**UNITED STATESSECURITIES A****NDEXCHANGE COMMISSION**

**Washington, DC 20549**

 

**Form 10-QSB**

 

| **ý****QUARTERLY REPORT  UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                        |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                          |
| **For the quarterly period ended September 30, 2003**                                                                                                    |
|                                                                                                                                                          |
| **o****TRANSITION REPORT  UNDER SECTION 13 OR 15(d) OF THE  EXCHANGE ACT**                                                                               |
|                                                                                                                                                          |
| **FOR THE TRANSITION PERIOD  FROM          TO          ** |
|                                                                                                                                                          |
| **Commission File Number 0-9587**                                                                                                                             |

 

**ELECTRO-SENSORS,INC.**

(Exact name of small business issuer asspecified in its charter)

 

| **Minnesota**                                                    |   | **41-0943459**                    |
|------------------------------------------------------------------|--------|-----------------------------------|
| (State or other jurisdiction of  incorporation or  organization) |   | (IRS Employer Identification No.) |

 

## **6111 Blue Circle DriveMinnetonka, Minnesota 55343-9108**

(Address ofprincipal executive offices)

** **

## **(952) 930-0100**

(Issuer’s telephonenumber)

 

Check whether the issuer (1) filed all reports required to be filed bySection 13 of 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.

Yes ý  No o

 

The number of shares outstanding of the registrant’s Common Stock,$0.10 par value, on November 12, 2003 was 3,174,522.

 

Transitional Small Business Disclosure Format (check one): o Yes   ý No

 

 

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**ELECTRO-SENSORS, INC.**

**Form 10-QSB**

**For the Period Ended September 30, 2003**

 

**TABLE OF CONTENTS**

 
| **PART I – FINANCIAL INFORMATION**                                 |   |
|-------------------------------------------------------------------------|--------|
|                                                                    |   |
| Item 1. Financial Statements                                            |   |
| Item 2. Management’s Discussion and  Analysis or Plan of Operation |   |
| Item 3. Controls and Procedures                                         |   |
|                                                                    |   |
| **PART II – OTHER INFORMATION**                                    |   |
|                                                                    |   |
| Item 6. Exhibits and Reports on Form 8-K                                |   |
|                                                                    |   |
| **SIGNATURES**                                                          |   |
|                                                                    |   |
| **EXHIBITS**                                                            |   |

 

2

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**PART I – FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

**INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 
| Consolidated Balance Sheets – As of September 30, 2003 and  December 31, 2002                                                  |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated Statements of Operations – For  the Three and Nine-Month Periods Ended September 30, 2003 and  September 30, 2002 |   |
| Consolidated Statements of Cash Flows – For  the Nine-Month Periods Ended September 30, 2003 and September 30,  2002           |   |
| Notes to Consolidated Financial Statements                                                                                                    |   |

 

3

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**ELECTRO-SENSORS,INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCESHEETS**

 
|                                                                                                                        |   | **September 30,  2003** |           | **December 31,  2002** |       |
|-----------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|----------------|-----------------------------|------------|
|                                                                                                                        |   | **(unaudited)**              |           | **(audited****)**           |       |
| **ASSETS**                                                                                                                  |   |                         |           |                        |       |
| **CURRENT ASSETS**                                                                                                          |   |                         |           |                        |       |
|                                                                                                                        |   |                         |           |                        |       |
| Cash and  cash equivalents                                                                                                  |   | $                            | 6,192,746      |                        | $          | 6,723,160 |   |
| Investments                                                                                                                 |   | 10,927,856                   |           | 4,202,210                   |       |
| Trade  receivables                                                                                                          |   | 585,358                      |           | 550,252                     |       |
| Less  allowance for doubtful accounts of $20,820 and $7,000, respectively                                                   |   |                         |           |                        |       |
| Inventories                                                                                                                 |   | 728,304                      |           | 738,012                     |       |
| Prepaid  income taxes                                                                                                       |   | 217,926                      |           | 342,735                     |       |
| Other  current assets                                                                                                       |   | 77,053                       |           | 69,748                      |       |
| **Total current  assets**                                                                                                   |   | 18,729,243                   |           | 12,626,117                  |       |
| **Property and  equipment, net**                                                                                            |   | 1,490,476                    |           | 1,544,146                   |       |
| **Investment in  equity method investee**                                                                                   |   | 192,318                      |           | 502,181                     |       |
| **TOTAL ASSETS**                                                                                                            |   | **$**                        | **20,412,037** | ** **                  | **$**      | **14,672,444** | ** ** |
|                                                                                                                        |   |                         | ** **     |                        | ** ** |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                              |   |                         |           |                        |       |
| **CURRENT LIABILITIES**                                                                                                     |   |                         |           |                        |       |
| Accounts  payable                                                                                                           |   | $                            | 121,782        |                        | $          | 285,539 |   |
| Accrued  expenses                                                                                                           |   | 164,036                      |           | 211,912                     |       |
| Deferred  revenue                                                                                                           |   | 35,684                       |           | 50,398                      |       |
| Deferred  income taxes                                                                                                      |   | 3,855,694                    |           | 1,424,600                   |       |
| **Total current  liabilities**                                                                                              |   | 4,177,195                    |           | 1,972,449                   |       |
| **Deferred income taxes**                                                                                                   |   | 35,000                       |           | 30,000                      |       |
| **Total liabilities**                                                                                                       |   | 4,212,195                    |           | 2,002,449                   |       |
|                                                                                                                        |   |                         |           |                        |       |
| **STOCKHOLDERS’ EQUITY**                                                                                               |   |                         | ** **     |                        | ** ** |
| Common  stock par value $0.10 per share;authorized 10,000,000 shares; issued 3,174,522 and 3,155,260 shares,  respectively. |   | 317,452                      |           | 315,526                     |       |
| Additional  paid-in capital                                                                                                 |   | 999,762                      |           | 966,447                     |       |
| Retained  earnings                                                                                                          |   | 8,115,484                    |           | 8,860,476                   |       |
| Accumulated  other comprehensive income                                                                                     |   | 6,767,144                    |           | 2,527,546                   |       |
| **Total stockholders’  equity**                                                                                        |   | 16,199,842                   |           | 12,669,995                  |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                         |   | **$**                        | **20,412,037** | ** **                  | **$**      | **14,672,444** | ** ** |

 

See accompanying notes to consolidatedfinancial statements

 

4

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**ELECTRO-SENSORS,INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                  |   | **Three Months Ended  September 30,** |      | **Nine Months Ended  September 30,** |   |
|-------------------------------------------------------|--------|--------------------------------------------|-----------|-------------------------------------------|--------|
|                                                  |   | **2003**                                   |      | **2002**                                  |   | **2003** |   | **2002** |   |
|                                                  |   |                                       |      |                                      |   |   |   |   |   |
| **Net sales**                                         |   | $                                          | 1,147,210 |                                      | $      | 1,154,287 |   | $ | 3,157,996 |   | $ | 3,417,382 |   |
| **Cost of goods sold**                                |   | 429,515                                    |      | 480,038                                   |   | 1,215,441 |   | 1,451,111 |   |
| **Gross profit**                                      |   | 717,695                                    |      | 674,249                                   |   | 1,942,555 |   | 1,966,271 |   |
|                                                  |   |                                       |      |                                      |   |   |   |   |   |
| **Operating expenses:**                               |   |                                       |      |                                      |   |   |   |   |   |
| Selling and marketing                                 |   | 268,218                                    |      | 300,650                                   |   | 879,448 |   | 838,542 |   |
| General and administrative                            |   | 205,108                                    |      | 245,555                                   |   | 741,639 |   | 688,379 |   |
| Research and development                              |   | 157,189                                    |      | 272,100                                   |   | 574,813 |   | 818,279 |   |
| **Total operating  expenses**                         |   | 630,515                                    |      | 818,305                                   |   | 2,195,901 |   | 2,345,200 |   |
| **Operating income  (loss)**                          |   | 87,180                                     |      | (144,056                                  | )      | (253,346 | ) | (378,929 | ) |
|                                                  |   |                                       |      |                                      |   |   |   |   |   |
| **Non-operating  income (expense):**                  |   |                                       |      |                                      |   |   |   |   |   |
| Gain on sale of investment securities                 |   | 516,639                                    |      | 121,313                                   |   | 546,168 |   | 2,218,886 |   |
| Interest income                                       |   | 11,633                                     |      | 27,840                                    |   | 43,146 |   | 197,801 |   |
| Other income (expense)                                |   | 870                                        |      | (29                                       | )      | 5,598 |   | (26,191 | ) |
| Equity in losses of equity method investee            |   | (207,303                                   | )         | (245,697                                  | )      | (694,222 | ) | (245,697 | ) |
| **Total non-operating  income (expense)**             |   | 321,839                                    |      | (96,573                                   | )      | (99,310 | ) | 2,144,799 |   |
|                                                  |   |                                       |      |                                      |   |   |   |   |   |
| **Income (loss)  before income taxes**                |   | 409,019                                    |      | (240,629                                  | )      | (352,656 | ) | 1,765,870 |   |
|                                                  |   |                                       |      |                                      |   |   |   |   |   |
| **Federal and state  income tax provision (benefit)** |   | 260,187                                    |      | (85,328                                   | )      | 107,659 |   | (665,996 | ) |
|                                                  |   |                                       |      |                                      |   |   |   |   |   |
| **Net income (loss)**                                 |   | $                                          | 148,832   |                                      | $      | (155,301 | ) | $ | (460,315 | ) | $ | 1,099,874 |   |
|                                                  |   |                                       |      |                                      |   |   |   |   |   |
| **Per share data:**                                   |   |                                       |      |                                      |   |   |   |   |   |
| Weighted  average basic shares outstanding            |   | 3,168,938                                  |      | 3,154,627                                 |   | 3,162,792 |   | 3,155,047 |   |
| Basic net  income (loss) per share                    |   | $                                          | 0.05      |                                      | $      | (0.05 | ) | $ | (0.15 | ) | $ | 0.35 |   |
| Weighted  average diluted shares outstanding          |   | 3,235,272                                  |      | 3,154,627                                 |   | 3,162,792 |   | 3,240,137 |   |
| Diluted net income (loss) per share                   |   | $                                          | 0.05      |                                      | $      | (0.05 | ) | $ | (0.15 | ) | $ | 0.34 |   |

 

See accompanying notes to consolidatedfinancial statements

 

5

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**ELECTRO-SENSORS,INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

** **
|                                                                                  |   | **Nine Months Ended  September 30,** |       |
|---------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|
|                                                                                  |   | **2003**                                  |       | **2002** |   |
| **Cash flows from  operating activities**                                             |   |                                      |       |   |   |
|                                                                                  |   |                                      |       |   |   |
| **Net income (loss)**                                                                 |   | $                                         | (460,315   | ) | $ | 1,099,874 |   |
| Adjustments  to reconcile net income (loss) to net cash used in operating activities: |   |                                      |       |   |   |
| Depreciation                                                                          |   | 76,336                                    |       | 36,534 |   |
| Deferred  taxes                                                                       |   | 0                                         |       | (200 | ) |
| Realized  gain on sale of investments                                                 |   | (546,168                                  | )          | (2,218,886 | ) |
| Equity in loss of equity method investee                                              |   | 694,222                                   |       | 245,697 |   |
| (Increase)/decrease  in:                                                              |   |                                      |       |   |   |
| Trade  receivables                                                                    |   | (35,106                                   | )          | (127,069 | ) |
| Inventory                                                                             |   | 9,708                                     |       | 81,679 |   |
| Other  current assets                                                                 |   | (7,305                                    | )          | (69,833 | ) |
| Prepaid  income taxes                                                                 |   | 124,809                                   |       | (303,739 | ) |
| Increase/(decrease)  in:                                                              |   |                                      |       |   |   |
| Accounts  payable                                                                     |   | (163,758                                  | )          | 156,585 |   |
| Accrued  expenses                                                                     |   | (47,876                                   | )          | 110,218 |   |
| Deferred  revenue                                                                     |   | (14,714                                   | )          | 0 |   |
| Accrued  income taxes                                                                 |   | (91,650                                   | )          | (1,647,470 | ) |
| Net cash  used in operating activities                                                |   | (461,817                                  | )          | (2,636,610 | ) |
|                                                                                  |   |                                      |       |   |   |
| Cash  flows from investing activities:                                                |   |                                      |       |   |   |
| Proceeds  from sale of investments                                                    |   | 587,864                                   |       | 2,237,706 |   |
| Additional  investment in equity method investee                                      |   | (384,359                                  | )          | (1,108,684 | ) |
| Purchase  of property and equipment                                                   |   | (22,666                                   | )          | (61,922 | ) |
| Principal  payments received on note receivable                                       |   | 0                                         |       | 8,709 |   |
| Net cash  provided by investing activities                                            |   | 180,839                                   |       | 1,075,809 |   |
|                                                                                  |   |                                      |       |   |   |
| Cash  flows from financing activities:                                                |   |                                      |       |   |   |
| Proceeds  from issuance of stock                                                      |   | 35,241                                    |       | 75,675 |   |
| Dividends  paid                                                                       |   | (284,677                                  | )          | (282,964 | ) |
|                                                                                  |   |                                      |       |   |   |
| Net cash  used in financing activities                                                |   | (249,436                                  | )          | (207,289 | ) |
|                                                                                  |   |                                      |       |   |   |
| Net  decrease in cash & cash equivalents                                          |   | (530,414                                  | )          | (1,768,090 | ) |
| Cash  & cash equivalents, beginning                                               |   | 6,723,160                                 |       | 8,389,691 |   |
| Cash  & cash equivalents, ending                                                  |   | $                                         | 6,192,746  |   | $ | 6,621,601 |   |
|                                                                                  |   |                                      |       |   |   |
| **Supplemental schedule of non-cash investing and financing  activities**        |   |                                      | ** ** |   | ** ** |
| Net  change in unrealized gain/ (loss) on investments                                 |   | $                                         | 4,181,048  |   | $ | (4,693,016 | ) |

 

See accompanying notes to consolidatedfinancial statements

 

6

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**ELECTRO-SENSORS, INC. AND SUBSIDIARIES**

##### **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1.  Nature of Business**

 

The accompanying consolidated financialstatements include the accounts of Electro-Sensors, Inc. and its wholly-ownedsubsidiaries, ESI Investment Company and Senstar.  Senstar has substantially no assets and no operations.  Intercompany accounts, transactions andearnings have been eliminated in consolidation.  The consolidated entity is referred to as “the Company.”

 

Electro-Sensors, Inc. (ESI) operates twodistinct businesses.  The first is theControls Division, a division of ESI. This division manufactures and markets a complete line of speedmonitoring and motor control systems for industrial machinery.  The Controls Division utilizes leading-edgetechnology to continuously improve its products and make them easier touse.  The Controls Division’s goal is tomanufacture the industry-preferred product for every market served.  These products are sold through an internalsales staff and distributors to a wide variety of manufacturers, OEM’s andprocessors to monitor process machinery operations.  The Controls Division markets its products to a number ofdifferent industries located throughout the United States and abroad.

 

The second business is AutoData Systems(ADS), also a division of ESI.  ADSdesigns and markets desktop software systems that read hand-printed characters,checkmarks and bar code information from scanned or faxed forms.  ADS products are designed to providecapabilities to automate data collection and are marketed to end users,resellers and developers in the United States, Canada, Europe and Asia.

 

Inboth divisions, the Company grants credit to customers under normal industryterms, generally 45 days.

 

ESIInvestment Company (INV) owns marketable securities, primarily equitysecurities in August Technology, Inc. and PPT Vision, Inc (PPTV).  The value of INV’s marketable securitieshave experienced significant appreciation in value since the IPO ofAugust Technology in 2000.  DuringMay 2002, INV participated in a rights offering by PPTV.  As a result of the additional investment inPPTV, the Company has changed its reporting of this investment to the equitymethod of accounting.  See Note 6 foradditional information about the Company’s investments and this change to theequity method.

 

**Note 2.  Basis of Presentation**

 

The accompanying unaudited consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and with the instructions to Form 10-QSB.  Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements.  It is the opinion ofmanagement that the unaudited condensed consolidated financial statementsinclude all adjustments, consisting of normal recurring accruals, necessary tofairly state the financial position and results of operations for the three andnine-month periods ended September 30, 2003 and 2002. The results ofinterim periods may not be indicative of results to be expected for the year.

 

The Balance Sheet at December 31, 2002has been derived from the Company’s audited financial statements for the yearended December 31, 2002, but does not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates of America for complete financial statements.  For further information, refer to the financial statements andfootnotes thereto included in the Company’s annual report on Form 10-KSB forthe year ended December 31, 2002.

 

7

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**Note 3.  Revenue Recognition**

 

**Revenue recognition of production monitoring equipment:**

 

All production monitoring equipment is shipped without an evaluation oracceptance period. Revenues from the sale of the products and any relatedwarranty costs are recognized at the time of shipment. The Company’sdistributors are not granted any price protection. Sales to all customers,including distributors, are final and no right of return after shipment exists.

 

**Software revenue recognition:**

 

TheCompany recognizes revenue upon shipment of its character recognition software.The product is sold to the end user and risk of loss is transferred, and theCompany has no continuing obligations, once its products are delivered to theshipper. The Company recognizes revenue upon shipment, net of return reservesbased on historical experience. To recognize revenue, it must also be probablethat the Company will collect the accounts receivable from its customers. Insome situations, the Company receives advance payments from its customers.Revenue associated with these advance payments is deferred until the product isshipped.

 

**Note 4. Stock-Based Compensation**

 

In accordance with Accounting Principles Board (APB) Opinion No. 25 andrelated interpretations, the Company uses the intrinsic value-based method formeasuring stock-based compensation cost which measures compensation cost as theexcess, if any, of quoted market price of the Company’s common stock at thegrant date over the amount the employee must pay for the stock.  The Company’s general policy is to grantstock options at fair value at the date of grant.

 

Had compensation cost been recognized based on the fair values ofoptions at the grant dates consistent with the provisions of Statement ofFinancial Accounting Standards (SFAS) No. 123, “Accounting for Stock BasedCompensation,” the Company’s net income (loss) and basic and diluted net income(loss) per common share would have been changed to the following pro formaamounts:

 
|                                         |   | **Three Months  Ended  September 30,** |    | **Nine Months  Ended  September 30,** |   |
|----------------------------------------------|--------|---------------------------------------------|---------|--------------------------------------------|--------|
|                                         |   | **2003**                                    |    | **2002**                                   |   | **2003** |   | **2002** |   |
| Net income (loss):                           |   |                                        |    |                                       |   |   |   |   |   |
| As reported                                  |   | $                                           | 148,832 |                                       | $      | (155,301 | ) | $ | (460,315 | ) | $ | 1,099,874 |   |
| Pro forma                                    |   | $                                           | 141,199 |                                       | $      | (165,519 | ) | $ | (478,954 | ) | $ | 1,063,744 |   |
| Basic net income (loss) per common  share:   |   |                                        |    |                                       |   |   |   |   |   |
| As reported                                  |   | $                                           | .05     |                                       | $      | (.05 | ) | $ | (.15 | ) | $ | .35 |   |
| Pro forma                                    |   | $                                           | .04     |                                       | $      | (.05 | ) | $ | (.15 | ) | $ | .34 |   |
| Diluted net income (loss) per common  share: |   |                                        |    |                                       |   |   |   |   |   |
| As reported                                  |   | $                                           | .05     |                                       | $      | (.05 | ) | $ | (.15 | ) | $ | .34 |   |
| Pro forma                                    |   | $                                           | .04     |                                       | $      | (.05 | ) | $ | (.15 | ) | $ | .33 |   |
| Stock based compensation:                    |   |                                        |    |                                       |   |   |   |   |   |
| As reported                                  |   | 0                                           |    | 0                                          |   | 0 |   | 0 |   |
| Pro forma                                    |   | $                                           | 7,633   |                                       | $      | 10,218 |   | $ | 18,639 |   | $ | 36,130 |   |

 

8

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In determining the compensation cost of options granted during thethree and nine months ended September 30, 2003 and 2002, as specified bySFAS No. 123, the fair value of each option grant has been estimated on thedate of grant using the Black-Scholes option pricing model and the weightedaverage assumptions used in these calculations are summarized as follows:

 
|                             |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|----------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
|                             |   | **2003**                                    |   | **2002**                                   |   | **2003** |   | **2002** |   |
|                             |   |                                        |   |                                       |   |   |   |   |   |
| Risk-free interest rate          |   | N/A                                         |   | 4.62                                       | %      | N/A |   | 4.62 | % |
| Expected life of options granted |   | N/A                                         |   | 5  years                                   |   | N/A |   | 5  years |   |
| Expected volatility              |   | N/A                                         |   | 52.2                                       | %      | N/A |   | 52.2 | % |
| Expected dividend yield          |   | N/A                                         |   | 2.67                                       | %      | N/A |   | 2.67 | % |

 

**Note 5.  Net Income(loss) Per Share**

 

TheCompany’s basic net income (loss) per share amounts have been computed bydividing net income (loss) by the weighted average number of outstanding commonshares. The Company’s diluted net income (loss) per share is computed bydividing net income (loss) by the weighted average number of outstanding commonshares and common share equivalents relating to stock options and warrants,when dilutive. For the three months ended September 30, 2003, 66,334shares of common stock equivalents were included in the computation of dilutednet income (loss) per share. For the nine months ended September 30, 2003,the shares were anti-dilutive.

 

Optionsto purchase 36,500 shares of common stock with a weighted average exerciseprice of $4.28 were outstanding for the three months ending September 30,2003, but were excluded from the computation of common share equivalentsbecause their exercise prices were greater than the average market price of thecommon shares for the period

 

#### **Note 6. Investments**

#### ** **

INV’sinvestments consist of marketable equity securities, primarily common stocks,government debt securities, money market funds and unregistered equitysecurities. The estimated fair value of marketable equity securities is basedon quoted market prices and therefore subject to the inherent risk of marketfluctuations.

 

Managementdetermines the appropriate classification of securities at the date individualinvestments are acquired, and evaluates the appropriateness of suchclassification at each balance sheet date.

 

Sincethe Company does not buy investments in anticipation of short-term fluctuationsin market prices, investments in marketable equity securities are classified asavailable-for-sale. Available-for-sale securities are stated at fair value, andunrealized holding gains and losses, net of the related deferred tax effect,are reported as separate component of stockholders’ equity.  Investments in unregistered securities arereported at original cost. Dividends on equity securities held for investmentare recognized in income when declared.

 

Realizedgains and losses, including losses from declines in value of specificsecurities determined by management to be other-than-temporary, are included inincome in the period realized.

 

9

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At September 30, 2003, the Company owned2,207,036 shares of PPTV, which is 21.8% of PPTV’s outstanding commonstock.  The fair value of its holdingsbased on the quoted market price at September 30, 2003 was approximately$1,655,277.  The Company exercised itswarrants to purchase 549,084 additional shares of PPTV common stock at a pershare price of $0.70 on September 29, 2003.  The Company holds no more warrants to purchase additional PPTVcommon stock.

 

In connection with a 2002 additional investment inPPTV, it was determined, solely for financial accounting purposes, that theCompany could likely exercise significant influence over the operations ofPPTV.  As a result, its ownershipinterest is now reported using the equity method of accounting forinvestments.  The investment waspreviously reported as an available-for-sale security, showing the market valueon the balance sheet and recording any unrealized gains and losses in othercomprehensive income.

 

Under the equity method of accounting, theCompany’s proportionate share of PPTV income or loss is included in theCompany’s net income (loss) with a corresponding increase or decrease in thecarrying value of its investment.

 

**Note 7. Comprehensive Income**

 

Comprehensive income includesthe Company’s net income (loss) plus other comprehensive income items that areexcluded from net income (loss).  TheCompany’s other income consists of unrealized gains (losses), net of incometaxes and reclassification adjustments for gains and losses included in netincome (loss).

 
|                                                                 |   | **Three Months Ended  September 30,** |       | **Nine Months Ended  September 30,** |       |
|----------------------------------------------------------------------|--------|--------------------------------------------|------------|-------------------------------------------|------------|
|                                                                 |   | **2003**                                   |       | **2002**                                  |       | **2003** |   | **2002** |   |
| **Net Income (Loss)**                                                |   | $                                          | 148,832    |                                      | $          | (155,301 | ) | $ | (460,315 | ) | $ | 1,099,874 |   |
|                                                                 |   |                                       | ** ** |                                      | ** ** |   | ** ** |   | ** ** |
| **Other Comprehensive  Gain (Loss):**                                |   |                                       | ** ** |                                      | ** ** |   | ** ** |   | ** ** |
| Change in unrealized value of investments,  net of income taxes      |   | 4,025,841                                  |       | (2,628,252                                | )          | 5,246,081 |   | (4,277,335 | ) |
|                                                                 |   |                                       |       |                                      |       |   |   |   |   |
| **Less:**                                                            |   |                                       |       |                                      |       |   |   |   |   |
| Reclassification  adjustment for gains included in net income (loss) |   | (516,639                                   | )          | (102,756                                  | )          | (546,168 | ) | (1,565,555 | ) |
|                                                                 |   |                                       |       |                                      |       |   |   |   |   |
| Total comprehensive income (loss)                                    |   | $                                          | 3,658,034  |                                      | $          | (2,886,309 | ) | $ | 4,239,598 |   | $ | (4,693,016 | ) |

 

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**Note 8. Segment Information**

 

The Company has three reportableoperating segments based on the nature of its product lines:  production monitoring, characterrecognition, and investments.  Theproduction monitoring division (or Controls Division) manufactures and marketsa complete line of speed monitoring and motor control systems for industrialmachinery.  The Character recognitiondivision (or ADS) designs and markets a desktop software-based system thatreads hand-printed characters, checkmarks, and bar code information fromscanned or faxed forms.  Sales of thissystem include software and can include hardware.  The investments division (or INV) holds investments in marketableand non-marketable securities.

 

In evaluating segmentperformance, management focuses on sales and income before taxes.  The Company has no inter-segment sales.

 

The following is financialinformation relating to the continuing operating segments:

 
|                                   |   | **Three Months Ended  September 30,** |          | **Nine Months Ended  September 30,** |   |
|----------------------------------------|--------|--------------------------------------------|---------------|-------------------------------------------|--------|
|                                   |   | **2003**                                   |          | **2002**                                  |   | **2003** |   | **2002** |   |
| **External sales**                     |   |                                       |          |                                      |   |   |   |   |   |
| Production monitoring                  |   | $                                          | 1,038,542     |                                      | $      | 974,886 |   | $ | 2,760,872 |   | $ | 2,828,457 |   |
| Character recognition                  |   | 108,668                                    |          | 179,401                                   |   | 397,124 |   | 588,925 |   |
| Investments                            |   | 0                                          |          | 0                                         |   | 0 |   | 0 |   |
| **Total**                              |   | **$**                                      | **1,147,210** | ** **                                | **$**  | **1,154,287** | ** ** | **$** | **3,157,996** | ** ** | **$** | **3,417,382** | ** ** |
|                                   |   |                                       |          |                                      |   |   |   |   |   |
| **Income (loss)  before income taxes** |   |                                       |          |                                      |   |   |   |   |   |
| Production monitoring                  |   | $                                          | 216,009       |                                      | $      | (20,759 | ) | $ | 109,517 |   | $ | (46,499 | ) |
| Character recognition                  |   | (35,214                                    | )             | (85,500                                   | )      | (78,046 | ) | (154,568 | ) |
| Investments                            |   | 228,222                                    |          | (134,370                                  | )      | (384,130 | ) | 1,966,937 |   |
| **Total**                              |   | **$**                                      | **409,019**   | ** **                                | **$**  | **(240,629** | **)** | **$** | **(352,656** | **)** | **$** | **1,765,870** | ** ** |

 

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**Item 2. Management’s Discussion and Analysis or Plan of Operation**

 

**RESULTS OF OPERATIONS**

 

***NetSales***

 

Net sales for the three-month periodended September 30, 2003 decreased $7,077 or 0.60% when compared to netsales for the same period in 2002. For the nine-month period endedSeptember 30, 2003, net sales decreased $259,386 or 8.2% for the sameperiod in 2002.

 

The decrease from the three-monthsending September 30, 2003 when compared to the same period in 2002,includes an increase in Net sales from the Controls Division of $63,655 or 6.1%offset by a decrease of $70,733 from ADS. For the nine-months ending September 30, 2003, net sales from theControls Division decreased $67,585 and net sales from ADS decreased$191,801.  The Controls Divisionincrease in net revenues for the three months ended September 30, 2003reflects, we believe, a gradual improvement in the economic conditions of thebusinesses in its core markets.  Inaddition, we have hired four manufacturer representation firms across thecountry to work with Controls Division products to better market the productsin certain areas of the USA.  Our insidesales reps have increasingly been personally traveling to meet with current andprospective customers to attempt to increase net sales.  This decrease in ADS net sales for the threeand nine-month periods is primarily due to the decrease in sales of ExpertScan,which was released for BETA sale in September 2002.

 

***Costof Goods Sold***

 

The Company’s cost of goods solddecreased $50,523 or 11.7% for the three months ended September 30, 2003when comparing the same period in 2002. This decrease is a direct result of decreased sales in the three monthsended September 30, 2003, but is offset by decreased cost savings fromimproved operating efficiencies resulting in increased gross profitpercentages.

 

When comparing the nine-monthperiod ending September 30, 2003 to the same period in 2002, the decreaseis $235,620 or 19.4%.  In addition tothe decrease resulting from the lower sales volume, cost of sales was reducedas a result of staff reduction and the Company’s efforts to reduce productioncosts.

 

***GrossProfit***

 

Gross margins for thethree-month period ended September 30, 2003 were 62.6% versus 58.4% forthe same period of the prior fiscal year. Gross margins for the nine-month period ended September 30, 2003were 61.5% versus 57.5% for the same period of the prior fiscal year.  In line with the cost of sales decrease, theincreases in margins are due to the Company’s efforts to reduce productioncosts.  There are less personnelinvolved in production when comparing the nine-month period endingSeptember 30, 2003 to the same period ending September 30, 2002.  Also, business insurance premiums havedecreased by 14.3%, a significant decrease when comparing the three- andnine-month periods ending September 30, 2003 to the same periods endingSeptember 30, 2002.

 

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***OperatingExpenses***

 

Total operating expensesdecreased $187,790 or 29.8% for the three months ended September 30, 2003when compared to the same period of the prior year.  Operating expenses for the nine-month period ended September 30,2003 decreased $149,300 or 6.8%.

 

Selling and marketing costsdecreased $32,432 or 12.1% for the three months ended September 30, 2003when compared to the same period in 2002. Of this decrease, the Controls Division contributed $38,455, which isoffset by an increase from ADS of $6,023. For the nine-month period ended September 30, 2003, the selling andmarketing costs increased $40,906 or 4.7% when compared to the same period for2002.  Of this increase, the ControlsDivision contributed a decrease of $20,743 and ADS contributed an increase of  $61,649.  Marketingcommunications development for product launches, a greater number of fieldsales trips, new literature, and ad development are the predominant expenses inthe increases.  Salaries and personnelexpenses are up due to sales and marketing personnel being hired in the secondhalf of 2002 in both divisions when comparing 2003 versus 2002.

 

General and administrative costsdecreased $40,447 or 19.7% for the three months ended September 30, 2003compared to the same period in 2002. Of this decrease, the Controls Divisioncontributed $48,886 offset by and increase of $8,439 from ADS.  For the nine-month period endedSeptember 30, 2003, the general and administrative costs increased $53,260or 7.2%.  Of this increase, the ControlsDivision contributed $5,163 and ADS contributed $48,097.  The increase is primarily due to a change inprocedure for accounting for general company expenses.  Historically, the company divided generalexpenses such as liability insurance, office supplies, and building expensesover the various departments based on a set percentage.  Beginning January 2003, we havedetermined to classify such general expenses into General and Administrativecosts.

 

Research and development costsdecreased $114,911 or 73.1% for the three months ended September 30, 2003compared to the same period in 2002.  Ofthis decrease, ESI contributed $62,805 and ADS contributed $52,106.  The decrease in ESI is due to reducedoutside development costs in both contract engineering and prototypedevelopment.  The decrease in ADS is dueto reduced development expenses for the ExpertScan products, which werereleased in December 2002. Software personnel for on-going product development have been broughtin-house at a lower cost than external services.

 

***Non-OperatingIncome (Loss)***

 

Non-operating income increasedby $418,412 for the three-month period ending September 30, 2003 comparedto the same period for 2002.  For thenine-month period ending September 30, 2003, non-operating incomedecreased $2,244,109.  Non-operatingincome decreased primarily due to reduced sales of investment securities.  As the market value of August Technologystock recovered from previous lows, management decided to increase the numberof August Technology shares sold during the three-months endedSeptember 30, 2003.

 

***Income(Loss) Before Income Taxes***

 

Income (loss) before incometaxes increased $649,648 to an income of $409,019 for the three-month periodended September 30, 2003 compared to the same period in 2002.  When comparing the nine-month period endedSeptember 30, 2003 to the same period in 2002, income (loss) before incometaxes decreased $2,118,526, to a loss of $352,656.

 

The Controls Division had incomebefore income taxes of $216,011 for the three months ended September 30,2003 compared to a net loss of $20,769 for the same period in 2002.  For the nine-month period endedSeptember 30, 2003, the Controls Division had income before income taxesof $109,517, compared to a net loss before income taxes of $22,267 for the sameperiod in 2002.  This difference is dueto sales revenue declines that occurred at a faster rate than did expensereductions.  However, the ControlsDivision experienced increased sales during the three months endingSeptember 30, 2003.

 

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ADS had a net loss before incometaxes of $35,214 for the three months ending September 30, 2003 comparedto the net loss before income taxes of $85,500 for same period in 2002. For thenine-month period ended September 30, 2003, ADS had a net loss beforeincome taxes of $78,046, compared to a net loss before income taxes of $154,568for the same period in 2002. These decreases are mainly attributable to reducedresearch and development costs following the ExpertScan software release inDecember 2002.

 

Investment income frominvestment securities increased $362,582 for an income before income taxes of$228,222 for the three months ended September 30, 2003 compared to thesame period in 2002.  For the nine-monthperiod ended September 30, 2003, the investment income decreased$2,326,835 to a net loss before income taxes of $384,130.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Cash and cashequivalents were $6,192,746 at September 30, 2003 and $6,621,601 atSeptember 30, 2002. Cash used in operating activities of $461,817 forthe nine months ended September 30, 2003 was primarily a result of our netloss adjusted for non-cash charges.

 

Cash providedby investing activities was $180,839 for the nine-month period endedSeptember 30, 2003 and $1,075,809 at September 30, 2002.  Cashused for capital expenditures was $22,666 and $61,922 for the nine months endedSeptember 30, 2003 and 2002, respectively.  Proceeds from the sale of investments for the nine months endedSeptember 30, 2003 declined to $587,864 from $2,237,706 when compared tothe same period in 2002.

 

Cash used infinancing activities was $249,436 and $207,289 for the nine months endedSeptember 30, 2003 and 2002, respectively.  During the nine months ended September 30, 2003 and 2002,the Company paid aggregate dividends of $284,677 and $282,964, respectively.

 

Our ongoing cash requirements will beprimarily for capital expenditures, acquisitions, research and development andworking capital.  Management believes that cash on hand and any cashprovided by operations will be sufficient to meet our cash requirements throughat least the next 12 months.

 

**FORWARD-LOOKING STATEMENTS**

 

This Form 10-QSB containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, including statements regarding the Company’s expectations, beliefs,intentions or strategies regarding the future. Forward-looking statements include, but are not limited to, statementsregarding the extent and timing of future revenues and expenses and customerdemand, the market value of our investment securities, future financialcondition and availability of capital resources, changes in worldwide generaleconomic conditions, cyclical capital spending by customers, the Company’sability to keep pace with technological developments and evolving industrystandards, worldwide competition, and the Company’s ability to protect its existingintellectual property from challenges from third parties and otherfactors.  Any statement that is notbased upon historical facts should be considered a forward-looking statement.

 

All forward-looking statementsin this document are based on information available to the Company as of thedate hereof, and the Company assumes no obligation to update any suchforward-looking statements.  It isimportant to note that the Company’s actual results could differ materiallyfrom those in such forward-looking statements. The forward-looking statements of the Company are subject to risks anduncertainties.  Some of the factors thatcould cause future results to differ materially from the Company’s recentresults or those projected in the forward-looking statements are detailed inthe Company’s Annual Report on Form 10-KSB for the year ended December 31,2002, filed with the Securities and Exchange Commission.

 

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**Item 3. Controls and Procedures.**

 

As of the end of the period covered by thisreport, the Company conducted an evaluation, under the supervision and with theparticipation of the principal executive officer and principal financialofficer, of the Company’s disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the“Exchange Act”)).  Based on thisevaluation, the principal executive officer and principal financial officerconcluded that the Company’s disclosure controls and procedures are effectiveto ensure that information required to be disclosed by the Company in reportsthat it files or submits under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in Securities andExchange Commission rules and forms.

 

There was no change in the Company’s internalcontrol over financial reporting during the Company’s most recently completedfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

**PART II – OTHER INFORMATION**

 
| **Item 6.** |   | **Exhibits and Reports on Form 8-K** |
|-------------|--------|--------------------------------------|
|        |   |                                 |
| (a)         |   | Exhibits                             |
|        |   | 31.1                                 | Certification of CEO and CFO  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|        |   | 32.1                                 | Certification of CEO and CFO  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|        |   |                                 |
| (b)         |   | Reports on Form 8-K – None.     |

 

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**SIGNATURES**

 

In accordance with therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| **Electro-Sensors, Inc.** |                                                      |
|---------------------------|-----------------------------------------------------------|
|                      |                                                      |
| November 14, 2003    | /s/  Bradley D. Slye                                      |   |
|                      | Bradley  D. Slye                                          |   |
|                      | Chief  Executive Officer and Principal Accounting Officer |   |

 

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**EXHIBIT INDEX**

 

**ELECTRO-SENSORS, INC.**

 

**FORM 10-QSB FOR QUARTER ENDED SEPTEMBER 30, 2003**

 
| **Exhibit** |   | **Description**                                                                              |
|-------------|--------|----------------------------------------------------------------------------------------------|
|        |   |                                                                                         |
| 31.1        |   | Certification of  CEO and CFO Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
|        |   |                                                                                         |
| 32.1        |   | Certification of  CEO and CFO Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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