**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

#### **Washington, D.C. 20549**

#### ** **

##### **FORM10-Q**

##### ** **

**(MarkOne)**

**ý****Quarterly Report Pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934**

 

**For the Quarter Ended March 31,2006**

 

**or**

 

**o****Transition Report Pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934**

 

**For the transition period from          to          **

 

**CommissionFile Number 000-09273**

** **

**MOCON, INC.**

(Exact name ofregistrant as specified in its charter)

 

| **Minnesota**                   | ** ** | **41-0903312**      |
|---------------------------------|------------|---------------------|
| (State or other jurisdiction of |       | (I.R.S. employer    |
| incorporation or organization)  |       | identification no.) |

 

**7500 Boone Avenue North, Minneapolis, Minnesota55428**

(Address of principal executiveoffices)           (Zipcode)

 

**(763) 493-6370**

(Registrant’s telephone number, including area code)

 

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

 

YES  ý    NO  o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeraccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

| Large accelerated  filer:  o |   | Accelerated filer:  o |   | Non-accelerated filer:  ý |
|----------------------------------------|--------|---------------------------------|--------|------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

YES  o    NO  ý

 

5,417,698 Common Shareswere outstanding as of April 30, 2006.

 

 

----

 

MOCON, INC. AND SUBSIDIARIES

 

INDEX TO FORM 10-Q

For the Quarter Ended March 31, 2006

 
| ** **                                                                                                   | ** ** | **Page  Number** |
|--------------------------------------------------------------------------------------------------------------|------------|------------------|
| PART I. FINANCIAL INFORMATION                                                                                |       |             |
|                                                                                                         |       |             |
| Item 1.  Financial Statements                                                                                |       |             |
| Condensed  Consolidated Balance Sheets  March 31, 2006 (Unaudited) and December 31, 2005                |       | 1                |
|                                                                                                         |       |             |
| Condensed  Consolidated Statements of Income (Unaudited)  Three months ended March 31, 2006 and 2005         |       | 2                |
|                                                                                                         |       |             |
| Condensed  Consolidated Statements of Cash Flows (Unaudited)  Three months ended March 31, 2006 and 2005     |       | 3                |
|                                                                                                         |       |             |
| Notes  to Condensed Consolidated Financial Statements (Unaudited)                                            |       | 4-10             |
|                                                                                                         |       |             |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations         |       | 11-19            |
|                                                                                                         |       |             |
| Item  3. Quantitative and Qualitative Disclosures About Market Risk                                          |       | 19               |
|                                                                                                         |       |             |
| Item  4. Controls and Procedures                                                                             |       | 19-20            |
|                                                                                                         |       |             |
| PART II. OTHER INFORMATION                                                                                   |       |             |
|                                                                                                         |       |             |
| Item 1A. Risk  Factors                                                                                       |       | 21               |
|                                                                                                         |       |             |
| Item  2. Unregistered Sales of Equity Securities, Use of Proceeds and Issuer  Purchases of Equity Securities |       | 21               |
|                                                                                                         |       |             |
| Item 6. Exhibits                                                                                             |       | 22               |
|                                                                                                         |       |             |
| Signatures                                                                                                   |       | 23               |

 

*Inthis report, references to “MOCON,” “the Company,” “we,” “our,” or “us,” unlessthe context otherwise requires, refer to MOCON, Inc. and its subsidiaries.*

 

*All trademarks or trade names referred to in this report arethe property of their respective owners.*

 

----

 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

MOCON, INC. AND SUBSIDIARIES

 

CONDENSEDCONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                                                                        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| ** **                                                                                                                                        | ** ** | **(Unaudited)**     | ** ** | **(Audited)**          | ** ** |
| ASSETS                                                                                                                                            |       |                |       |                   |       |
| Current assets:                                                                                                                                   |       |                |       |                   |       |
| Cash and cash  equivalents                                                                                                                        |       | $                   | 4,303,154  |                   | $          | 2,889,323 |   |
| Marketable  securities, current                                                                                                                   |       | 5,705,808           |       | 5,961,793              |       |
| Trade accounts  receivable, less allowance for doubtful accounts of $192,182 in 2006 and  $192,446 in 2005                                        |       | 3,930,357           |       | 4,237,240              |       |
| Other  receivables                                                                                                                                |       | 130,144             |       | 124,403                |       |
| Inventories                                                                                                                                       |       | 3,853,705           |       | 4,057,514              |       |
| Prepaid expenses                                                                                                                                  |       | 269,302             |       | 313,042                |       |
| Deferred income  taxes                                                                                                                            |       | 582,948             |       | 582,948                |       |
| Assets held for  sale                                                                                                                             |       | —              |       | 90,809                 |       |
| Total current  assets                                                                                                                             |       | 18,775,418          |       | 18,257,072             |       |
|                                                                                                                                              |       |                |       |                   |       |
| Marketable  securities, noncurrent                                                                                                                |       | —              |       | 170,253                |       |
|                                                                                                                                              |       |                |       |                   |       |
| Property, plant  and equipment, net of accumulated depreciation of $4,544,149 in 2006 and  $4,460,559 in 2005                                     |       | 1,559,078           |       | 1,551,883              |       |
|                                                                                                                                              |       |                |       |                   |       |
| Other assets:                                                                                                                                     |       |                |       |                   |       |
| Software  development costs, net of accumulated amortization of $960,837 in 2006 and  $943,743 in 2005                                            |       | 45,584              |       | 62,678                 |       |
| Goodwill                                                                                                                                          |       | 2,641,599           |       | 2,641,599              |       |
| Technology  rights and other intangibles, net                                                                                                     |       | 759,519             |       | 808,266                |       |
| Other                                                                                                                                             |       | 166,855             |       | 165,137                |       |
| Total other  assets                                                                                                                               |       | 3,613,557           |       | 3,677,680              |       |
|                                                                                                                                              |       |                |       |                   |       |
| TOTAL ASSETS                                                                                                                                      |       | $                   | 23,948,053 |                   | $          | 23,656,888 |   |
|                                                                                                                                              |       |                |       |                   |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                         |       |                |       |                   |       |
| Current  liabilities:                                                                                                                             |       |                |       |                   |       |
| Accounts payable                                                                                                                                  |       | $                   | 1,438,831  |                   | $          | 1,847,133 |   |
| Accrued  compensation and vacation                                                                                                                |       | 796,323             |       | 995,528                |       |
| Other accrued  expenses                                                                                                                           |       | 511,336             |       | 440,510                |       |
| Accrued product  warranties                                                                                                                       |       | 273,695             |       | 327,015                |       |
| Accrued income  taxes                                                                                                                             |       | 597,715             |       | 402,285                |       |
| Dividends  payable                                                                                                                                |       | 405,532             |       | 405,268                |       |
| Total current  liabilities                                                                                                                        |       | 4,023,432           |       | 4,417,739              |       |
|                                                                                                                                              |       |                |       |                   |       |
| Obligations to  former employees                                                                                                                  |       | 95,571              |       | 93,735                 |       |
| Minimum earnout  payable                                                                                                                          |       | —              |       | 107,514                |       |
| Deferred income  taxes                                                                                                                            |       | 222,592             |       | 239,282                |       |
| Total noncurrent  liabilities                                                                                                                     |       | 318,163             |       | 440,531                |       |
|                                                                                                                                              |       |                |       |                   |       |
| Total  liabilities                                                                                                                                |       | 4,341,595           |       | 4,858,270              |       |
|                                                                                                                                              |       |                |       |                   |       |
| Stockholders’  equity:                                                                                                                       |       |                |       |                   |       |
| Capital stock –  undesignated – authorized 3,000,000 shares                                                                             |       | —              |       | —                 |       |
| Common stock –  $0.10 par value. Authorized 22,000,000 shares; issued and outstanding  5,411,636 shares in 2006 and 5,403,573 shares in 2005 |       | 541,164             |       | 540,357                |       |
| Capital in  excess of par value                                                                                                                   |       | 639,751             |       | 592,796                |       |
| Retained earnings                                                                                                                                 |       | 18,488,081          |       | 17,759,120             |       |
| Accumulated  other comprehensive loss                                                                                                             |       | (62,538             | )          | (93,655                | )          |
| Total  stockholders’ equity                                                                                                                  |       | 19,606,458          |       | 18,798,618             |       |
|                                                                                                                                              |       |                |       |                   |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                  |       | $                   | 23,948,053 |                   | $          | 23,656,888 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

1

----

 

MOCON, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Unaudited)

 
| ** **                                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                             | ** ** | **2006**                          | ** ** | **2005** | ** ** |
|                                                   |       |                              |       |   |   |
| Sales:                                                 |       |                              |       |   |   |
| Products                                               |       | $                                 | 6,081,098  |   | $ | 6,112,087 |   |
| Consulting  services                                   |       | 437,814                           |       | 332,308 |   |
| Total sales                                            |       | 6,518,912                         |       | 6,444,395 |   |
|                                                   |       |                              |       |   |   |
| Cost of sales:                                         |       |                              |       |   |   |
| Products                                               |       | 2,475,246                         |       | 2,641,580 |   |
| Consulting  services                                   |       | 225,545                           |       | 241,620 |   |
| Total cost of  sales                                   |       | 2,700,791                         |       | 2,883,200 |   |
|                                                   |       |                              |       |   |   |
| Gross profit                                           |       | 3,818,121                         |       | 3,561,195 |   |
|                                                   |       |                              |       |   |   |
| Selling, general and administrative expenses           |       | 1,919,140                         |       | 2,082,588 |   |
|                                                   |       |                              |       |   |   |
| Research and development expenses                      |       | 453,519                           |       | 420,628 |   |
|                                                   |       |                              |       |   |   |
| Operating income                                       |       | 1,445,462                         |       | 1,057,979 |   |
|                                                   |       |                              |       |   |   |
| Other income                                           |       | 155,297                           |       | 91,205 |   |
|                                                   |       |                              |       |   |   |
| Income from  continuing operations before income taxes |       | 1,600,759                         |       | 1,149,184 |   |
|                                                   |       |                              |       |   |   |
| Income taxes                                           |       | 488,225                           |       | 223,560 |   |
|                                                   |       |                              |       |   |   |
| Income from  continuing operations                     |       | 1,112,534                         |       | 925,624 |   |
|                                                   |       |                              |       |   |   |
| Gain (loss) from discontinued operations, net of tax   |       | 22,225                            |       | (131,453 | ) |
|                                                   |       |                              |       |   |   |
| Net income                                             |       | $                                 | 1,134,759  |   | $ | 794,171 |   |
|                                                   |       |                              |       |   |   |
| Basic net income per common share:                     |       |                              |       |   |   |
| Income from  continuing operations                     |       | $                                 | 0.21       |   | $ | 0.17 |   |
| Gain (loss) from  discontinued operations              |       | —                            |       | (0.02 | ) |
| Basic net income  per common share:                    |       | $                                 | 0.21       |   | $ | 0.15 |   |
|                                                   |       |                              |       |   |   |
| Basic weighted  average common shares outstanding      |       | 5,404,917                         |       | 5,339,177 |   |
|                                                   |       |                              |       |   |   |
| Diluted net income per common share:                   |       |                              |       |   |   |
| Income from  continuing operations                     |       | $                                 | 0.21       |   | $ | 0.16 |   |
| Gain (loss) from  discontinued operations              |       | —                            |       | (0.02 | ) |
| Diluted net  income per common share:                  |       | $                                 | 0.21       |   | $ | 0.14 |   |
|                                                   |       |                              |       |   |   |
| Diluted weighted  average common shares outstanding    |       | 5,404,917                         |       | 5,519,994 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

2

----

 

MOCON, INC. AND SUBSIDIARIES

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 
| ** **                                                                                                   | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                   | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Cash flows from operating activities:                                                                        |       |                              |       |   |   |
| Net income                                                                                                   |       | $                                 | 1,134,759  |   | $ | 794,171 |   |
| (Gain) loss from  discontinued operations, net of tax                                                        |       | (22,225                           | )          | 131,453 |   |
| Income from  continuing operations                                                                           |       | 1,112,534                         |       | 925,624 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities of  continuing operations: |       |                              |       |   |   |
| Stock-based  compensation expense                                                                            |       | 45,369                            |       | — |   |
| (Gain) loss on  disposition of long-term assets                                                              |       | (92,345                           | )          | 1,611 |   |
| Depreciation and  amortization                                                                               |       | 189,197                           |       | 288,516 |   |
| Deferred income  taxes                                                                                       |       | (16,690                           | )          | (16,690 | ) |
| Changes in  operating assets and liabilities, net of effect of divestitures in 2006 and  2005:               |       |                              |       |   |   |
| Trade accounts  receivable                                                                                   |       | 220,797                           |       | 257,547 |   |
| Other  receivables                                                                                           |       | (5,358                            | )          | (30,159 | ) |
| Inventories                                                                                                  |       | 56,913                            |       | (400,016 | ) |
| Prepaid expenses                                                                                             |       | 41,956                            |       | 60,071 |   |
| Accounts payable                                                                                             |       | (444,524                          | )          | (101,917 | ) |
| Accrued  compensation and vacation                                                                           |       | (198,194                          | )          | (170,856 | ) |
| Other accrued  expenses                                                                                      |       | (88,811                           | )          | (284,395 | ) |
| Accrued product  warranties                                                                                  |       | (21,000                           | )          | — |   |
| Accrued income  taxes                                                                                        |       | 195,422                           |       | (70,734 | ) |
| Net cash provided  by operating activities of continuing operations                                          |       | 995,266                           |       | 458,602 |   |
|                                                                                                         |       |                              |       |   |   |
| Cash flows from investing activities:                                                                        |       |                              |       |   |   |
| Proceeds from  sale of subsidiary                                                                            |       | 478,721                           |       | — |   |
| Purchases of  marketable securities                                                                          |       | (1,586,664                        | )          | (2,431,781 | ) |
| Proceeds from sales  or maturities of marketable securities                                                  |       | 2,010,560                         |       | 1,494,131 |   |
| Purchases of  property and equipment                                                                         |       | (121,017                          | )          | (58,133 | ) |
| Proceeds from  sale of property and equipment                                                                |       | 18,858                            |       | — |   |
| Purchases of  patents and trademarks                                                                         |       | (22,966                           | )          | (34,211 | ) |
| Other                                                                                                        |       | (1,718                            | )          | (16,182 | ) |
| Net cash  provided by (used in) investing activities of continuing operations                                |       | 775,774                           |       | (1,046,176 | ) |
|                                                                                                         |       |                              |       |   |   |
| Cash flows from financing activities:                                                                        |       |                              |       |   |   |
| Proceeds from  the exercise of stock options                                                                 |       | 260,518                           |       | 28,134 |   |
| Purchases and retirement  of common stock                                                                    |       | (258,125                          | )          | — |   |
| Dividends paid                                                                                               |       | (405,533                          | )          | (373,694 | ) |
| Net cash used in  financing activities of continuing operations                                              |       | (403,140                          | )          | (345,560 | ) |
|                                                                                                         |       |                              |       |   |   |
| Net cash provided by discontinued operations                                                                 |       | 22,225                            |       | 36,121 |   |
|                                                                                                         |       |                              |       |   |   |
| Effect of exchange rate changes on cash                                                                      |       | 23,706                            |       | (42,617 | ) |
|                                                                                                         |       |                              |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                                         |       | 1,413,831                         |       | (939,630 | ) |
|                                                                                                         |       |                              |       |   |   |
| Cash and cash equivalents:                                                                                   |       |                              |       |   |   |
| Beginning of  period                                                                                         |       | 2,889,323                         |       | 2,648,879 |   |
| End of period                                                                                                |       | $                                 | 4,303,154  |   | $ | 1,709,249 |   |
|                                                                                                         |       |                              |       |   |   |
| Supplemental disclosures of cash flow information:                                                           |       |                              |       |   |   |
| Cash paid during  the period for income taxes                                                                |       | $                                 | 309,322    |   | $ | 279,112 |   |
|                                                                                                         |       |                              |       |   |   |
| Supplemental schedule of noncash investing and  financing activities:                                        |       |                              |       |   |   |
| Unrealized  holding loss on available-for-sale securities                                                    |       | $                                 | (2,342     | ) | $ | (6,625 | ) |
| Dividends  accrued                                                                                           |       | 405,532                           |       | 373,694 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

3

----

 

MOCON, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

Note 1 – CondensedConsolidated Financial Statements

 

The condensedconsolidated balance sheet as of March 31, 2006, the condensed consolidatedstatements of income for the three-month periods ended March 31, 2006 and 2005,and the condensed consolidated statements of cash flows for the three-monthperiods ended March 31, 2006 and 2005 have been prepared by us, without audit. However,all adjustments (consisting solely of normal recurring adjustments) which are,in the opinion of management, necessary to present fairly the financialposition, results of operations and cash flows at March 31, 2006, and for allperiods presented, have been made. The results of operations for the three-monthperiods ended March 31, 2006 are not necessarily indicative of operatingresults for the full year.

 

Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted. It is suggested that these condensedconsolidated financial statements be read in conjunction with the consolidatedfinancial statements and notes included in our Annual Report on Form 10-K forthe fiscal year ended December 31, 2005, previously filed with theSecurities and Exchange Commission.

 

We operate in a singleindustry segment:  the development,manufacturing, and marketing of measurement, analytical, monitoring andconsulting products used to detect, measure, and analyze gases and chemicalcompounds for customers in the barrier packaging, food, pharmaceutical, andother industries throughout the world.

 

*Principlesof Consolidation*

 

The condensed consolidatedfinancial statements include the accounts of MOCON, Inc. and our subsidiariesafter elimination of inter-company transactions and accounts.

 

*ForeignCurrency Translation*

 

The financial statementsfor operations outside the United States are maintained in their local currency.All assets and liabilities of our foreign subsidiary are translated to UnitedStates dollars at period-end exchange rates, while revenue and expense accountsare translated at the average exchange rates during the period transactionsoccurred. Translation adjustments arising from the use of differing exchangerates are included in accumulated other comprehensive income or loss instockholders’ equity. Gains and losses on foreign currency transactions areincluded in other income or loss.

 

*Use ofEstimates*

 

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe consolidated financial statements and the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from thoseestimates.

 

4

----

 

*Share-BasedCompensation Expense*

 

Effective January 1,2006, we adopted Statement of Financial Accounting Standards No. 123 (revised2004), “Share-Based Payment” (SFAS 123(R)) which requires the measurement andrecognition of compensation expense for all share-based payment awards made toemployees and directors. SFAS 123(R) supersedes our previous accounting underAccounting Principles Board Opinion No. 25, Accounting for Stock Issued toEmployees (APB 25).

 

We adopted the modifiedprospective transition method of applying SFAS 123(R) which requires theapplication of the standard as of January 1, 2006. As a result, as of March 31,2006, our results of operations reflected compensation expense for new stockoptions granted and vested during the first three months of fiscal 2006 and theunvested portion of previous stock option grants which will vest during fiscal2006. Our consolidated financial statements for prior periods have not beenrestated to reflect, and do not include, the impact of SFAS 123(R).

 

Amounts recognized inthe consolidated financial statements related to stock-based compensation areas follows:

 

| ** **                                                  | ** ** | **Three Months  Ended  March 31,  2006** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------|------------|
| Total cost of  stock-based compensation                     |       | $                                        | 45,369     |   |
| Amount  capitalized in inventory and property and equipment |       | —                                   |       |
| Amounts charged  against income, before income taxes        |       | 45,369                                   |       |
| Amount of income  tax benefit recognized in earnings        |       | —                                   |       |
| Amount charged  against net income                          |       | $                                        | 45,369     |   |
|                                                        |       |                                     |       |
| Impact on net  income per common share:                     |       |                                     |       |
| Basic                                                       |       | $                                        | 0.01       |   |
| Diluted                                                     |       | $                                        | 0.01       |   |

 

Stock-based compensationexpense was reflected in the statement of operations for the first quarter offiscal 2006 as follows:

 

| ** **                                   | ** ** | **Three Months  Ended  March 31,  2006** | ** ** |
|----------------------------------------------|------------|------------------------------------------|------------|
| Cost of sales                                |       | $                                        | 13,380     |   |
| Selling, general and administrative expenses |       | 26,612                                   |       |
| Research and development expenses            |       | 5,377                                    |       |
|                                         |       | $                                        | 45,369     |   |

 

Prior to the firstquarter of fiscal 2006, we accounted for stock-based employee compensationarrangements in accordance with the provisions and related interpretations ofAPB 25, using the intrinsic-value method. Under the guidelines of APB 25compensation cost for stock-based employee compensation plans is recognizedbased on the difference, if any, between the quoted market price of the stockon the date of grant and the amount an employee must pay to acquire the stock. TheCompany had adopted the disclosure-only provisions for employee stock-basedcompensation, and therefore, had not recorded compensation cost in itsfinancial statements. Had compensation cost for

 

5

----

 

stock-based compensationbeen determined consistent with SFAS 123(R), net income and net income pershare would have been adjusted to the following pro forma amounts:

 

| ** **                                                                                                                                    | ** ** | **Three Months  Ended  March 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| Net income – as reported                                                                                                                 |       | $                                        | 794,171    |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (28,829                                  | )          |
| Net income – pro forma                                                                                                                   |       | $                                        | 765,342    |   |
|                                                                                                                                          |       |                                     |       |
| Net income per common share – as reported:                                                                                               |       |                                     |       |
| Basic                                                                                                                                         |       | $                                        | 0.15       |   |
| Diluted                                                                                                                                       |       | $                                        | 0.14       |   |
| Net income per common share – pro forma:                                                                                                 |       |                                     |       |
| Basic                                                                                                                                         |       | $                                        | 0.14       |   |
| Diluted                                                                                                                                       |       | $                                        | 0.14       |   |

 

The fair value of eachoption grant is estimated on the date of grant using the Black-Scholesoption-pricing model (Black-Scholes). We use historical data to estimate theexpected price volatility, the expected option life and expected forfeiturerate. The risk-free interest rate is based on the U.S. Treasury yield curve ineffect at the time of grant for the estimated life of the option. The dividendyield is calculated based upon the dividend payments made during the prior fourquarters as a percent of the average stock price for that period. The followingassumptions were used to estimate the fair value of options granted during thefirst quarter of fiscal 2006 and 2005 using the Black-Scholes model:

 

| ** **                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------|------------|-----------------------------------|------------|
| ** **                    | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Stock options:                |       |                              |       |   |   |
| Volatility                    |       | 31                                | %          | 32 | % |
| Risk-free  interest rate      |       | 4.0                               | %          | 3.4 | % |
| Expected option  life (years) |       | 7.9                               |       | 7.8 |   |
| Dividend yield                |       | 3.0                               | %          | 3.1 | % |

 

A summary of the optionactivity for the first three months of fiscal 2006 is as follows:

 
| ** **                       | ** ** | **Number of  Shares** | ** ** | **Weighted-  average  Exercise  Price per  Share** | ** ** | **Weighted-  average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|----------------------------------|------------|-----------------------|------------|----------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at December 31, 2005 |       | 850,449               |       | $                                                  | 7.70       |                                                 | 6.7        |                            |       |   |
| Options granted                  |       | 3,000                 |       | 8.90                                               |       | 10.0                                                 |       |                            |       |
| Options  forfeited               |       | (13,562               | )          | 9.42                                               |       | —                                               |       |                            |       |
| Options expired                  |       | —                |       | —                                             |       | —                                               |       |                            |       |
| Options  exercised               |       | (37,563               | )          | 6.94                                               |       | —                                               |       |                            |       |
| Outstanding at March 31, 2006    |       | 802,324               |       | $                                                  | 7.72       |                                                 | 6.3        |                            | $          | 1,124,108 |   |
|                             |       |                  |       |                                               |       |                                                 |       |                            |       |
| Exercisable at March 31, 2006    |       | 634,999               |       | $                                                  | 7.48       |                                                 | 5.7        |                            | $          | 1,052,991 |   |

 

6

----

 

The weighted averagegrant date fair value based on the Black-Scholes model for options granted inthe first quarter of fiscal 2006 was $2.10. There were no options granted inthe first quarter of fiscal 2005. The Company issues new shares of common stockupon exercise of stock options.  Thetotal intrinsic value of options exercised was $72,649 and $9,881 during thefirst quarters of fiscal 2006 and 2005, respectively.

 

A summary of the statusof our unvested option shares as of March 31, 2006 is as follows:

 

| ** **                    | ** ** | **Number of  Shares** | ** ** | **Weighted-  average  Grant-Date  Fair Value** | ** ** |
|-------------------------------|------------|-----------------------|------------|------------------------------------------------|------------|
| Unvested at December 31, 2005 |       | 175,887               |       | 2.26                                           |       |
| Options granted               |       | 3,000                 |       | 2.10                                           |       |
| Options  forfeited            |       | (8,562                | )          | 2.27                                           |       |
| Options vested                |       | (3,000                | )          | 2.10                                           |       |
| Unvested at March 31, 2006    |       | 167,325               |       | 2.26                                           |       |

 

As of March 31, 2006,there was $358,722 of total unrecognized compensation cost related to unvestedshare-based compensation granted under our plans. That cost is expected to berecognized over a weighted-average period of 2.4 years. The total fair value ofoptions shares vested was $6,300 and $0 for the first quarters of fiscal 2006and 2005, respectively.

 

*NewAccounting Pronouncements*

 

In September 2005,the FASB issued SFAS No. 154, *AccountingChanges and Error Corrections – a replacement of APB No. 20 and SFAS No. 3*(SFAS 154)*.*SFAS 154 provides guidance on the accounting for andreporting of accounting changes and error corrections. It establishes, unlessimpracticable, retrospective application as the required method for reporting achange in accounting principle in the absence of explicit transitionrequirements specific to the newly adopted accounting principle. SFAS 154 alsoprovides guidance for determining whether retrospective application of a changein accounting principle is impracticable and for reporting a change whenretrospective application is impracticable. The correction of an error inpreviously issued financial statements is not an accounting change. However,the reporting of an error correction involves adjustments to previously issuedfinancial statements similar to those generally applicable to reporting anaccounting change retrospectively. Therefore, the reporting of a correction ofan error by restating previously issued financial statements is also addressedby SFAS 154. SFAS 154 is required to be adopted in fiscal years beginning afterDecember 15, 2005. Accordingly, we have adopted SFAS 154 in our fiscal yearbeginning January 1, 2006. Adoption of SFAS 154 did not have a material effecton our financial position, results of operations or cash flows.

 

InNovember 2004, the FASB issued SFAS No. 151, *InventoryCosts*, an amendment of ARB No. 43, Chapter 4 (SFAS 151) to clarifythat abnormal amounts of idle facility expense, freight, handling costs, andwasted material (spoilage) should be recognized as current period charges, andthat fixed production overheads should be allocated to inventory based onnormal capacity of production facilities. This statement is effective forinventory costs incurred during fiscal years beginning after June 15, 2005.Accordingly, we have adopted SFAS 151 in our fiscal year beginningJanuary 1, 2006. Adoption of SFAS 151 did not have a material effect onour financial position, results of operations or cash flows.

 

7

----

 

Note 2 – Inventories

 

Inventories consistof the following:

 

| ** **        | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------|------------|---------------------|------------|-----------------------------|------------|
| Finished products |       | $                   | 587,185    |                        | $          | 656,587 |   |
| Work-in-process   |       | 1,547,773           |       | 1,511,314                   |       |
| Raw materials     |       | 1,718,747           |       | 1,889,613                   |       |
|              |       | $                   | 3,853,705  |                        | $          | 4,057,514 |   |

 

Note 3 – Net Income PerCommon Share

 

Basic net income percommon share is computed by dividing net income by the weighted average numberof shares of common stock outstanding during the period. Diluted net income percommon share is computed using the treasury stock method to compute the weightedaverage common stock outstanding assuming the conversion of potential dilutivecommon shares.

 

The following tablepresents a reconciliation of the denominators used in the computation of netincome per common share – basic, and net income per common share – diluted, forthe three-month periods ended March 31,2006 and 2005:

 

| ** **                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                              | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Weighted shares  of common stock outstanding – basic               |       | 5,404,917                         |       | 5,339,177 |   |
| Weighted shares  of common stock assumed upon exercise of stock options |       | —                            |       | 180,817 |   |
| Weighted shares  of common stock outstanding – diluted             |       | 5,404,917                         |       | 5,519,994 |   |

 

Note 4 – Goodwill andIntangible Assets

 

As of March 31, 2006 andDecember 31, 2005, unamortized goodwill amounted to $2,641,599. Otheridentifiable intangible assets are as follows:

 
| ** **                 | ** ** | **As of March 31, 2006** | ** ** |
|----------------------------|------------|--------------------------|------------|
| ** **                 | ** ** | **Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** | **Estimated  Useful Lives** | ** ** |
| Patents                    |       | $                        | 637,240    |   | $ | (259,018 | ) | $ | 378,222 |   | 10 to 17 years |   |
| Trademarks and trade names |       | 385,375                  |       | (178,109 | ) | 207,266 |   | 5 to 17 years |   |
| Technology rights          |       | 184,008                  |       | (153,340 | ) | 30,668 |   | 7 to 10 years |   |
| Other intangibles          |       | 715,043                  |       | (571,680 | ) | 143,363 |   | Less than 1 year to 5  years |   |
|                       |       | $                        | 1,921,666  |   | $ | (1,162,147 | ) | $ | 759,519 |   |   |   |

 

8

----

 
| ** **                 | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------|------------|----------------------------------|------------|
| ** **                 | ** ** | **Carrying  Amount**             | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** | **Estimated  Useful Lives** | ** ** |
| Patents                    |       | $                                | 614,594    |   | $ | (249,713 | ) | $ | 364,881 |   | 10 to 17 years |   |
| Trademarks and trade names |       | 385,053                          |       | (160,069 | ) | 224,984 |   | 5 to 17 years |   |
| Technology rights          |       | 184,008                          |       | (146,768 | ) | 37,240 |   | 7 to 10 years |   |
| Other intangibles          |       | 715,043                          |       | (533,882 | ) | 181,161 |   | Less than 1 year to 5  years |   |
|                       |       | $                                | 1,898,698  |   | $ | (1,090,432 | ) | $ | 808,266 |   |   |   |

 

Total amortizationexpense for the three months ended March 31, 2006 was $71,714. Estimatedamortization expense for the remainder of 2006 and each of the four succeedingfiscal years based on the intangible assets as of March 31, 2006 is as follows:

 

| ** ** | ** ** | **Estimated  Expense** | ** ** |
|------------|------------|------------------------|------------|
| 2006       |       | $                      | 204,083    |   |   |
| 2007       |       | $                      | 164,603    |   |   |
| 2008       |       | $                      | 107,871    |   |   |
| 2009       |       | $                      | 45,031     |   |   |
| 2010       |       | $                      | 29,411     |   |   |

###  

### Note 5 –Marketable Securities

###  

Available-for-salesecurities are recorded at fair value. Unrealized holding gains and losses onavailable-for-sale securities are excluded from income and are reported as aseparate component of stockholders’ equity until realized. At March 31, 2006and March 31, 2005, this resulted in a net cumulative unrealized loss of $9,474and $6,625, respectively, within stockholders’ equity. A decline in the marketvalue of any available-for-sale security below cost that is deemed other thantemporary is charged to income resulting in the establishment of a new costbasis for the security.

 

Note 6 – ComprehensiveIncome

 

Other comprehensiveincome pertains to net unrealized gains and losses on marketable securities andforeign currency translation adjustments that are not included in net incomebut rather are recorded directly in stockholders’ equity.

 
| ** **                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                   | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Net income                                   |       | $                                 | 1,134,759  |   | $ | 794,171 |   |
| Foreign currency translation adjustment      |       | 33,459                            |       | (58,685 | ) |
| Net unrealized loss on marketable securities |       | (2,342                            | )          | (3,865 | ) |
| Comprehensive income                         |       | $                                 | 1,165,876  |   | $ | 731,621 |   |

 

9

----

 

Note 7 – Warranty

 

We provide a warranty formost of our products. Warranties are for periods ranging from ninety days toone year, and cover parts and labor for non-maintenance repairs, at ourlocation. Operator abuse, improper use, alteration, damage resulting fromaccident, or failure to follow manufacturer’s directions, are excluded fromwarranty coverage.

 

Warranty expense isaccrued at the time of sale based on historical claims experience. Specialwarranty reserves are also accrued for special rework campaigns for known majorproduct modifications. We also offer service contracts for select products whenthe factory warranty period expires.

 

Warranty provisions andclaims for the three-month periods ended March 31, 2006 and 2005 were asfollows:

 
| ** **                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------|------------|-----------------------------------|------------|
| ** **                  | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Beginning balance           |       | $                                 | 327,015    |   | $ | 352,634 |   |
| Warranty provisions         |       | 118,538                           |       | 44,360 |   |
| Warranty claims             |       | (138,610                          | )          | (48,254 | ) |
| Decrease due to sale of LCI |       | (33,248                           | )          | — |   |
| Ending balance              |       | $                                 | 273,695    |   | $ | 348,740 |   |

 

Note 8 – Sale of Subsidiary

 

In February 2006, we soldall the outstanding common stock of Lab Connections, Inc. (LCI), a wholly-ownedsubsidiary of the Company. Pursuant to the sale agreement, we received a net cashpayment of $478,721 in exchange for all the outstanding shares of LCI. As aresult of the sale, we recognized an after-tax gain of approximately $92,000 inthe first quarter of fiscal 2006. This gain was reflected in the other incomeline on the condensed consolidated statements of income. In addition, we havesigned a manufacturing agreement with the purchaser which provides that we willbe the exclusive manufacturer/supplier of the LCI equipment for at least oneyear.

 

Note 9 – DiscontinuedOperations

 

In July 2005, wesold substantially all of the assets used in our discontinued Vaculok productline. Pursuant to the sale agreement, we received an up-front payment of$125,000, along with the right to receive an additional amount upon theoccurrence of certain post-closing events. In the first quarter of fiscal 2006,we received an additional $35,000 related to this previous sale. The after-taxeffect of this additional payment is a gain of $22,225 which is reflected onthe gain (loss) from discontinued operations line of the condensed consolidatedstatements of income.

 

10

----

 

Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations

 

This Management’sDiscussion and Analysis provides material historical and prospectivedisclosures intended to enable investors and other users to assess ourfinancial condition and results of operations. Statements that are nothistorical are forward-looking and involve risks and uncertainties discussedbelow under the caption “Forward-Looking Statements.”  The following discussion of the results ofoperations and financial condition of MOCON should be read in conjunction withour condensed consolidated financial statements and the related notes theretoincluded elsewhere in this report.

 

### ***Overview***

###  

MOCON, Inc.designs, manufactures, markets and services products and provides consultingservices primarily in the measurement and analytical instrument and servicesmarkets. Our products include instruments that detect, measure and monitorgases and chemical compounds. Although some of the markets for our products arematuring, we continually seek growth opportunities through technological andproduct improvement, by acquiring and developing new products, and by acquiringnew companies.

 

We have threeprimary operating locations in the United States – Minnesota, Colorado andTexas – and one in Germany. We use a direct sales force and independent salesrepresentatives to market our products and services in the United States,Canada and Germany and use a network of independent sales representatives tomarket and service our products and services in other foreign countries.

 

Prior to 1998, weexpanded our business primarily through internally developing new products andtechnologies and licensing products and technology. Since 1998, we havesupplemented our internal growth through acquisitions that have provided uswith additional technologies, products and product development expertise. Duringthe last twelve months, we divested two product lines to allow us to better concentrateon our core product lines, particularly our gas detection and measurementproducts.

 

We completed ourmost recent acquisition effective January 1, 2004, by acquiring Paul LippkeHandels-GmbH Prozess- und Laborsysteme (Lippke), which is located in Germany. Weacquired all of the shares of Lippke for a base purchase price plus threeearnout payments based on the net profits of Lippke in each of the years 2004,2005 and 2006, with a minimum payment amount of 100,000 euros per year. It isanticipated that the remaining earnout payment will be made at or near the endof the first quarter of 2007. The earnout payment due for 2005 based on Lippke’s2005 net profits in the amount of $433,339 was paid during the first quarter2006.

 

In March 2005, wecommitted to a plan to discontinue production of our Vaculok® vacuum insulatedpanels and exit this product line as the result of the poor financialperformance since it was acquired in November 2003. We recorded a one-timepre-tax charge to earnings in our first quarter 2005, totaling approximately$207,000, to reflect the results of operations and asset impairment write-downassociated with the discontinuation of our Vaculok business. The $207,000charge included a non-cash asset impairment charge of $162,000 relating toequipment and inventory used in the Vaculok business. The after-tax loss reflectedin the first quarter 2005 was $131,453. We sold the assets associated with thevacuum insulated panel product line in July 2005 in exchange for an up frontpayment of $125,000, along with the right to receive up to an additional$60,000 upon the occurrence of certain post-closing events. As a result of thesale, we recognized a pre-tax gain of approximately $69,000 in the thirdquarter 2005. We received an additional $35,000 in the first quarter 2006,which resulted in an after-tax gain of $22,225. The results of this line ofbusiness are shown in the “discontinued operations” section of our consolidatedstatements of income.

 

In February 2006,we sold the capital stock of Lab Connections, Inc. in exchange for $517,296 incash, subject to a purchase price adjustment based on the amount of LabConnections’ net tangible assets as of the closing date. As a result of thesale, we recognized an after-tax gain of approximately $92,000

 

11

----

 

in the firstquarter 2006.

 

Effective January1, 2006, we adopted Statement of Financial Accounting Standards No.123(revised), “Share-Based Payment” (SFAS 123 (R)) which requires the measurementand recognition of compensation expense for all share-based payment awards madeto employees and directors. As a result, as of March 31, 2006, our results ofoperations reflected compensation expense for new stock options granted andvested during the first three months of fiscal 2006 and the unvested portion ofprevious stock option grants which will vest during fiscal 2006. The totalamount charged to operations in the first quarter of 2006 was $45,369.

 

### ***Results of Operations***

###  

The followingtable sets forth the relationship between various components of our results ofoperations, stated as a percent of sales, for the three-month periods ended March31, 2006, and 2005.

 

| ** **                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                           | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Sales                                                |       | 100.0                             |       | 100.0 |   |
| Cost of sales                                        |       | 41.4                              |       | 44.7 |   |
| Gross profit                                         |       | 58.6                              |       | 55.3 |   |
| Selling, general and administrative expenses         |       | 29.4                              |       | 32.4 |   |
| Research and development expenses                    |       | 7.0                               |       | 6.5 |   |
| Operating income                                     |       | 22.2                              |       | 16.4 |   |
| Other income                                         |       | 2.4                               |       | 1.4 |   |
| Income before  income taxes                          |       | 24.6                              |       | 17.8 |   |
| Income taxes                                         |       | 7.5                               |       | 3.4 |   |
| Income from  continuing operations                   |       | 17.1                              |       | 14.4 |   |
| Gain (loss) from discontinued operations, net of tax |       | 0.3                               |       | (2.1 | ) |
| Net income                                           |       | 17.4                              |       | 12.3 |   |

###  

### *Comparisonof Financial Results for the Three Months Ended March 31, 2006 and 2005*

###  

### *Sales*

###  

Sales for the firstquarter 2006 were $6,518,912, up 1% compared to $6,444,395 for the same periodin 2005. On a product line basis, this increase was primarily due to increasedsales of our weighing and pharmaceutical products, headspace analyzer and gaschromatography products, offset somewhat by a decrease in sales of our permeationand leak detection products. There were no significant price increases ordecreases during the first quarter 2006 compared to the same period in 2005.

 

12

----

 

Thefollowing table summarizes total sales by product line for the three-monthperiods ended March 31, 2006 and 2005.

 

| ** **                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------|------------|-----------------------------------|------------|
| ** **                                  | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Permeation Products and Services            |       | $                                 | 3,496,238  |   | $ | 3,838,332 |   |
| Gas, Headspace, and Other Analyzer Products |       | 2,631,765                         |       | 2,150,712 |   |
| Other                                       |       | 390,909                           |       | 455,351 |   |
| Total sales                                 |       | $                                 | 6,518,912  |   | $ | 6,444,395 |   |

 

The followingtable sets forth the relationship between various components of domestic andforeign sales for the three-month periods ended March 31, 2006 and 2005.

 

| ** **           | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------|------------|-----------------------------------|------------|
| ** **           | ** ** | **2006**                          | ** ** | **2005** | ** ** |
| Domestic sales       |       | $                                 | 3,100,384  |   | $ | 3,104,802 |   |
| Foreign sales:       |       |                              |       |   |   |
| Europe               |       | 1,524,400                         |       | 1,520,664 |   |
| Asia                 |       | 1,393,352                         |       | 1,386,997 |   |
| Other                |       | 500,776                           |       | 431,932 |   |
| Total foreign  sales |       | 3,418,528                         |       | 3,339,593 |   |
| Total sales          |       | $                                 | 6,518,912  |   | $ | 6,444,395 |   |

 

Sales of ourpermeation products and services which accounted for approximately 54% and 60%of our consolidated first quarter sales in 2006 and 2005, respectively,decreased 9% during the first quarter 2006 compared to the same period in 2005.This was due to a decrease in demand in both our foreign and domestic markets. Ourdomestic shipments were affected by reduced capital spending by some customerswho have experienced escalating material and energy costs (including post-HurricaneKatrina), as well as other hurricane-related problems, such as disruptedcustomer order patterns and material shortages. Our international bookings wereup in the first quarter 2006 compared to the same period in 2005, but due tothe timing of the orders, not all were shippable in the first quarter 2006.

 

Sales of our gas,headspace, and other analyzer products which accounted for 40% and 33% of ourconsolidated first quarter sales in 2006 and 2005, respectively, increased 22%during the first quarter 2006 compared to the same period in 2005. Within thisgroup, sales of our weighing and pharmaceutical products increased by 272%,which was evenly spread between domestic and foreign markets, and resulted froman increase in orders for our VERICAP® high-speed capsule weighing systems. Salesof our headspace analyzer products increased by 32% in the first quarter 2006compared to the same quarter in 2005, primarily in our domestic markets, andwas partially due to a new product offering in our PAC CHECK® series ofanalyzers. Sales of our gas analyzer products through our Baseline subsidiaryincreased by 8% in the first quarter 2006 compared to the same quarter in 2005,with a significant increase in shipments of equipment and sensors into ourforeign markets, offset somewhat by a decrease in domestic shipments. Sales ofour leak detection products decreased 35% during the first quarter 2006compared to the same period in 2005, as a result of decreased demand in both ourdomestic and foreign markets.

 

Sales in our othercategory which accounted for 6% and 7% of our consolidated first quarter salesin 2006 and 2005, respectively, decreased by 14% during the first quarter 2006compared to the same period in 2005. Sales in our Microanalytics subsidiaryincreased 160% in the first quarter 2006

 

13

----

 

compared to thesame quarter in 2005 as we experienced an uptrend in the demand for contract analyticaltesting services. As a result of its sale in first quarter 2006, sales of ourLab Connections subsidiary decreased by 76% during the first quarter 2006compared to the same quarter in 2005.

 

On a geographicalbasis, domestic and foreign sales accounted for 48% and 52%, respectively, ofour consolidated first quarter sales in both 2006 and 2005.

 

### *GrossProfit*

###  

The gross profitmargins for our products were 59.3% and 56.8% for the first quarters 2006 and2005, respectively. The higher margin for first quarter 2006 was primarily dueto the elimination of production inefficiencies due to the sale of our LabConnections subsidiary and bringing production of certain products in house, afavorable product mix and a decrease in accrued product warranties.  Under our manufacturing agreement with thepurchaser of LCI we will continue to manufacture and sell equipment for atleast one year and expect to realize normal gross margins on these sales.

 

The gross profitmargins for our consulting services were 48.5% and 27.3%, respectively, for thethree-month periods ended March 31, 2006 and 2005. This increase was primarilydue to the increase in sales and the related fixed costs which were slightlyreduced.

 

*Selling, General and Administrative Expenses*

 

### Selling, general andadministrative (SG&A) expenses in the first quarter 2006 were $1,919,140,or 29.4% of sales, compared to $2,082,588, or 32.4% of sales in the firstquarter 2005. The decrease in SG&A expenses was primarily due to lowerheadcount in 2006 as well reduced operating costs in our Lab Connectionssubsidiary which was sold during the first quarter 2006.

###  

### *Researchand Development Expenses*

###  

Research anddevelopment (R&D) expenses were $453,519, or approximately 7.0% of sales,in the first quarter 2006, compared to $420,628, or approximately 6.5% ofsales, in the same period of 2005. This planned increase in R&Dexpenditures is considered by management to be necessary to develop newproducts to expand in our niche markets. For the foreseeable future, we expectto allocate on an annual basis approximately 6% to 8% of sales to research anddevelopment.

 

### *OtherIncome*

###  

Other income forthe three months ended March 31, 2006 consisted of a $92,345 gain on the saleof Lab Connections, interest income of $80,977 and other income of $1,287, offsetby a loss on foreign currency exchange of $19,312. Other income for the three monthsended March 31, 2005 consisted of interest income of $37,927, gain on foreigncurrency exchange of $41,569 and other income of $11,709. Interest incomeincreased for the three months ended March 31, 2006, due both to higher averageyields and higher average cash balances.

 

### *IncomeTax Expense*

###  

Our provision forincome taxes from continuing operations was 30.5% of income before income taxesfor the three months ended March 31, 2006, compared to 19.5% of income beforeincome taxes for the three months ended March 31, 2005. The rate for the first quarter2006 was favorably impacted by the resolution of a proposed income taxassessment in the state of New Jersey, which reduced income tax expense byapproximately $50,000. Also, because the sale of Lab Connections generated ataxable loss, there was no tax provision applicable to the $92,345 gain thatwas realized in the first quarter 2006. The rate for the first quarter 2005 wasfavorably impacted by the finalization of an Internal Revenue Serviceexamination which reduced income tax expense by approximately $156,000 in the

 

14

----

 

first quarter 2005as well as benefiting from the newly enacted tax law. Based on currentoperating conditions and income tax laws, we expect the tax rate for theremaining quarters of 2006 to be in the range of 33% to 36%.

 

### *NetIncome*

###  

Net income was $1,134,759in the first quarter 2006, compared to $794,171 in the first quarter 2005. Dilutednet income was $0.21 per share in the first quarter 2006 compared to $0.14 pershare in the first quarter 2005.

 

*Liquidityand Capital Resources*

 

We have historically financed our operations, capital expenditures andother liquidity needs through our cash flows generated from operations. Totalcash, cash equivalents and marketable securities increased $987,593 during thefirst quarter 2006 to $10,008,962 as of March 31, 2006, compared to $9,021,369at December 31, 2005 due in part to a significant reduction in tradeaccounts receivable, the receipt of the net proceeds from the sale of LabConnections of $478,721, and the exercise of stock options. Our working capitalas of March 31, 2006 increased $912,653 to $14,751,986, as compared to $13,839,333at December 31, 2005. We believe that a combination of our existing cash,cash equivalents and marketable securities, plus an expected continuation ofcash flow from operations, will continue to be adequate to fund our operations,capital expenditures, dividend payments, stock repurchases, and requiredearnout payment to the former parent company of Lippke, for at least the nexttwelve months. However, one of our strategic objectives is, as market andbusiness conditions warrant, to consider acquisitions of businesses, productsor technologies. We may need to fund such activities, should they arise, withdebt and/or equity financing, although no assurance can be given that such debtand/or equity financing will be available at reasonable terms or at all.

 

*Cash Flow*

 

Cash Flow from Operating Activities

 

Our primary sourceof funds is cash provided by operating activities of continuing operationswhich totaled $995,266 and $458,602 in the first quarters 2006 and 2005,respectively. In the first quarter 2006, the cash provided by operating activitiesincreased by $536,664, or 117%, compared to the first quarter 2005. The keycomponents of the increases in the 2006 amount were net income of $1,112,534,decrease in accounts receivable of $220,797, increase in accrued income taxesof $195,422, and add-back of non-cash depreciation and amortization of $189,197.Offsetting these increases were reductions in accounts payable and accruedcompensation and vacation of $444,524 and $198,194, respectively, and the gainon disposition of long-term assets of $92,345.

 

### Cash Flow fromInvesting Activities

###  

Cash provided by (usedin) investing activities of continuing operations totaled $775,774 and ($1,046,176)in the first quarters 2006 and 2005, respectively. The proceeds from sale ofsubsidiary of $478,721 in 2006 related to the sale of Lab Connections. Proceedsof marketable securities, net of purchases, were $423,896 in the first quarter2006. Purchases of property, plant and equipment totaled $121,017 in the first quarter2006, primarily for additions of office, manufacturing and laboratoryequipment, as compared to $58,133 in the first quarter 2005. We had no materialcommitments for capital expenditures as of March 31, 2006. We presently do notbelieve that any significant property, plant and equipment expenditures arerequired to accommodate our current level of operations.

 

Cash Flow fromFinancing Activities

 

Cash used infinancing activities of continuing operations consists primarily of the paymentof dividends

 

15

----

 

to ourshareholders. During the first quarters 2006 and 2005, we made dividendpayments to our shareholders of $405,533 and $373,694, respectively. Offsettingthis was the proceeds from the exercise of stock options in the amount of$260,518 and $28,134 in 2006 and 2005, respectively.

 

Our Board ofDirectors has authorized, depending upon market conditions and other factors,the repurchase of up to a total of $2,000,000 of our common stock. As of March31, 2006, we had repurchased 29,500 shares of MOCON common stock under theprogram at a total cumulative cost of $258,125; therefore, as of March 31,2006, $1,741,875 was remaining in this authorization.

 

***Contractual Obligations***

 

We refer you toour Annual Report on Form 10-K for the year ended December 31, 2005 for asummary of our contractual obligations. Except for the earnout payment paid inconnection with the Lippke acquisition, there has been no material change inthis information.

 

### ***Off-Balance Sheet Arrangements***

###  

Except for operatingleases entered into in the ordinary course of business and customaryindemnification obligations under certain of our agreements entered into in theordinary course of business, we do not have any material off-balance sheetarrangements.

 

***Critical Accounting Policies***

 

Our significantaccounting policies are described in Note 1 to our consolidated financialstatements. This Management’s Discussion and Analysis of Financial Conditionand Results of Operations is based upon our consolidated financial statements,which have been prepared in accordance with accounting principles generallyaccepted in the United States of America. The preparation of these consolidatedfinancial statements requires management to make estimates and judgments thataffect the reported amount of assets, liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities. The Securities andExchange Commission has defined a company’s most critical accounting policiesas those that are most important to the portrayal of its financial conditionand results of operations, and which require the company to make its mostdifficult and subjective judgments, often as a result of the need to makeestimates of matters that are inherently uncertain. Based on this definition,we have identified the following critical accounting policies. Although webelieve that our estimates and assumptions are reasonable, they are based uponinformation available when they are made. Actual results may differsignificantly from these estimates under different assumptions or conditions.

 

*Allowancefor doubtful accounts and sales returns* – Our allowance for doubtful accounts and salesreturns is for accounts receivable balances that are estimated to beuncollectible as well as sales returns. The reserve is based on a number offactors, including:  (1) an analysis ofcustomer accounts and (2) our historical experience with accounts receivablewrite-offs and sales returns. The analysis includes the age of the receivable,the financial condition of a customer or industry, and general economicconditions. We believe our financial results could be materially different ifhistorical trends do not reflect actual results or if economic conditionsworsened for our customers. In the event we determined that a smaller or largerallowance for doubtful accounts is appropriate, we would record a credit orcharge to selling, general and administrative expense in the period that wemade such a determination. As of March 31, 2006, we had $192,182 reservedagainst our accounts receivable for doubtful accounts and sales returns.

 

*Allowancefor excess and obsolete inventories —*We perform an analysis toidentify excess and obsolete inventory. We record a charge to cost of sales foramounts identified. Our analysis includes inventory levels, the nature of thefinished product and its inherent risk of obsolescence and the on-handquantities relative to the sales history of that finished product. We believethat our financial results could be materially different if historical trendsdo not reflect actual results or if demand for our

 

16

----

 

products decreased because of economic or competitive conditions orotherwise.

 

*Recoverabilityof long-lived assets —*We assess the recoverability of goodwill andother long-lived assets annually or whenever events or changes in circumstancesindicate that expected future undiscounted cash flows might not be sufficientto support the carrying amount of an asset. We deem an asset to be impaired ifa forecast of undiscounted future operating cash flows is less than an asset’scarrying amount. If an asset is determined to be impaired, the loss is measuredas the amount by which the carrying value of the asset exceeds its fair value. Changesin our business strategies, changes in the economic environment in which weoperate, competitive conditions, and other factors could result in futureimpairment charges.

 

*Accruedproduct warranties —*Our products are generally covered by awarranty, with warranty periods ranging from ninety days to one year from thedate of sale. Estimated warranty costs are accrued in the same period in whichthe related revenue is recognized, based on anticipated parts and labor costs,utilizing historical experience. Special warranty reserves are also accrued formajor rework campaigns. We periodically assess the adequacy of our warrantyreserves based on changes in these factors and record any necessary adjustmentsif actual claim experience indicates that adjustments are necessary. Althoughwe believe the likelihood to be relatively low, warranty claims experiencecould be materially different from actual results due to manufacturing changes thatcould impact product quality, a change in our warranty policy in response toindustry trends, as yet unrecognized defects in products sold, or other factors.As of March 31, 2006,we had $273,695 accrued related to future estimated warranty claims.

 

*Incometaxes —*In the preparation of our consolidated financialstatements, management is required to estimate income taxes in each of thejurisdictions in which we operate. This process involves estimating actualcurrent tax exposures together with assessing temporary differences resultingfrom differing treatment of items for tax and accounting purposes. Thesedifferences result in deferred tax assets and liabilities, which are includedin our consolidated balance sheet.

 

We havesignificant amounts of deferred tax assets. Management reviews the deferred taxassets for recoverability on a quarterly basis and assesses the need forvaluation allowances. These deferred tax assets are evaluated by consideringhistorical levels of income, estimates of future taxable income streams and theimpact of tax planning strategies. A valuation allowance is recorded to reducedeferred tax assets when it is determined that it is more likely than not thatwe would not be able to realize all or part of its deferred tax assets. Wecarried no valuation allowance against our net deferred tax assets at eitherMarch 31, 2006 or 2005.

 

### ***Forward-Looking Statements***

###  

This quarterly report onForm 10-Q contains not only historical information, but also forward-lookingstatements within the meaning of Section 27A of the Securities Act of 1933and Section 21E of the Securities Exchange Act of 1934, and are subject tothe safe harbor created by those statutes. In addition, we or others on ourbehalf may make forward-looking statements from time to time in oralpresentations, including telephone conferences and/or web casts open to thepublic, in press releases or reports, on our internet website or otherwise. Statementsthat are not historical are forward-looking and reflect expectations and assumptions.We try to identify forward-looking statements in this report and elsewhere byusing words such as “may,” “will,” “should,” “expects,” “anticipates,” “contemplates,”“estimates,” “believes,” “plans,” “projected,” “predicts,” “potential” or “continue”or the negative of these or similar terms. Examples of forward-lookingstatements in this report include, but are not limited to, statements regardingour international sales continuing to account for a significant portion of ourrevenues, our acquisition of Lippke continuing to have a positive impact on oursales in 2006, our allocation of 6% to 8% of our sales to research anddevelopment expenses, our expected tax rate for the remaining quarters of 2006being in the range of 33% to 36%, our belief that no significant future capitalexpenditures are required to accommodate our current level of operations, ourexpectations

 

17

----

 

regarding future cashexpenditures, and the effect of new accounting pronouncements on our financialposition, results of operations and cash flows.

 

Forward-lookingstatements are based on current expectations about future events affecting usand are subject to uncertainties and factors that affect all businessesoperating in a global market as well as matters specific to MOCON. Theseuncertainties and factors are difficult to predict and many of them are beyondour control. The following are some of the uncertainties and factors known tous that could cause our actual results to differ materially from what we haveanticipated in our forward-looking statements:

 

•      Increases inprices for raw materials;

•      Risks inherentin operating internationally and selling and shipping our products andpurchasing our products and components internationally;

•      Fluctuations inforeign currency exchange rates and interest rates;

•      Failure todevelop new products and technologies, delays in new product introduction andlack of market acceptance of new products;

•      Failure toeffect strategic acquisitions and integrate effectively newly acquiredoperations;

•      Incurrence ofadditional debt, contingent liabilities and expenses in connection with futureacquisitions;

•      Decreases incapital spending

•      Exposure toassertions of intellectual property claims and failure to protect ourintellectual property;

•      Disruption inour ability to manufacture our products or the ability of our key suppliers toprovide us products or components or raw materials for products resulting inour inability to supply market demand for our products;

•      Reliance onindependent sales distributors and sales associates to market and sell ourproducts;

•      Highlycompetitive nature of the markets in which we sell our products and theintroduction of competing products;

•      Loss ofcustomers;

•      Failure toretain senior management or replace lost senior management;

•      Employeeslowdowns, strikes or similar actions;

•      Reliance on ourmanagement information systems for inventory management, distribution and otherfunctions;

•      Effects of anypending or threatened litigation;

•      Failure tocomply with applicable laws and regulations and adverse changes in applicablelaws or regulations;

•      Changes ingenerally accepted accounting principles; or

•      Conditions andchanges in general economic and business conditions.

 

For more informationregarding these and other uncertainties and factors that could cause our actualresults to differ materially from what we have anticipated in ourforward-looking statements or otherwise could materially adversely affect ourbusiness, financial condition or operating results, see our annual report onForm 10-K for the fiscal year ended December 31, 2005 under the heading “Part I– Item 1A. Risk Factors” on pages 8 through 13 of such report.

 

All forward-lookingstatements included in this report are expressly qualified in their entirety bythe foregoing cautionary statements. We wish to caution readers not to placeundue reliance on any forward-looking statement that speaks only as of the datemade and to recognize that forward-looking statements are predictions of futureresults, which may not occur as anticipated. Actual results could differmaterially from those anticipated in the forward-looking statements and fromhistorical results, due

 

18

----

 

to the risks anduncertainties described below, as well as others that we may considerimmaterial or do not anticipate at this time. Although we believe that theexpectations reflected in our forward-looking statements are reasonable, we donot know whether our expectations will prove correct. Our expectationsreflected in our forward-looking statements can be affected by inaccurateassumptions we might make or by known or unknown uncertainties and factors,including those described above. The risks and uncertainties described aboveare not exclusive and further information concerning us and our business,including factors that potentially could materially affect our financialresults or condition, may emerge from time to time. We assume no obligation toupdate forward-looking statements to reflect actual results or changes infactors or assumptions affecting such forward-looking statements. We adviseyou, however, to consult any further disclosures we make on related subjects inour quarterly reports on Form 10-Q and current reports on Form 8-K we file withor furnish to the Securities and Exchange Commission.

 

Item 3. Quantitativeand Qualitative Disclosures About Market Risk

 

*EquityPrice and Interest Rate Risk*

 

Substantially all of ourmarketable securities are at fixed interest rates and all of our marketablesecurities mature within one year or less; therefore, we believe that themarket risk arising from the holding of these financial instruments is minimal.

 

### *ForeignCurrency Exchange Risk*

###  

Because our products aremanufactured or sourced primarily from the United States, a stronger U.S.dollar generally has a negative impact on our results from operations outsideof the United States while a weaker dollar generally has a positive effect. Wecurrently sell our products and services in United States dollars or the localcurrency of our foreign subsidiary (euros). Accordingly, our foreign operationsexpose us to foreign currency exchange risk when the euro currency results ofoperations are translated to United States dollars. While we historically havenot experienced any material foreign currency translation losses, we may engagein hedging activity in the future to minimize this risk. Our net investment inforeign subsidiary translated into U.S. dollars is not hedged. Any changes inforeign currency exchange rates will be reflected as a foreign currencytranslation adjustment, a component of accumulated other comprehensive incomein stockholders’ equity, and would not impact our net income.

 

Item 4. Controls andProcedures

 

*Evaluationof Disclosure Controls and Procedures*

 

We maintain disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-15(e) and15d-15(e)) that are designed to ensure that information required to be disclosedby us in the reports we file or submit under the Securities Exchange Act of1934, as amended, is recorded, processed, summarized, and reported, within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to ourmanagement, including our principal executive and principal financial officers,or persons performing similar functions, as appropriate to allow timelydecisions regarding required disclosure. In designing and evaluating ourdisclosure controls and procedures, we recognize that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, and wenecessarily are required to apply our judgment in evaluating the cost-benefitrelationship of possible controls and procedures. Our management evaluated,with the participation of our Chief Executive Officer and Chief FinancialOfficer, the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered in this

 

19

----

 

Quarterly Report on Form10-Q. Based on that evaluation, our Chief Executive Officer and Chief FinancialOfficer concluded that our disclosure controls and procedures were effective asof the end of such period, to provide reasonable assurance that informationrequired to be disclosed in our Exchange Act reports is recorded, processed,summarized, and reported within the time periods specified in the SEC’s rulesand forms, and that material information relating to our Company and ourconsolidated subsidiaries is made known to management, including our ChiefExecutive Officer, and Chief Financial Officer, particularly during the periodwhen our periodic reports are being prepared.

 

*Changesin Internal Control Over Financial Reporting*

 

There was no change inour internal control over financial reporting that occurred during our quarterended March 31, 2006 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

20

----

 

PART II. OTHERINFORMATION

 

Item 1A. Risk Factors

 

We are affected byrisks specific to us as well as factors that affect all businesses operating ina global market. The significant factors known to us that could materiallyadversely affect our business, financial condition or operating results aredescribed in our annual report on Form 10-K for the fiscal year ended December31, 2005 under the heading “Part I – Item 1A. Risk Factors.”  There has been no material change in thoserisk factors.

 

Item 2. UnregisteredSales of Equity Securities, Use of Proceeds and Issuer Purchases of EquitySecurities

 

*UnregisteredSales of Equity Securities*

 

We did not sellany equity securities of MOCON, Inc. during the three months ended March 31,2006 that were not registered under the Securities Act of 1933.

 

*IssuerRepurchases of Equity Securities*

 

The followingtable shows our stock repurchase activity during the three months ended March31, 2006:

 
| **Period**                                  | ** ** | **Total Number  of Shares  Purchased (1)** | ** ** | **Average  Price  Paid Per  Share** | ** ** | **Total Number  of Shares  Purchased as  Part of  Publicly  Announced  Plans or  Programs** | ** ** | **Maximum  Amount of  Authorization  Remaining  Under the  Plan** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------|------------|---------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| January 1, 2006  through January 31, 2006   |       | —                                     |       | $                                   | —     |                                                                                        | —     |                                                              | $          | 2,000,000 |   |
| February 1, 2006  through February 28, 2006 |       | —                                     |       | —                              |       | —                                                                                      |       | 2,000,000                                                         |       |
| March 1, 2006  through March 31, 2006       |       | 29,500                                     |       | 8.75                                |       | 29,500                                                                                      |       | 1,741,875                                                         |       |
|                                             |            |                                            |            |                                     |            |                                                                                             |            |                                                                   |            |  |  |

 

----

(1)   On November 9, 2005, our Board of Directorsauthorized the repurchase of up to a total of $2,000,000 of our common stock. Thisprogram has no expiration date but may be suspended or discontinued at any timeby our Board of Directors at any time. We purchased 29,500 shares during theperiods indicated above under this program.

 

21

----

 

Item 6. Exhibits

 

31.1         Certificationof Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of2002

 

31.2         Certificationof Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of2002

 

32.1         Certificationof Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of2002

 

32.2         Certificationof Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of2002

 

22

----

 

SIGNATURES

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|                | MOCON, INC.                                   |
|---------------------|-----------------------------------------------|
|                |                                          |
|                |                                          |
| Date: May 15,  2006 | /s/ Robert L.  Demorest                       |   |
|                | Robert L.  Demorest                           |
|                | Chairman,  President and Chief                |
|                | Executive  Officer                            |
|                | (Principal  Executive Officer)                |
|                |                                          |
|                |                                          |
| Date: May 15,  2006 | /s/ Darrell B.  Lee                           |   |
|                | Darrell B. Lee                                |
|                | Vice President,  Treasurer and Chief          |
|                | Financial  Officer                            |
|                | (Principal  Financial and Accounting Officer) |

 

23

----

 

MOCON, INC.

QUARTERLY REPORT ON FORM 10-Q

QUARTER ENDED MARCH 31, 2006

 

EXHIBIT INDEX

 
| **Exhibit  No.** | ** ** | **Description**                                                                                          | ** ** | **Method of  Filing** |
|------------------|------------|----------------------------------------------------------------------------------------------------------|------------|-----------------------|
| 31.1             |       | Certification of Chief Executive Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |       | Filed herewith        |
| 31.2             |       | Certification of Chief Financial Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |       | Filed herewith        |
| 32.1             |       | Certification of Chief Executive Officer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |       | Furnished herewith    |
| 32.2             |       | Certification of Chief Financial Officer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |       | Furnished herewith    |

 

24

----