** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

# ** **

# **Form 10-QSB**

 

**ý****  QUARTERLY REPORT UNDERSECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarterly period endedMarch 31, 2003**

** **

**o****  TRANSITION REPORTUNDER SECTION 13 OR 15(d) OF THE EXCHANGEACT FOR THE TRANSITION PERIODFROM              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 of principalexecutive offices)

 

## **(952)930-0100**(Issuer’s telephonenumber)

 

Check whether the issuer (1) filed all reportsrequired to be filed by Section 13 of 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 to suchfiling requirements for the past 90 days.

Yes ý   No o

 

The number of sharesoutstanding of the registrant’s Common Stock, $0.10 par value, on May 13, 2003was 3,160,938.

 

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

 

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**ELECTRO-SENSORS, INC.**

**Form 10-QSB**

**For the Period Ended March 31,2003**

 

**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 1. Legal Proceedings                                               |   |
| Item 2. Changes in  Securities                                          |   |
| Item 3.  Defaults Upon Senior Securities                                |   |
| Item  4. Submission of Matters to a Vote of Security Holders            |   |
| Item 5. Other Information                                               |   |
| Item 6.  Exhibits and Reports on Form 8-K                               |   |
|                                                                    |   |
|                                                                    |   |
| **SIGNATURES**                                                          |   |
|                                                                    |   |
| **CERTIFICATIONS**                                                      |   |

 

 

2

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**PART I — FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

**INDEX TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 
| Consolidated  Balance Sheets — As of March 31, 2003 and December 31, 2002                                     |   |
|--------------------------------------------------------------------------------------------------------------------|--------|
| Consolidated  Statements of Income — For the Three-Month Periods Ended March 31, 2003 and  March 31, 2002     |   |
| Consolidated  Statements of Cash Flows — For the Three-Month Periods Ended March 31, 2003  and March 31, 2002 |   |
| Notes to  Consolidated Financial Statements                                                                        |   |

 

 

3

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

**CONSOLIDATED BALANCE SHEETS**

 

 
|                                                                                                                     |   | **March 31,  2003** |           | **December  31,  2002** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|---------------------|----------------|-------------------------|--------|
|                                                                                                                     |   | **(unaudited)**     |           |                    |   |
| **ASSETS**                                                                                                               |   |                |           |                    |   |
| **CURRENT ASSETS**                                                                                                       |   |                |           |                    |   |
|                                                                                                                     |   |                |           |                    |   |
| Cash And Cash Equivalents                                                                                                |   | $                   | 6,354,554      |                    | $      | 6,723,160 |   |
| Investments                                                                                                              |   | 3,143,774           |           | 4,202,210               |   |
| Trade Receivables                                                                                                        |   | 536,855             |           | 550,252                 |   |
| Less Allowance for Doubtful Accounts of  $12,739 and $7,000, respectively.                                               |   |                |           |                    |   |
| Inventories                                                                                                              |   | 720,601             |           | 738,012                 |   |
| Prepaid Income Taxes                                                                                                     |   | 422,686             |           | 342,735                 |   |
| Other Current Assets                                                                                                     |   | 66,753              |           | 69,748                  |   |
| **Total Current Assets**                                                                                                 |   | 11,245,223          |           | 12,626,117              |   |
| **Property and Equipment,  Net**                                                                                         |   | 1,531,250           |           | 1,544,146               |   |
| **Investment in Equity  Method Investee**                                                                                |   | 306,710             |           | 502,181                 |   |
| **TOTAL ASSETS**                                                                                                         |   | **$**               | **13,083,183** | ** **              | **$**  | **14,672,444** |   |
|                                                                                                                     |   |                |           |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY****CURRENT LIABILITIES**                                                |   |                |           |                    |   |
| Accounts Payable                                                                                                         |   | $                   | 207,671        |                    | $      | 285,539 |   |
| Accrued Expenses                                                                                                         |   | 179,348             |           | 211,912                 |   |
| Accrued Income Taxes                                                                                                     |   | 0                   |           | 0                       |   |
| Deferred Revenue                                                                                                         |   | 40,387              |           | 50,398                  |   |
| Deferred Income Taxes                                                                                                    |   | 1,058,137           |           | 1,424,600               |   |
| **Total Current Liabilities**                                                                                            |   | 1,485,543           |           | 1,972,449               |   |
| **DEFERRED INCOME TAXES**                                                                                                |   | 35,000              |           | 30,000                  |   |
|                                                                                                                     |   |                |           |                    |   |
| **STOCKHOLDERS’ EQUITY**                                                                                            |   |                |           |                    |   |
| Common Stock par value $0.10 per share;Authorized 10,000,000 shares; Issued 3,160,938and 3,155,260 shares, respectively. |   | 316,094             |           | 315,526                 |   |
| Additional Paid-In Capital                                                                                               |   | 976,151             |           | 966,447                 |   |
| Retained Earnings                                                                                                        |   | 8,439,550           |           | 8,860,476               |   |
| Accumulated Other Comprehensive Income                                                                                   |   | 1,830,845           |           | 2,527,546               |   |
| **Total Stockholders’ Equity**                                                                                      |   | 11,562,640          |           | 12,669,995              |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                     |   | **$**               | **13,083,183** | ** **              | **$**  | **14,672,444** |   |

 

See Accompanying Notesto Consolidated Financial Statements

 

 

4

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

**CONSOLIDATED STATEMENTS OFINCOME**

**(Unaudited)**

 
|                                         |   | **Three  Months Ended March 31,** |         |
|----------------------------------------------|--------|-----------------------------------|--------------|
|                                         |   | **2003**                          |         | **2002** |   |
|                                         |   |                              |         |   |   |
| **Net Sales**                                |   | $                                 | 986,539      |   | $ | 1,138,656 |   |
| **Cost of Goods Sold**                       |   | 400,522                           |         | 493,227 |   |
| **Gross Profit**                             |   | 586,017                           |         | 645,429 |   |
|                                         |   |                              |         |   |   |
| **Operating Expenses:**                      |   |                              |         |   |   |
| Selling and Marketing                        |   | 315,989                           |         | 281,134 |   |
| General and Administrative                   |   | 297,845                           |         | 211,350 |   |
| Research and Development                     |   | 211,598                           |         | 225,141 |   |
| **Total Operating Expenses**                 |   | 825,432                           |         | 717,625 |   |
| **Operating Income (Loss)**                  |   | (239,415                          | )            | (72,196 | ) |
|                                         |   |                              |         |   |   |
| **Non-Operating Income (Expense):**          |   |                              |         |   |   |
| Gain (Loss) on Sale of Investment Securities |   | 12,104                            |         | 632,774 |   |
| Interest Income                              |   | 16,123                            |         | 142,937 |   |
| Other Income (Expense)                       |   | (246                              | )            | (22,743 | ) |
| Equity Gain (Loss) of Equity Method Investee |   | (195,471                          | )            | 0 |   |
| **Total Non-Operating Income (Expense)**     |   | (167,490                          | )            | 752,968 |   |
|                                         |   |                              |         |   |   |
| **Net Income (Loss)**                        |   |                              |         |   |   |
| **Before Income Taxes**                      |   | (406,906                          | )            | 680,772 |   |
|                                         |   |                              |         |   |   |
| **Federal and State Income Taxes**           |   | (79,950                           | )            | 264,859 |   |
|                                         |   |                              |         |   |   |
| **Net Income (Loss)**                        |   | **$**                             | **(326,955** | **)** | **$** | **415,913** |   |
|                                         |   |                              |         |   |   |
| **Per share data:**                          |   |                              |         |   |   |
| Weighted average basic shares outstanding    |   | 3,159,167                         |         | 3,123,558 |   |
| Basic Net Income (Loss) Per Share            |   | (0.10                             | )            | 0.13 |   |
|                                         |   |                              |         |   |   |
| Weighted average diluted shares outstanding  |   | 3,197,752                         |         | 3,433,064 |   |
| Diluted Net Income (Loss) Per Share          |   | (0.10                             | )            | 0.12 |   |

 

See AccompanyingNotes to Consolidated Financial Statements

 

 

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

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(Unaudited)**

** **
|                                                                                         |   | **Three  Months Ended March 31,** |     |
|----------------------------------------------------------------------------------------------|--------|-----------------------------------|----------|
|                                                                                         |   | **2003**                          |     | **2002** |   |
| **Reconciliation of Net Income to Net Cash Provided  By/(used in) Operating Activities**     |   |                              |     |   |   |
|                                                                                         |   |                              |     |   |   |
| **Net Income**                                                                               |   | $                                 | (326,955 | ) | $ | 415,913 |   |
| Adjustments to Reconcile Net Income to Net Cash Provided By/(used in)  Operating Activities: |   |                              |     |   |   |
| Provision for Losses on Trade Receivables                                                    |   | 0                                 |     | (5,000 | ) |
| Loss of Disposal of Segment                                                                  |   | 0                                 |     | 0 |   |
| Depreciation                                                                                 |   | 27,076                            |     | 9,622 |   |
| Deferred Taxes                                                                               |   | 0                                 |     | 0 |   |
| Realized (Gain)/Loss on Sale of Investments                                                  |   | (12,104                           | )        | (638,874 | ) |
| Equity Gain (Loss) of Equity Method   Investee                                          |   | 195,471                           |     | 0 |   |
| (Increase)/Decrease In:                                                                      |   |                              |     |   |   |
| Trade Receivables                                                                            |   | 13,397                            |     | (132,056 | ) |
| Inventory                                                                                    |   | 17,411                            |     | 31,603 |   |
| Other Current Assets                                                                         |   | 2,995                             |     | (49,865 | ) |
| Prepaid Income Taxes                                                                         |   | (79,951                           | )        | 0 |   |
| Increase/(Decrease) in:                                                                      |   |                              |     |   |   |
| Accounts Payable                                                                             |   | (77,868                           | )        | 56,568 |   |
| Customer Deposits                                                                            |   | 0                                 |     | 2,856 |   |
| Accrued Expenses                                                                             |   | (32,564                           | )        | 58,274 |   |
| Deferred Revenue                                                                             |   | (10,011                           | )        | 0 |   |
| Accrued Income Taxes                                                                         |   | 0                                 |     | (1,441,377 | ) |
| Net Cash Provided by Operating Activities                                                    |   | (283,103                          | )        | (1,692,336 | ) |
|                                                                                         |   |                              |     |   |   |
| Cash Flows from Investing Activities:                                                        |   |                              |     |   |   |
| Proceeds From Sale of Investments                                                            |   | 12,374                            |     | 632,774 |   |
| Purchase of Property and Equipment                                                           |   | (14,180                           | )        | (1,290 | ) |
| Principal Payments Received on Note Receivable                                               |   | 0                                 |     | 5,000 |   |
| Net Cash Provided By/ (used in) Investing Activities                                         |   | (1,806                            | )        | 636,484 |   |
|                                                                                         |   |                              |     |   |   |
| Cash Flows from Financing Activities:                                                        |   |                              |     |   |   |
| Proceeds from Issuance of Stock                                                              |   | 10,272                            |     | 21,288 |   |
| Dividends Paid                                                                               |   | (93,971                           | )        | (93,668 | ) |
|                                                                                         |   |                              |     |   |   |
| Net Cash Provided By/ (used in) Financing Activities                                         |   | (83,699                           | )        | (72,380 | ) |
|                                                                                         |   |                              |     |   |   |
| Net Increase (Decrease) in Cash & Cash Equivalents                                       |   | (368,606                          | )        | (1,128,232 | ) |
| Cash & Cash Equivalents, Beginning                                                       |   | 6,723,160                         |     | 8,389,691 |   |
| Cash & Cash Equivalents, Ending                                                          |   | 6,354,554                         |     | 7,261,459 |   |
|                                                                                         |   |                              |     |   |   |
| **Supplemental Schedule of Non-Cash Investing and  Financing Activities**                    |   |                              |     |   |   |
|                                                                                         |   |                              |     |   |   |
| Net change in Unrealized Gain/ (Loss) on Marketable Securities                               |   | (696,701                          | )        | 1,190,277 |   |
|                                                                                              |        |                                   |          |  |  |  |  |

 

See Accompanying Notes to Consolidated FinancialStatements

 

 

6

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

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

**(Unaudited)**

 

**Note 1.  Nature of Business**

 

The accompanyingconsolidated financial statements include the accounts of Electro-Sensors, Inc.and its wholly-owned subsidiary, ESI Investment Company.  Intercompany accounts, transactions andearnings have been eliminated in consolidation.  The consolidated entity is referred to as “the Company.”

 

Electro-Sensors,Inc. operates two distinct businesses. The first is the Controls Division, a division of Electro-Sensors,Inc.  This division manufactures andmarkets a complete line of speed monitoring and motor control systems forindustrial machinery.  The ControlsDivision utilizes leading-edge technology to continuously improve its productsand make them easier to use.  TheControls Division’s goal is to manufacture the industry-preferred product forevery market served.  These products aresold through an internal sales staff and distributors to a wide variety ofmanufacturers, OEM’s and processors to monitor process machineryoperations.  The Controls Divisionmarkets its products to a number of different industries located throughout theUnited States and abroad.

 

The secondbusiness is AutoData Systems (ADS), a division of Electro-Sensors, Inc.  ADS designs and markets desktop softwaresystems that read hand printed characters, checkmarks and bar code informationfrom scanned or faxed forms.  ADSproducts are designed to provide capabilities to automate data collection toend users, resellers and developers in the United States, Canada, Europe andAsia.

 

Inboth divisions, the Company grants credits to customers under normal industry terms,generally 30 days.

 

ESI Investment Company owns marketablesecurities which have experienced significant appreciation in value since theIPO of August Technology in 2000. Since late 2000, the Company has recognizedincome from the sale of its holdings in August Technology Corporation. See Note4 for additional information regarding its investments. During May 2002, ESIInvestment participated in a rights offering by PPT Vision, Inc. (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 4 foradditional information about this investment and the related change to theequity method.  The Company’sinvestments in marketable securities are subject to normal market risks, whichare unhedged.

 

**Note 2.  Basis of Presentation**

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial information and with the instructions to Form 10-QSB andRule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for complete financial statements. In the opinion of management, all adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation have beenincluded.

 

The Balance Sheetat December 31, 2002 has been derived from the Company’s audited financialstatements for the year ended December 31, 2002, but does not include all ofthe information and footnotes required by accounting principles generallyaccepted in the United States of America for complete financial statements.

 

For furtherinformation, refer to the financial statements and footnotes thereto includedin the Company’s annual report on Form 10-KSB for the year ended December 31,2002.

 

 

7

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**Note 3.  Revenue Recognition**

 

**Revenue recognition of production monitoring equipment:**

 

All productionmonitoring equipment is shipped without an evaluation or acceptance period.Revenues from the sale of the products and any related warranty costs arerecognized at the time of shipment. The Company’s distributors are not grantedany price protection. Sales to all customers, including distributors, are finaland no right of return after shipment exists.

 

**Software revenue recognition:**

 

The Company recognizes revenue upon shipmentof its character recognition software. The product is sold to the end user andrisk of loss is transferred, and the Company has no continuing obligations,once its products are delivered to the shipper. The Company recognizes revenueupon shipment, net of return reserves based on historical experience. Torecognize revenue, it must also be probable that the Company will collect theaccounts receivable from its customers. In some situations, the Companyreceives advance payments from its customers. Revenue associated with theseadvance payments is deferred until the product is shipped. Warranty reservesare provided at the time revenue is recognized for the estimated cost ofreplacing defective products.

 

 

#### **Note 4.  Investments**

 

The Company’s investments consist of marketableequity securities, primarily common stocks, government debt securities, moneymarket funds and unregistered equity securities. The estimated fair value ofmarketable equity securities is based on quoted market prices and thereforesubject to the inherent risk of market fluctuations.

 

Management determines the appropriateclassification of securities at the date individual investments are acquired,and evaluates the appropriateness of such classification at each balance sheetdate.

 

Since the Company does not buy investments inanticipation of short-term fluctuations in market prices, the investments inmarketable equity securities has been classified as available-for-sale.Available-for-sale securities are stated at fair value, and unrealized holdinggains and losses, net of the related deferred tax effect, are reported asseparate component of stockholders’ equity. Investments in unregistered securities are reported at original cost.Dividends on equity securities held for investment are recognized in incomewhen declared.

 

Realized gains and losses, including lossesfrom declines in value of specific securities determined by management to beother-than-temporary, are included in income. Realized gains and losses aredetermined on the basis of the specific securities sold.

 

 

**Change in Reporting for theCompany’s Investment in PPT Vision, Inc.**

 

During 2002, theCompany purchased 1,108,868 shares of common stock of PPT Vision, Inc.(PPT).   PPT is a publicly-tradedcorporation in which the Company had previously owned 549,084 shares, or 10.0%,of PPT’s outstanding common stock.  AtMarch 31, 2003, the Company owned 1,657,952 shares of PPT, which is 16.4% ofPPT’s outstanding common stock.  Thefair value of its holdings based on the quoted market price at March 31, 2003was approximately $828,976.  The Companyalso owns warrants to purchase approximately 549,084 additional shares of PPTcommon stock at a per share price of $2.50. The warrants are currently exercisable, and expire September 30, 2003.

 

 

8

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In connection withthe additional investment in PPT, it was determined that the Company couldexercise significant influence over the operations of PPT.  As a result, its ownership interest is nowreported using the equity method of accounting for investments.  The investment was previously reported as anavailable-for-sale security, showing the market value on the balance sheet andrecording any unrealized gains and losses in other comprehensive income.

 

Under the equitymethod of accounting, the Company’s proportionate share of PPT income or lossthrough January 31, 2003 is included in the Company’s net income with acorresponding increase or decrease in the carrying value of its investment.

 

As a result ofthis change to the equity method of accounting, the balance sheets at March 31,2002 and December 31, 2002 have been adjusted to show the Company’s investmentin PPT based on the equity method rather than based on market value method ofaccounting.  Retained earnings at thosedates have been adjusted to reflect equity method earnings from prior periodsand accumulated other comprehensive income at those dates has been adjusted toeliminate unrealized gains and losses from PPT that were recorded in prior periods.  In addition, the income statements for thethree months ended March 31, 2003 and 2002 show the Company’s portion of PPT’searnings from those periods.

 

Realized gains andlosses, including losses from declines in value of specific securities determinedby management to be other-than-temporary, are included in income.  Realized gains and losses are determined onthe basis of the specific securities sold.

 

**Note 5. Comprehensive Income**

 

Comprehensive incomeincludes the Company’s net income plus other comprehensive income items, whichare excluded from net income.  TheCompany’s other income consists of unrealized gains (losses), net of incometaxes and reclassification adjustments for gains and losses included in netincome.

 
|                                                         |   | **Three  Months Ended March 31,** |       |
|--------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                         |   | **2003**                          |       | **2002** |   |
| **Net Income**                                               |   | $                                 | (326,955   | ) | $ | 415,913 |   |
|                                                         |   |                              |       |   |   |
| **Other Comprehensive Gain:**                                |   |                              |       |   |   |
| Change in Unrealized Value Investments, net                  |   | (688,701                          | )          | 1,624,900 |   |
|                                                         |   |                              |       |   |   |
| **Less:**                                                    |   |                              |       |   |   |
| Reclassification Adjustment for Gains Included In Net Income |   | (8,000                            | )          | (428,793 | ) |
|                                                         |   |                              |       |   |   |
| Total Comprehensive Income                                   |   | $                                 | (1,023,656 | ) | (1,612,020 | ) |
|                                                              |        |                                   |            |  |  |  |  |

 

 

9

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**Note 6.  SegmentInformation**

 

The Company has threereportable operating segments based on the nature of its product lines:  Production Monitoring, CharacterRecognition, and Investments.  TheProduction Monitoring Division manufactures and markets a complete line ofspeed monitoring and motor control systems for industrial machinery.  The Character Recognition Division designsand markets a desktop software-based system that reads hand printed characters,checkmarks, and bar code information from scanned or faxed forms.  Sales of this system include software andcan include hardware.  The InvestmentsDivision holds investments in marketable and non-marketable securities.

 

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

 

The following isfinancial information relating to the continuing operating segments:

 
|                                                    |   | **Three  Months Ended March 31,** |         |
|---------------------------------------------------------|--------|-----------------------------------|--------------|
|                                                    |   | **2003**                          |         | **2002** |   |
| **External Sales**                                      |   |                              |         |   |   |
| Production Monitoring                                   |   | $                                 | 844,013      |   | $ | 932,464 |   |
| Character Recognition                                   |   | 142,526                           |         | 206,192 |   |
| Investments                                             |   | 0                                 |         | 0 |   |
| **Total**                                               |   | **$**                             | **986,539**  | ** ** | **$** | **1,138,656** | ** ** |
|                                                    |   |                              |         |   |   |
| **Net Income Before Taxes and Discontinued Operations** |   |                              |         |   |   |
| Production Monitoring                                   |   | $                                 | (121,939     | ) | $ | 30,830 |   |
| Character Recognition                                   |   | (28,670                           | )            | (307 | ) |
| Investments                                             |   | (256,297                          | )            | 650,249 |   |
| **Total**                                               |   | **$**                             | **(406,906** | **)** | **$** | **680,772** | ** ** |

 

 

10

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

 

**RESULTS OF OPERATIONS**

 

**Comparison of Quarter 1, 2003 vs. Quarter 1, 2002**

 

***Net Revenues***

 

Net revenues for thethree-month period ended March 31, 2003 decreased $152,117, or 13.4%, whencompared to net revenues for the same period in 2002. Of this decrease, $88,441is attributable to the Controls Division, and $63,676 is due to the CharacterRecognition Division.  This decline indemand for production control instruments is attributable to the decreasedpurchases by machine and process equipment builders that supply productionmachinery for new manufacturing processes. All products contributed to the decrease in sales equally. New productsfor monitoring a larger range of machine vibration sensing and slide gateposition are being developed to expand the range of product applications.

 

***Cost of Sales***

 

The Company’s cost ofsales decreased $92,705, or 18.8%, for the three months ended March 31, 2003when comparing the same period in 2002. In addition to the decrease resulting from the lower sales volume, costof sales was reduced as a result of the company’s efforts to reduce productioncosts.  The cost improvements wereaccomplished principally from a reduction in production personnel.

 

***Gross Margins***

 

Gross margins for thethree-month period ended March 31, 2003 were 59.4% versus 58.4% for the sameperiod of the prior fiscal year.  Theimprovement in gross margin percentage is due mainly to reductions in productionstaffing, implemented during the 3rd and 4th quarter of2002.

 

***Operating Expenses***

 

Total operatingexpenses increased $107,807, or 15.0% for the three months ended March 31, 2003when compared to the same period of the prior year.

 

Selling and marketingcosts increased  $34,855, or 12.4%, forthe three-months ended March 31, 2003 when compared to the same period in2002.  Of this increase, the ControlsDivision contributed $11,829, and the Character Recognition Divisioncontributed $23,027.  This increase inselling and marketing expense is predominantly due to marketing expenses forproduct launches, a greater number of sales trips, new literature, and addevelopment.

 

General andadministrative costs increased $86,495, or 40.9%, for the three-months endedMarch 31, 2003 compared to the same period in 2002.  The increase is primarily due to a change in procedure foraccounting for general company expenses. Historically, the company would divide general expenses such asliability insurance, office supplies, and building expenses over the variousdepartments based on a set percentage. Beginning January 2003, for ease of accounting and analysis, we havedetermined to classify such general expenses into General and Administrativecosts.  Of the increase, the ControlsDivision contributed $64,978 and the Character Recognition Division contributed$21,527.

 

Research anddevelopment costs decreased $13,543, or 6.0%, for the three months ended March31, 2003 compared to the same period in 2002. Of this decrease, the Character Recognition Division contributed a 31.7%decrease and the Controls Division contributed an increase of 15.4%.  The decrease in the Character RecognitionDivision is due to reduced development expenses this quarter on the ExpertScanproduct.  This product was released inDecember 2002.  The increase in theControls Division is primarily due to the Company’s increased effort indeveloping new products to be introduced to our market.

 

 

11

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***Non-Operating Income (Loss)***

 

Non-Operating Incomedecreased by $920,458 from March 31, 2002 compared to March 31, 2003 or adecrease of 122.2%.  Of this decrease,$126,814 is from interest income, a result of reduced rates on temporary cashinvestments and a reduction in amounts invested.  $620,670 of the decrease is due to Gain on the sale ofsecurities, which fluctuates from quarter to quarter due to management’sevaluation of the securities held. As a result of recent declines in the marketprice of technology stocks, management decided to reduced the number of AugustTechnology shares sold during the three months ended March 31, 2003.

 

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

 

Net income beforetaxes decreased $1,087,680, or 160%, to a loss of $406,906 for the three-monthperiod ended March 31, 2003 compared to the same period in 2002.  Of the $406,906 loss for the first threemonths of 2003, $195,471 is due to the PPT equity method accounting.

 

The Controls Divisionhad a net loss of $121,939 for the three months ended March 31, 2003 comparedto net income of $30,830 for the same period in 2002.  This difference is due to reduced sales revenue coveringconsistent overhead costs, continued new product development expenditures,marketing expenses related to new product release, and the software conversionand related training and operational support costs.

 

The CharacterRecognition Division had a net loss of $28,670 for the three months endingMarch 31, 2003 compared to the loss of $307 for same period in 2002. Thisincrease is mainly attributable to increased marketing costs to the productrelease and launch of the new ExpertScan software product and the decrease insales revenue for the quarter.  Theoverall operating expenses for this division increased 6.24%.

 

Investment incomefrom investment securities decreased $620,670, or 98.1%, for the three monthsended March 31, 2003 compared to the same period in 2002.  As a result of the general decline in thestock market and particularly the decline in the price of August Technology,the Company reduced the number of shares sold as compared to the priorquarters.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Cash and cashequivalents were $6,354,554 at March 31, 2003 and $6,723,160 at March 31, 2002.Cash used in operating activities of $283,103 for the three months endedMarch 31, 2003 was primarily a result of our net loss adjusted for non-cashcharges.

 

Cash (used)/provided ininvesting activities was ($1,806) and $636,484 for the three months ended March31, 2003 and 2002, respectively.  Cash used for capital expenditures was$14,180 and $1,290 for the three months ended March 31, 2003 and 2002,respectively.  Proceeds from the sale ofinvestments declined from $632,774 for the three months ended March 31, 2003 to$12,374 for the same period in 2002.

 

The Company holds a relatively large investment inAugust Technology, which is valued at quoted market price on March 31,2003.  The quoted market pricesrepresent an estimate of what the Company may have realized if the shares weretraded on the open exchange. The potential amount realized from a sale of asignificant portion of the Company’s holdings in either August or PPT may beaffected by factors other than those reflected in the quoted market price.  The most significant of which is themarket’s ability to absorb a large block of securities. In addition the marketvalue of the securities may be subject to significant fluctuation in quotedmarket prices. The market value of the investment in August Technology  at March 31, 2003 and May 12, 2003 was$2,984,000 and $3,101,000 respectively. The market value of the equity method investment in PPT is approximately$829,000 at March 31, 2002 and $1,243,000 at May 12, 2003.

 

 

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Cash used in financingactivities was ($83,699) and ($72,380) for the three months ended March31, 2003 and 2002, respectively.  For the three months ended March 31,2003, our employees purchased $10,272 of common stock under our employeeplans.  During the three months endedMarch 31, 2003 and 2002, the Company paid aggregate dividends of $93,971 and$93,668, respectively.

 

Ourongoing cash requirements will be primarily for capital expenditures,acquisitions, research and development and working capital.  Managementbelieves that cash on hand and any cash provided by operations will besufficient to meet our cash requirements through at least the remainder of theyear.

 

**FORWARD-LOOKING STATEMENTS**

 

This Form 10-QSBcontains forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of 1934,including statements regarding the Company’s expectations, beliefs, intentionsor 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, future financial condition and availability of capital resources,changes in worldwide general economic conditions, cyclical capital spending bycustomers, the Company’s ability to keep pace with technological developmentsand evolving industry standards, worldwide competition, and the Company’sability to protect its existing intellectual property from challenges fromthird parties and other factors.  Anystatement that is not based upon historical facts should be considered aforward-looking statement.

 

All forward-lookingstatements in this document are based on information available to the Companyas of the date 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, 2001,filed with the Securities and Exchange Commission.

 

**Item 3.  Controls and Procedures.**

 

The Company’s ChiefExecutive Officer and Chief Financial Officer ****(its principal executive officer and principal financialofficer, respectively)****, evaluated theCompany’s disclosure controls and procedures (as defined in Rule13a — 14(c) under the Securities and Exchange Act of 1934, asamended) within 90 days prior to the filing date of this quarterly report.Based on this evaluation the Chief Executive Officer and Chief FinancialOfficer concluded that the Company’s disclosure controls and procedures areeffective. There were no significant changes in internal controls that couldsignificantly affect the disclosure controls and procedures since the date ofthe evaluation.

 

**PART II — OTHER INFORMATION**

 

**Item 1.  Legal Proceedings**

 

There were nomaterial developments in previously reported legal proceedings.

 

**Item 2.  Changes in Securities**

 

No changes have beenmade to any registered securities nor were there any sales of unregisteredsecurities during the quarter ended March 31, 2003.

 

**Item 3.  Defaults Upon SeniorSecurities**

 

No event constitutinga default has occurred with respect to any senior security of the Registrant.

 

 

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**Item 4.  Submission of Matters toa Vote of Security Holders**

 

None.

 

**Item 5.  Other Information**

 

None.

 

**Item 6.  Exhibits and Reports onForm 8-K**

 

(a)          Exhibits99.1 Certification Pursuant to Section 906 of Sarbanes-Oxley Act of 2002.

(b)         Reports on Form8-K — No reports on Form 8-K were filed during the three months endedMarch 31, 2003

 

**SIGNATURES**

 

In accordance withthe requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

**Electro-Sensors, Inc.**

** **
| May 13, 2003 | /s/ Bradley D. Slye                                         |
|--------------|-------------------------------------------------------------|
|         | Bradley D. Slye,  President                                 |
|         | (Chief Executive  Officer and Principal Accounting Officer) |

 

 

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**CERTIFICATION**

 

I, Bradley D. Slye, Chief Executive Officerand Chief Financial Officer of Electro-Sensors, Inc., certify that:

 

1.               I have reviewedthis quarterly report on Form 10-QSB of Electro-Sensors Inc.

 

2.               Based on my knowledge, thisquarterly report does not contain any untrue statement of a material fact oromit to state a material fact necessary to make the statements made, in lightof the circumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.               Based on my knowledge, thefinancial statements, and other financial information included in thisquarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, and for,the periods presented in this quarterly report

 

4.               The registrant’s othercertifying officers and I are responsible for establishing and maintainingdisclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and15d-14) for the registrant and we have:

 

a)              designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)             evaluated the effectivenessof the registrant’s disclosure controls and procedures as of a date within 90days prior to the filing date of this quarterly report (the “Evaluation Date”);and

 

c)              presented in this quarterlyreport our conclusions about the effectiveness of the disclosure controls andprocedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’s othercertifying officers and I have disclosed, based on our most recent evaluation,to the registrant’s auditors and the audit committee of registrant’s board ofdirectors (or persons performing the equivalent function);

 

a)              all significant deficienciesin the design or operation of internal controls which could adversely affectthe registrant’s ability to record, process, summarize and report financialdata and have identified for the registrant’s auditors any material weaknessesin internal controls; and

 

b)             any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

 

6.               The registrant’s othercertifying officers and I have indicated in this quarterly report whether ornot there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
| May 13, 2003 |                                                            |
|--------------|-----------------------------------------------------------------|
|         |                                                            |
|         |                                                            | /s/  Bradley D. Slye |
|         | Bradley  D. Slye, President                                     |
|         | (Principal Executive  Officer and Principal Accounting Officer) |

 

 

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**EXHIBIT INDEX**

 

**ELECTRO-SENSORS, INC.**

 

**FORM 10-QSB FOR QUARTER ENDEDMARCH 31, 2003**

 

** **
| **Exhibit** |   | **Description**                                                      |
|-------------|--------|----------------------------------------------------------------------|
|        |   |                                                                 |
| 99.1        |   | Certification Pursuant  to Section 906 of Sarbanes-Oxley Act of 2002 |

 

 

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