**UNITEDSTATES**SECURITIES AND EXCHANGECOMMISSION

**Washington, DC 20549**

 

**Form10-QSB**

 
| **ý****QUARTERLY REPORT UNDER SECTION  13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                         |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                      |
| **For the quarterly period ended September 30,  2004**                                                                                                                    |
| ** **                                                                                                                                                                |
| **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 as specified in its charter)

 
| **Minnesota**                                                   | ** ** | **41-0943459**                    |
|-----------------------------------------------------------------|------------|-----------------------------------|
| (State or other jurisdiction of incorporation or  organization) |       | (IRS Employer Identification No.) |
| ** **                                                      |       |                              |
| **6111 Blue Circle Drive  Minnetonka, Minnesota 55343-9108**    |
| (Address of principal executive offices)                        |
| ** **                                                      |
| **(952) 930-0100**                                              |
| (Issuer’s telephone number)                                |

 

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 shares outstanding of theregistrant’s Common Stock, $0.10 par value, on November 15, 2004 was 3,218,345.

 

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

 

 

----

 

**ELECTRO-SENSORS, INC.**

**Form 10-QSB**

**For the Period Ended September 30, 2004**

 

**TABLE OF CONTENTS**

 
| **PART I – FINANCIAL INFORMATION**                                                                                             |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|
| ** **                                                                                                                          |   |
| Item 1. Financial Statements                                                                                                        |   |
|                                                                                                                                |   |
| Consolidated Balance Sheets – As of   September 30, 2004 and December 31, 2003                                       |   |
| Consolidated Statements of Operations – For  the Three and Nine Month Periods Ended September 30, 2004 and September 30,  2003 |   |
| Consolidated Statements of Cash Flows – For  the Nine Month Periods Ended September 30, 2004 and September 30, 2003            |   |
| Notes to Consolidated 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                                                                                                                    |   |
|                                                                                                                                |   |
| **SIGNATURES**                                                                                                                      |   |
|                                                                                                                                |   |
| **EXHIBITS**                                                                                                                        |   |

 

2

----

 

**PART I.    FINANCIAL INFORMATION**

 

**Item 1.  Financial Statements**

 

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

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                   | ** ** | **September 30,  2004** | ** **     | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|----------------|-----------------------------|------------|
| ** **                                                                                                                   | ** ** | **(unaudited)**         | ** **     | ** **                  | ** ** |
| **ASSETS**                                                                                                                   |       |                    |           |                        |       |
|                                                                                                                         |       |                    |           |                        |       |
| **CURRENT ASSETS**                                                                                                           |       |                    |           |                        |       |
|                                                                                                                         |       |                    |           |                        |       |
| Cash and cash equivalents                                                                                                    | ** ** | **$**                   | **6,620,384**  |                        | $          | 6,863,046 |   |
| Investments                                                                                                                  | ** ** | **4,933,801**           |           | 13,415,625                  |       |
| Trade receivables, less allowance for  doubtful accounts of $7,483 and $6,000, respectively                                  |       | **575,581**             |           | 515,351                     |       |
| Inventories                                                                                                                  | ** ** | **803,723**             |           | 758,103                     |       |
| Prepaid income tax                                                                                                           | ** ** | **52,860**              |           | 0                           |       |
| Other current assets                                                                                                         | ** ** | **63,988**              |           | 62,123                      |       |
|                                                                                                                         |       |                    |           |                        |       |
| **Total current assets**                                                                                                     | ** ** | **13,050,337**          |           | 21,614,248                  |       |
|                                                                                                                         |       |                    |           |                        |       |
| **Property and equipment, net**                                                                                              | ** ** | **1,422,657**           |           | 1,470,133                   |       |
|                                                                                                                         |       |                    |           |                        |       |
| **Investment in equity method investee**                                                                                     | ** ** | **146,985**             |           | 152,115                     |       |
| ** **                                                                                                                   | ** ** | ** **              | ** **     | ** **                  | ** ** |
| **TOTAL ASSETS**                                                                                                             | ** ** | **$**                   | **14,619,979** |                        | $          | 23,236,496 |   |
| ** **                                                                                                                   | ** ** | ** **              | ** **     | ** **                  | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                |       |                    |           |                        |       |
|                                                                                                                         |       |                    |           |                        |       |
| **CURRENT LIABILITIES**                                                                                                      |       |                    |           |                        |       |
|                                                                                                                         |       |                    |           |                        |       |
| Accounts payable                                                                                                             | ** ** | **$**                   | **159,818**    |                        | $          | 106,065 |   |
| Accrued expenses                                                                                                             | ** ** | **308,393**             |           | 263,143                     |       |
| Deferred revenue                                                                                                             | ** ** | **54,933**              |           | 48,022                      |       |
| Deferred income tax                                                                                                          | ** ** | **1,689,361**           |           | 4,795,000                   |       |
| Accrued income tax                                                                                                           | ** ** | **0**                   |           | 96,196                      |       |
|                                                                                                                         |       |                    |           |                        |       |
| **Total current liabilities**                                                                                                | ** ** | **2,212,505**           |           | 5,308,426                   |       |
|                                                                                                                         |       |                    |           |                        |       |
| **Deferred income taxes**                                                                                                    | ** ** | **26,000**              |           | 26,000                      |       |
|                                                                                                                         |       |                    |           |                        |       |
| **TOTAL LIABILITIES**                                                                                                        | ** ** | **$**                   | **2,238,505**  |                        | $          | 5,334,426 |   |
|                                                                                                                         |       |                    |           |                        |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                | ** ** | ** **              | ** **     | ** **                  | ** ** |
|                                                                                                                         |       |                    |           |                        |       |
| Common stock par value $0.10 per share;  authorized 10,000,000 shares; issued 3,218,345 and 3,174,522 shares,  respectively. | ** ** | **321,835**             |           | 317,452                     |       |
| Additional paid-in capital                                                                                                   | ** ** | **1,103,948**           |           | 999,762                     |       |
| Retained earnings                                                                                                            | ** ** | **8,031,402**           |           | 8,304,737                   |       |
| Accumulated other comprehensive income                                                                                       | ** ** | **2,924,289**           |           | 8,280,119                   |       |
|                                                                                                                         |       |                    |           |                        |       |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                                          | ** ** | **12,381,474**          |           | 17,902,070                  |       |
| ** **                                                                                                                   | ** ** | ** **              | ** **     | ** **                  | ** ** |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                          | ** ** | **$**                   | **14,619,979** |                        | $          | 23,236,496 |   |
|                                                                                                                              |            |                         |                |                             |            |  |  |  |  |

 

See accompanying notes to consolidated financial statements

 

3

----

 

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

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                            | ** ** | **Three Months Ended  September 30,** | ** **    | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|---------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **2004**                                   | ** **    | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Net sales**                                         | ** ** | **$**                                      | **1,242,642** |                                      | $          | 1,147,210 | ** ** | **$** | **3,664,207** |   | $ | 3,157,996 |   |
| **Cost of goods sold**                                | ** ** | **452,669**                                |          | 429,515                                   | ** ** | **1,368,288** |   | 1,215,441 |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Gross profit**                                      | ** ** | **789,973**                                |          | 717,695                                   | ** ** | **2,295,919** |   | 1,942,555 |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Operating expenses:**                               |       |                                       |          |                                      |       |   |   |   |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| Selling and marketing                                 | ** ** | **340,529**                                |          | 268,218                                   | ** ** | **967,785** |   | 879,448 |   |
| General and administrative                            | ** ** | **254,515**                                |          | 205,108                                   | ** ** | **774,615** |   | 741,639 |   |
| Research and development                              | ** ** | **205,993**                                |          | 157,189                                   | ** ** | **566,525** |   | 574,813 |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Total operating expenses**                          | ** ** | **801,037**                                |          | 630,515                                   | ** ** | **2,308,925** |   | 2,195,901 |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Operating income (loss)**                           | ** ** | **(11,064**                                | **)**         | 87,180                                    | ** ** | **(13,006** | **)** | (253,346 | ) |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Non-operating income (expense):**                   |       |                                       |          |                                      |       |   |   |   |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| Gain (loss) on sale of investment  securities         | ** ** | **(957**                                   | **)**         | 516,639                                   | ** ** | **425,339** |   | 546,168 |   |
| Interest income                                       | ** ** | **18,931**                                 |          | 11,633                                    | ** ** | **42,696** |   | 43,146 |   |
| Other income (expense)                                | ** ** | **2,304**                                  |          | 870                                       | ** ** | **8,742** |   | 5,598 |   |
| Equity in losses of equity method investee            | ** ** | **(39,972**                                | **)**         | (207,303                                  | )          | **(165,130** | **)** | (694,222 | ) |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Total non-operating income (expense)**              | ** ** | **(19,694**                                | **)**         | 321,839                                   | ** ** | **311,647** |   | (99,310 | ) |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Income (loss) before income taxes**                 | ** ** | **(30,758**                                | **)**         | 409,019                                   | ** ** | **298,641** |   | (352,656 | ) |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Federal and state income tax provision  (benefit)** | ** ** | **4,457**                                  |          | 260,187                                   | ** ** | **187,422** |   | 107,659 |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Net income (loss)**                                 | ** ** | **$**                                      | **(35,215**   | **)**                                     | $          | 148,832 | ** ** | **$** | **111,219** |   | $ | (460,315 | ) |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Net income (loss) per share data:**                 |       |                                       |          |                                      |       |   |   |   |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Basic**                                             |       |                                       |          |                                      |       |   |   |   |   |
| Net income (loss) per share                           | ** ** | **$**                                      | **(0.01**     | **)**                                     | $          | 0.05 | ** ** | **$** | **0.03** |   | $ | (0.15 | ) |
| Weighted average shares                               | ** ** | **3,218,009**                              |          | 3,168,938                                 | ** ** | **3,202,089** |   | 3,162,792 |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Diluted**                                           |       |                                       |          |                                      |       |   |   |   |   |
| Net income (loss) per share                           | ** ** | **$**                                      | **(0.01**     | **)**                                     | $          | 0.05 | ** ** | **$** | **0.03** |   | $ | (0.15 | ) |
| Weighted average shares                               | ** ** | **3,326,575**                              |          | 3,235,272                                 | ** ** | **3,312,835** |   | 3,162,792 |   |
|                                                  |       |                                       |          |                                      |       |   |   |   |   |
| **Dividends paid per share**                          | ** ** | **$**                                      | **0.04**      |                                      | $          | 0.03 | ** ** | **$** | **0.12** |   | $ | 0.09 |   |
|                                                       |            |                                            |               |                                           |            |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements

 

4

----

 

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                            | ** ** | **Nine Months Ended  September 30,** | ** **     |
|---------------------------------------------------------------------------------------|------------|--------------------------------------|----------------|
| ** **                                                                            | ** ** | **2004**                             | ** **     | **2003** | ** ** |
| **Cash flows from operating activities**                                              |       |                                 | ** **     |   |   |
|                                                                                  |       |                                 | ** **     |   |   |
| **Net income (loss)**                                                                 | ** ** | **$**                                | **111,219**    | ** ** | $ | (460,315 | ) |
|                                                                                  |       |                                 | ** **     |   |   |
| Adjustments to reconcile net income (loss)  to net cash used in operating activities: |       |                                 | ** **     |   |   |
|                                                                                  |       |                                 | ** **     |   |   |
| Depreciation                                                                          | ** ** | **68,328**                           | ** **     | 76,336 |   |
| Realized (gain)/loss on sale of investments                                           | ** ** | **(425,339**                         | **)**          | (546,168 | ) |
| Equity in loss of equity method investee                                              | ** ** | **165,130**                          | ** **     | 694,222 |   |
| (Increase)/decrease in:                                                               |       |                                 | ** **     |   |   |
| Trade receivables                                                                     | ** ** | **(60,230**                          | **)**          | (35,106 | ) |
| Inventory                                                                             | ** ** | **(45,620**                          | **)**          | 9,708 |   |
| Other current assets                                                                  | ** ** | **(1,865**                           | **)**          | (7,305 | ) |
| Prepaid income taxes                                                                  | ** ** | **(52,860**                          | **)**          | 124,809 |   |
| Increase/(decrease) in:                                                               |       |                                 | ** **     |   |   |
| Accounts payable                                                                      | ** ** | **53,753**                           | ** **     | (163,758 | ) |
| Accrued expenses                                                                      | ** ** | **45,250**                           | ** **     | (47,876 | ) |
| Deferred revenue                                                                      | ** ** | **6,911**                            | ** **     | (14,714 | ) |
| Accrued income taxes                                                                  | ** ** | **(96,196**                          | **)**          | (91,650 | ) |
|                                                                                  |       |                                 | ** **     |   |   |
| Net cash provided by/(used) in operating  activities                                  | ** ** | **(231,519**                         | **)**          | (461,817 | ) |
|                                                                                  |       |                                 | ** **     |   |   |
| Cash flows from investing activities:                                                 |       |                                 | ** **     |   |   |
|                                                                                  |       |                                 | ** **     |   |   |
| Proceeds from sale of investments                                                     | ** ** | **771,895**                          | ** **     | 587,864 |   |
| Purchase of equity securities                                                         | ** ** | **(326,202**                         | **)**          | 0 |   |
| Payment for purchase of investments                                                   | ** ** | **(160,000**                         | **)**          | (384,359 | ) |
| Purchase of property and equipment                                                    | ** ** | **(20,852**                          | **)**          | (22,666 | ) |
|                                                                                  |       |                                 | ** **     |   |   |
| Net cash provided by/(used) in investing  activities                                  | ** ** | **264,841**                          | ** **     | 180,839 |   |
|                                                                                  |       |                                 | ** **     |   |   |
| Cash flows from financing activities:                                                 |       |                                 | ** **     |   |   |
|                                                                                  |       |                                 | ** **     |   |   |
| Proceeds from issuance of stock                                                       | ** ** | **108,569**                          | ** **     | 35,241 |   |
| Dividends paid                                                                        | ** ** | **(384,554**                         | **)**          | (284,677 | ) |
|                                                                                  |       |                                 | ** **     |   |   |
| Net cash provided by/(used) in financing  activities                                  | ** ** | **(275,985**                         | **)**          | (249,436 | ) |
|                                                                                  |       |                                 | ** **     |   |   |
| Net increase/(decrease) in cash & cash  equivalents                               | ** ** | **(242,662**                         | **)**          | (530,414 | ) |
|                                                                                  |       |                                 | ** **     |   |   |
| Cash & cash equivalents, beginning                                                | ** ** | **6,863,046**                        | ** **     | 6,723,160 |   |
| Cash & cash equivalents, ending                                                   | ** ** | **6,620,384**                        | ** **     | 6,192,746 |   |
|                                                                                  |       |                                 | ** **     |   |   |
| **Supplemental schedule of non-cash investing  and financing activities**             | ** ** | ** **                           | ** **     | ** ** | ** ** |
| Net change in unrealized gain/ (loss) on  investments                                 | ** ** | **$**                                | **(8,461,469** | **)** | $ | 4,181,048 |   |

 

See accompanying notes to consolidated financial statements

 

5

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**Note 1.  Nature of Business**

 

Theaccompanying consolidated financial statements include the accounts ofElectro-Sensors, Inc. and its wholly owned subsidiary ESI Investment Company.Intercompany accounts, transactions and earnings have been eliminated inconsolidation. The consolidated entity is referred to as “the Company.”

 

Electro-Sensors,Inc. operates two distinct businesses. The first is the Controls Division,which manufactures and markets a complete line of speed monitoring and motorcontrol systems for industrial machinery. The Controls Division utilizesleading-edge technology to continuously improve its products and make themeasier to use. The Controls Division’s goal is to manufacture theindustry-preferred product for every market served. These products are soldthrough an internal sales staff, manufacturers representatives, anddistributors to a wide variety of manufacturers, OEM’s and processors tomonitor process machinery operations. The Controls Division markets itsproducts to a number of different industries located throughout the UnitedStates and abroad.

 

Thesecond business is AutoData Systems (ADS). ADS designs and markets a desktop software-based system that reads handprinted characters, checkmarks and bar code information from scanned or faxedforms. ADS products are designed to provide capabilities to automate datacollection and are sold by internal sales staff to end users, resellers anddevelopers in the United States, Canada, Europe and Asia.

 

Inboth divisions, the Company grants credit to customers under normal industryterms, generally 30 days.

 

ESIInvestment Company (INV) owns equity securities in August TechnologyCorporation and PPTV Vision Inc. (PPTV), and membership interests in a la mode,LLC, among other investments.  Shares ofAugust Technology common stock have experienced significant appreciation invalue since its initial public offering in 2000.  ESI Investment acquired shares of PPTV in May2002 and September 2003.  In May 2002,the Company adopted the equity method of accounting for its investments inPPTV.  In April 2004, ESI Investmentpurchased 20% of a la mode, LLC’s membership interests for $160,000.  The Company has adopted the equity method ofaccounting to report this investment. The Company’s investments in securities are subject to market and otherinvestment risks.  See Note 6 foradditional information regarding INV’s investments.

 

**Note 2.  Basis of Presentation**

 

The accompanying unaudited consolidated financial statements have beenprepared in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and with theinstructions to Form 10-QSB. Accordingly, they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements.  It is theopinion of management that the unaudited condensed consolidated financialstatements include all adjustments, consisting of normal recurring accruals,necessary to fairly state the financial position and results of operations forthe three and nine month periods ended September 30, 2004 and September 30,2003. The results of interim periods may not be indicative of results to beexpected for the year.

 

The Balance Sheet at December 31, 2003 has been derived from theCompany’s audited financial statements for the year ended December 31,2003, but does not include all of the information and footnotes required byaccounting principles generally accepted in the United States of America forcomplete financial statements.  Forfurther information, refer to the financial statements and footnotes theretoincluded in the Company’s annual report on Form 10-KSB for the year endedDecember 31, 2003.

 

**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.

 

6

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**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 basedon the fair values of options at the grant dates consistent with the provisionsof Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting forStock Based Compensation,” the Company’s net income (loss) and basic anddiluted net income (loss) per common share would have been changed to thefollowing pro forma amounts:

 
| ** **                                  | ** ** | **Three Months  Ended  September 30,** | ** ** | **Nine Months  Ended  September 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                  | ** ** | **2004**                                    | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (loss):                          |       |                                        |       |                                       |       |   |   |   |   |
| As reported                                 |       | $                                           | (35,215    | )                                          | $          | 148,832 |   | $ | 111,219 |   | $ | (460,315 | ) |
| Pro forma                                   |       | $                                           | (68,225    | )                                          | $          | 141,199 |   | $ | 66,650 |   | $ | (478,954 | ) |
| Basic net income (loss) per common share:   |       |                                        |       |                                       |       |   |   |   |   |
| As reported                                 |       | (0.01                                       | )          | 0.05                                       |       | 0.03 |   | (0.15 | ) |
| Pro forma                                   |       | (0.02                                       | )          | 0.04                                       |       | 0.02 |   | (0.15 | ) |
| Diluted net income (loss) per common share: |       |                                        |       |                                       |       |   |   |   |   |
| As reported                                 |       | (0.01                                       | )          | 0.05                                       |       | 0.03 |   | (0.15 | ) |
| Pro forma                                   |       | (0.02                                       | )          | 0.04                                       |       | 0.02 |   | (0.15 | ) |
| Stock based compensation:                   |       |                                        |       |                                       |       |   |   |   |   |
| As reported                                 |       | 0                                           |       | 0                                          |       | 0 |   | 0 |   |
| Pro forma                                   |       | $                                           | 33,010     |                                       | $          | 7,633 |   | $ | 44,569 |   | $ | 18,639 |   |
|                                             |            |                                             |            |                                            |            |  |  |  |  |  |  |  |  |  |  |

 

In determining the compensation cost ofoptions granted during the three and nine months ended September 30, 2004and 2003, as specified by SFAS No. 123, the fair value of each option grant hasbeen estimated on the date of grant using the Black-Scholes option pricingmodel and the weighted average assumptions used in these calculations aresummarized as follows:

 
| ** **                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                             |       |                                       |       |                                      |       |   |   |   |   |
| Risk-free interest rate          |       | 3.00                                       | %          | N/A                                       |       | 3.00 | % | N/A |   |
| Expected life of options granted |       | 5 years                                    |       | N/A                                       |       | 5 years |   | N/A |   |
| Expected volatility              |       | 52.19                                      | %          | N/A                                       |       | 52.19 | % | N/A |   |
| Expected dividend yield          |       | 0.00                                       | %          | N/A                                       |       | 0.00 | % | N/A |   |

 

**Note 5.  NetIncome (Loss) Per Share**

 

The Company’s basic net income(loss) per share amounts have been computed by dividing net income (loss) bythe weighted average number of outstanding common shares. The Company’s dilutednet income (loss) per share is computed by dividing net income (loss) by theweighted average number of outstanding common shares and common shareequivalents relating to stock options and warrants, when dilutive. For thethree months ended September 30, 2004, 108,566 shares of common stockequivalents were excluded from the computation of diluted net income (loss) pershare as their effect was anti-dilutive due to our reported net loss for theperiod.  For the nine months endedSeptember 30, 2004, 110,746 shares of common stock equivalents were included inthe computation of diluted net income (loss) per share.  For the three months ended June 30, 2003,66,334 shares of common stock equivalents were included in the computation ofdiluted net income (loss) per share.  Forthe nine months ended September 30, 2003, the shares were anti-dilutive.

 

7

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Options to purchase 9,000 shares ofcommon stock with a weighted average exercise price of $4.49 were outstandingfor the three months ending September 30, 2004, but were excluded from thecomputation of common share equivalents because their exercise prices weregreater than the average market price of the common shares for the period.

 

#### **Note6.  Investments**

 

INV’sinvestments consist of equity securities, primarily common stocks, governmentdebt securities and money market funds. The estimated fair value of publiclytraded equity securities (other than those accounted for based upon the equitymethod of accounting) is based on quoted market prices, and therefore subjectto the inherent risk of market fluctuations. Shares of common stock for which there is no readily determinable value(i.e., no quoted market price) are accounted for on a historical cost method(unless accounted for based upon the equity method of accounting).  Managementdetermines the appropriate classification of securities at the date individualinvestments are acquired, and evaluates the appropriateness of such classificationat each balance sheet date.

 

Sincethe Company generally does not buy investments in anticipation of short-termfluctuations in market prices, investments in equity securities are classifiedas available-for-sale (unless accounted for on the equity method ofaccounting).  Available-for-salesecurities with readily determinable values 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.

 

Realizedgains and losses on securities, including losses from declines in value ofspecific securities determined by management to be other-than-temporary (unlessaccounted for on the equity method of accounting), are included in income inthe period realized.

 

AtSeptember 30, 2004, the Company owned 671,215 shares of August Technology.  The fair value of its holdings based on thequoted market price at September 30, 2004 was approximately $4,611,247.  Shares of August Technology common stock areeligible for trading on the Nasdaq National Market.  The Company’s investment in August Technologyare classified as available-for-sale securities.

 

AtSeptember 30, 2004, the Company owned 2,207,036 shares of PPTV, which is 18.2%of PPTV’s outstanding common stock.  Thefair value of its holdings based on the quoted market price at September 30,2004 was approximately $1,677,347. Shares of PPTV common stock are eligible for trading on the NasdaqSmallCap Market.  The Company exercisedwarrants to purchase 549,084 additional shares of PPTV common stock at a pershare price of $0.70 in September 2003. The Company holds no more warrants to purchase additional PPTV commonstock.  In connection with a 2002investment in PPTV, the Company determined, solely for financial accountingpurposes, that it could likely exercise significant influence over theoperations of PPTV.  As a result, theCompany’s ownership interest is reported using the equity method ofaccounting.  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.

 

InApril 2004, ESI Investment purchased 20% of a la mode, LLC’s outstandingmembership interests for $160,000. *** ***TheCompany has adopted the equity method of accounting for this investment.

 

Underthe equity method of accounting, the Company’s proportionate share of PPTV anda la mode income or loss is included in the Company’s net income (loss) with acorresponding increase or decrease in the carrying value of its investment.

 

**Note 7. Comprehensive Income**

 

Comprehensive income includes the Company’snet income (loss) plus other comprehensive income items that are excluded fromnet income (loss).  The Company’s other incomeconsists of unrealized gains (losses), net of income taxes and reclassificationadjustments for gains and losses included in net income (loss).

 
| ** **                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Net Income (Loss)**                                         |       | $                                          | (35,215    | )                                         | $          | 148,832 |   | $ | 111,219 |   | $ | (460,315 | ) |
| ** **                                                    | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Other Comprehensive Gain (Loss):**                          | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Change in unrealized value investments, net                   |       | (2,388,542                                 | )          | 4,025,841                                 |       | (5,355,830 | ) | 5,246,081 |   |
|                                                          |       |                                       |       |                                      |       |   |   |   |   |
| **Less:**                                                     |       |                                       |       |                                      |       |   |   |   |   |
| Reclassification adjustment for gains  included in net income |       | 0                                          |       | (516,639                                  | )          | (297,704 | ) | (546,168 | ) |
|                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Total comprehensive income (loss)                             |       | $                                          | (2,423,757 | )                                         | $          | 3,658,034 |   | $ | (5,642,315 | ) | $ | 4,239,598 |   |

 

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**Note 8. Segment Information**

 

The Company has three reportable operatingsegments based on the nature of its product lines:  production monitoring, character recognition,and investments.  The production monitoringdivision (or Controls Division) manufactures and markets a complete line ofspeed monitoring and motor control systems for industrial machinery.  The character recognition division (or ADS)designs and markets a desktop software-based system that reads hand-printedcharacters, checkmarks, and bar code information from scanned or faxedforms.  Sales of this system includesoftware and can include hardware.  Theinvestments division (or INV) holds investments in freely tradeable andrestricted securities.

 

In evaluating segment performance, managementfocuses on sales and income before taxes. The Company has no inter-segment sales.

 

The following is financial informationrelating to the continuing operating segments:

 
| ** **                                               | ** ** | **Three Months Ended  September 30,** | ** **    | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------------|---------------|-------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                   | ** **    | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **External sales**                                       |       |                                       |          |                                      |       |   |   |   |   |
| Production monitoring                                    |       | $                                          | 1,030,770     |                                      | $          | 1,038,542 |   | $ | 3,090,484 |   | $ | 2,760,872 |   |
| Character recognition                                    |       | 211,872                                    |          | 108,668                                   |       | 573,723 |   | 397,124 |   |
| Investments                                              |       | 0                                          |          | 0                                         |       | 0 |   | 0 |   |
| **Total**                                                | ** ** | **$**                                      | **1,242,642** | ** **                                | **$**      | **1,147,210** | ** ** | **$** | **3,664,207** | ** ** | **$** | **3,157,996** | ** ** |
|                                                     |       |                                       |          |                                      |       |   |   |   |   |
| **Net income before taxes and discontinued  operations** |       |                                       |          |                                      |       |   |   |   |   |
| Production monitoring                                    |       | $                                          | 96,649        |                                      | $          | 216,009 |   | $ | 373,045 |   | $ | 109,517 |   |
| Character recognition                                    |       | 8,939                                      |          | (35,214                                   | )          | (33,724 | ) | (78,046 | ) |
| Investments                                              |       | (136,346                                   | )             | 228,222                                   |       | (40,680 | ) | (384,130 | ) |
| **Total**                                                | ** ** | **$**                                      | **(30,758**   | **)**                                     | **$**      | **409,019** | ** ** | **$** | **298,641** | ** ** | **$** | **(352,656** | **)** |

 

Certain expenses related to the conduct ofour investment activities are included in general and administrative expensesin the accompanying consolidated statements of operations, but have beenallocated to net income (loss) from our Investments segment in the above table.

 

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

 

**RESULTS OF OPERATIONS**

 

***Net Sales***

 

Net sales for the three month period endedSeptember 30, 2004 increased $95,432 or 8.3% when compared to net sales for thesame period in 2003.  For the nine monthperiod ended September 30, 2004, net sales increased $506,211 or 16.0% whencompared to the same period in 2003.

 

The increase from the three months endedSeptember 30, 2004 from the same period in 2003, includes a decrease in netsales from the Controls Division of $7,772 or 0.07%.  For the nine-months ended September 30, 2004compared to the same period in 2003, the Controls Division contributed anincrease in net sales of $329,612 or 11.9%. The Controls Division has experienced an increase in sales for the firstand second quarter of 2004 due in part to the recovery in the US economy andincreased capital spending by our installed customer base.   The bulk of our sales volume continues to bederived from the Speed Monitoring product lines to the grain and feed markets,as well as other key industrial markets.

 

ADS had an increase in net sales of $103,204or 95.0% from the three months ended September 30, 2004 to the same period in2003.  For the nine months endedSeptember 30, 2004 compared to the same period in 2003, ADS contributed anincrease in net sales of $176,599 or 44.5%. The ExpertScan software product has become the leading product for thedivision and is well-received by customers for its performance and ease of use.

 

***Cost of Goods Sold***

 

The Company’s cost of goods sold increased$23,154 or 5.4% for the three months ended September 30, 2004 from the sameperiod in 2003.  For the nine monthsended September 30, 2004, the cost of goods sold increased by $152,847 or12.6%.  These increases are a directresult of increased sales for both divisions.

 

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***Gross Profit***

 

Gross margins for the three month periodended September 30, 2004 were 63.6% versus 62.6% for the same period in2003.  For the nine months endedSeptember 30, 2004 gross margins were 62.7% versus 61.5% for the same period in2003.  The increases in margins are dueprimarily to the Company’s continuing efforts to effectively manage and reduceproduction costs in both divisions.

 

***Operating Expenses***

 

Total operating expenses increased $170,522or 27.0% for the three months ended September 30, 2004 when compared to thesame period of the prior year.  Of thisincrease, the Controls Division contributed $110,200 or 24.0%, ADS’ contributed$37,788 or 22.0%, and INV contributed an increase of $22,534 or 100%.

 

For the nine months ended September 30, 2004operating expenses increased $113,024 or 5.1% from the same period for2003.  Of this increase, the ControlsDivision contributed a decrease of $47,752 or 2.9% which was offset by anincrease in operating expenses for both ADS and INV.  ADS’ increase in operating expenses was$89,520 or 16.7%, and INV contributed an increase of $71,256, or 100%.

 

Selling and marketing costs increased $72,311or 27.0% for the three months ended September 30, 2004 when compared to thesame period in 2003.  For the nine monthsended September 30, 2004, selling and marketing costs increased $88,337 or10.0%.  Of the increase for the threemonths ended September 30, 2004, the Controls Division contributed $75,817 or39.2%, which was offset by a decrease from ADS of $3,506 or 4.7%.  Of the increase for the nine months endedSeptember 30, 2004, the Controls Division contributed $80,788 or 12.7%, ADScontributed an increase of $7,549 or 3.1%. Marketing communications development for product launches, new literature,and ad development are the predominant expenses in the increase for both ADSand the Controls Division.

 

General and administrative costs increased$49,407 or 24.1% for the three months ended September 30, 2004 compared to thesame period in 2003. For the nine months ended September 30, 2004, general andadministrative costs increased $32,976 or 4.4%. Of this increase for the three months ended September 30, 2004, theControls Division contributed an increase of $18,591 or 9.7%, ADS contributedan increase of $8,283 or 62.0%, and INV contributed an increase of $22,533 or100%.  Of the increase for the ninemonths ended September 30, 2004, the Controls Division contributed a decreaseof $50,384 or 7.4%, offset by increases in both ADS and INV.  ADS increase for the nine months endedSeptember 30, 2004 was $12,106 or 20.2%, and INV contributed an increase of$71,257 or 100%.  The overall decrease ingeneral and administrative costs from the Controls Division was due to a fewkey expenses, mainly general liability insurance, and some personnel costs.  This decrease was offset by increasing costsof being a publicly held company.

 

Research and development costs increased$48,804 or 31.0% for the three months ended September 30, 2004 compared to thesame period in 2003.  For the nine monthsended September 30, 2004 compared to the same period in 2003, research anddevelopment costs decreased $8,289 or 1.4%. Of the increase for the three months ended September 30, 2004, theControls Division contributed $15,793 or 21.5%, and ADS contributed an increaseof $33,011 or 39.4%.  For the nine monthsended September 30, 2004, compared to the same period in 2003, the ControlsDivision contributed a decrease of $78,156 or 22.9% offset by in increase fromADS of $69,869 or 29.9%.  The decrease inthe Controls Division was due to reduced outside development costs in bothcontract engineering and prototype development. The increase in ADS was due to increased software development costs.

 

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

 

Non-operating income decreased by $341,533 forthe three-month period ended September 30, 2004 compared to the same period for2003.  For the nine months endedSeptember 30, 2004, compared to the same period in 2003, non-operating incomeincreased $410,957.

 

Gain on the sale of investment securities decreased$517,596 for the three month period ended September 30, 2004, compared to thesame period in 2003.  For the nine monthperiod ended September 30, 2004, gain on sale of investment securitiesdecreased $120,829 compared to the same period in 2003.

 

Interest income increased $7,298 or 62.7%when comparing the three months ended September 30, 2004 to the same period in2003.  This increase was due to thehigher interest rates on treasury bills. For the nine months ended September 30, 2004, the decrease was $450 or1.0% when compared to the same period in 2003.

 

Equity in losses of equity method investeedecreased $167,331 or 80.7% for the three months ended September 30, 2004 whencompared to the same period in 2003.  Forthe nine months ended September 30, 2004, the loss decreased $529,092 or 76.2%.

 

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

 

Income before income taxes decreased$439,777, to a loss of $30,758 for the three-month period ended September 30,2004 compared to the same period in 2003. For the nine month period ended September 30, 2004, income before incometaxes was $298,641, an increase of $651,297 when compared to the same periodfor 2003.

 

The Controls Division had income beforeincome taxes of $96,649 for the three months ended September 30, 2004 comparedto $216,009 for the same period in 2003, a decrease of $119,360.  This decrease was primarily due to increasedoperating expenses.  For the nine monthsended September 30, 2004, the Controls Division had income before taxes of$373,045 compared to $109,417, an increase of $263,628 for the same period in2003.  In addition to the increased salesfor the Controls Division, for the nine months ended September 30, 2004, ouroverall efforts to reduce operating expenses contributed to the increase in netincome before income taxes.

 

ADS had net income before income taxes of$8,939 for the three months ended September 30, 2004 compared to the net lossbefore income taxes of $35,214 for same period in 2003.  For the nine months ended September 30, 2004,ADS had a loss of $33,724 compared to a loss of $78,046 for the same period in2003, or an increase of $44,322.  Thisincrease is due to increased sales in this division.

 

Investment income from investment securitiesdecreased $364,568 to a loss before income taxes of $136,346 for the threemonths ended September 30, 2004 compared to the same period in 2003.  For the nine months ended September 30, 2004,investment income increased $343,450 to net loss before income tax of$40,680.  These changes are explainedunder the section titled non-operating income (loss) in the management’sdiscussion and analysis section of this 10-QSB filing.

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

Cash and cashequivalents were $6,620,384 at September 30, 2004 and $6,192,746 at September30, 2003.  Cash used in operatingactivities of $231,519 for the nine months ended September 30, 2004 wasprimarily a result of our net operating loss adjusted for non-cash charges.

 

Cash providedby investing activities was $264,841 for the nine month period ended September30, 2004 and $180,839 for the same period in 2003.  Proceeds from the saleof investments for the nine months ended September 30, 2004 increased to$771,895 from $587,864 when compared to the same period in 2003.

 

Cash used infinancing activities was $275,985 and $249,436 for the nine months endedSeptember 30, 2004 and September 30, 2003, respectively.  During the nine months ended September 30,2004 and 2003, the Company paid aggregate dividends of $384,554 and $284,677,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.

 

INV’s primary investments are 671,215 sharesof August Technology Corporation and 2,207,036 shares of PPT Vision, Inc. bothof which are traded on the Nasdaq Stock Exchange.  The investment in PPTV is accounted for underthe equity method of accounting.  Thesestocks are subject to fluctuations in price and could have a negative effect onthe liquidity of the Company.

 

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**FORWARD-LOOKING STATEMENTS**

 

This Form 10-QSB contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933 andSection 21E of the Securities Exchange Act of 1934, including statementsregarding the Company’s expectations, beliefs, intentions or strategiesregarding the future.  Forward-lookingstatements include, but are not limited to, statements regarding the extent andtiming of future revenues and expenses and customer demand, the market value ofour investment securities, future financial condition and availability ofcapital resources, changes in worldwide general economic conditions, cyclicalcapital spending by customers, the Company’s ability to keep pace withtechnological developments and evolving industry standards, worldwidecompetition, and the Company’s ability to protect its existing intellectualproperty from challenges from third parties and other factors.  Any statement that is not based solely uponhistorical facts, including strategies for the future and the outcome of eventsthat have not yet occurred, is considered a forward-looking statement.

 

All forward-looking statements in thisdocument are based on information available to the Company as of the datehereof, 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 31,2003, filed with the Securities and Exchange Commission.

 

**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 “ExchangeAct”)).  Based on this evaluation, theprincipal executive officer and principal financial officer concluded that theCompany’s disclosure controls and procedures are effective to ensure thatinformation required to be disclosed by the Company in reports that it files orsubmits under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in Securities and Exchange Commission rulesand 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**

 

(a)           Exhibits - See Exhibit Indexfollowing signature page.

 

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**SIGNATURES**

 

In accordance with the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
| **Electro-Sensors, Inc.** |                                                      |
|---------------------------|-----------------------------------------------------------|
|                      |                                                      |
| November 15, 2004         | /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, 2004**

 
| **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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