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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION    FORM 10-QSB  
 For the Quarter Ended June 30, 2004
    
    Commission File Number: 001-15637
 WINLAND ELECTRONICS, INC.  Minnesota
    
    41-0992135(state or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification Number)
 1950 Excel Drive, Mankato, Minnesota 56001
(Address of principal executive offices) (507) 625-7231
(Issuers telephone number)    Check whether the Issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for
such shorter period that the Issuer was required to file such reports) and
(2) has been subject to such filing requirements for the past 90 days. Yes [X] No [   ]
 There were 3,365,046 shares of Common Stock, $.01 par value, outstanding as of
July 30, 2004. Transitional Small Business
Disclosure Format (check one): Yes [   ] No [X] 1




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TABLE OF CONTENTS  PART I-FINANCIAL INFORMATIONITEM 1: FINANCIAL STATEMENTSITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONITEM 3. CONTROLS AND PROCEDURESPART II  OTHER INFORMATIONITEM 1. LEGAL PROCEEDINGSITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSITEM 6. EXHIBITS AND REPORTS ON FORM 8-KSIGNATURESCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906    Table of Contents  
 PART I-FINANCIAL INFORMATION 
 ITEM 1: FINANCIAL STATEMENTS WINLAND ELECTRONICS, INC.BALANCE SHEETS June 30,
    
    December 31,2004
    
    2003(UNAUDITED)ASSETSCurrent AssetsCash
    
    $
    205,892
    
    
    $
    1,412,058Accounts receivable, net
    
    
    2,979,301
    
    
    
    2,255,003Income tax receivable
    
    
    20,607
    
    
    
    138,234Inventories
    
    
    3,719,086
    
    
    
    1,861,135Prepaid expenses
    
    
    262,294
    
    
    
    195,278Deferred taxes
    
    
    186,300
    
    
    
    179,500Total current assets
    
    
    7,373,480
    
    
    
    6,041,208Other Assets
    
    
    97
    
    
    
    174Total other assets
    
    
    97
    
    
    
    174Property and Equipment, at cost:Land and land improvements
    
    
    272,901
    
    
    
    272,901Building
    
    
    2,983,586
    
    
    
    2,983,586Machinery and equipment
    
    
    4,715,272
    
    
    
    3,905,882Data processing equipment
    
    
    1,383,789
    
    
    
    1,323,660Office furniture and equipment
    
    
    366,915
    
    
    
    364,715Total property and equipment
    
    
    9,722,463
    
    
    
    8,850,744Less accumulated depreciation
    
    
    (5,263,687
    )
    
    
    (5,258,004
    )Net property and equipment
    
    
    4,458,776
    
    
    
    3,592,740Total assets
    
    $
    11,832,353
    
    
    $
    9,634,122
 See Notes to the Interim Financial Statements 2




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WINLAND ELECTRONICS, INC.BALANCE SHEETS June 30,
    
    December 31,2004
    
    2003(UNAUDITED)LIABILITIES AND STOCKHOLDERS EQUITYCurrent LiabilitiesNote payable to bank
    
    $
    470,000
    
    
    $
    Current maturities of long-term debt
    
    
    1,509,016
    
    
    
    408,833Accounts payable
    
    
    2,163,059
    
    
    
    1,192,391Accrued expenses:Compensation
    
    
    617,046
    
    
    
    612,590Other
    
    
    35,194
    
    
    
    245,765Total current liabilities
    
    
    4,794,315
    
    
    
    2,459,579Long Term LiabilitiesDeferred taxes
    
    
    87,100
    
    
    
    94,300Deferred revenue
    
    
    166,748
    
    
    
    170,818Long-term debt, less current maturities
    
    
    811,799
    
    
    
    1,248,671Total long-term liabilities
    
    
    1,065,647
    
    
    
    1,513,789Total liabilities
    
    
    5,859,962
    
    
    
    3,973,368Stockholders EquityCommon stock
    
    
    33,623
    
    
    
    33,570Additional paid-in capital
    
    
    3,900,910
    
    
    
    3,886,717Retained earnings
    
    
    2,037,858
    
    
    
    1,740,467Total stockholders equity
    
    
    5,972,391
    
    
    
    5,660,754Total liabilities and stockholders equity
    
    $
    11,832,353
    
    
    $
    9,634,122
 See Notes to the Interim Financial Statements 3




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WINLAND ELECTRONICS, INC.STATEMENTS OF INCOMEFor the Three Months Ended June 30, 2004 and 2003(UNAUDITED) 2004
    
    2003Net sales
    
    $
    5,775,879
    
    
    $
    4,347,028Cost of sales
    
    
    4,786,771
    
    
    
    3,360,629Gross profit
    
    
    989,108
    
    
    
    986,399Operating expenses:General and administrative
    
    
    357,831
    
    
    
    337,567Sales and marketing
    
    
    313,961
    
    
    
    224,127Research and development
    
    
    160,033
    
    
    
    180,089831,825
    
    
    
    741,783Operating income
    
    
    157,283
    
    
    
    244,616Other income (expenses):Interest expense
    
    
    (34,152
    )
    
    
    (35,661
    )Other, net
    
    
    13,735
    
    
    
    3,994(20,417
    )
    
    
    (31,667
    )Income before income taxes
    
    
    136,866
    
    
    
    212,949Income tax expense
    
    
    (58,000
    )
    
    
    (79,000
    )Net income
    
    $
    78,866
    
    
    $
    133,949Earnings per share data:Basic
    
    $
    0.02
    
    
    $
    0.04Diluted
    
    
    0.02
    
    
    
    0.04Weighted-average number of common shares outstanding:Basic
    
    
    3,358,788
    
    
    
    3,284,109Diluted
    
    
    3,538,104
    
    
    
    3,419,748
 See Notes to the Interim Financial Statements 4




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WINLAND ELECTRONICS, INC.
STATEMENTS OF INCOME
For the Six Months Ended June 30, 2004 and 2003
(UNAUDITED) 2004
    
    2003Net sales
    
    $
    10,935,439
    
    
    $
    9,790,181Cost of sales
    
    
    8,534,061
    
    
    
    7,389,540Gross profit
    
    
    2,401,378
    
    
    
    2,400,641Operating expenses:General and administrative
    
    
    825,418
    
    
    
    716,660Sales and marketing
    
    
    630,499
    
    
    
    456,045Research and development
    
    
    415,733
    
    
    
    376,5271,871,650
    
    
    
    1,549,232Operating income
    
    
    529,728
    
    
    
    851,409Other income (expenses):Interest expense
    
    
    (64,182
    )
    
    
    (78,991
    )Other, net
    
    
    21,844
    
    
    
    4,222(42,338
    )
    
    
    (74,769
    )Income before income taxes
    
    
    487,390
    
    
    
    776,640Income tax expense
    
    
    (190,000
    )
    
    
    (284,000
    )Net income
    
    $
    297,390
    
    
    $
    492,640Earnings per share data:Basic
    
    $
    0.09
    
    
    $
    0.15Diluted
    
    
    0.08
    
    
    
    0.14Weighted-average number of common shares outstanding:Basic
    
    
    3,358,169
    
    
    
    3,280,066Diluted
    
    
    3,563,973
    
    
    
    3,420,329
 See Notes to the Interim Financial Statements 5




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WINLAND ELECTRONICS, INC.
STATEMENTS OF CASH FLOWS
For the Six Months Ended June 30, 2004 and 2003
(UNAUDITED) 2004
    
    2003Cash Flows From Operating ActivitiesNet income
    
    $
    297,390
    
    
    $
    492,640Adjustments to reconcile net income to net cash
provided by (used in) operating activities:Depreciation and amortization
    
    
    322,432
    
    
    
    344,209(Gain) loss on disposal of equipment
    
    
    (6,142
    )
    
    
    711Investor relations expense, warrants issued
    
    
    10,794
    
    
    
    7,822Deferred taxes
    
    
    (14,000
    )
    
    
    Changes in assets and liabilities:Accounts receivable
    
    
    (724,298
    )
    
    
    58,851Income tax receivable
    
    
    117,627
    
    
    
    Inventories
    
    
    (1,857,951
    )
    
    
    149,861Prepaid expenses
    
    
    (77,810
    )
    
    
    (135,339
    )Accounts payable
    
    
    970,668
    
    
    
    (99,139
    )Accrued expenses, including deferred
revenue and income taxes payable
    
    
    (210,185
    )
    
    
    (12,613
    )Net cash provided by (used in) operating activities
    
    
    (1,171,475
    )
    
    
    807,003Cash Flows From Investing ActivitiesPurchases of property and equipment
    
    
    (1,189,249
    )
    
    
    (81,625
    )Proceeds from the sale of equipment
    
    
    7,000
    
    
    
    Net cash used in investing activities
    
    
    (1,182,249
    )
    
    
    (81,625
    )Cash flows From Financing ActivitiesNet borrowings on revolving line of credit
    
    
    470,000
    
    
    
    Proceeds from note payable to bank
    
    
    1,000,000
    
    
    
    Payments on long-term borrowings, including capital
lease obligations
    
    
    (336,689
    )
    
    
    (676,846
    )Proceeds from issuance of common stock
    
    
    14,246
    
    
    
    10,013Net cash provided by (used in) financing activities
    
    
    1,147,557
    
    
    
    (666,833
    )Net increase (decrease) in cash
    
    
    (1,206,167
    )
    
    
    58,545CashBeginning
    
    
    1,412,058
    
    
    
    692,700End
    
    $
    205,891
    
    
    $
    751,245Supplemental Disclosures of Cash Flow Information
Cash payments for:Interest
    
    $
    64,106
    
    
    $
    78,405Income tax
    
    
    173,750
    
    
    
    412,830Supplemental Schedule of Noncash Financing Activities
Warrants Issued in Connection with Investors Relations
Services to be Provided
    
    $
    
    
    
    $
    43,178
 See Notes to the Interim Financial Statements 6




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Note 1. Basis of Presentation The accompanying unaudited financial statements have been prepared by the
Company in accordance with generally accepted accounting principles in the
United States of America, pursuant to the rules and regulations of the
Securities and Exchange Commission. In managements opinion all adjustments
necessary for a fair presentation of the results for the interim period have
been reflected in the interim financial statements. The results of operations
for any interim period are not necessarily indicative of the results for a full
year. All adjustments to the financial statements are of a normal recurring
nature. Certain information and footnote disclosures normally included in
financial statements have been condensed or omitted. Such disclosures are
those that would substantially duplicate information contained in the most
recent audited financial statements of the Company, such as significant
accounting policies, lease and license commitments and stock options.
Management presumes that users of the interim statements have read or have
access to the audited financial statements included in the Companys most
recent annual report on Form 10-KSB. Note 2. Inventories Major components of inventory at June 30, 2004 and December 31, 2003 as follows: June 30, 2004
    
    December 31, 2003Raw Materials
    
    $
    2,121,030
    
    
    $
    1,091,213Work In Process
    
    
    864,919
    
    
    
    146,307Finished Goods
    
    
    933,137
    
    
    
    786,615Obsolescence reserve
    
    
    (200,000
    )
    
    
    (163,000
    )Total
    
    $
    3,719,086
    
    
    $
    1,861,135
 Note 3. Financing Arrangement The Company has a $2,500,000 annual revolving line-of-credit agreement with M&I
Bank of Minneapolis, Minnesota through June 28, 2005. Advances are due on
demand, secured by substantially all assets of the Company, and are subject to
a defined borrowing base equal to 75 percent of qualified accounts receivable,
and 50 percent of qualified inventory. The total unused availability on the
line of credit was $2,030,000 at June 30, 2004. Interest on advances accrues
at the banks reference rate (4 1/4 % at June 30, 2004), is due monthly and
is subject to certain restrictive covenants. There were advances of $470,000
outstanding on the revolving line of credit agreement at June 30, 2004, and
there were no advances outstanding at December 31, 2003. On April 15, 2004, the Company signed an amendment to the original credit
agreement that will provide the Company with a $1.5 million term loan for the
purpose of purchasing capital equipment. As of April 15, 2004, the Company had
drawn $1,000,000 under this agreement, which amount is to be repaid in monthly
installments of $20,833 plus interest at 4.91% through March of 2008. This
agreement is subject to the same restrictive covenants as the revolving line of
credit agreement. 7




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Note 4. Major Customers and Enterprisewide Disclosures Major Customers:The Company has customers that accounted for more than 10
percent of net sales for
The three and six months ended June 30, 2004 and 2003, as follows: Three Months Ended
    
    Three Months EndedJune 30, 2004
    
    June 30, 2003Sales percentage:Customer A
    
    
    58
    %
    
    
    58
    %Customer B
    
    
    11
    %
    
    
    0
    %Customer C
    
    
    4
    %
    
    
    17
    %
 Six Months Ended
    
    Six Months EndedJune 30, 2004
    
    June 30, 2003Sales percentage:Customer A
    
    
    60
    %
    
    
    55
    %Customer B
    
    
    8
    %
    
    
    0
    %Customer C
    
    
    5
    %
    
    
    19
    %
 The above customers had net receivables at June 30, 2004 and December 31, 2003 as follows: June 30, 2004
    
    December 31, 2003Accounts receivable percentage:Customer A
    
    
    47
    %
    
    
    55
    %Customer B
    
    
    15
    %
    
    
    0
    %Customer C
    
    
    4
    %
    
    
    13
    %
 Enterprisewide Disclosures:The following table presents revenues from external customers for
each of the Companys groups of products and services: Three Months Ended
    
    Three Months EndedJune 30, 2004
    
    June 30, 2003Proprietary microprocessors and mechanically
controlled sensors and alarms
    
    $
    588,658
    
    
    $
    545,765Electronic controls and assemblies for
OEM customers
    
    
    5,187,221
    
    
    
    3,801,263$
    5,775,879
    
    
    $
    4,347,028
 Six Months Ended
    
    Six Months EndedJune 30, 2004
    
    June 30, 2003Proprietary microprocessors and mechanically
controlled sensors and alarms
    
    $
    1,310,510
    
    
    $
    1,219,378Electronic controls and assemblies for
OEM customers
    
    
    9,624,929
    
    
    
    8,570,803$
    10,935,439
    
    
    $
    9,790,181
 8




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Note 5. Earnings Per Share Basic earnings per share is computed by dividing net earnings by the
weighted-average number of common shares outstanding during the period. Diluted
earnings per share is computed by dividing net earnings by the weighted-average
number of common shares outstanding during the period, including potentially
dilutive shares such as the options and warrants to purchase shares of common
stock at various amounts per share. The dilutive effect of the additional
shares for the three and six months ended June 30, 2004 and 2003 increased the
weighted-average shares outstanding by 179,316 and 205,804 compared to 135,639
and 140,263, respectively. Note 6. Stock Options, Warrants and Stock-Based Compensation Plans Warrants:On February 19, 2003, the Company granted to Hayden Communications,
Inc., an investor relations firm, warrants to purchase 39,697 shares of common
stock. Warrants to purchase 1,654 shares of common stock vest each month
beginning March 19, 2003 and continuing for the two-year contractual period.
The warrants term will extend three years from the date of full vesting. The
contract for services to be provided by Hayden Communications, Inc. does
provide both parties with a cancellation right. Such a cancellation would
limit the warrants to those vested up to the time of termination. On June 30,
2004, warrants to purchase 39,697 shares of common stock were outstanding, of
which 26,464 shares were exercisable. The exercise price of such outstanding
warrants is $1.85 per share. The warrants were valued using the Black-Scholes pricing model. Because the
contract can be terminated, the Company is reflecting the value of the warrants
as a prepaid expense and amortizing the expense as investor relations expense
over the life of the contract. In addition, the total value of the outstanding
warrants, $43,178, is reflected in the stockholders equity section at June 30,
2004. Stock-Based Compensation Plans:The Company has a stock-based compensation
plan. The Company accounts for this plan under the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and
related interpretations. Accordingly, no stock-based employee compensation cost
has been recognized, as all options granted under this plan had an exercise
price equal to the market value of the underlying common stock on the date of
grant. There were 43,000 options to purchase shares issued to employees and
directors during the three months ended June 30, 2004, representing gross
compensation expense of $76,320. The effect on net income and earnings per
share for the compensation cost for the stock-based compensation plan has been
determined based on the grant date fair values of awards (the method described
in FASB Statement No. 123, Accounting for Stock Based Compensation) and is
reflected in the table below. Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net Income:As reported
    
    $
    78,866
    
    
    $
    133,949
    
    
    $
    297,390
    
    
    $
    492,640Deduct total stock-based employee compensation
expense determined under the fair value-based
method for all awards net of related tax effects
    
    
    (25,189
    )
    
    
    (25,980
    )
    
    
    (36,838
    )
    
    
    (35,311
    )Pro forma
    
    $
    53,677
    
    
    $
    107,969
    
    
    $
    260,552
    
    
    $
    457,329Basic Earnings per shareAs reported
    
    $
    0.02
    
    
    $
    0.04
    
    
    $
    0.09
    
    
    $
    0.15Pro forma
    
    $
    0.02
    
    
    $
    0.03
    
    
    $
    0.08
    
    
    $
    0.14Diluted Earnings per shareAs reported
    
    $
    0.02
    
    
    $
    0.04
    
    
    $
    0.08
    
    
    $
    0.14Pro forma
    
    $
    0.02
    
    
    $
    0.03
    
    
    $
    0.07
    
    
    $
    0.13
 9




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Note 7. Product Warranties: The Company provides a limited warranty for a period of one year for its
products. The Companys standard warranties require the Company to repair or
replace defective products during such warranty period at no cost to the
customer. The Company estimates the costs that may be incurred under its basic
limited warranty and records a liability in the amount of such costs at the
time product revenue is recognized. Factors that affect the Companys warranty
liability include the number of units sold, historical and anticipated rates of
warranty claims, and cost per claim. The Company periodically assesses the
adequacy of its recorded warranty liabilities and adjusts the amounts as
necessary. The Company utilizes historical trends and actuarial analysis tools
to assist in determining the appropriate loss reserve levels. Changes in the Companys warranty liability, which is included in other
accruals on the balance sheets, during the period are approximately as follows: Six Months Ended June 30,2004
    
    2003Balance, Beginning
    
    $
    131,000
    
    
    $
    95,000Accruals for products Sold
    
    
    54,633
    
    
    
    100,400Charges in accruals for pre-existing warranties
    
    
    (69,633
    )
    
    
    (68,400
    )Balance, Ending
    
    $
    116,000
    
    
    $
    127,000
 Note 8. New Accounting Standards In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities. This interpretation establishes standards for
identifying a variable interest entity and for determining under what
circumstances a variable interest entity should be consolidated with its
primary beneficiary. Until now, a company generally has included another entity
in its consolidated financial statements only if it controlled the entity
through voting interests. Interpretation No. 46 changes that by requiring a
variable interest entity to be consolidated by a company if that company is
subject to a majority of the risk of loss from the variable interest entitys
activities or is entitled to receive a majority of the entitys residual
returns or both. As of June 30, 2004, the requirements of Interpretation No. 46
do not apply to the Company. In May 2003, the Financial Accounting Standards Board (FASB) issued Statement
No. 150, Accounting for Certain Financial Instruments With Characteristics of
Both Liabilities and Equity, which requires the issuer to classify certain
freestanding financial instruments as liabilities. Under the provisions of
Statement No. 150, common stock issued with mandatory redemption features that
require the Company to repurchase the shares upon an event that is certain to
occur, such as termination of employment or death of the stockholder, is no
longer classified as equity; instead, these shares will be reported as shares
subject to mandatory redemptionand classified as a liability in the balance
sheet. In such circumstances, disclosure of the components of this liability
will be included in the notes to the financial statements. The requirements of
Statement No. 150 will apply to the Company for its quarter ending September
30, 2004. The effect of the adoption of this standard will be reported as a
cumulative effect of a change in accounting principle in the year of adoption,
and restatement of previously issued financial statements is not permitted. As
of June 30, 2004, the requirements of FASB No. 150 do not apply to the Company. 10




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ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION RESULTS OF OPERATIONS
Three and six months ended June 30, 2004 v.
Three and six months ended June 30, 2003 Net Sales: The Company recorded net sales of $5,775,879 and $10,935,439 for
the three and six months ended June 30, 2004, an increase of 33% and 12% from
$4,347,028 and $9,790,181 for the same periods in 2003, respectively. The
increase in sales for the three and six months ended June 30, 2004 is primarily
attributed to increased sales to original equipment manufacture (OEM)
customers, offset in part by the decline in sales to Johnson Outdoors, Inc for
the current quarter and the first six months of 2004. Sales of Winlands
proprietary products primarily for the security/industrial sector, motor
controls and utility controls, increased 8% for the three months ended June 30,
2004 and 7% for the first six months of 2004, compared to 2003. The Company has received from its OEM customers purchase orders having an
aggregate value of $10.8 million for delivery during the remainder of 2004 and
into 2005. The Company expects to receive additional orders from current OEM
customers for future production. Although the Company has purchase orders in
place for many of its OEM customers that are scheduled to be fulfilled in 2004,
these customers may terminate their relationship with the Company at any time
pursuant to certain cancellation provisions. Therefore, there is no assurance
that the Company will continue to be engaged by any of these customers. In
June of 2003 the Company announced that orders from Johnson Outdoors, Inc.
(JOI) would be reduced in the coming years. Sales to JOI represented 4.6% of
total sales for first six months of 2004 compared to 19.4% for the same period
in 2003. The Company has continued to provide a full range of Electronic Manufacturing
Services (EMS) to OEM customers, delivering product needs from early concept
through product realization. The Company continues to explore additional
geographic regions to market its OEM services, primarily through networking
with referral sources in the Chicago and Minneapolis areas. In addition to the
networking and referral sources, the Company has signed representative
agreements with two manufacturers representative firms in the Illinois and
Kansas areas. The loss of any significant OEM customer would likely have an
adverse effect on the Companys short-term, and potentially long-term, results. Gross Profits: Gross profit dollars increased slightly to $989,108 or 17.1% of
net sales for the three months ended June 30, 2004, compared to $986,399 or
22.7% of net sales for the same period in 2003. Gross profit dollars remained
relatively consistent at $2,401,378 for the six months ended June 30, 2004,
compared to $2,400,641 for the same period in 2003. Gross profit decreased as
a percentage of net sales from 24.5% in 2003 to 22.0% in 2004. The decline in
gross profit as a percentage of net sales for the quarter and the six months
ended June 30, 2004 is attributed to additional production costs, including
component preparation, manual component placements and manual testing
associated with 23 new product introductions for the quarter and 44 new
products in the first six months of 2004. During the second quarter and the
six months ended June 30, 2004, additional labor costs due to overtime and the
increased use of a temporary labor force, as well as increased costs associated
with billable engineering projects and increased freight, offset in part by
reduced warranty and obsolescence expenses and a reduction in employee
incentive plan accruals when compared to the same period in 2003 also
contributed to the increased manufacturing variances that resulted from the
higher volume of new product design. Operating Expenses: General and administrative expense was $357,831 or 6.2% of
net sales and $825,418 or 7.5% of net sales for the three and six months ended
June 30, 2004, compared to $337,567 or 7.8% of net sales and $716,660 or 7.3%
of net sales for the same periods in 2003. The increase in general and administrative expense for the three and six months
ended June 30, 2004 is attributed to increased salaries and related expenses,
board of directors expense, directors and officers insurance expense, legal and
professional fees as well as donations expense, offset in part by a decline in
bad debt and a reduction in employee incentive plan accruals when compared to
the same period in 2003. Investor relations expense declined slightly for the
quarter but was up for the first six months of 2004. 11




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Sales and marketing expense (including project management) was $313,961 or 5.4%
of net sales and $630,499 or 5.8% of net sales for the three and six months
ended June 30, 2004, compared to $224,127 or 5.2% of net sales and $456,045 or
4.7% of net sales for the same periods in 2003, respectively. The increase in
sales and marketing expense for the three and six months ended June 30, 2004
are directly associated with increased salaries and related expenses,
commissions expense and travel expense, offset in part by a reduction in leased
vehicle expense and employee training expense. Winlands sales and marketing efforts are focused on building long-term
relationships with targeted OEM strategic accounts in the markets that it
serves. The Company relies on direct sales people along with a referral
network to promote its services and uncover new opportunities. Management
believes that augmenting its direct sales force with a referral network and
utilizing independent sales representatives on a limited basis will effectively
provide Winland an opportunity to build market share in the EMS (Electronic
Manufacturing Services) market. In 2003, the Company added the new sales
position of EMS business development manager to focus exclusively on strategic
account development at select targeted accounts that best align with the
products and services offered by the Company. Winlands proprietary products in the Environmental Sensors and Security Retail
sectors are marketed through a network of dealers and distributors and
supported by internal staff. In an effort to develop the Environmental and
Security Retail portion of the business, the Company added the position of
Manager for Environmental Security Products and initiated strategic planning
for its proprietary products in late 2003. Research and development expense (primarily design services and support to the
OEM customer base) was $160,033 or 2.8% of net sales for the three months ended
June 30, 2004 and $415,733 or 3.8% of net sales for the first six months of
2004, compared to $180,089 or 4.1% of net sales and $376,527 or 3.8% of net
sales for the same periods in 2003. The increase in research and development
expense for the first six months of 2004 compared to the same period in 2003 is
primarily attributed to increased design failure guarantee expense associated
with designs for customers, offset in part by amounts allocated to billable
engineering projects and a reduction in employee incentive plan accruals when
compared to the same period in 2003. Expenses were down slightly for the
second quarter of 2004 due to amounts allocated to billable engineering
projects and a reduction in employee incentive plan accruals when compared to
the same period in 2003. Interest Expense: Interest expense was $34,152 and $64,182 or 0.6% of net
sales for the three and six months ended June 30, 2004, compared to $35,661 and
78,991 or 0.8% of net sales for the same periods in 2003, respectively. The
decline in interest expense for the second quarter and first six months of 2004
was due to the timing of new borrowings. With the increase in short-term and
long-term borrowings the Company expects to see an increase in interest expense
for subsequent periods. Net Earnings: The Company reported net income of $78,866 or $0.02 per basic
and diluted share for the three months ended June 30, 2004 and $297,390 or
$0.09 per basic and $0.08 per diluted shared for the first six months of 2004,
compared to net income of $133,949 or $0.04 per basic and diluted share and
$492,640 or $0.15 per basic shared and $0.14 per diluted share for the same
periods in 2003, respectively. The decline in net income for the quarter and
first six months of 2004 is primarily attributed to a decline in gross
profits, increased operating expenses, offset in part by a reduction in
interest expense and income tax expense. The Company believes inflation has not significantly affected its results of
operations. The Company uses a 39% blended federal and state income tax rate. Year-to-date
pre-tax net income was $487,390 for 2004 and $776,640 for 2003, resulting in
income tax expense of $190,000 and $284,000, respectively. 12




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LIQUIDITY AND CAPITAL RESOURCES Cash used in operating activities was $1,171,475 for the six months ended June
30, 2004, compared to cash provided by operating activities of $807,003 for the
same period in 2003, a decline of $1,978,478. This change was primarily due to
decreased net income levels and increases in inventory levels, accounts
receivable, prepaid expenses as well as a decline in accrued expenses, offset
in part by increased accounts payable balances and a reduction in income tax
receivable. Cash used in operations resulted in a decrease in reserves
partially offset by borrowings on the bank line-of-credit and proceeds from
long term debt. The current ratio at June 30, 2004 was 1.54 to 1, compared to 2.46 to 1 at
December 31, 2003. Working capital equaled $2,579,165 on June 30, 2004,
compared to $3,581,629 on December 31, 2003. The decline in working capital is
primarily attributed to a decrease in cash, used to fund current operating
activities and increased current maturities of long term debt associated with
the maturity date on the mortgages with the City of Mankato in January of 2005
as well as increased short-term borrowings, offset in part by increased
inventory levels, accounts receivable and increased prepaid expenses. On June 25, 2004 the Company extended its revolving credit agreement with the
M&I Bank of Minneapolis, Minnesota with a renewal date of June 28, 2005. There
was $470,000 of advances outstanding on the revolving line-of-credit agreement
at June 30, 2004, with no advances outstanding at December 31, 2003. The
interest rate on the revolving line-of-credit is at the banks reference rate,
4.25% at June 30, 2004. The agreement with M&I Bank is also subject to certain
restrictive covenants. On April 15, 2004 the Company signed an amendment to
the original credit agreement that will provide the Company with a $1.5 million
dollar term loan for the financing of its capital equipment purchases. M&I
Bank has advanced $1,000,000 to the Company as of April 15, 2004, the stated
interest rate is fixed at 4.91% on this advance. The loan will be amortized in
full over 48 months. Management believes that our cash balance, availability of funds under the line
of credit agreement, the amendment adding the $1.5 million dollar term loan and
anticipated cash flows from operations will be adequate to fund our cash
requirements for the next twelve months. A summary of our contractual cash obligations at June 30, 2004 is as follows: Payments due by periodRemainder
    
    
    
    
    
    
    
    
    
    2007Of
    
    
    
    
    
    
    
    
    
    andContractual Obligations
    
    Total
    
    2004
    
    2005
    
    2006
    
    ThereafterLong-term debt,
including interest
    
    $
    2,479,600
    
    
    $
    380,100
    
    
    $
    1,395,400
    
    
    $
    359,000
    
    
    $
    345,100
 Other commercial commitments as described below: Other Commercial
    
    
    
    
    
    Outstanding BalanceCommitment
    
    Total Amount Committed
    
    06/30/04
    
    Date of ExpirationLine of Credit
    
    $
    2,500,000.00
    
    
    $
    470,000.00
    
    
    June 28, 2005
 There are no off balance sheet contractual cash obligations. 13




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CRITICAL ACCOUNTING POLICIES AND ESTIMATES The critical accounting policies and estimates to follow include, but are not
limited to, revenue recognition, income taxes, product warranties, depreciation
and long-lived assets. Some of the most critical policies and estimates are
also discussed below. The Company derives revenue from primarily two sources: (1) product sales and
out of warranty repair revenue, which includes custom electronic controls and
assemblies for original equipment manufacturers and proprietary products in the
security/industrial and motor control markets and (2) engineering design
services that may include programming and prototypes. The Company recognizes
revenue from the sale of products and out of warranty repairs when the product
is delivered to a common carrier for shipment to a customer. A portion of the
Companys business involves the Company shipping product to a primary
customers location where it is held in a separate warehouse. Revenue is
recognized when the customer notifies the Company that the inventory has been
removed from that warehouse and title to the product is transferred. Revenue
recognition occurs for engineering design services as the progress billings are
made and at the conclusion of the project. For all sales, the Company uses
either a binding purchase order or customer accepted and signed engineering
quote as evidence of the arrangement. The allowance for doubtful accounts is estimated at $10,000 at June 30, 2004.
The Company has not experienced significant bad debt write offs the last
several years, therefore, the current allowance is believed to be adequate for
any exposures to loss on June 2004 accounts receivable. Factors considered in
establishing the reserves include economic conditions and customer financial
strength. The Company has established a reserve for slow moving and obsolete inventories
and believes the reserve of $200,000 at June 30, 2004 is adequate. The reserve
is based on an analysis of the existing inventory, including applying
probability of obsolescence percentages to the aged inventory brackets and
specific identification of obsolete inventory in connection with decisions to
exit certain markets. In addition, the Company has established a reserve of $116,000 for rework and
warranties. This reserve is based on historical experience and analysis of
specific known and potential warranty issues. A portion of the reserve is
based on a percentage of the sales for the six-month period ended June 30,
2004. The percentage used reflects historical experience. Specifically
identified or potential warranty issues are analyzed to determine the
probability and the Companys financial exposure and the reserve is
established. The Company believes that the estimated reserve at June 30, 2004
is adequate. At June 30, 2004, the financial statements reflect deferred tax assets of
$186,300 and deferred tax liabilities of $87,100. Deferred taxes are provided
on an asset and liability method, whereby deferred tax assets are recognized
for deductible temporary differences and operating loss and tax credit
carryforwards, and deferred tax liabilities are recognized for taxable
temporary differences. Temporary differences are the differences between the
reported amounts of assets and liabilities and their tax basis. Deferred tax
assets are reduced by a valuation allowance when, in the opinion of management,
it is more likely than not that some portion or all of the deferred tax assets
will not be realized. Realization of deferred tax assets is dependent on future
taxable income during the period that deductible temporary differences and
carryforwards are to be available to reduce taxable income. The Company depreciates property and equipment over its estimated useful life.
There were no impairment charges taken for the three and six month periods
ended June 30, 2004. CAUTIONARY STATEMENTS Certain statements contained in this Quarterly Report on Form 10-QSB and other
written and oral statements made from time to time by the Company do not relate
strictly to historical or current facts. As such, they are considered
forward-looking statements that provide current expectations or forecasts of
future events. Such statements can be identified by the use of terminology
such as anticipate, believe, estimate, expect, intend, may,
could, possible, plan, project, should, will, 14




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forecast and similar words or expressions. The Companys forward-looking
statements generally relate to the Companys purchase order levels, building
market share in the EMS market, growth strategies, financial results, product
development, sales efforts and sufficiency of capital. One must carefully
consider forward-looking statements and understand that such statements involve
a variety of risks and uncertainties, known and unknown, and may be affected by
inaccurate assumptions, including, among others, those discussed below.
Consequently, no forward-looking statement can be guaranteed and actual results
may vary materially. As provided for under the Private Securities Litigation
Reform Act of 1995, the Company wishes to caution investors that the following
important factors, among others, in some cases have affected and in the future
could affect the Companys actual results of operations and cause such results
to differ materially from those anticipated in forward-looking statements made
in this document and elsewhere by or on behalf of the Company. The Company derives a significant portion of its revenues from a small number
of major OEM customers that are not subject to any long-term contracts with the
Company. If any major customers should for any reason decrease the volume of
their business or stop doing business with the Company, the Companys business
would be adversely affected. Some of the Companys customers are not large,
well-established companies, and the business of each customer is subject to
various risks such as market acceptance of new products and continuing
availability of financing. To the extent that the Companys customers
encounter difficulties, or the Company is unable to meet the demands of its OEM
customers, the Company could be adversely affected. The Companys ability to increase revenues and profits is dependent upon its
ability to retain valued existing customers and obtain new customers that fit
its customer profile. The Company competes for new customers with numerous
independent contract design and manufacturing firms in the United States and
abroad, many of whom have greater financial resources and more established
reputations. The Companys ability to compete successfully in this industry
depends, in part, upon the price at which the Company is willing to manufacture
a proposed product and the quality of the Companys design and manufacturing
services. There is no assurance that the Company will be able to continue to
obtain contracts from existing and new customers on financially advantageous
terms, and the failure to do so could prevent the Company from achieving the
growth it anticipates. The Companys ability to execute its initiatives to increase sales and expand
market share depends upon its ability to develop additional value added
capabilities and/or proprietary products and technologies and on the
availability of sufficient financing, both equity and debt, to meet fixed and
variable costs associated with such growth. In the current economic
environment, banks and other sources of financing are conservative in their
lending and investment policies. There is no assurance that the Company will
be able to obtain the financing necessary to achieve its goals. The Companys success in providing an improved mix of higher margin products
and services depends on the effectiveness of its new product development and
planning efforts as well as the timing of such and the availability and costs
of any competing products or services on the market. 
 ITEM 3. CONTROLS AND PROCEDURES  (a) Evaluation of Disclosure Controls Procedures.The Companys Chief Executive Officer, Lorin E. Krueger, and Chief
Financial Officer, Jennifer A. Thompson, have reviewed the Companys
disclosure controls and procedures as of the end of the period
covered by this report. Based upon this review, these officers
believe that the Companys disclosure controls and procedures are
effective in ensuring that information that is required to be
disclosed by the Company in reports that it files under the
Securities Exchange Act of 1934 is recorded, processed and
summarized and reported within the time periods specified in the
rules of the Securities and Exchange Commission. 15




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##### Table of Contents



(b) Changes in Internal Controls.There were no changes in the Companys internal controls over
financial reporting that occurred during the period covered by this
report that have materially affected, or are reasonably likely to
materially affect, the Companys internal control over financial
reporting. 16




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PART II  OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS  (a)
    
    The Company has been named a party in a suit in
the Commonwealth of Massachusetts dated April 12, 2004. The parties to the suit
are: The Charter Oak
Insurance Co., Travelers Property Casualty Co of America
(Plaintiffs) v. Joseph Carista d/b/a Prestige Alarm and
Service, Winland Electronics Inc., ADD Inc., and Panitsas
Engineering Associates, Inc. (Defendants). The suit claims
that on January 12, 2004 the fire protection system sprinkler
head located in an unheated area of the 6th floor of 210
Commercial Street Boston, Massachusetts froze and caused
catastrophic water loss damages. The Plaintiffs are seeking $1
million dollars in damages collectively from the Defendants.
The Company denies any liability for the loss because of the
alleged improper installation of the TA-40 Fixed Temp Atert sold
by the Company. Management does not believe that the resolution
of this suit will have a material financial impact on the
Company. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS  The Company held its Annual Meeting on May 11, 2005.Proxies for the annual meeting were solicited pursuant Regulation
14A under the Securities and Exchange Act of 1394. There was no
solicitation in opposition to managements nominees as listed in
the proxy statement, and all nominees were elected.The number of directors was set at five by eliciting the following
persons to serve as directors of the Company until the next annual
meeting of shareholders with the following votes: Number of
    
    Number ofNominee
    
    Votes For
    
    Votes WithheldThomas J. de Petra
    
    
    2,878,330
    
    
    
    263,956S. Robert Dessalet
    
    
    3,093,735
    
    
    
    48,551Lorin E. Krueger
    
    
    3,094,210
    
    
    
    48,076James L. Reissner
    
    
    3,094,430
    
    
    
    47,856Richard T. Speckman
    
    
    3,094,430
    
    
    
    47,856
 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    Exhibits. See Exhibit Index following the
signature page.(b)
    
    Reports onForm 8-K.The Company filed (i) a
Form 8-K dated April 4, 2004 announcing first quarter earnings
for 2004 and (ii) a Form 8-K dated May 21, 2004 to provide the
first quarter 2004 letter to shareholders. 17




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of
1934, the Company has caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized. WINLAND ELECTRONICS, INC.(Company)Dated: August 16, 2004
    
    /s/ Lorin E. KruegerLorin E. Krueger, President andChief Executive Officer (PrincipalExecutive Officer)/s/ Jennifer A. ThompsonJennifer A. Thompson, ChiefFinancial Officer (PrincipalFinancial and Accounting Officer)
 18




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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 EXHIBIT INDEX TO FORM 10-QSB For the fiscal quarter ended
    
    Commission File No. 0-18393June 30, 2004
   WINLAND ELECTRONICS,
INC.   Exhibit No.
    
    Description31.1
    
    Certification of Chief Executive Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200231.2
    
    Certification of Chief Financial Officer Pursuant to Section 302 of the
Sarbanes-Oxley Act of 200232.1
    
    Certification of Chief Executive Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 200232.2
    
    Certification of Chief Financial Officer Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
 19