, current portion                      |       | $                       | 2,371      |     | $          | 2,371 |   |
| Accrued liabilities, including accrued  warranties |       | 443                     |       | 423      |       |
| Inventories                                        |       | 240                     |       | 171      |       |
| Allowance for doubtful accounts and sales  returns |       | 218                     |       | 112      |       |
| Other                                              |       | 151                     |       | 182      |       |
| Current deferred income taxes                      |       | 3,423                   |       | 3,259    |       |
| Tax goodwill, net of current portion               |       | 14,559                  |       | 16,922   |       |
| Depreciation and amortization                      |       | (258                    | )          | (158     | )          |
| Other                                              |       | 59                      |       | 202      |       |
| Long-term deferred income taxes                    |       | 14,360                  |       | 16,966   |       |
| Total deferred income taxes                        |       | $                       | 17,783     |     | $          | 20,225 |   |

 

F-15

----

 

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

 
| ** **                                            | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                            | ** ** | **(in thousands)** | ** ** |
| Provision  for federal income taxes at statutory rate |       | $                       | 5,114      |     | $          | 3,758    |       | $ | 3,599 |   |
| State income  taxes, net of federal benefit           |       | 263                     |       | 192      |       | 184      |       |
| Research and  experimentation credits                 |       | (354                    | )          | (603     | )          | (456     | )          |
| Other                                                 |       | (80                     | )          | (9       | )          | 17       |       |
|                                                  |       | $                       | 4,943      |     | $          | 3,338    |       | $ | 3,344 |   |

 

The realization of thedeferred tax assets is dependent upon the Company’s ability to generatesufficient future taxable income which management believes is more likely thannot. Historically, the Company has generated operating income and the Companyanticipates future taxable income sufficient to realize the recorded deferredtax assets. Future taxable income is based on management’s forecasts of theoperating results of the Company, and there can be no assurance that suchresults will be achieved.

** **

**7.****     ****Commitments andContingencies**

 

The Company leases office,warehouse and manufacturing space under an operating lease that expires inDecember 2006.  In December 2005, theCompany amended the lease to extend the term of the lease from January 2007 toDecember 2016. The effectiveness of the lease amendment is subject to theapproval of certain governmental organizations for additional parking as wellas a build out of additional office space. Future minimum lease payments,excluding common area maintenance expenses, at December 31, 2005, consistof the following:

 
| ** **                    | ** ** | **(in thousands)** | ** ** |
|-------------------------------|------------|-------------------------|------------|
| 2006                          |       | $                       | 518        |   |
| 2007                          |       | 481                     |       |
| 2008                          |       | 481                     |       |
| 2009                          |       | 481                     |       |
| 2010                          |       | 481                     |       |
| Thereafter                    |       | 3,248                   |       |
| Total  minimum lease payments |       | $                       | 5,690      |   |

 

Total rent expense,including common area maintenance expenses, for the years endedDecember 31, 2005, 2004 and 2003, was $909,000, $857,000 and $918,000,respectively.

 

The Company has entered intounconditional purchase agreements with certain suppliers which may require theCompany to purchase up to $1,728,000 of inventories. The agreements arereviewed on a semi-annual basis, and unless terminated by either party,automatically renew for an additional six-month period. The agreements may beterminated by either party with a 30-day written notice. In 2002, theCompany entered into an agreement with Sony Chemical Corporation, a subsidiaryof Sony Corporation. Under this agreement, the Company agreed to purchase fromSony, and Sony has agreed to sell to the Company on an exclusive, worldwidebasis, Sony’s dye-sublimation printer ribbons for its products for a ten-yearperiod. The Company’s obligations under this agreement, which include arequirement to purchase $4 million of printer ribbons each year, are conditionalupon Sony continuing to meet a number of obligations set forth in theagreement.

 

On June 19, 2001 (the“Effective Date”) the Company entered into a management and employmentagreement with its Chief Executive Officer (“CEO”), which provides certain benefitsto the CEO upon termination, as defined in the agreement. The agreement had aninitial term expiring in December 2003 and was renewed automatically. Theagreement renews automatically thereafter on the anniversary of the EffectiveDate (the “Renewal Date”) unless either party gives the other written noticeprior to such Renewal Date of his or its determination not to extend theagreement, whereupon this agreement shall terminate on the anniversary of suchRenewal Date. The agreement was renewed automatically in June 2005. Underthe agreement, upon termination

 

F-16

----

 

without cause, certain events defined as good cause for the CEO toterminate or a change in control, the CEO will be entitled to receive a lumpsum cash payment of up to 250% of base salary plus accrued bonus amounts andfull vesting of any restricted stock or stock options held, group health,dental and life insurance benefits and a monthly cash allowance of $1,000 for aperiod of 30 months.

 

In December 2005, allother Company’s executive officers other than the CEO executed amendments totheir Officers Agreements pursuant to which the Company agreed to providecertain benefits to these executives if they are terminated in connection witha change in control of the Company. These agreements are effective untilDecember 31, 2006. Under the agreements, these individuals will beentitled to receive a lump sum cash payment of up to 150% of their base salaryplus full vesting of any restricted stock or stock options held.

 

We filed a patentinfringement complaint against Iris Ltd., Inc. on February 24, 2004in Federal District Court in the State of Minnesota and served this complainton Iris Ltd., Inc. on March 26, 2004. Our complaint alleges infringementof one or more of our patents relating to our printer ribbon product. We areseeking injunctive relief, damages and legal fees. In open court onSeptember 8, 2004, Iris agreed to cease selling its infringing ribbons. Inearly 2005, Iris announced another ribbon core and began soliciting orders forthis ribbon. We believe this product infringes upon our patents and may violatethe cessation of sales agreed to in open court. On November 30, 2005, the courtgranted partial summary judgment for IRIS on claims related to the 5,755,519patent based on a technical legal reading of the patent and invalidated some ofthe claims contained in the patent. The lawsuit is continuing on the claimsrelated to the 6,152,625 patent and other non-patent related claims, includingtrademark infringement.  We have statedthat we anticipate appealing the ruling once the Federal District Court hasissued a final determination of all issues in the lawsuit.

 

On October 27, 2003, weinstituted an administrative action in the Shenzhen Intellectual PropertyOffice, which is a branch of the Chinese Intellectual Property Office, claimingthat Shenzhen Kanon Industrial Development Company Ltd. is infringing upon oneor more of our patents related to our printer ribbon products. We are seeking apermanent injunction, a request for payment of all costs incurred by us in thecase, a public apology and compensation for damages resulting from our lostsales. On November 17, 2004, the Shenzhen Municipal Intellectual PropertyOffice issued an opinion that Shenzhen Kanon Industrial Development Company isinfringing upon our patents and has ordered Shenzhen Kanon to cease suchinfringement. If Shenzhen Kanon does not cease its activities, criminal chargesmay be filed against Shenzhen Kanon.  Aslate as May 2005, Shenzhen Kanon reiterated its offers to sell products thatinfringe upon the ribbon patents.  We areevaluating our options but anticipate this lawsuit continuing.

 

In addition, we are party tovarious other litigation matters arising from time to time in the ordinarycourse of business. We do not believe that any such legal matters exist thatwould have a material adverse effect on our financial position, results ofoperations or cash flows.

** **

**8.      Segment Data andExport Sales**

 

The Company’s business isorganized in one business unit and is managed and internally reported as asingle segment. All of the company’s long-lived assets are located in theUnited States.

 

The following table presentsrevenues by geographic region.

 
| ** **                                              | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                              | ** ** | **(in thousands)** | ** ** |
| United  States                                          |       | $                       | 44,512     |     | $          | 40,544   |       | $ | 37,717 |   |
| Europe                                                  |       | 10,869                  |       | 9,751    |       | 9,408    |       |
| Asia and  Australia                                     |       | 8,213                   |       | 7,881    |       | 6,569    |       |
| North and  South America (other than the United States) |       | 8,773                   |       | 8,212    |       | 7,795    |       |
| Middle East  and Africa                                 |       | 8,661                   |       | 6,005    |       | 4,002    |       |
|                                                    |       | $                       | 81,028     |     | $          | 72,393   |       | $ | 65,491 |   |

 

Sales are based oncontractual shipment destinations by customer, as determined by theirdistributor agreement.

 

F-17

----

 

The following table presentsrevenue by product type.

 
| ** **              | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **              | ** ** | **(in thousands)** | ** ** |
| Printer/encoder  sales  |       | $                       | 31,673     |     | $          | 28,944   |       | $ | 25,925 |   |
| Secure  materials sales |       | 49,355                  |       | 43,449   |       | 39,566   |       |
|                    |       | $                       | 81,028     |     | $          | 72,393   |       | $ | 65,491 |   |

 

 

**9.      Quarterly Results**

** **

Thefollowing table sets forth certain unaudited quarterly financial data for 2005and 2004. This unaudited information has been prepared on the same basis as theaudited information and includes all adjustments (consisting only of normalrecurring adjustments) necessary to present fairly the information set forththerein. The operating results for any quarter are not necessarily indicativeof results for any future period.
| ** **                     | ** ** | **Three Months Ended**                                                | ** ** |
|--------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **March 31,  2004**                                                        | ** ** | **June 30,  2004** | ** ** | **September 30,  2004** | ** ** | **December 31,  2004** | ** ** |
| ** **                     | ** ** | **(Amounts in thousands, except per share data)** | ** ** |
| Net  sales                     |       | $                                                                               | 15,554     |   | $ | 17,545 |   | $ | 19,626 |   | $ | 19,668 |   |
| Gross  profit                  |       | 6,521                                                                           |       | 6,812 |   | 8,068 |   | 7,673 |   |
| Operating  expenses            |       | 4,379                                                                           |       | 4,257 |   | 4,909 |   | 4,666 |   |
| Operating  income              |       | 2,142                                                                           |       | 2,555 |   | 3,159 |   | 3,007 |   |
| Net  income                    |       | $                                                                               | 1,427      |   | $ | 1,747 |   | $ | 2,305 |   | $ | 2,237 |   |
| Net  income per common share:  |       |                                                                            |       |   |   |   |   |   |   |
| Basic earnings per  share(1)   |       | $                                                                               | 0.11       |   | $ | 0.14 |   | $ | 0.18 |   | $ | 0.18 |   |
| Diluted earnings per  share(1) |       | $                                                                               | 0.11       |   | $ | 0.14 |   | $ | 0.18 |   | $ | 0.17 |   |

 
| ** **                     | ** ** | **Three Months Ended**                                                | ** ** |
|--------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **March 31,  2005**                                                        | ** ** | **June 30,  2005** | ** ** | **September 30,  2005** | ** ** | **December 31,  2005** | ** ** |
| ** **                     | ** ** | **(Amounts in thousands, except per share data)** | ** ** |
| Net sales                      |       | $                                                                               | 18,657     |   | $ | 18,886 |   | $ | 22,456 |   | $ | 21,029 |   |
| Gross profit                   |       | 7,944                                                                           |       | 8,320 |   | 9,737 |   | 9,233 |   |
| Operating  expenses            |       | 4,923                                                                           |       | 5,342 |   | 5,412 |   | 5,786 |   |
| Operating  income              |       | 3,021                                                                           |       | 2,978 |   | 4,325 |   | 3,447 |   |
| Net income                     |       | $                                                                               | 2,149      |   | $ | 2,366 |   | $ | 3,071 |   | $ | 2,511 |   |
| Net income  per common share:  |       |                                                                            |       |   |   |   |   |   |   |
| Basic earnings per  share(1)   |       | $                                                                               | 0.17       |   | $ | 0.19 |   | $ | 0.24 |   | $ | 0.20 |   |
| Diluted earnings per  share(1) |       | $                                                                               | 0.17       |   | $ | 0.18 |   | $ | 0.23 |   | $ | 0.19 |   |

 

----

(1)    The summation of quarterly per shareamounts may not equal the calculation for the full year, as each quarterlycalculation is performed discretely.

 

F-18

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**FARGOELECTRONICS, INC.Exhibit Index to Annual Reporton Form 10-KFor the fiscal year ended December 31, 2005**

 
| **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) |
| 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).                       |
| 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                                                    |       | Incorporated by reference to  Exhibit 10.10 to Fargo’s Registration Statement on Form S-1                                                       |

 

E-1

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| **Item  No.** | ** ** | **Description**                                                                                                                                                                                                                                                              | ** ** | **Method  of Filing**                                                                                                                                             |
|---------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|          |       | Cummins and certain Investors,  as amended                                                                                                                                                                                                                                   |       | (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).                         |
| 10.11         |       | 2001 Employee Stock Purchase  Plan, as amended                                                                                                                                                                                                                               |       | As filed herewith.                                                                                                                                                |
| 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         |       | 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)           |
| 10.17         |       | 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)           |
| 10.18         |       | 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). |
| 10.19         |       | 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). |
| 10.20         |       | 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). |
| 10.21         |       | 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).     |
| 10.22         |       | Form of Non-qualified  Stock Option agreement under the 2003 Stock Incentive Plan                                                                                                                                                                                       |       | Incorporated by reference to  Exhibit 10.30 to Fargo’s Form 10-K for the fiscal year ended  December 31, 2003 (File No. 000-29029). |

 

E-2

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| **Item  No.** | ** ** | **Description**                                                                                                                                                                                                                     | ** ** | **Method  of Filing**                                                                                                                                             |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23         |       | 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                                  |       | Incorporated by reference to  Exhibit 10.31 to Fargo’s Form 10-K for the fiscal year ended  December 31, 2003 (File No. 000-29029). |
| 10.24         |       | Form of Direct Reports  Agreement dated December 15, 2003 between Fargo Electronics, Inc.  and Paul W.B. Stephenson                                                                                                  |       | Incorporated by reference to  Exhibit 10.11 to Fargo’s Form 10-Q for the quarter ended  June 30, 2004 (File No. 000-29029).         |
| 10.25         |       | Amendment No. 1 to Amended  and Restated Credit Agreement, dated as of April 1, 2004 between Fargo  Electronics, Inc. and LaSalle Bank National Association                                                          |       | Incorporated by reference to  Exhibit 10.31 to Fargo’s Form 10-K for the fiscal year ended  December 31, 2003 (File No. 000-29029). |
| 10.26         |       | Form of Officers Agreement  dated December 8, 2004, as amended.                                                                                                                                                           |       | Incorporated by reference to  Exhibit 10.1 of Fargo’s Form 8-K filed on  December 13, 2005 (File No. 000-29029).               |
| 10.27         |       | 2006 Non-Employee Director  Compensation                                                                                                                                                                                            |       | Incorporated by reference to  Exhibit 10.3 of Fargo’s Form 8-K filed on March 2, 2006  (File No. 000-29029).                        |
| 10.28         |       | Amendment No. 2 to Amended  and Restated Credit Agreement, dated March 22, 2005, between Fargo  Electronics, Inc. and LaSalle Bank National Association                                                              |       | Incorporated by reference to  Exhibit 10.1 to Fargo’s Form 10-Q for the quarter ended  March 31, 2005 (File No. 000-29029).         |
| 10.29         |       | Description of 2006 Success  Sharing Bonus Plan                                                                                                                                                                                     |       | Incorporated by reference to  Exhibit 10.1 of Fargo’s Form 8-K filed on March 2, 2006  (File No. 000-29029).                   |
| 10.30         |       | 2006 Compensation Arrangements  for Named Executive Officers                                                                                                                                                                        |       | Incorporated by reference to  Exhibit 10.2 of Fargo’s Form 8-K filed on March 2, 2006  (File No. 000-29029).                        |
| 10.31         |       | Settlement Agreement, Release  and Covenant Not to Sue, dated May 17, 2005, by and between Fargo  Electronics, Inc., Toppan Printing Co., Ltd., Viisage  Technology, Inc. and Trans Digital Technologies Corporation |       | Incorporated by reference to  Exhibit 10.1 of Fargo’s Form 8-K filed on May 23, 2005  (File No. 000-29029).                    |
| 10.32         |       | Fourth Amendment to  Office/Warehouse Lease, Dated June 10, 1996, between Fargo  Electronics, Inc. and Flying Cloud Centre Investors LLC (successor to  Aetna Life Insurance Company and Opus Northwest LLC)              |       | Incorporated by reference to  Exhibit 10.1 of Fargo’s Form 8-K filed on  January 10, 2006 (File No. 000-29029).                |
| 23.1          |       | Consent of Independent  Registered Public Accounting Firm                                                                                                                                                                           |       | 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.                                                                                                                                    |

 

E-3

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| **Item  No.** | ** ** | **Description**                                                                                                                                             | ** ** | **Method  of Filing**          |
|---------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|
| 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-4

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